How to Pass Cost Accounting Second and Third Levels Teacher’s Guide How to Pass Cost Accounting Second and Third Levels Teacher’s Guide Derek Skidmore MSc FCCA ACMA FLCC First published in 1998 London Chamber of Commerce and Industry Examinations Board 1998 ISBN 1 86247 015 4 British Library Cataloguing-in-Publication Data A CIP catalogue record for this book can be obtained from the British Library. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1P 9HE. 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CONTENTS page Introduction vii Lessons 1-3 Introduction to cost accounting 1 Lessons 4-6 Material cost 14 Lessons 7-9* Further aspects of material cost 27 Lessons 10-12 Costing for labour 37 Lessons 13-15 Costing for overheads (1) 48 Lessons 16-18 Costing for overheads (2) 60 Lessons 19-21* More advanced aspects of costing for overheads 73 Lessons 22-24 Job, batch and contract costing 84 Lessons 25-27 Continuous process costing (1) 97 Lessons 28-30* Continuous process costing (2) 114 Lessons 31-33 Marginal costing (1) 132 Lessons 34-36* Marginal costing (2) 148 Lessons 37-39* Marginal costing (3) 163 Lessons 40-42* Breakeven charts and profit graphs 181 Lessons 43-45 Budgeting and budgetary control 192 Lessons 46-48* Budgeting (2) 204 Lessons 49-51 Standard costing (1) 218 Lessons 52-54* Standard costing (2) 235 Lessons 55-57 Costing systems (1) 254 Lessons 58-60* Costing systems (2) 270 * Third Level only v About the author Derek Skidmore is a former Head of the West Midlands School of Accountancy at Sandwell College of Further and Higher Education, and has over 30 years of teaching experience in a number of accountancy subjects at all levels. His association with the LCCIEB extends over 20 years. He now works on a freelance basis as a business consultant and as a visiting lecturer at the University of Central England. Acknowledgements In the preparation of this book, my thanks are again due to Geoff Rhodes MSc ACMA, moderator of LCCIEB, formerly Examiner of LCCIEB, and Senior Lecturer at the University of Derby, for his careful reading of the draft of the book, and for his valuable suggestions for its improvement. Any mistakes that remain are my own. vi INTRODUCTION This text has been prepared to help teachers who are preparing candidates for the Second and Third Level LCCI examinations in Cost Accounting. Teachers are advised to use this in conjuction with: 1 The syllabus 2 The extended syllabus 3 The textbook How to Pass Cost Accounting 4 Past examination papers of the LCCI 5 Suggested answers to past examination papers of the LCCI 6 Examiners’ reports It is the extended syllabus which is of most importance. In writing this Teacher’s Guide I do not seek to dictate to teachers of Cost Accounting how they should conduct their classes. However, many years of association with the LCCI, and over 35 years of teaching and lecturing in Cost Accounting perhaps mean that some, at least, of my advice may be found useful. There are 60 lessons in the book, arranged in 20 groups of 3. The 20 groups correspond to the 20 chapters of the textbook How to Pass Cost Accounting. All 60 lessons will be needed to take a candidate having no knowledge of Cost Accounting at all to a position where he or she could attempt the Third Level Cost Accounting paper with a reasonable chance of success. On average, the 60 lessons will need a minimum of 120 hours of class time. If your available time is less than this, you will need to select some aspects of each lesson to cover in class time, and then carefully direct the students to study privately those areas that you have not been able to cover. The amount of time needed to deal with the content of each lesson is left open. Certainly, most lessons will need at least 2 class hours. Some lessons will perhaps need more; a few may need fewer. You are encouraged to develop understanding in your students. Rote learning is not recommended. Neither is the development of artificial ways of remembering. Both of these will let the student down at critical moments. The student who understands the subject has no need for such aids. Do emphasise to your students that question practice is important. Some of this may take place in class time. However, the serious student will also need to devote private time to it. vii Note carefully the lessons that you will need to use: If you are preparing candidates for the Second Level LCCI examinations: Lessons 1, 2, 3, 4, 5, 6, 10, 11, 12, 13, 14, 15, 16, 17, 18, 22, 23, 24, 25, 26, 27, 31, 32, 33, 43, 44, 45, 49, 50, 51, 55, 56 and 57. If you are preparing candidates for the Third Level LCCI examinations, who have already studied for, and have passed, the Second Level examinations: Lessons 7, 8, 9, 19, 20, 21, 28, 29, 30, 34, 35, 36, 37, 38, 39, 40, 41, 42, 46, 47, 48, 52, 53, 54, 58, 59 and 60. If you are preparing candidates for the Third Level LCCI examinations, who have not previously studied Cost Accounting, or who have not passed the Second Level examinations: All Lessons from 1 to 60. viii Introduction to cost accounting LESSON 1 Main subject Introduction to cost accounting Textbook reference Chapter 1: Page 1 Syllabus reference 1 General Lesson topics Introduction to Cost Accounting Cost units Cost centres Extended syllabus reference 1.1 1.2 1.3 1.4 1.5 1.6 Understand the meaning of cost accounting terms as defined in the CIMA Official Terminology Understand the meaning and purpose of cost accounting Explain the relationship between cost accounting, financial accounting and management accounting Explain cost centres and cost units Select suitable cost centres for a particular industry or organisation Select suitable cost units for given industries and organisations Required for Candidates for Second Level and Third Level Aims of the lesson • To introduce the subject of cost accounting • To explain the nature of cost centres and cost units, and provide guidelines for their selection The lesson ▲ Begin by explaining the nature of business activity. Your examples should, if possible, be drawn from the students' own local environment. Explain that some businesses are owned and run by one person. Others may be owned and run by a number of partners. Still others may be operated as limited companies. Explain that limited companies may be quite small, family-owned companies in which the owners – the shareholders – may also be the managers. Contrast this with larger companies, with many shareholders. Point out that owner-shareholders of larger companies may be other overseas companies, most of whom will play no part in the daily management of the company. Ask the class to give a local example of each of these four types. 1 Cost Accounting – Teacher’s Guide ▲ Now point to the different activities of these businesses. Some will simply trade, buying goods at one price (sometimes importing them) and selling them at a higher price. This category will include small, sole-trader retail businesses, but may also include major companies which perhaps import, and then wholesale goods. Again, encourage the class to identify local examples. Other businesses will manufacture products. They will purchase raw materials and components (perhaps imported) and apply skill, expertise and know-how to turn these into finished products. Explain that this category could include small businesses (for example, a family-owned bakery), or large companies (for example, a motor car manufacturer). Again, encourage the class to identify local examples. Finally, point out that some businesses provide services rather than goods. These might be small, sole-trader businesses (such as a hairdresser), or partnerships (for example, an accountancy firm), or large limited companies (for example, a haulage business or a bank). Again, encourage the class to identify local examples. ▲ Now explain that most of these businesses are attempting to make a profit. This allows sole traders and partners to take money out of the business as drawings. The more profit they make, the more is available to be taken out. In the case of companies, the profit is taken out as dividends, the level of these being decided by the directors of the company. Point out that financial accounts are prepared, therefore, to show (in the profit and loss account) how much profit has been made in a particular year, and to show (in the balance sheet) the position of the business at the end of the year. With large companies, these reports have to be audited before being presented to the shareholders. Explain that these historical reports are too late, and lack the necessary detail, to help those who manage the business on a day-to-day basis. Managers need, every day, to plan, make decisions, control, etc, and need financial information to help them. ▲ Now introduce the CIMA definition of cost accounting on page 2 of the textbook. Make sure that the class understands every word in this definition, and what it is saying. Take the class, point by point, through the explanation which follows the definition on page 2. Before continuing, make sure the class understands that cost accounting is needed for small businesses and large businesses, for trading firms, for manufacturers and for service industries. ▲ Cost centres and cost units These terms are introduced at the bottom of page 2. Take the class through the definitions at the top of page 3. Emphasise that cost centres are organisational subdivisions. They reflect the way a business is organised. They do not relate to the output or the service produced. Cost centres identify parts of the organisation – a machine, a group of identical machines, a department, a process, a depot, a sales team, etc. They exist, of course, because of what the business produces. For example, a business would not have purchased an oven, if it did not intend to bake bread. 2 Introduction to cost accounting The primary purpose of cost centres is to accumulate total costs for each centre, for cost accounting. We can then decide how much of this cost is attributable to each unit of output (or service) which the cost centre produces. As an example, point out that the oven in a bakery is a production facility. It is a cost centre, and the business must know what it costs to run in terms of labour, electricity, maintenance, depreciation, and so on – but it is not the product. The product is bread, perhaps of many different loaf-sizes and specifications. The cost unit is a loaf of bread. This allows production costs to be expressed in terms of the product (or output) – in this case, the cost per loaf of bread. It is most important that this distinction between a cost centre and a cost unit is understood, as well as why each is needed. Make sure that the class can follow Example 2 on page 4 of the textbook, and the way in which a cost code is set up to define the cost centres. It would be beneficial to get the class (or a number of workgroups within the class) to choose a local manufacturing business, and to identify a number of likely cost centres and appropriate cost units within it. Alternatively, as the teacher, you might want to choose the local industry yourself, so that you will have some idea of the 'sense' of the answers offered by the class. Reminders At the end of the lesson, re-state the main points again: The meaning and purpose of cost accounting The purpose of, and distinction between, cost centres and cost units 3 Cost Accounting – Teacher’s Guide LESSON 2 Main subject Introduction to cost accounting Textbook reference Chapter 1: Page 1 Syllabus reference 1 General Lesson topics Coding Cost classification Extended syllabus reference 1.7 1.8 1.9 Understand the principles of cost code design Construct a simple cost code for a given situation Classify costs by element, function, controllability, and normality Required for Candidates for Second Level and Third Level Aims of the lesson • To explain how a cost code can be constructed, to allow costs to be identified with the incurring cost centre, and so that the nature of the cost can be identified • To show how one cost can be classified in a number of different ways, and to explain why this is important The lesson ▲ Begin by reminding the class what a cost centre is, and that (for a number of reasons including the control of cost) we need to know how much each cost centre spends, and what a particular amount has been spent on. For example, we might know that in Week 14, £1,569 was spent on repairing the doughmixing machine in a bakery. Part of the repair was carried out by an outside firm, and part was done by the bakery's own maintenance team. Ask the class how we know the figure of £1,569. The answer is that – somehow – the invoice from the outside firm, and the time spent by the bakery's maintenance staff, must have been recorded against the dough-mixing machine. This can only have been done if we had a code to identify the dough-mixing machine, and also a code to identify repair costs. 4 Introduction to cost accounting The first code could be (say) 346, and the second code could be (say) 27. Therefore '34627 £1,569' tells the full story. Emphasise the advantage of a code: 34627 £1,569 is quicker, and more accurate, than having to say, '£1,569 has been spent on repairing the dough-mixing machine.'. Point out that proper coding is essential for a computerised cost accounting system. Take the class once again through Example 2 on page 4, through to page 6. ▲ Cost classification Begin with the CIMA definition on page 6. Emphasise, with the example that follows at the top of page 7, that we shall be looking at different ways of classifying the same cost. Students sometimes wonder why different classifications of the same cost are needed – won't one do? Use the textbook illustration to answer this: The breakdown of the student group to male/female has implications for planning college facilities. The breakdown of the student group to those who have passed the Second Level and those who have not, has implications for the teaching approach – and perhaps for the need for extra classes for some students. ▲ Move on to the classification of cost by element as introduced on page 7. Emphasise the CIMA definition of a direct cost. Make sure that each part of the prime cost is understood, and that the class is aware that the sum of the indirect costs is termed overhead. Work carefully through Example 3 on pages 8-9 of the textbook, to show how the cost of a good product must absorb the cost of those normally scrapped. ▲ Now ask the class to work through the following example: A company has a particular product made by outworkers in their own home. The outworkers are supplied with the materials. They are supplied with 5 square metres of material to make each product. The material costs the company £18 per square metre. Each outworker is expected to return the offcuts that remain from the making of each product, and the company can sell these for £6. The outworker is paid £42 for each acceptable product made, but only £18 for those that prove to be not of acceptable quality. Questions: (a) Which of the costs mentioned are direct costs, and which are overhead? (b) What is the cost of each product made, if all products made are of acceptable quality? (c) What is the cost of each acceptable product made if, when the production is returned, 10% are found to be unacceptable, and the material (in addition to the offcuts) can be sold for £9 each? 5 Cost Accounting – Teacher’s Guide You will need to allow the class some time to think about these, and discuss them, before periodically checking to see what progress is being made. The answers should be: (a) All of the costs mentioned are direct costs. The material supplied to the outworkers is direct material cost, and the saleable value of any offcuts is a reduction of this cost. The payment made to the outworker is a direct expense. It is not direct labour because, usually, outworkers are not employees of the company in a legal sense, and are only given work when work is available. (b) £ Direct material 5 sq. metres × £18 less sale of offcuts Direct material cost 90.00 (6.00) 84.00 42.00 126.00 Direct expense Prime cost (c) £ Direct material cost of 10 products 10 × £84 Less sale of material from one (10%) unacceptable product Outwork cost of 10 products 10 × £42 Less outwork cost saving from one unacceptable product £42 – £18 Cost of 9 acceptable products Cost of 1 acceptable product: Direct material £831/9 Outwork £396/9 Prime cost 840.00 (9.00) 831.00 420.00 (24.00) 396.00 1,227.00 92.33 44.00 136.33 Most of the class should manage to get the answer to (b) without too much trouble. Almost certainly, they will need help with (c). There are, of course, other ways to the same solution. ▲ Now explain the classification of cost by function. This will require some explanation of the functions of business and, in particular, the dividing line between the production function and the distribution function. For example, a company making perfume may decide that the bottle, and the box in which the bottle of perfume is put, will be counted as primary packaging and as the final stage of production cost. In contrast, the carton into which (say) 200 individual bottles are packed will be counted as secondary packaging, and as the first stage of distribution cost. 6 Introduction to cost accounting Take the class through Example 4 on pages 9 and 10 of the textbook. ▲ Now take a local industry known to you and the class, and ask each member of the class, in turn, to name a particular cost incurred by that industry, and to classify their named cost by element and by function. ▲ Finally, explain the distinction between a normal and an abnormal cost. Emphasise that the £136.33 cost, produced earlier in this lesson, assumes that it is normal for an outworker to make one unacceptable product out of every 10 that he makes. Because it is considered normal, the cost was increased from £126 to £136.33 to absorb the net cost of the unacceptable item. Emphasise the importance of this to management for control purposes. If an outworker produces 100 products and 90 are acceptable, no management action is needed. 10 rejects is normal. If the outworker produces 100 products and 88 are acceptable, management action may be required, because 2 products more than normal have been declared unacceptable. There is an abnormal loss of 2 products. If the outworker produces 100 products and 92 are acceptable, there is an abnormal gain of 2 products. Management would want to reproduce the conditions that brought this improvement about. Take the class through Example 5 on page 11 of the textbook. Reminders At the end of the lesson, re-state the main points again: A carefully-constructed, numerical cost code is used to define cost centres and expense headings. Costs can be classified by element, by function and by normality. Another classification will be looked at in the next lesson. 7 Cost Accounting – Teacher’s Guide LESSON 3 Main subject Introduction to cost accounting Textbook reference Chapter 1: Page 1 Syllabus reference 1 General Lesson topics Cost classification by variability Introduction to accounting entries Extended syllabus reference 1.10 Classify costs by behaviour, i.e. into variable, semi-variable, semi-fixed and fixed categories 1.11 Identify the behavioural classification for a cost, from a given total or unit cost/volume graph 2.16 Make accounting entries for materials in an integrated accounting system 3.11 Make accounting entries for labour in an integrated accounting system 4.16 Make accounting entries for overhead in an integrated accounting system Required for Candidates for Second Level and Third Level Aim of the lesson • To introduce the subject of cost behaviour The lesson ▲ Begin by reminding the class that each cost can be classified in a number of ways, and that the same cost can be looked at in different ways. For example, the cost of maintaining the production process will include indirect material cost and indirect labour cost. It is part of overhead cost. By function it is a production cost. It may be normal or abnormal. For example, it could be much more than the amount budgeted because of an unexpected process breakdown, the cause of which should be investigated. Explain that you are now introducing the classification by cost behaviour, that is, how the cost behaves when something else changes. That 'something else' is usually the level of activity, often output. We are saying, 'How does the amount spent on a particular cost behave as output rises or falls – does the amount spent tend to rise, to fall, or stay the same?'. 8 Introduction to cost accounting Point out that, although you have said the activity could be output (in the sense of units of product), it could be other things. For example, we could be asking, 'As the number of students in a class increases, what happens to the college bill for paying lecturing staff?' or 'As we increase the number of miles travelled in our car, what happens to the total amount we spend on petrol?'. Explain that in these examples, the number of students and the miles travelled are perfectly good 'activity' measures. To support this, point to the introduction on pages 12 and 13 of the textbook. Take the class through it line by line – it is that important! Draw particular attention to the CIMA definitions of variable cost, fixed cost and semi-variable cost. Emphasise these points with the following: ▲ A company makes a product, and must pay the inventor of the product a royalty of £8 on every product manufactured. Units made 1 50 100 Royalty each Total cost £ £ 8 8 8 8 400 800 Point out that the royalty is an example of a variable cost. (It is common for students to think that perhaps it is a fixed cost because it is fixed at £8 per unit.) You must make it very clear that the reference to a cost in the CIMA definition of a variable cost is to the total cost – in this case the total royalty cost – and not to the unit figure. It is because the progression of the total royalty cost (£8, £400, £800) is exactly in line with the output progression (1, 50, 100) that we can define this cost as a variable cost. ▲ Another example is: A machine can be set up ready for production at a cost of £380. It only has to be re-set if more than 400 units are made in a run. Production units 1 30 70 Setting cost £ 380 380 380 Setting cost per unit £ 380.00 12.67 5.43 Again, it is common for students to think that this must be a variable cost because the setting cost per unit changes as output changes. 9 Cost Accounting – Teacher’s Guide Point out clearly that this is not the case. Setting is a fixed cost, because – as with the variable cost – the reference to 'the cost' in the definition is to the total cost. In this case the total cost is fixed at £380. ▲ Finally, explain the semi-variable cost, again pointing to the CIMA definition on page 13. Return to the royalty example, and explain that now the agreement with the inventor is that he will be paid £300 per month, even if there is no production, plus £8 for each unit manufactured. Units made in the month Royalty each unit Fixed royalty £ 8 8 8 £ 300 300 300 1 50 100 Total cost £ 308 700 1,100 Point out that when the royalty was just £8 per unit, a doubling of the units manufactured (from 50 to 100) resulted in a doubling of the cost (from £400 to £800). Now, for a semi-variable cost, the doubling of the output only increases the cost from £700 to £1,100; it hasn't doubled. Explain that this is why the CIMA definition says 'partly affected.' You are advised to take particular care in ensuring that the class understands this section, and the way in which individual costs react (behave) differently, in response to activity changes. ▲ Emphasise that students must be able to recognise cost behaviour, from given figures for a particular cost, or from a sketch graph showing either the total cost or the cost per unit. As an example, give the class these figures for a particular cost: Output Cost £ 5 20 50 90 75 300 750 1,350 Ask the class what sort of cost this is. Clearly, they should be able to eliminate the possibility of its being a fixed cost – all the costs are different. However, it could be a semi-variable cost. An easy check is to work out the cost per unit. In each case this is £15. This should allow the class to conclude that it is a variable cost. 10 Introduction to cost accounting You should now suggest to the class that, instead of giving the figures, you could have given sketch graphs. Tell them that you could have given a graph showing the total cost against different activity (output) levels. Sketch the graph on the board. It would appear as follows: Total cost Output Make certain the class understands that this would be recognised as a variable cost because it rises against output in a linear way, and because the line commences at the point of origin, i.e. no output, no cost. Point out that you could also have given a sketch graph showing cost per unit against output. Because for a variable cost the cost per unit is a constant, the graph is a horizontal line. The sketch graph would appear as follows: Cost per unit Output Now show the class similar graphs for a fixed cost. They would appear as follows: First for the total cost, Total cost Output 11 Cost Accounting – Teacher’s Guide and then for the cost per unit: Cost per unit Output It is important that the class recognises that the curve for the fixed cost per unit falls sharply, then begins to flatten out, but will never reach zero and will never become flat – although it will get close to both of these. It is best to show this to the class with some figures. For example: Output units 1 2 3 4,000 30,000 Cost £ 300 300 300 300 300 Cost per unit £ 300.00 150.00 100.00 0.08 0.01 Finally, ask the class if they can sketch graphs for a semi-variable cost – firstly, for the total cost against output, and then for the cost per unit against output. Remind them that a semi-variable cost is a bit of each of the other two – part variable and part fixed. This should give them the necessary clue to produce the graphs. Their answers should be: Total cost Output Cost per unit Output 12 Introduction to cost accounting Emphasise that they would recognise these as a semi-variable cost – if given the graphs – because the total cost line in the first graph does not proceed from the point of origin, and because the cost per unit curve in the second graph does not run close to the horizontal axis (since the cost per unit cannot be lower than the variable cost element of the semi-variable cost). ▲ Finally, in this lesson, introduce the recording aspect of cost accounting by mentioning the main control accounts that will be used in later chapters. These are introduced on pages 15-18 of the textbook. You may want to ask the class to read these pages in their own time, rather than disturb their thinking on cost behaviour, which has been the main focus of this lesson. Reminders At the end of the lesson, re-state the main points again: Costs can be classified by 'behaviour' – how they react to a change in activity (output). A variable cost is one for which the total cost incurred increases in proportion to an output increase. A fixed cost is one for which the total cost incurred is unchanged as output increases (or, of course, decreases). A semi-variable cost is one having both variable and fixed cost components. The behaviour of a cost can be deduced from looking at a given table of output/ cost figures, or at cost graphs. 13 Cost Accounting – Teacher’s Guide LESSON 4 Main subject Material cost Textbook reference Chapter 2: Page 25 Syllabus reference 2 Costing for materials Lesson topics Procedures for ordering, receiving, storing and issuing materials Stock-carrying costs, costs of a stock-out Perpetual inventory and continuous stock-taking Extended syllabus reference 2.1 2.2 Understand the need to plan material requirements Calculate material requirements, making allowance for sales, product stock changes and material stock changes 2.3 Understand the procedures leading to the selection of a supplier 2.4 Explain and illustrate the various documents used in the process of ordering and receiving materials 2.5 Understand the procedures to be followed upon the receipt of materials from a supplier 2.6 List and explain various stock categories, and why such stocks are carried e.g. raw materials, work-in-progress, finished stocks, fuel stocks, consumable stocks etc. 2.7 List and explain costs of carrying stocks and of running out of stock 2.8 Prepare records of stock movement in quantity and value terms 2.9 Understand the meaning of perpetual inventory records and how they relate to continuous stock-taking 2.10 Suggest reasons for discrepancies between the inventory record and physical stock 2.11 Explain the meaning of allocated and free stock (Calculations will not be required at Second Level.) Required for Candidates for Second Level and Third Level 14 Material cost Aims of the lesson • To introduce the calculation of material requirements • To describe all procedures, documentation, etc. associated with materials, from their purchase to their use • To explain the costs which arise from carrying stock, and from running out of stock • To emphasise the need to control the physical flow of materials • To show that physical stock can be reserved for a particular customer The lesson Note: Much of the content of this lesson is descriptive, and should not present you (as the teacher) with major preparation problems. The comments made here will mainly focus on any calculations that are required for the lesson. ▲ Begin by pointing out that purchasing, stock-holding, and the other routines described in Chapter 2, apply not only to the purchases of raw materials, components and other items which might be needed for the manufacture of products. They apply also to the purchase and stocking of general consumables, fuels, maintenance materials and spare parts, stationery, and so on, which the company needs. It would be useful, next, to spend some time taking the class through the diagram on page 26 of the textbook. This will allow them to see the scope of the topic and, particularly, the distinction between the physical flow of the materials and the flow of value (cost). You should specifically draw the attention of the class to this aspect. Point out that a company should only purchase materials that are required. This may sound obvious, but it does mean the company needs to plan. Tell the class that this is the first bit of budgeting they have met – a lot more will come later! Emphasise that material requirements depend upon what products we intend to produce, and that in turn, we only produce what, in time, we expect to sell. Illustrate this with the example of a shopkeeper. He will only purchase and fill his shelves with goods that he believes people will want to buy, at a price that they can afford to pay, and at which he can make a profit. Emphasise that you used the word ‘believes’. Goods are made by industry (and therefore materials and components are bought to make them) in anticipation of being able to sell them, that is, quantities are based upon sales forecasts and budgets. ▲ Take the class through the important Examples 1 and 2 on pages 27-30 of the textbook. Example 2 is particularly important in showing that the materials needed for production may not be the materials purchased, because of planned changes in the level of material stocks. Make certain that the class understands the change to just-in-time (JIT) purchasing arrangements, since this is the first mention of this approach. Draw attention to the CIMA definition of JIT on page 29. 15 Cost Accounting – Teacher’s Guide Take the class carefully through the descriptive routines on pages 30-35. It may be that some members of the class will be able to contribute, in observing how the routines at their business differ (if differ they do) from those outlined in the textbook. ▲ Stocks Explain why stocks may be carried, for example: as a safeguard against unexpected demand, in case the supplier fails to deliver on time, because a better price makes it worthwhile to buy more than will be immediately used. You may want to draw these reasons from the class before you give them. Identify the different categories of stock, including work-in-progress and finished goods. Explain that there is a conflict between the benefits of carrying stock (and that such benefits may be lost if stock is not carried) and the costs of carrying stock. Take the class through the examples of stock-carrying costs on page 35, and of the costs of not carrying stocks on page 36. Emphasise that they must be able to give examples of both in the examination. Point out, again, that there are two aspects to stock: the physical amount of stock carried, for example 45 kg, or 16 packets, or 5 drums, and the value of stock carried. Remind the class that a large amount of stock may have a low value, or a small amount of stock may have a large value. As an example of the latter category, a jeweller may carry small amounts of gold, but the stock will have a high value. Concentrate, for the moment, on the quantity of stock carried. Take the class through the 12 points under the heading ‘Stock records’ on pages 36 and 37, and then through Example 3. ▲ Introduce the stock record itself, by referring to the one at the top of page 39. Relate this to the CIMA definition of a perpetual inventory on page 38. Explain how the balances on this record are ‘book balances’ only, and need to be periodically checked against the physical stock – what is really there! This introduces continuous stock-taking. Draw particular attention to the reasons for any discrepancy, given at the top of page 40. The class may be able to suggest other reasons. ▲ Finally, point out that stock can be reserved for, or allocated to, a particular customer’s order, leaving the rest of the stock to be considered free and therefore available for other uses. This is explained on page 40. Do point out, however, that if material on order is included in this model, then it goes beyond the physical stock in hand, which has been the main emphasis of this lesson. Note that Second Level students need only be concerned with the idea of allocated and free stock, not with its working. 16 Material cost Reminders At the end of the lesson, re-state the main points again: There are two aspects to materials – its physical quantity and its value. Although the cost of carrying stocks and the cost of stock-out have been discussed, the major focus of this lesson has been on the physical quantity of materials – planning requirements, ordering, receiving, recording and verifying. 17 Cost Accounting – Teacher’s Guide LESSON 5 Main subject Material cost Textbook reference Chapter 2: Page 25 Syllabus reference 2 Costing for materials Lesson topic Methods of pricing materials from stock and the effect of each method on production costs and upon stock valuation Extended syllabus reference 2.12 Price issues from stock using FIFO, LIFO, Specific price, Weighted average, and Standard price. (Periodic weighted average prices will not be examined at Second Level.) 2.13 Explain and contrast the effect of alternative pricing methods on production costs, stock values and reported profits Required for Candidates for Second Level and Third Level Aims of the lesson • To introduce a number of pricing methods which can be used to charge materials from stock to work-in-progress or to overhead accounts • To emphasise that pricing methods are concerned with the flow of cost and not with the physical flow of materials • To show that each method has a residual effect on the value of stock remaining The lesson ▲ Explain that the need to price an issue of materials applies to any material that is carried in stock for use at a later date. Therefore, it applies to fuel stocks, general consumables, stationery, and so on, as well as to raw materials and components to be used in production, and to finished products. The nature of the stock makes no difference to the principles to be explained. 18 Material cost Also explain – at the outset – that any pricing method simply apportions the balance on the stock account between the cost of materials used, and the cost of materials remaining in stock. Illustrate this with: Material RP9 Stock 1 January Purchases between 1 January and 31 March Materials used between 1 January and 31 March Stock 31 March kg 450 1,200 1,650 £ 9,000 26,400 35,400 1,070 580 Make it clear to the class that the pricing problem is how to apportion £35,400 between the 1,070 kg of material used, and the 580 kg remaining in stock. For example, to be silly about it, if the 1,070 kg was charged to the user department for £1 per kg, it would leave £34,330 as the value of the remaining 580 kg. The class should easily see what is silly about this suggestion: a department is being charged £1 per kg for materials when the most recent price has been £22 kg (£26,400/1,200), and the opening stock was carried at £20 kg (£9,000/450 kg). You should make it clear that the problem is to choose a pricing method which – somehow – fairly relates the price charged (to the user of the material) to the price(s) actually paid for the materials. In this introduction, you should also explain that the pricing method is nothing to do with the physical issue of the material. Good storekeeping practice may dictate that material that has been in stock longest, should be used first. But this does not determine the pricing method. Sometimes, when a later delivery has been placed on top of earlier stock, the more recent deliveries might be used first. Again, this does not determine the pricing method. Finally, before illustrating the pricing methods, point out that if issues are priced, the value of the remaining stock is the balancing figure. However, an equally valid approach is to value the remaining stock, leaving the value on the materials issued as the balancing figure. For example, in the preceding example, we could price the 1,070 kg issued, and what remains of the £35,400 is the value applicable to the remaining stock . Or, we could value the remaining stock of 580 kg, and the balance of the £35,400 is the value applicable to the 1,070 kg issued. ▲ Now introduce the pricing methods needed for the Second Level candidate. These are covered in the textbook between pages 42 and 52. First explain the 3 categories into which pricing methods fall. These are given at the top of page 43. Explain that if 10 tonnes of material were purchased at £200 per tonne, and 5 tonnes were purchased at £240 per tonne, then either £200 per tonne or £240 per tonne are cost prices which could be prices at which material is issued. 19 Cost Accounting – Teacher’s Guide Alternatively, ((10 × £200) + (5 × £240))/15 = £213.33 is a price derived from cost (we have used cost prices to get it), but it is not actually a price that we have paid. If someone says, ‘Why don’t we issue materials at £230 per tonne?’ – that is a notional price. It is neither a price actually paid, nor derived from any price paid. You should note that the pricing methods are illustrated in the textbook using the same basic data (as given on page 43). This allows the class to compare the results of the methods used. It would be sensible to use new data here to introduce the subject. The class can then use the examples in the textbook to reinforce their knowledge and understanding. Preferably, use data with a distinct price trend (say, upwards), and for the purchase of a product for retail sale at a fixed price. You could use the following data: John Stone is a retailer. He purchases and sells one product. The selling price is £75 each product. Stock in hand, 1 January, 20 units, which were purchased for £30 each. Purchases in the 3 months ended 31 March were: 10 February, 30 units for £32 each 15 March, 40 units for £40 each Sales made were: 12 January, 13 units 19 February, 16 units 22 March, 46 units Give these figures to the class. Point out that the trend of purchase prices is steadily upwards (£30, £32 and £40) and that – because the selling price of the product is a constant £75 – the trend of gross profit will be steadily downwards. You could issue some blank pro-forma stock record sheets to the class, so that all they have to do is enter the purchase and issue transactions, and the stock balances. ▲ Do ‘First In First Out’ (FIFO) with them first. Date 1 Jan 12 Jan 10 Feb 19 Feb 15 Mar 22 Mar Qty 30 40 Receipts Price £ £32 £40 Qty Issues Price 13 £30 £ 390 960 16 498 46 1,672 1,600 Stock Balance Qty Price £ 20 £30 600 7 210 37 1,170 21 672 61 2,272 15 600 Carefully explain the issue pricing to the class. The February issue is (7 × £30) + (9 × £32). The March issue is (21 × £32) + (25 × £40). Point out, too, that the stock valuation under FIFO is easily checked. Here it is 15 × £40, the last price paid. 20 Material cost Ask the class what gross profit John Stone has made in the 3 months to 31 March, if he prices issues on a FIFO basis. The answer is (Sales 75 units × £75) – (Costs £390 + £498 + £1,672) = Profit £3,065. Now ask the class to work through Example 5 on page 44 of the textbook, either in class, or in their own time. Ask them to pay particular attention to the Notes to the solution. ▲ Now do ‘Last In First Out’ (LIFO) with them. Date 1 Jan 12 Jan 10 Feb 19 Feb 15 Mar 22 Mar Receipts Qty Price £ 30 40 £32 £40 Qty Issues Price 13 £30 390 16 £32 512 £ 960 1,600 46 1,792 Stock Balance Qty Price £ 20 £30 600 7 210 37 1,170 21 658 61 2,258 15 466 Carefully explain the LIFO issue pricing to the class. The March issue is (40 × £40) + (6 × £32). Point out that the stock valuation under LIFO is not so easily checked. Here it is (8 × £32) + (7 × £30). Ask the class what gross profit John Stone has made in the 3 months to 31 March, if he prices issues on a LIFO basis. The answer is (Sales 75 units × £75) – (Costs £390 + £512 + £1,792) = Profit £2,931. Emphasise that this profit is £134 less than under FIFO, because the LIFO pricing method allows the rising prices to come into costs more quickly. This also reflects the closing stock value, which is £134 less under LIFO. Ask the class to work through Example 6 on page 45 of the textbook, either in class or in their own time. Ask them, again, to pay particular attention to the Notes to the solution. ▲ Now tell the class that you are moving to a pricing method derived from cost, the ‘weighted average’ pricing method. Date 1 Jan 12 Jan 10 Feb 19 Feb 15 Mar 22 Mar Receipts Qty Price £ 30 40 £32 £40 Qty Issues Price 13 £30 390 16 £31.62 506 46 £37.11 1,707 £ 960 1,600 Stock balance Qty Price £ 20 £30 600 7 210 37 £31.62 1,170 21 664 61 £37.11 2,264 15 557 21 Cost Accounting – Teacher’s Guide Ask the class what gross profit John Stone has made in the 3 months to 31 March, if he prices issues on a weighted average basis. The answer is (Sales 75 units × £75) – (Costs £390 + £506 + £1,707) = Profit £3,022. Ask the class to work through Example 9 on page 47 of the textbook, either in class or in their own time. Once again, ask them to pay particular attention to the Notes to the solution. ▲ Finally, tell the class that you intend to illustrate one notional pricing method, namely ‘standard price’. To illustrate this, you will need to set a standard price. Suggest that this should be £35, and explain that the price variance (the difference between the standard price and actual price paid) will be taken on purchase. Therefore, only standard price entries will appear in the stock account. Date 1 Jan 12 Jan 10 Feb 19 Feb 15 Mar 22 Mar Qty 30 40 Receipts Price £ £35 £35 Qty Issues Price 13 £35 455 16 £35 560 46 £35 1,610 £ 1,050 1,400 Stock balance Qty Price £ 20 £35 700 7 245 37 1,295 21 735 61 2,135 15 525 Point out that the opening stock has been re-valued on the new standard price of £35 per unit, so that all entries in the account are at £35 per unit. Ask the class what gross profit John Stone has made in the 3 months to 31 March, if he prices issues on a standard price basis. The answer is (Sales 75 units × £75) – (Costs £455 + £560 +£1,610) = Profit £3,000. This could have been calculated 75 units × (£75 – £35). Point out that this is not, however, the whole story: Purchases have been put into stock at £35 unit, when different prices have actually been paid. If these price variances are favourable, they will increase profits; if adverse, they will decrease profits. Applying these to the data: Purchase 10 Feb, put into stock £1,050, actual cost £960; Favourable variance £90 Purchase 15 March, put into stock £1,400, actual cost £1,600; Adverse variance £200 Opening stock revaluation: Favourable variance £100 Therefore the profit is £3,000 + £90 – £200 + £100 = £2,990. 22 Material cost Ask the class to work through Example 10 on page 49 of the textbook, either in class, or in their own time. Again, ask them to pay particular attention to the Notes to the solution, and especially to the second part of the Solution, where the price variance is taken on issue, rather than on purchase. Reminders At the end of the lesson, re-state the main points again: Pricing is concerned with the flow of costs. Alternatives are cost prices, prices derived from cost and notional prices. Any pricing method has an effect on cost of sales, on the remaining stock valuation, and on the reported profit for the period. 23 Cost Accounting – Teacher’s Guide LESSON 6 Main subject Material cost Textbook reference Chapter 2: Page 25 Syllabus reference 2 Costing for materials Lesson topic Introduction to material stock control Extended syllabus reference 2.14 Understand the principles of stock control 2.15 Calculate reorder level, maximum stock, minimum stock, average stock and average stock investment (Calculation of reorder quantity will not be required at Second Level) Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the principles of stock control • To explain how to calculate specific measures for use in stock control The lesson ▲ The topic of this lesson starts on page 52 of the textbook under the heading ‘Controlling levels of stock’. Draw the attention of the class to the CIMA definition of stock control on page 52. Note the words ‘systematic regulation’ – stock levels should be planned. Remind the class that in a previous lesson (Lesson 4), the planning of material requirements was considered. If the purchasing of material is not precisely synchronised with the usage of material, then stock movements will occur. The class has also been told that carrying stock costs money. This must be justified. Use simple figures to show stock relationships: A material is purchased in 800 kg batches for £4.50 per kg. Stock-carrying costs amount to 9% per annum. The material is used at the consistent rate of 40 kg per day. The supplier takes 3 days to deliver an order. 24 Material cost Explain to the class the implications of this small example: It takes 20 days to use the amount delivered in one order (800 kg/40 kg). After 17 days, the stock will be down to 120 kg. This is 3 days’ supply. A new order must be placed after 17 days because the supplier takes 3 days to deliver. Stock will just have run out when the new supply arrives. Point out that if stock can be as high as 800 kg (when a delivery is made) and as low as zero (just before an order arrives), then the average stock must be 400 kg. Therefore, the investment in stock averages 400 kg × £4.50 = £1,800. Make it clear that sometimes the stock will be 800 kg × £4.50 = £3,600, and sometimes it will be nil. But it averages £1,800. Next ask the class what the 9% means. They should reply that it means that if stock costing £100 at purchase is carried in stock for a year, then it will cost £9 to do so. This £9 covers all the costs mentioned on page 35 of the textbook. The most significant of these is likely to be interest on capital. Go on to explain that, at this rate, an average stock investment of £1,800 will have annual stock-carrying costs of £162. Ask the class how this cost can be reduced. They should suggest that the order quantity might be reduced from 800 kg, provided the price per kg does not increase significantly as a result. Now get the class to sketch the stock graph (similar to the one illustrated on page 56 of the textbook). ▲ Now explain that this first example was too ‘neat and tidy’, mainly because we were certain that 40 kg of material would be used every day, and that the supplier could be relied upon to deliver in 3 days. Tell the class that you are now changing this, as follows: The rate of material usage varies between 32 and 46 kg per day, and the supplier sometimes delivers in 2 days, but could take as long as 6 days. We have now introduced uncertainty. Explain that we are taking the supplier’s 2 days and 6 days to be the ‘lead times’. (Point to the explanation of the meaning of lead time on page 54.) Now take the class through the following calculations. The calculations use the formulae set out on pages 57 and 58 of the textbook. Reorder level 46 kg × 6 days = 276 kg Point out that this takes the worst view both of material usage and of lead time. It should mean that a material stock-out will not occur. Maximum stock level 276 kg – (32 kg × 2 days) + 800 kg = 1,012 kg 25 Cost Accounting – Teacher’s Guide Minimum stock level 276 kg – (39 kg × 4 days) = 120 kg Average stock level (800 kg/2) + 120 kg = 520 kg Average stock investment 520 kg × £4.50 = £2,340 Annual stock-carrying costs £2,340 × 9% = £211 When the class understands the calculations made from this illustration, take them through Examples 11 and 12 on pages 55-59 of the textbook. Reminders At the end of the lesson, re-state the main points again: Stock levels should be planned with an understanding of the benefits of carrying stocks, and of the costs of doing so. Candidates must learn the formulae used in this lesson, both for certain and uncertain data. 26 Further aspects of material cost LESSON 7 Main subject Further aspects of material cost Textbook reference Chapter 3: Page 68 Syllabus reference 1 Further aspects of the Second Level Cost Accounting syllabus Lesson topic The preparation of a Material Requirements Plan, making allowance for product and process scrap Extended syllabus reference 1.1 1.2 Calculate the amount and cost of materials needed to meet the production plan, taking into account process wastage and products rejected at the end of each operation Understand the meaning of yield, by operation and overall Required for Candidates for Third Level only Aim of the lesson • To explain how product rejects and process scrap affect material requirements The lesson ▲ Begin by pointing out that products can be made without some of them being rejected, and without some material being lost in the production process. A situation where both product rejects and process scrap arise can be illustrated as follows: Each product may be made from 5 kg of steel In making the product, 1.5 kg of steel is machined away, leaving the finished product weighing 3.5 kg. The 1.5 kg is called process scrap. The products made, now weighing 3.5 kg, would be checked for quality, and 10% perhaps rejected. This is the product scrap or product rejects. Make sure that the class understands the distinction between process scrap and product scrap. 27 Cost Accounting – Teacher’s Guide Now show how this affects material requirements planning: Suppose the firm makes just one product, the XX4. Budgeted sales for Year 4 2,600 units Budgeted finished stock increase 280 units Material needed to make each XX4 4 kg No products are rejected on completion. No change is planned in material stock levels. Explain that the materials required will simply be: 2,880 units × 4 kg = 11,520 kg Now tell the class that 10% of all products made are rejected, and cannot be rectified. They just have to be scrapped. What are the material requirements now? The answer is: We need 2,880 good finished products – so more than this need to be made, to allow for those that will be rejected. We need to make 2,880/90% = 3,200, so that when 10% (320) of the 3,200 made are rejected, it leaves 3,200 – 320 = 2,880 good products. Go over this calculation several times until everyone understands it. The most common error is that the answer is given as 2,880 × 1.1 = 3,168. Material required now is 3,200 × 4 kg = 12,800 kg. Use the same figures to illustrate process scrap: Tell the class that 0.5 kg is process scrap, and therefore each finished product weighs 3.5 kg. Ask the class how much scrap is available for sale. The answer is 3,200 × 0.5 = 1,600 kg. However, the alert student will say, ‘What about the products that are rejected?’ If they can be sold as scrap, it is another 320 × 3.5 kg = 1.120 kg. (Emphasise the use of 3.5 kg, and not 4 kg, in this calculation.) ▲ Now tell the class that we are going to suppose that the product XX4 is made in 2 consecutive operations. The products made are inspected after the first operation, and 20% are rejected and scrapped. The products are again inspected after the second operation, and 10% are rejected and scrapped. Now what are our material requirements? The answer is: Since 2,880 products are needed, 3,200 must come out of the first operation and into the second operation. Therefore 3,200/80% = 4,000 products must be made in the first operation. The material requirements will therefore be 4,000 × 4 kg = 16,000 kg. 28 Further aspects of material cost Point out that the term ‘yield’ means output in relation to input. The yield of good products from operation 1 is 80% and from operation 2 it is 90%, making an overall yield of 72%. Since we need 2,880 good products we must make 2,880/72% = 4,000 products. Ask the class to calculate the total weight of scrap (process and product) available for sale. This is simply the difference between 4,000 × 4 kg = 16,000 kg, and the weight of the finished good products, which is 2,880 × 3.5 kg = 10,080 kg. The scrap therefore totals 5,920 kg. Finally, point out that although 16,000 kg of material are needed to meet production needs, it may be that the company is also planning to increase the amount of material stock carried. This would further increase the 16,000 kg. Now work through Examples 1, 2, 3, 4, and 5 on pages 69-77 of the textbook. Reminders At the end of the lesson, re-state the main points again: This has been a particularly important lesson. The class should understand the meaning of ‘yield’, and how to adjust the number of products to allow for rejection rates. 29 Cost Accounting – Teacher’s Guide LESSON 8 Main subject Further aspects of material cost Textbook reference Chapter 3: Page 68 Syllabus reference 2 Stock control – use of free stock balance; calculation and use of economic order quantity (EOQ) Lesson topics The calculation of economic order quantity Stock records to show allocated, free and ordered material Extended syllabus reference 2.1 2.2 2.3 2.4 2.5 2.6 2.7 Explain the significance of just-in-time purchasing and its relationship to average stock levels Understand the influence of RQ (the reorder quantity) on average stock levels and on average stock investment Use the EOQ model to calculate economic reorder quantity (EOQ) at a constant purchase price and where discount is given by the supplier for larger order quantities Construct a graph to show ordering costs, stock-carrying costs and total costs Tabulate items in 2.4 for discrete order quantities to select the optimal order size without using the EOQ model Apply the EOQ model to calculate the economic batch quantity for production Make calculations, and present a stock record showing for a particular material, orders placed, stock on hand, and allocated and free stock Required for Candidates for Third Level only Aims of the lesson • To show how the EOQ is calculated and what factors influence it • To show how stock records can be maintained which allow for material to be allocated to customers’ orders 30 Further aspects of material cost The lesson ▲ Begin by reminding the class that the material to be purchased depends upon the material needed for production (allowing for process scrap and rejects), and upon planned changes in material stock levels. If the material to be purchased in the year amounts to 50,000 kg, to be used over a 50week production year, the next question must be, ‘Is it an even production requirement, or are there high points and low points?’ If 1,000 kg will be used each week over the 50 weeks of 5 days each week, then: If ordered and delivered in 200 kg batches, the average stock carried is 100 kg. If ordered and delivered in 1,000 kg batches, the average stock carried is 500 kg. If ordered and delivered in 5,000 kg batches, the average stock carried is 2,500 kg. Remind the class that this is using RQ/2 to determine the average stock, and assumes that the stock of material reaches zero just as the next delivery arrives from the supplier. Remind the class, also, that if orders and deliveries are 200 kg for example, it means that deliveries must arrive from the supplier every day. The material must be there as required at the start of each day (just-in-time) and will gradually be used during the course of the day. Tell the class that if the purchase price is assumed to be £12 per kg, the average stock investment will be £1,200 (100 kg × £12), £6,000 (500 kg × £12), or £30,000 (2500 kg × £12). Remind the class that carrying stock has a cost, for example 9%, which means £9 to carry stock costing £100 for one year. So, if we want to minimise stock-carrying costs we should minimise average stock. In this example, we should purchase in 200 kg lots every day. Do emphasise that we are not referring to the cost of the average stock. We are referring to the cost of carrying the average stock. ▲ Now introduce ordering costs. Explain that each time an order is placed, there are costs involved in placing the order, progressing it, receiving the delivery, and so on. This might be (say) £30 per order. So, ordering in 200 kg lots may minimise stock-carrying costs but will cause the highest order costs, since 250 orders (50,000/200) would be placed each year. Explain that what we want to do, is minimise total costs – the aggregate of order costs and stock-carrying costs. We want to choose the order quantity that will do this. This is known as the economic order quantity (EOQ). Refer the class to the CIMA definition on page 84. Now point to the EOQ formula on page 86 and tell the class that they must know this and be able to use it. 31 Cost Accounting – Teacher’s Guide Use it for the figures you have used in the earlier part of the lesson: √ (2DCo)/Ch = √ ((2 × 50,000 × £30)/(9% × £12)) = 1,666.66 recurring. EOQ = Explain that this means that: £ Stock-carrying costs will be (1,666.666/2) × £12 × 9% = 900 Order costs will be (50,000/1,666.666) × £30 900 Aggregate of stock-carrying and order costs 1,800 Draw the attention of the class to the graph on page 87 of the textbook. You may want to get the class to prepare such a graph using the figures you have been using in this lesson. ▲ Tell the class that sometimes the examiner asks for figures to be tabulated for different order quantities. Point out that this approach can be used to get close to the EOQ, when the formula cannot be remembered. For example: Assume the EOQ is 1,000 kg: £ Stock-carrying costs 500 kg × £12 × 9% Order costs 50 × £30 540 1,500 2,040 Assume the EOQ is 2,000 kg: Stock-carrying costs 1,000 kg × £12 × 9% Order costs 25 × £30 £ 1,080 750 1,830 Calculations like this will eventually locate the EOQ, or can be used as the basis of producing a graph like the one on page 87, so that the EOQ could be visually estimated from the graph. ▲ Now take the class through Example 9 on pages 87-89 of the textbook. When you have explained the solution to parts (a) and (b) of the example, introduce the effect of discounts which a supplier might offer on purchases of larger quantities. Take the class carefully through the Solution to part (c), since this approach is adequate for many examination questions. Emphasise that the approach compares the saving in annual purchase costs (in terms of both the basic material cost and the ordering costs) with the extra cost of carrying higher average stocks. Using the figures from this lesson, you could say that the supplier will reduce the price to £11.80 per kg, if orders are placed in 5,000 kg batches. Saving in annual costs of material 50,000 kg × (£12.00 – £11.80) = £10,000 32 Further aspects of material cost Saving in order costs 50,000/5,000 = 10 × £30 = £300 compared to £900 at present = £600 saved Total savings £10,600 Additional costs: Average stock 2,500 × £11.80 = £29,500 Present average stock 1,666.666/2 × £12 = £10,000 Increase in average stock £19,500 × 9% = £1,755 It is worth spending £1,755 to save £10,600? Remind the class, again, that the comparison is not between £10,600 and £19,500 – a common error which causes candidates to say that the proposal is not worthwhile – but between £10,600 and 9% of £19,500. Finally, for this topic, take the class carefully through the addition to Example 9, which commences on line 7 of page 89 in the textbook, and ends at the foot of that page. ▲ Stock records to deal with allocated and free stock Explain why it might be prudent to reserve or allocate stock to a particular order, and how this then leaves a balance of free, or available, stock. The topic starts on page 77 of the textbook Emphasise that the first example, Example 6, is only concerned with physical stock, in other words, the stock in hand is either allocated or free. Work carefully through each transaction with the class. Then explain that it is possible to allocate material before it is even received from the supplier. This is illustrated by Example 7 on pages 80 and 81. Again, make sure that each transaction is understood by the class. Example 8 requires a reasoning approach to the solution, and will only be understood when the subject is familiar. This is an important example to work through with the class. You could perhaps add additional data for December to give the class further practice. Reminders At the end of the lesson, re-state the main points again: Emphasise the reasons for rising stock-carrying costs and for falling order costs and that the aim is to establish the EOQ – the order quantity that minimises the aggregate of these two costs. The model needs to be adapted when discounts are offered for larger order quantities. Stock in hand, and sometimes stock on order, can be allocated to orders, leaving a balance of free (available) stock. 33 Cost Accounting – Teacher’s Guide LESSON 9 Main subject Further aspects of material cost Textbook reference Chapter 3: Page 68 The specific lesson topic commences on page 90 of the textbook. Syllabus reference 1 Further aspects of the Second Level Cost Accounting syllabus Lesson topic Pricing materials to production – further aspects Extended syllabus reference 1.3 1.4 Price materials from stock using periodic weighted average price, where the period may be a week, a month, a quarter or a year Price materials from stock using replacement price, and understand how this affects the value of the stock balance Required for Candidates for Third Level only Aims of the lesson • To explain the calculation and use of periodic weighted average price • To explain the calculation and use of replacement price The lesson ▲ Begin by reminding the class that all pricing methods are simply ways of apportioning material cost. The apportionment is made between the costs of a period and the stock balance carried forward at the end of that period. Also, remind the class that pricing methods fall into three categories – cost prices, those derived from cost, and notional prices. This lesson considers 2 pricing methods not introduced at Second Level: periodic averages, which fall into the second category (prices derived from cost); and replacement price, which falls into the third category (notional prices). 34 Further aspects of material cost ▲ Periodic averages In practice, periodic averages are very common. Begin by reminding the class that weighted average was studied for Second Level. The approach used was that the weighted average price would be re-calculated each time a new purchase of material was made. The resulting price would then be used for all issues until another purchase was made. Use the following figures to illustrate your lesson: Kg 500 300 280 200 90 440 290 Stock 1 Jan Purchases 10 Jan Issues 15 Jan Purchases 17 Jan Issues 20 Jan Issues 24 Jan Purchases 28 Jan £ 21,000 12,000 8,600 13,050 Remind the class that if the issues were priced using the weighted average method as learned in Second Level, the stock record would show: Date Qty 1 Jan 10 Jan 300 15 Jan 17 Jan 200 20 Jan 24 Jan 28 Jan 290 Receipts Price £ Qty Issues Price £ 280 41.25 11,550 90 440 41.74 3,757 41.74 18,366 12,000 8,600 13,050 Stock balance Qty Price £ 500 21,000 800 41.25 33,000 520 21,450 720 41.74 30,050 630 26,293 190 7,927 480 43.70 20,977 Remind them that the average price has been re-calculated, on a weighted basis, each time a purchase has been made. Explain that if a periodic weighted average price is to be used, the period must be decided. It could be a week, or a month, or a year. A periodic average reduces the number of calculations made. This advantage may be lost if a weekly periodic average is applied. A month is therefore more likely to be the periodic basis of the calculation. Tell the class that you are illustrating a periodic average based upon the calendar month. This means that no pricing of issues can take place until the month has ended, unless the issues of one month are priced at the average price of the previous month. Using the above example, the periodic weighted average for January is (£21,000 + £12,000 + £8,600 + £13,050)/(500 + 300 + 200 + 290) = £42.36. Issues will be priced at (280 + 90 + 440) × £42.36 = £34,312. 35 Cost Accounting – Teacher’s Guide Closing stock will be £54,650 – £34,312 = £20,338. Get the class to compare this result with that obtained earlier for the basic weighted average method. You may want to give the class some purchase and issue figures for February. This would then allow you to illustrate a periodic average for the 2 month period. Finally, take the class carefully through Example 10 on pages 91-93 of the textbook. ▲ Replacement price Explain that it is argued that the real cost of using a material is the cost of replacing it on the day that it is used. Point out that this is a good argument but that its application causes 2 specific problems: (1) Every time material is issued from stock, there is the problem of establishing its replacement price at that specific moment. (2) The stock account is distorted by using a price for the issue which may never actually have been paid for material. Using the figures from the previous example, 90 kg of material were issued on 20 January, 3 days after paying £43 kg for material. However, suppose that on 20 January (unlikely as it may be!) such material could only be replaced at £62 kg. It is valid to price the issue at this figure, but it would leave the stock at £30,050 – (90 kg × £62) = £24,470. This is for 630 kg, an average of £38.84, a price lower than any price paid. Take the class through Example 11 on pages 94 and 95 of the textbook. Reminders At the end of the lesson, re-state the main points again: The main decision to be made in applying the pricing method of the periodic weighted average is the length of the period – it can be weekly, monthly, quarterly, annually. Monthly or quarterly are more likely to be used. The method simplifies issue pricing in that the number of different prices used is reduced to just one for each period. The use of replacement price has theoretical merit but presents real problems of application. 36 Costing for labour LESSON 10 Main subject Costing for labour Textbook reference Chapter 4: Page 104 Syllabus reference Second Level 3 Costing for labour Lesson topic Methods of remuneration Extended syllabus reference 3.1 3.2 3.3 Identify the main costs incurred by a business as a result of employing people Understand various methods of remuneration for individuals and for groups Calculate earnings and remuneration for various remuneration methods Required for Candidates for Second Level and Third Level Aims of the lesson • To introduce labour-costing principles and procedures • To explain methods of remuneration The lesson ▲ Begin by pointing out that because people are employed, various costs arise. Ask the class to suggest what these might be. They may suggest: Wages earned Holiday pay Sickness pay Maternity and paternity payments National Insurance contributions Pension contributions Subsidised meals Protective clothing Supervision Training 37 Cost Accounting – Teacher’s Guide These are just suggestions. Not all of these may be valid in your business environment. You may have others, specific to your environment, not mentioned in this list. Make it clear that many of these costs are overheads to the business, as a consequence of employing people. Point out that in an earlier lesson direct labour was distinguished from indirect labour. Revise this by taking the class through Example 1 on page 105 of the textbook. ▲ Now begin to talk about remuneration methods, that is, the way people are paid. Explain that remuneration may be on a basis of attendance (for example, a weekly wage of £180 for 40 hours, or a salary of £14,400 a year paid at £1,200 per calendar month), or based upon production (for example, £2.50 per unit made, making £120 for a week in which 48 units are made, and £75 for a week in which 30 units are made), or based upon both, some of the wage paid on attendance and some based upon output. Then explain that there are some jobs that are suitable for payment on an output basis, and others where this is unsuitable, and remuneration is best made on a time basis only. For example, a production worker could be remunerated on the basis of the number of good units produced, but it would be wrong to remunerate a surgeon on the time he can save in performing an operation. This might encourage carelessness. Explain, also, that some jobs are done by a team rather than individuals, and perhaps it would be better to look at team effort when thinking of how to remunerate team members. Draw the attention of the class to pages 106-108 in the textbook. ▲ Remuneration calculations Make sure that the class can quickly and accurately make remuneration calculations. Time rate payments An accountant is paid £25,920 per annum. He is not paid overtime. He is paid in 12 equal calendar monthly payments. In Month 4 he works 24 overtime hours because of the monthly accounts. What is his remuneration in Month 4? The answer is £25,920/12 = £2,160. A fork-lift truck driver is paid £313.50 for a basic 38-hour week. All overtime is paid at time and a half. He attends for 42 hours in Week 17. What is his remuneration for Week 17? The answer is £313.50 + (4 hours × £8.25 × 1.5) = £363. 38 Costing for labour A factory cleaner is paid £4.40 per hour for a basic 4 hours per day for a 5-day week. Time and a half is paid for any hours above the basic weekly hours. He was 1 hour late on one day; this hour is not paid. He attended for 23 hours in Week 34. What is his remuneration for Week 34? The answer is (19 hours × £4.40) + (1 overtime hour at £4.40 and 3 overtime hours at £4.40 × 1.5) = £107.80. Payment by results (PBR) Explain that some PBR schemes are based upon money, that is, prices are given for jobs done. For example, producing one unit of product DD9 may be worth £0.68 to the employee, whereas producing one unit of product RS4 may be worth £1.76 to the employee. Emphasise that if working at the same incentive rate, this implies that RS4 is expected to occupy the worker for longer than DD9. Further explain that some PBR schemes are based upon time. The employee is given an allowed time to complete the job. If he works at incentive speed, he should complete the job in less time and will be rewarded out of the time saved. Often he will only get a part of the time saved – hence these schemes are called ‘sharing plans’ or ‘bonus systems’. Point out that in either type, the firm has to decide what will happen when the employee produces unacceptable output. Will he still be paid or will he only be paid for good work? At this point, go through the section on page 113 of the textbook, ‘Remuneration on an output basis’ and through Example 3. This will help the class to understand the relationship between money-based and time-based incentives. ▲ Now do some remuneration calculations with the class. A production worker is paid on ‘piece-work’ (based upon production). He has no guaranteed basic remuneration. In Week 14, in 38 hours, he produces 168 units of Job 45, and 7 units of Job 34. The piece-work prices are £1.30 and £5.50 respectively. What is his remuneration in Week 14? The answer is (168 × £1.30) + (7 × £5.50) = £256.90. Emphasise that the hours worked were not relevant to this answer. In the same situation, the production worker is now guaranteed a minimum of £220 for a 38-hour week. What is his remuneration? The answer is no different because his earnings (£256.90) exceed the minimum (£220). 39 Cost Accounting – Teacher’s Guide In the same situation again, the production worker is guaranteed a minimum of £260 for a 38-hour week. What is his remuneration? The answer now changes. Emphasise the difference between his earnings of £256.90 and his guaranteed remuneration of £260. Point out that one possibility is being compared with another. Here, the earnings figure of £256.90 is rejected and replaced with the guaranteed £260. Tell the class to read questions on remuneration calculations carefully. An employee might get some of his remuneration on a time-rate basis and some extra on output, for example: A worker does a normal 38-hour week, for which he is paid £8.70 per hour. In addition, he is paid for his output. In Week 19 he produced 180 units of Job 36, for which the piece-work price was £0.42 per unit. What was his remuneration for Week 19? The answer is (38 × £8.70) + (180 × £0.42) = £406.20. A worker is employed for a basic 38-hour week at £7.40 per hour. A bonus of 40% of the time saved against standard allowed time is paid at basic rate. In Week 22 he produces 22 units of Job 316 (allowed time each unit 1.75 hours) and 12 units of Job 63 (allowed time each unit 2.10 hours). He worked no overtime, but 3 hours were unproductive, spent waiting for materials. These 3 hours are to be paid at average earnings. What was his remuneration in Week 22 The answer is: Basic hours 38 × £7.40 Allowed time (22 × 1.75) + (12 × 2.10) = 63.70 Time taken 38 – 3 = 35 hours Time saved 63.70 – 35 = 28.70 × 40% × £7.40 = Unproductive hours 3 × (£84.95/35) = £ 281.20 84.95 7.28 373.43 In going through this calculation with the class, emphasise the way in which the unproductive hours have been compensated, on the assumption that it wasn’t the fault of the worker that he was waiting for materials. 40 Costing for labour ▲ Now take the class carefully through Examples 4-9 on pages 116-133. This includes the section on Group bonus schemes, and covers specific points such as overtime treatment and shift allowances. The graphs may be ignored as specific comment on them is reserved until the next lesson. Reminders At the end of the lesson, re-state the main points again: The emphasis of this lesson has been on the calculation of remuneration, whether based upon time or upon output, and whether for the individual worker or for a group. 41 Cost Accounting – Teacher’s Guide LESSON 11 Main subject Costing for labour Textbook reference Chapter 4: Page 104 Syllabus reference Second Level 3 Costing for labour Lesson topic The effect of remuneration method on unit cost Extended syllabus reference 3.4 3.5 3.6 3.7 Appreciate the effect of each remuneration method on the unit cost of output Construct graphs to show total labour cost and the unit labour cost for alternative remuneration methods Distinguish between production and productivity Measure changes in production and productivity Required for Candidates for Second Level and Third Level Aims of the lesson • To show the effect of remuneration method on unit cost • To explain graphs of total remuneration and unit cost • To differentiate between an increase in production and an increase in productivity The lesson ▲ Begin by reminding the class of the previous lesson, in which the essential difference between remuneration on a time-rate basis and remuneration on an output basis was explained. Remind the class that if a worker is paid exclusively on time, his remuneration for a 38-hour basic week may be £235.60 irrespective of output and effort. The only way that he will be remunerated more than this is by doing overtime. What he produces, and the effort made, is irrelevant to what he is paid. Point out that if in the 38-hour week he only produces 1 unit of output, its unit cost is £235.60, but that if he can produce 10 units, the unit cost will be £23.56. The benefit of increased effort and output goes entirely to the employer! 42 Costing for labour This will allow you to explain the graph on page 110 of the textbook. Point out that although one scale is on the right of the graph, both are plotted and read from left to right. Emphasise the horizontal remuneration line, and the cost per unit curve. The graph on page 112 should also be explained in relation to Example 2. Now explain that if a worker is paid entirely on results, the remuneration line would be as the earnings line on the graph on page 119. This means that if the operative produces nothing, his remuneration is correspondingly zero. The cost per unit would be a constant £1.68. However, point out that the graph on page 119 illustrates what happens where remuneration is on output, but the worker has a basic time-rate guarantee. Explain that the cost per unit curve cannot fall below £1.68 but, as the graph shows, it can certainly be more than £1.68. The graph on page 122 illustrates 2 bonus schemes. It plots total remuneration. Remind the class that bonus schemes pay an addition to the basic time-rate payment. It would be a good exercise for the class to prepare a graph showing the cost per unit curve for each of the 2 schemes. ▲ Explain to the class the difference between production and productivity: Production is a quantity of output. For example, if 5 workers each produce 48 units of product each week, the weekly output is 240 units. If each worker is paid £312 per week, the total remuneration is £1,560 and the labour cost per unit is £6.50. There may be a need to increase output to 336 units per week, to meet demand. If 2 additional workers are taken on, and paid at the same rate, the total remuneration goes to £2,184, and the labour cost per unit is £2,184/336 = £6.50. There has been an increase in production (from 240 units a week to 336 units per week). There has been no change in productivity since unit labour cost is unchanged at £6.50. Productivity is the relationship between the output and the cost of the labour. If 2 additional workers cannot be taken on (for instance, there are none available, or there is no room for them), then can the additional output come from the 5 workers? We could offer each worker a weekly bonus of £124.80 if output per worker is increased to 67.20 units. Total remuneration will then be 5 × (£312 + £124.80) = £2,184. The labour cost per unit will be £2,184/336 = £6.50. Again, therefore, there has been an increase in production but no increase in productivity. If the output increase can be achieved with a weekly bonus of (say) £90, then total remuneration will be 5 × (£312 + £90) = £2,010, and the labour cost per unit will be £2,010/336 = £5.98. In this case there has been both an increase in production and an increase in productivity. 43 Cost Accounting – Teacher’s Guide These important contrasts must be made clear to the class. This topic is further illustrated on page 132 of the textbook. Example 9 on pages 132-133 should also be reviewed with the class. Reminders At the end of the lesson, re-state the main points again: The method of remuneration has an effect upon the unit labour cost. Any method of remuneration with a time-payment element will allow for a reduction in unit labour cost as production per hour increases. There is a clear difference between an increase in production and an increase in productivity. 44 Costing for labour LESSON 12 Main subject Costing for labour Textbook reference Chapter 4: Page 104 Syllabus reference Second Level 3 Costing for labour Lesson topic Payroll preparation and analysis Extended syllabus reference 3.8 Correctly treat overtime premium, shift allowances (premium) and idle time 3.9 Understand payroll preparation based upon time and/or output records 3.10 Understand the meaning of payroll analysis Required for Candidates for Second Level and Third Level Aims of the lesson • • • • To describe the routines of payroll preparation To explain the safeguards needed to prevent fraud in such a system To explain payroll analysis To show accounting entries for labour The lesson ▲ Begin by referring the class to page 133 of the textbook, where CIMA definitions of ‘payroll’ and ‘payroll analysis’ are given. Make certain that the class understands the distinction. Any business with employees will need to prepare a payroll, to deal with deductions from gross pay in order to obtain the net amount payable, and to account for the deductions which will later be paid over on behalf of the employee – for example to the tax authorities,. On the other hand, not all firms will have a cost accounting system. Those that do will want to undertake payroll analysis, to decide how much of the gross wage is direct and how much is indirect, and to determine the cost centres/cost units to which the wages should be charged. 45 Cost Accounting – Teacher’s Guide The gross wage earned by an employee will include any overtime which he has done. Overtime is normally paid at an hourly rate greater than the basic rate. Explain that the extra is called ‘overtime premium’. For example, if an employee is paid at a basic rate of £4.20 per hour, and overtime is paid at time and a third, then the premium is £1.40 per hour. Explain that overtime premium is generally treated as an overhead cost. However, point out that if the overtime has been done at the specific request of a customer, to speed delivery of his job, then the overtime premium can be treated as part of the direct labour cost. National Insurance contributions are payable in the UK. The employee’s contribution is deducted from the employee’s gross wage. The employer’s contribution is an additional cost, over and above the gross wage. It is normally treated as overhead. For the majority of firms, the payroll preparation and payroll analysis routines will be computerised. This is an area of the syllabus where members of the class might be able to contribute from their own experience. Emphasise the importance of accurate time and output records when calculating wages. Point out that even where all employees are paid on a time basis only, a reliable record is needed of times of arrival and departure, overtime, absence through sickness, holiday, and so on. Discuss with the class how this can be obtained. Then discuss what information is needed if an employee is to be paid wholly, or partly, on output. Again, encourage the class to draw on their own experience. ▲ Explain how the gross wage becomes the net wage. In the UK this is by the deduction of employees’ national insurance contributions, income tax, and other deductions such as contributions to pension schemes and contributions to charity. You should explain this in a local context, and it would be useful if the class could make calculations for (say) 3 imaginary employees. ▲ For payroll analysis, emphasise that the wages analysed must agree in total with the gross wage earned. As an example, point out that if Month 7 comprises Weeks 13, 14, 15 and 16, then the gross wages for those weeks must be analysed for cost accounting purposes, although the net wages relating to Week 16 will not be paid until Week 17. Take the class through Example 10 on page 135 of the textbook. In particular, emphasise the use of the wages control account and the wages payable account. If any of the class are weak on book-keeping principles, the debit and credit entries may need more explanation. ▲ Explain the ways in which safeguards can be introduced to reduce the possibility of fraud in payroll preparation. Again, it may be that members of the class can contribute to this discussion. 46 Costing for labour Reminders At the end of the lesson, re-state the main points again: Emphasise the difference between payroll preparation and payroll analysis, and the sources and type of information needed for each. 47 Cost Accounting – Teacher’s Guide LESSON 13 Main subject Costing for overheads (1) Textbook reference Chapter 5: Page 143 Syllabus reference Second Level 4 Costing for overheads Lesson topic Sources of overhead cost Extended syllabus reference 4.1 4.2 4.3 Identify possible sources of overhead cost Understand the purpose and content of a plant register Understand procedures for the collection of overhead cost against cost centres Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the various sources of overhead cost • To explain the nature of a plant register • To illustrate depreciation calculations by straight line, reducing balance, and machine hour methods • To explain how overhead costs are identified with incurring cost centres The lesson ▲ Begin by stating that this lesson and the next two lessons are the most important so far, for an understanding of cost accounting. ▲ Now draw the attention of the class to the CIMA definition of overhead on page 143 of the textbook. Emphasise 2 things: Overhead, by definition, cannot be identified with a saleable cost unit. If we make furniture, the cost of wood can be identified with a saleable cost unit, and it is therefore direct material. The cost of materials used to repair a machine that planes wood for furniture making cannot be identified with any particular saleable cost unit. This is therefore indirect material. Indirect material is part of overhead cost. 48 Costing for overheads (1) Point to the word ‘economically’ in the definition. For example, glue used in furnituremaking is really direct material, because the glue ends up in the saleable cost unit. However, it may not be worth the effort of treating it as direct, and it will be included in overhead. Tell the class that overhead cannot – or cannot economically – be identified with the saleable cost units. However, it must be identified with the cost centre which has wholly or partly incurred the cost. Overhead cost must be collected from its sources and charged to cost centres. Draw the attention of the class to the 6 sources of overhead cost given on pages 144145 of the textbook. Point particularly to Number 5, as depreciation must be seen as an overhead cost, even though not incurred in the same way as gas, electricity, indirect labour, etc. Example 1 on pages 145-147 is an important example. Make sure the class understands that all overhead incurred is debited to the production overhead account of the specific cost centre – and that the production overhead control account is a total account which carries the total debit for each expense. Again, make sure that the class understands where the credit entries are. Remind the class that each cost centre would be identified by a cost code as taught in an earlier lesson. ▲ Explain that Note 3 to the solution (on page 147) introduces 2 important words – allocation and apportionment. At this stage, point out that we like to be able to allocate cost. If we know that a supervisor only works in one cost centre, then – without any doubt – his salary can be allocated (or charged) straight to that one cost centre. We are not so keen on apportionment (sharing) because there will always be argument over the basis to use. If a supervisor divides his time between 2 cost centres, what will be the basis for sharing his salary between the 2 cost centres? That’s the problem! Make sure that the class understands this difficulty. It is fundamental to further study. ▲ Take the class through the essential elements of the fixed asset register on page 148. Point out that in times gone by this would have been a handwritten register. Today it is more likely to be on a computerised database. However, its purpose and content remain unchanged. Explain the purpose of depreciation as a means of apportioning the cost of an asset over its expected useful life. Explain that it is usually treated as part of fixed overhead cost because machines often make many different products, often stand idle, and have very variable workloads. It is usually not possible to properly identify depreciation exclusively with a particular saleable cost unit. 49 Cost Accounting – Teacher’s Guide Explain the depreciation calculations. Use the following figures to help understanding. Afterwards, refer to Example 2 on pages 149-150 of the textbook to reinforce the topic. Cost of machine £60,000 Estimated residual value £8,000 Estimated life 4 years Expected use: Year 1 4,000 hours Year 2 6,000 hours Year 3 5,000 hours Year 4 1,000 hours If straight line depreciation is used, the total depreciation will be £52,000, and will be £13,000 in each of the 4 years. If reducing balance method is used, the total depreciation will also be £52,000. The % to be applied is 39.57%. (Use the formula on page 150 of the textbook). The rate is being used to 2 decimal places so that the methods can be better compared. Tell the class that the examiner may give the % or that, as here, they could be required to calculate it. Depreciation for Year 1 39.57% of £60,000 £ 23,742 Depreciation for Year 2 39.57% of (£60,000 – £23,742) 14,347 Depreciation for Year 3 39.57% of (£60,000 – £38,089) 8,670 Depreciation for Year 4 39.57% of (£60,000 – £46,759) 5,239 2 Rounding adjustment needed Total depreciation 52,000 If the calculations are based on machine hour rate: (Rate = £52,000/16,000 hours = £3.25 per hour) £ Depreciation for Year 1 4,000 × £3.25 13,000 Depreciation for Year 2 6,000 × £3.25 19,500 Depreciation for Year 3 5,000 × £3.25 16,250 Depreciation for Year 4 1,000 × £3.25 3,250 Total depreciation 52,000 ▲ Now confirm that the class understands both these methods, and their effect upon annual overhead costs, by working through Example 2 on pages 149-150 in the textbook. 50 Costing for overheads (1) ▲ Finally, explain that overhead costs from all sources must be charged to incurring cost centres using cost centre codes and expense headings. The cost codes will cover all functions of the business, including production, administration, selling, distribution etc. At the end of the exercise we must know the total overhead incurred by each cost centre, and the breakdown of that total under expense headings of indirect labour, gas, electricity, depreciation, etc. As much of the overhead as possible will have been allocated, but some will have been apportioned. Reminders At the end of the lesson, re-state the main points again: By definition, overhead cannot be immediately identified with any saleable cost unit. However, it must be identified with incurring cost centres, using the cost code. Where possible, overhead should be allocated to the incurring cost centre. Where costs are shared by more than one cost centre, cost apportionment may be done, but this is always less satisfactory, since there will be debate as to an appropriate basis for sharing the cost. 51 Cost Accounting – Teacher’s Guide LESSON 14 Main subject Costing for overheads (1) Textbook reference Chapter 5: Page 143 Syllabus reference Second Level 4 Costing for overheads Lesson topic The overhead distribution sheet Extended syllabus reference 4.4 4.5 Allocate overhead to production and service cost centres Apportion overhead to production and service cost centres Required for Candidates for Second Level and Third Level Aim of the lesson • To explain the use of an overhead distribution sheet for collecting overhead against all production and service cost centres. The lesson ▲ Begin by reminding the class that overhead must be collected from a number of sources, and allocated or apportioned to cost centres. The columns of the overhead distribution sheet must each represent a cost centre, defined by the cost code. When the overhead distribution sheet is complete, we not only want to know how much each cost centre has incurred in total but, also, what the expenditure has been on. For this reason, each row of the overhead distribution sheet represents a particular expense heading, such as gas, electricity, insurance, etc. Draw a pro-forma overhead distribution sheet on the whiteboard or blackboard, or prepare one for showing on the overhead projector. 52 Costing for overheads (1) The following is a suitable example of a production overhead distribution sheet. All figures are in £’000 Production Cost Centres 101 107 109 201 207 01 02 03 04 05 06 Expense: Labour Idle time O’time prem Supervision Gas Electricity etc etc Total 10 2 1 5 2 4 12 8 3 3 5 3 4 1 1 45 32 32 19 209 Service Cost Centres 300 500 600 Total 14 13 6 8 5 1 5 1 1 9 14 6 2 2 3 1 2 3 1 5 104 11 7 32 11 29 38 34 26 24 14 19 264 3 6 Remind the class that the 3-digit numbers over the columns define the cost centres. 6 of these are production cost centres and 3 are service cost centres. The 2-digit numbers against the rows define expense headings. Overhead has been collected to this summary from different sources – for example, the payroll analysis has booked £3,000 of idle time to cost centre 109. The expense would have been booked to ‘10902’, so defining the particular overhead item, and identifying the incurring cost centre. Explain that the £264,000 of total production overhead is analysed to incurring cost centre (column totals), and to expense heading (row totals). Point out that similar overhead distribution sheets would be done for administration overhead, selling overhead, and so on. Emphasise that some overhead items would have been allocated (supervision, perhaps) but others would have been apportioned (electricity, perhaps). ▲ At this point it is worth discussing a number of overhead costs, whether or not they could be allocated, and if not, what would be a suitable basis of apportionment. You could discuss depreciation, supervision, rent and insurance. ▲ It is particularly important to emphasise that the cost of operating service departments must be established before any attempt is made to charge the cost to the departments which they serve. As an example, point out that £24,000 was the cost of service department 300 in this period. It is important to know this. In the next lesson, we will discuss how the cost of a service department will be charged to the cost centres benefiting from that service department. Stress that it is the total of £24,000 that will be charged out, not each expense individually. 53 Cost Accounting – Teacher’s Guide ▲ You should now take the class through Examples 3, 4, and 5 on pages 151-158 of the textbook. Give particular attention to Example 5 and its solution. Note how the data given must be used as the basis of apportioned costs. The apportioned costs are clearly indicated in the Solution on page 155. Reminders At the end of the lesson, re-state the main points again: An overhead distribution sheet may be manual or computerised. It uses columns to define cost centres and rows to define expense headings. Some overhead can be allocated from sources to cost centres. Less satisfactorily, some has to be apportioned. The total cost of running a service cost centre must be obtained before any attempt is made to re-charge service department costs to cost centres receiving the service. 54 Costing for overheads (1) LESSON 15 Main subject Costing for overheads (1) Textbook reference Chapter 5: Page 143 Syllabus reference Second Level 4 Costing for overheads Lesson topic The apportionment of service department costs Extended syllabus reference 4.6 Re-charge actual overhead from service cost centres to production cost centres using repeated distribution/continuous allotment method Required for Candidates for Second Level and Third Level Aims of the lesson • To explain that the costs incurred by a service department may be charged to other service departments, but that, eventually, all service department costs must be charged to production departments. • To explain ‘benefit received or receivable’ as a basis for re-charging service department costs The lesson ▲ Begin by explaining that service departments do not in themselves produce the goods that a firm sells. Service departments are set up to assist and smooth the production process. For example, a maintenance department is established to carry out planned maintenance in the hope that this will reduce, or prevent, major breakdowns of production equipment. It will also carry out breakdown maintenance, to repair equipment that has broken down as efficiently and quickly as possible, so as to return it to productive use. For example: A toolroom is established to make tools to be used in production, or to repair tools that have broken, or to sharpen tools that have become blunt. A canteen is established to provide food for employees at a reasonable price and quality. A despatch department is established to ensure that orders are properly packed, and to select the best means of delivering the orders to customers. 55 Cost Accounting – Teacher’s Guide Emphasise that these departments do not produce saleable cost units. The cost of running these departments must be charged to the departments which they serve. One service department may serve another service department – for example, the employees of the maintenance department may eat in the canteen. Emphasise that, ultimately, all service department costs must be re-charged to production departments – because only from the production departments can the cost be charged to saleable cost units. ▲ Use the following example to explain the benefit basis for charging out the costs of a service department: A company has 3 production departments, A, B and C, and 1 service department, X: If C receives no benefit from the existence of X, then it should not be charged with any of X’s cost. For instance, if X is a maintenance department, and C is a department where employees assemble a product by hand, using no equipment, then there is no equipment in C to be maintained. The alert student may suggest that the department itself may need some maintenance – such as painting the walls or repairing the floor. Point out that perhaps the cost of a service department should be charged to other departments on the basis of benefit receivable, rather than benefit received. You can illustrate this by pointing out that all citizens should pay towards the cost of building and running hospitals, although as individuals we hope that we will never have to use the services of one. ▲ Now take the class through Example 6 on page 159 of the textbook. Point out that the canteen cost has been apportioned on a benefit receivable basis, and that this point is discussed in the Notes to the solution. Then take the class through Example 7. Draw particular attention to Note 1 to the solution because, usually, the examiner will express the benefits received from service departments as percentages. Explain that if the examiner says that 20% of the costs of service department X should be charged to production department B, it is because B obtains 20% of the benefit arising from the existence of X. ▲ Now use the following figures to show the class how to deal with service department costs: Department Allocated & Apportioned cost 56 A £’000 B £’000 C £’000 X £’000 Y £’000 Total £’000 280 430 170 40 80 1,000 Costing for overheads (1) Tell the class that A, B, and C are production departments and X and Y are service departments. Remind them of the importance of the total column on the right-hand side. It controls the accuracy of the apportionments, and must always be used. Also remind the class of the meaning of ‘allocated’ and ‘apportioned’ cost. Ask for an example of each for production department (cost centre) A. An example of an allocated cost would be the salary of the manager of department A. An example of an apportioned cost would be a share of the buildings insurance premium. Now tell the class that service department X only does work for department A, and service department Y only does work for department C. Therefore A gets 100% of the benefit from the existence of X, and C gets 100% of the benefit from the existence of Y. Department Allocated & Apportioned cost Service depts Total A £’000 B £’000 C £’000 X £’000 Y £’000 Total £’000 280 40 320 430 – 430 170 80 250 40 (40) – 80 (80) – 1,000 – 1,000 Remind the class again of the importance of the total column. Point out that all of the overhead cost has now been collected on the 3 production departments, from where it can be charged to saleable cost units made in those departments. ▲ Now tell the class that the benefits from the service departments are being changed: The benefits from X are 40% for A, 20% for B, 35% for C and 5% for service department Y. The benefits from Y are 50% for A and 50% for C. Point out that this means that the cost of service department X must be charged out first, because service department Y benefits from service department X Department Allocated & Apportioned cost Charge out X Subtotal Charge out Y Total A £’000 B £’000 C £’000 X £’000 Y £’000 Total £’000 280 16 296 41 337 430 8 438 – 438 170 14 184 41 225 40 (40) – – – 80 2 82 (82) – 1,000 – 1,000 – 1,000 57 Cost Accounting – Teacher’s Guide ▲ When the class understands what has been done so far, explain that one more change is being made: The benefits from service department Y are now 50% for A, 40% for C and 10% for X. Explain that we now have benefits from both service departments to each other to consider. Service department X does work for service department Y, and service department Y does work for service department X. Further explain that one approach is to ignore the work between service departments. This would result in the cost of service department X being charged 40/95 of the cost to A, 20/95 of the cost to B and 35/95 of the cost to C. Similarly, the cost of service department Y would be charged 50/90 to A and 40/90 to C, with the following result: Department Allocated & Apportioned cost Apportion X Apportion Y Total A £’000 B £’000 C £’000 X £’000 Y £’000 Total £’000 280 17 44 341 430 8 – 438 170 15 36 221 40 (40) – – 80 – (80) – 1,000 – – 1,000 (Apportionments have been made to the nearest £1,000.) To confirm their understanding of this method, now take the class through part (a) of Example 8 on page 163 of the textbook. ▲ Finally, you should explain that the work between service departments can be considered by means of the repeated distribution, or continuous allotment, method, as follows: Department Allocated & Apportioned cost Apportion Y Sub-total Apportion X Sub-total Apportion Y Total A £’000 B £’000 C £’000 X £’000 Y £’000 Total £’000 280 40 320 19 339 1 340 430 – 430 10 440 – 440 170 32 202 17 219 1 220 40 8 48 (48) – – – 80 (80) – 2 2 (2) – 1,000 – 1,000 – 1,000 – 1,000 Ask the class to note how small the differences are in the figures for the last two solutions. ▲ Now take the class through part (b) of the Solution to Example 8. 58 Costing for overheads (1) Reminders At the end of the lesson, re-state the main points again: Service department costs should be charged to user departments on the basis of benefit received or benefit receivable. Work between service departments can be ignored unless it is significant. All service department costs must ultimately be charged to production cost centres, from where they can be charged to saleable cost units. 59 Cost Accounting – Teacher’s Guide LESSON 16 Main subject Costing for overheads (2) Textbook reference Chapter 6: Page 167 Syllabus reference Second Level 4 Costing for overheads Lesson topic Introduction to the absorption of production overheads Extended syllabus reference 4.7 4.8 4.9 4.10 Understand the purpose of overhead absorption Understand the meaning of full cost absorption Understand the reason(s) for using pre-determined absorption rates Calculate and apply production overhead using a unit of output absorption rate Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the meaning and purpose of overhead absorption • To explain full cost absorption • To contrast absorption rates based on production overhead incurred with pre-determined rates based upon budgeted production overhead • To emphasise that pre-determined rates are preferred. The lesson ▲ Begin by reminding the class where the previous lesson concluded: Production overhead, where possible, has been allocated to the cost centre incurring the cost – either a production cost centre or a service cost centre. Where allocation has not been possible, the overhead has been apportioned to the production and service cost centres, on some equitable basis. Finally, the total cost of each service department has then been apportioned to the cost centres deemed to have received benefit from that service department. Sometimes that has meant apportioning the cost of one service department to another service department, but eventually all of the production overhead has been located on production cost centres. 60 Costing for overheads (2) Do not proceed until you are satisfied that the class understands the processes that have brought us to this point. ▲ Now introduce overhead absorption. Begin by referring to the CIMA definition on page 167 of the textbook. Emphasise the word ‘attributing’. This means that we want to decide the appropriate amount of production overhead that belongs to each unit of product we make, or unit of service that we give. Give this example: Prime cost of 1 unit of Product XP1 Direct material 4 kg Direct labour 3 hrs Direct expense Prime cost £ 32.00 27.00 4.00 63.00 Remind the class that what makes these costs direct is our ability to identify them with a saleable cost unit, in this case 1 unit of XP1. Explain that there are still problems – a pricing method has had to be selected for the materials, and a decision has had to be made on how to treat overtime premium. Despite these difficulties, it is comparatively easy to establish the prime cost of a product or service. But what is the total cost of production for a unit of XP1? To find that, we need to add something for electricity, gas, supervision, machine repairs, canteen, depreciation and heating, and all the other production overheads that we have been talking about. A little bit of each of these costs has to be absorbed into the cost of each unit of XP1 made. Point out that the meaning of ‘full cost absorption’ is that no items of production overhead are left out. This will be contrasted later with an approach that does leave out some items. Suppose that XP1 is made in 3 production cost centres, and that when all of the production overheads have been allocated and apportioned and the service department costs apportioned, the overheads incurred for Year 9 were: Production cost centre Production overhead incurred A B C £ 87,120 £ 61,920 £ 110,160 Emphasise to the class that the word ‘incurred’ has been used. These are historical production overhead costs, amounts actually incurred in Year 9. Now explain that in some way, the production overhead incurred must be related to the cost of 1 unit of XP1. 61 Cost Accounting – Teacher’s Guide As a first step, tell the class we will assume that this firm only makes one product, the XP1, and that in Year 9, the output was 7,200 units of XP1. Point out that this is a most unusual situation, and that it means – in effect – that the production overheads could be considered to be direct costs, because if only one product is made, than all costs incurred by the firm are attributable to that one product! The full or total cost of a unit of XP1 was: Direct material 4 kg Direct labour 3 hrs Direct expense Prime cost Production overhead: A £87,120/7,200 B £61,920/7,200 C £110,160/7,200 Full or total production cost £ 32.00 27.00 4.00 63.00 12.10 8.60 15.30 99.00 Explain that this ‘per unit’ approach to absorbing production overhead can only be used if a single product is made, a rare situation indeed! For additional reinforcement, take the class through Example 1 on page 168 of the textbook. Draw attention to Note 3 to the solution. This explains how full production cost can be used for stock valuation purposes. ▲ Finally in this lesson, explain how inconvenient it is to have to wait until the actual overhead has been collected at the end of the period, before any product costs can be completed. Tell the class that in many businesses, selling prices have to be quoted before orders are obtained and it is therefore necessary to include an estimate of production overhead cost in these price calculations. For these reasons, pre-determined production overhead rates are usually used. These are based on budgeted production overheads, not actual production overheads. (Example 2 on page 169 of the textbook is based on historical costs. The examples which follow it are based on budgeted production overheads and budgeted output.) 62 Costing for overheads (2) Reminders At the end of the lesson, re-state the main points again: The prime cost of a unit of product, or of service, can be established relatively easily. To find the full costs of production, production overhead must be charged or attributed to the cost unit. This can be done using the actual production overhead incurred, but this is inconvenient. It is more usual to use pre-determined or budgeted production overhead absorption rates. A unit basis for absorption is possible only in the rare situation in which a single product is made. 63 Cost Accounting – Teacher’s Guide LESSON 17 Main subject Costing for overheads (2) Textbook reference Chapter 6: Page 167 Syllabus reference Second Level 4 Costing for overheads Lesson topic Comparison of alternative bases for the absorption of production overhead. Extended syllabus reference 4.11 Calculate and apply production overhead absorption rates based upon direct material cost, direct labour cost, prime cost 4.12 Calculate and apply production overhead absorption rates based upon time – direct labour hours, machine hours, process hours Required for Candidates for Second Level and Third Level Aim of the lesson • To explain how to calculate, and use, pre-determined production overhead absorption rates The lesson ▲ Tell the class that in this lesson it will be assumed that the firm makes just 2 products, the DR6 and the DR7, and that production overhead rates will be budgeted or predetermined Use the following data to illustrate your lesson: Product Direct material Direct labour Direct expense Prime cost 6 hrs @ 3 hrs @ £8 £7 DR6 £ 20 48 13 81 DR7 £ 50 21 10 81 The budgeted production overhead for Year 5 is £150,000. Budgeted production is 1,000 units of DR6 and 600 units of DR7. 64 Costing for overheads (2) The products are made by machine, but the direct labour is also involved in setting up the machine. 5 machine-running hours are needed to make a unit of DR6, and 2 hours to make a unit of DR7. Tell the class that you are going to use these figures to show the effect of using different methods of absorption on the full, or total, production cost of the two products. ▲ First, tell the class that you will illustrate methods based on value. These are % on direct material cost, % on direct labour cost and % on prime cost. % on material cost Calculate the cost of material which we expect to use in the year. This is: (1,000 × £20) + (600 × £50) = £50,000 The production overhead absorption rate is therefore: (£150,000/£50,000) × 100 = 300% Using this, the production cost of each unit is: Product Direct material Direct labour 6 hrs 3 hrs Direct expense Prime cost Production overhead Production cost DR6 £ 20 48 13 81 60 141 DR7 £ 50 21 10 81 150 231 Remind the class that the absorption rate is calculated £150,000/£50,000 and not £50,000/£150,000 – a common error made by students. Point out that the production overhead on DR6 is £60 because £60 is 300% of £20. In other words, £3 of production overhead is added to the cost of the unit for every £1 of direct material cost. % on direct labour cost Calculate the cost of direct labour which we expect to use in the year. This is: (1,000 × £48) + (600 × £21) = £60,600 The production overhead absorption rate is therefore: (£150,000/£60,600) × 100 = 247.52%, say 248% 65 Cost Accounting – Teacher’s Guide Using this, the production cost of each unit is: Product Direct material Direct labour 6 hrs 3 hrs DR6 £ 20 48 Direct expense 13 Prime cost 81 Production overhead (nearest £) 119 Production cost 200 DR7 £ 50 21 10 81 52 133 Point out that now the production overhead on DR6 is £119, because £119 is 248% of £48. In other words, £2.48 of production overhead is added to the cost of the unit for every £1 of direct labour cost. Even at this early stage, get the class to consider the results of the 2 methods used so far, and to note how different the costs are. % on prime cost Calculate the prime cost which we expect to incur in the year. This is: direct material £50,000 + direct labour £60,600 + direct expense (1,000 × £13) + (600 × £10) = £129,600. The production overhead absorption rate is therefore: (£150,000/£129,600) × 100 = 115.74%, say, 116%. Using this, the production cost of each unit is: Product Direct material Direct labour 6 hrs 3 hrs DR6 £ 20 48 Direct expense 13 Prime cost 81 Production overhead (nearest £) 94 Production cost 175 DR7 £ 50 21 10 81 94 175 Point out that this time the production overhead on DR6 is £94, because £94 is 116% of £81. In other words, £1.16 of production overhead is added to the cost of the unit for every £1 of prime cost. 66 Costing for overheads (2) ▲ When all members of the class understand the calculation and application of the 3 methods used so far, then – and only then – proceed to illustrate absorption rates based on time. Labour hour rate Calculate the direct labour hours to be worked in the year. These will be: (1,000 × 6) + (600 × 3) = 7,800 hours The production overhead absorption rate will be £150,000/7,800 direct labour hours = £19.23 per direct labour hour. Using this, the production cost of each unit is: Product Direct material Direct labour 6 hrs 3 hrs DR6 £ 20 48 Direct expense 13 Prime cost 81 Production overhead (nearest £) 115 Production cost 196 DR7 £ 50 21 10 81 58 139 Point out that the production overhead on DR6 is £115, because £115 is 6 hours × £19.23. £19.23 of production overhead is added to the cost of the unit for every direct labour hour used to make the unit. Machine hour rate Calculate the machine hours to be worked in the year. These will be: (1,000 × 5) + (600 × 2) = 6,200 hours The production overhead absorption rate will be £150,000/6,200 machine hours = £24.19 per machine hour. Using this, the production cost of each unit is: Product Direct material Direct labour 6 hrs 3 hrs DR6 £ 20 48 13 Direct expense Prime cost 81 Production overhead (nearest £) 121 Production cost 202 DR7 £ 50 21 10 81 48 129 67 Cost Accounting – Teacher’s Guide Point out that the production overhead on DR6 is £121 because £121 is 5 hours × £24.19. £24.19 of production overhead is added to the cost of the unit for every machine hour used to make the unit. ▲ This lesson has been about how to calculate and apply production overhead absorption rates. Ask the class to look at the production costs per unit that result from each absorption method. This comparison will be the basis of the next lesson. ▲ To finish this lesson, take the class through Examples 2, 3 and 4 on pages 169-181 of the textbook. Remember that Example 2 is based upon historical overhead, but that Examples 3 and 4 are based upon budgeted production overheads and budgeted output. The important Example 4 should be particularly understood before proceeding further. Reminders At the end of the lesson, re-state the main points again: Overhead absorption is used to transfer production overhead from the production cost centres into the cost of the saleable cost unit. Methods can be based upon value – direct material cost, direct labour cost, prime cost – or upon time – direct labour hours, machine hours etc. When calculating production overhead absorption rates, the production overhead is always the numerator. 68 Costing for overheads (2) LESSON 18 Main subject Costing for overheads (2) Textbook reference Chapter 6: Page 167 Syllabus reference Second Level 4 Costing for overheads Lesson topics Comparison of unit costs arising from the use of different production overhead absorption methods Under- and over-absorptions of production overhead Extended syllabus reference 4.13 Explain, in a simple way, why time-based rates are preferred to moneybased rates 4.14 Calculate and deal with any under- or over-absorption of overhead 4.15 Calculate a rate to absorb Administration, Selling and Distribution overheads 4.16 Make accounting entries for overhead in an integrated accounting system Required for Candidates for Second Level and Third Level Aims of the lesson • To explain why one method of overhead absorption may be more appropriate than another • To explain the meaning of, and treatment of, under and over-absorbed overhead 69 Cost Accounting – Teacher’s Guide The lesson ▲ Begin the lesson by comparing the unit production costs of each product based on different absorption methods, as calculated earlier: Product DR6 DR7 £ 141 200 175 196 202 231 133 175 139 129 £ Absorption method: % on direct material % on direct labour % on prime cost Labour hour rate Machine hour rate It is common for students to think that there must be a clear and definite cost of making any product. Emphasise that this is not so. We can be fairly confident up to the prime cost stage, but the addition of production overhead takes on some arbitrary aspects. Point out to the class that, depending upon the absorption method used, the cost of 1 unit of DR6 ranges from £141 to £202, and the cost of 1 unit of DR7 ranges from £129 to £231. Point out, also, that the cost of DR6 is lowest when the cost of DR7 is highest. This is because whichever method is used, the production overhead is £150,000 – and the more of this that is charged to DR6, the less there is to be charged to DR7. Is it fair to say that 1 unit of DR6 costs less than 1 unit of DR7 (as shown by the first method used), or the same (as shown by the third method used), or more (as shown by methods 2, 4 and 5)? You need to get the class discussing this. Point out that a unit of DR6 uses much less material than a unit of DR7, and that this is why method 1 (% on direct material) gives a production overhead cost of £60 for DR6 compared to the higher £150 for DR7. In all other aspects (except prime cost, which is identical at £81) DR6 uses more resources than DR7: direct labour £48 compared with £21 for DR7; labour hours 6 compared with 3 for DR7; machine hours 5 compared with 2 for DR7. ▲ Now discuss whether production overheads are caused by using materials (purchasing costs, stock-carrying costs, materials handling, etc), by using labour (employment taxes, holiday pay, supervision, etc), or by using machines (electricity, maintenance, depreciation, etc). The conclusion should be that not many overheads are incurred because of the materials used. This casts doubt on any method which includes direct materials i.e. on the methods of % on direct material, % on prime cost. Point out that whilst % on direct labour and labour hour rate will tend to give the same result, in this case % on direct labour gives a production cost of £200 for 1 unit of DR6. The labour hour rate method gives £196. The cost of DR7 is £133 for % on direct labour, but £139 for labour hour rate. 70 Costing for overheads (2) These differences reflect the difference between labour time and labour cost. A unit of DR6 uses twice the hours as a unit of DR7, but the direct labour cost of a unit of DR6 is more than twice the direct labour cost of a unit of DR7. This is because the direct labour which makes DR6 gets £8 per hour, whereas the direct labour which makes DR7 only gets £7 per hour. Since many overheads accrue on a time basis, labour hour and machine hour rates are considered to give more sensible results. ▲ To support this discussion, now take the class through pages 181-186 of the textbook. ▲ Over- and under-absorption of production overhead Remind the class that whichever method of absorption is used, it will be based upon budgeted overheads and budgeted output. Budgeted output, as we have seen, can be in terms of budgeted direct material cost, budgeted direct labour cost, budgeted prime cost, budgeted direct labour hours or budgeted machine hours. Because the actual production overhead and the actual output will never be as budgeted, costs will never be exactly absorbed. Use the following figures to illustrate this point: Budgeted production overhead Budgeted machine hours Therefore, budgeted or pre-determined production overhead absorption rate £84,000 7,000 £12 Emphasise that these figures are set in advance. At the end of the budget period, actual figures are: Actual production overhead Actual machine hours £81,600 6,300 Tell the class immediately that we don’t get the under- or over-absorbed overhead by comparing the budget of £84,000 with the actual of £81,600. We get it by comparing the absorbed overhead with the actual overhead. Importantly, we get the absorbed overhead by applying the pre-determined absorption rate to the actual output. In this case, our measure of actual output is the 6,300 machine hours. Therefore the production overhead absorbed is: 6,300 × £12 = £75,600 and there is an under-absorption of £6,000. Even at this early stage, get the class to see that the reason(s) for an under-absorption is either excess spending on overheads, or a shortfall in production, or a bit of both. ▲ Take the class carefully through Examples 7 and 8 on pages 187-191. Take the opportunity to reinforce the features of the production overhead account, and its relationship with the work-in-progress account. 71 Cost Accounting – Teacher’s Guide ▲ Finally, explain what can be done with an under- or over-absorption of production overhead. Emphasise that the most usual treatment is to write it off to the profit and loss account. Help the class see that this means the actual production overhead for a period is debited partly to work-in-progress and partly (if an under-absorption) to profit and loss. Take the class through, and discuss, Example 7 on pages 191 and 192 of the textbook. Reminders At the end of the lesson, re-state the main points again: The use of absorption rates which use, or include, direct material in the output base (% on direct material, % on prime cost) will usually give misleading results. The % on direct labour and the labour hour rate methods will usually give results that are quite close, but will differ because of different rates of pay. Time based rates (labour hour and machine hour) are preferred. The use of pre-determined overhead absorption rates give rise to under- and over-absorptions, which are usually immediately written off to the profit and loss account. 72 More advanced aspects of costing for overheads LESSON 19 Main subject More advanced aspects of costing for overheads Textbook reference Chapter 7: Page 210 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topics The use of simultaneous equations to deal with inter- service department transfers The use of service department absorption rates Extended syllabus reference 1.7 1.8 Use simultaneous equations to deal with reciprocal service department charges of actual or budgeted costs Calculate and apply a pre-determined service department absorption rate Required for Candidates for Third Level only Aims of the lesson • To show how to deal with inter- service department charges without using the continuous allotment/repeated distribution method • To explain that service departments can also use pre-determined absorption rates, giving rise to under- or over-absorption The lesson ▲ Begin by reminding the class of the earlier lesson in which inter-service department charges were considered. If inter-service department charges were not significant they could be ignored. For example, if the following applied: Cost centre Overhead A £’000 160 B £’000 250 X £’000 60 Y £’000 90 Total £’000 560 A and B are production cost centres. X and Y are service cost centres. Benefit obtained from X is A 40%, B 55% and Y 5%. Benefit obtained from Y is A 30%, B 68% and X 2%. 73 Cost Accounting – Teacher’s Guide Point out that the amount of inter- service department work is fairly small at 5% and 2%, and could be ignored. The service department costs would then be apportioned: Cost centre Overhead X Y A £’000 160 25 28 213 B £’000 250 35 62 347 X £’000 60 (60) – – Y £’000 90 – (90) – Total £’000 560 – – 560 Remind the class how these apportionments have been made. For example, X’s apportionment to A is (40/95) × 60. Now change the figures and tell the class that the following will apply: Cost centre Overhead A £’000 160 B £’000 250 X £’000 60 Y £’000 90 Total £’000 560 A and B are production cost centres. X and Y are service cost centres. Benefit obtained from X is A 35%, B 45% and Y 20%. Benefit obtained from Y is A 30%, B 68% and X 2%. Point out that the % of work done by Y for X is still comparatively insignificant – even though Y’s overhead is more than X’s overhead, but X does 20% of its work for Y, which is far more significant. Therefore deal with X first and then deal with Y, ignoring the work done by Y for X. Cost centre Overhead X Y A £’000 160 21 31 212 B £’000 250 27 71 348 X £’000 60 (60) – – Y £’000 90 12 (102) – Total £’000 560 – – 560 Remind the class how these apportionments have been made. For example, Y’s apportionment to A is (30/98) × 102. Now change the figures again and tell the class that the following will apply: Cost centre Overhead A £’000 160 B £’000 250 X £’000 60 Y £’000 90 A and B are production cost centres. X and Y are service cost centres. Benefit obtained from X is A 35%, B 45% and Y 20%. Benefit obtained from Y is A 20%, B 55% and X 25%. 74 Total £’000 560 More advanced aspects of costing for overheads The work done by X for Y, and by Y for X, is now significant, and neither should be ignored. Remind the class of the solution by repeated distribution/continuous allotment: Cost centre Overhead Apportion Apportion Apportion Apportion Apportion Y X Y X Y A £’000 160 18 29 3 1 – 211 B £’000 250 50 37 9 2 1 349 X £’000 60 22 (82) 4 (4) – – Y £’000 90 (90) 16 (16) 1 (1) – Total £’000 560 – – – – – 560 ▲ Now use the figures used for the last illustration to explain and illustrate the use of simultaneous equations. First, tell the class that the examiner might set a question with (say) 3 service departments, but only 2 of these will do work for each other. Therefore, there will only be two unknowns to deal with. Emphasise that because this is a mathematical solution, great care must be taken with plus and minus signs, so that accuracy is maintained. Begin by emphasising that, at the start, there are 2 unknowns: We don’t know the total overhead incurred by service department X, because it has to include some of the overhead of service department Y. Neither do we know the total overhead incurred by service department Y, because it has to include some of the overhead of service department X! First, give the unknowns a term or ‘label’. Use x to represent the total overhead incurred by service department X. Use y to represent the total overhead incurred by service department Y. We can then say that: x = £60,000 + 0.25y, and y = £90,000 + 0.20x Remind the class that this is saying, ‘We won’t know the total overhead of service department X until we have added 25% of the total overhead of service department Y’, and ‘We won’t know the total overhead of service department Y until we have added 20% of the total overhead of service department X’. If we re-arrange one of the equations – say the first – we have: -0.25y = £60,000 – x y = £90,000 + 0.20x Now, we can either multiply the first equation by 4 or multiply the second equation by 5. It doesn’t matter which. 75 Cost Accounting – Teacher’s Guide We will multiply the first equation by 4. -y = £240,000 – 4x y = £90,000 + 0.20x Explain that we can now add the equations so that y + (-y) = 0. This was why we chose to multiply the first equation by 4. So, adding the equations: 0 = £330,000 – 3.80x Therefore, 3.80x = £330,000 and = £86,842. x This is the total overhead of service department X. Therefore, since y = £90,000 + 0.20x, y must equal £90,000 + 0.20 (£86,842) = £107,368. The final apportionments, therefore, are: Cost centre Overhead Apportion X Apportion Y In £’000 A B X Y £ Total £ £ 160,000 250,000 60,000 £ 90,000 560,000 £ 30,395 39,079 (86,842) 17,368 – (107,368) 21,474 59,052 26,842 211,869 348,131 – – 560,000 – 212 348 – – 560 Point out to the class that this answer should be identical to that obtained from the use of continuous allotment/repeated distribution. The slight differences are due to rounding. ▲ Now take the class through Examples 1 and 2 on pages 211-215 of the textbook. Make sure that these examples, and others which you can easily devise, are worked through by the class using a blank sheet of paper. This topic is one that seems easy as it is taught, and when following examples in the textbook. However, mistakes are easily made under examination conditions. ▲ Finally in this lesson, point out that it may not be the actual costs incurred that are apportioned from a service department. Just like a production cost centre, a predetermined or budgeted rate can be used. Example 3 on pages 215-218 of the textbook was devised to illustrate this. Simultaneous equations are still used in this example. It is important that you work through it carefully with the class. 76 More advanced aspects of costing for overheads Reminders At the end of the lesson, re-state the main points again: Simultaneous equations are a way of dealing with inter- service department charges between two service departments. They offer an alternative method to continuous allotment/repeated distribution Care is needed in solving the equations, particularly with regard to signs. Pre-determined absorption rates can be used for service cost centres as well as for production cost centres. 77 Cost Accounting – Teacher’s Guide LESSON 20 Main subject More advanced aspects of costing for overheads Textbook reference Chapter 7: Page 210 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topic The use of normal capacity as a basis for overhead absorption and its effect upon the interpretation of under- and over-absorptions Extended syllabus reference 1.9 Understand and calculate the effect of absorbing production overheads on a normal hours basis rather than on a basis of budgeted hours 1.11 Explain the causes of under- or over-absorbed production overhead in terms of expenditure, volume and efficiency Required for Candidates for Third Level only Aims of the lesson • To explain the concept of normal capacity and how it relates to overhead absorption • To explain how under- or over-absorbed overhead can be analysed by cause The lesson ▲ Begin by reminding the class that any overhead absorption rate is calculated by expressing the budgeted production overhead in relation to a budgeted measure of output. For example, if the budgeted production overhead is £150,000 and the budgeted material cost is £20,000, then the absorption rate can be expressed as 750% on direct material. Alternatively, if the budgeted machine hours are 12,000, then the absorption rate can be expressed as £12.50 per machine hour. ▲ Now remind the class about principles of cost behaviour: Some overhead costs, such as the electricity that drives the machines, could be considered as variable – the more machine hours that are done, the more will be spent on electricity. No machine hours – no electricity cost. Electricity cost for 4,000 hours would be twice as much as the electricity cost for 2,000 hours. 78 More advanced aspects of costing for overheads On the other hand, some overhead costs, such as the supervisor’s salary, could be considered as fixed. The supervisor may be paid £18,000, whether 8,000 machine hours or 15,000 machine hours are worked. Now explain the importance of this distinction. First, suppose that all of the budgeted production overheads are considered to be variable. Further suppose that the absorption method to be used is the machine-hour-rate basis. Budgeted production overhead/budgeted machine hours = absorption rate Therefore: £150,000/12,000 = £12.50 per machine hour. Now ask the class what the absorption rate would be if the budget was reconsidered, and it was now thought that only 10,000 machine hours would be worked. The incorrect answer will often be given as £150,000/10,000 = £15.00 per machine hour. The correct answer is that it won’t change, because the budgeted production overhead will fall if the budgeted machine hours fall – because the costs are variable. £125,000/10,000 = £12.50 per machine hour. Now, suppose that all of the budgeted production overheads are considered to be fixed. Further, suppose that the absorption method to be used is still the machine hour rate basis. Budgeted production overhead/budgeted machine hours = absorption rate Therefore: £150,000/12,000 = £12.50 per machine hour. Now ask the class what the absorption rate would be if the budget was reconsidered and it was now thought that only 10,000 machine hours would be worked. This time the correct answer is £150,000/10,000 = £15.00 per machine hour. Point out that if the budget was revised upwards, say to 15,000 machine hours the rate would be £150,000/15,000 = £10.00 per machine hour. Now explain that this is particularly important when costing a product, or when estimating before quoting a price to a potential customer. ▲ Ask the class to consider a job which is estimated to have a prime cost per unit of £36.00 per unit, and which takes 4.5 machine hours to make. Point out that if the production overheads are all variable, it doesn’t matter whether the budget is set on 10,000 machine hours, 12,000 machine hours, or 15,000 machine hours. The rate per hour will always be £12.50 per machine hour, and the product cost will be: Prime cost Production overhead 4.5 × £12.50 Production cost £ 36.00 56.25 92.25 79 Cost Accounting – Teacher’s Guide Now show the class what happens if the budgeted production overheads are all fixed. There are now 3 different absorption rates, depending on whether the machine hours are expected to be 10,000, or 12,000 or 15,000. The absorption rate would then be £15.00, or £12.50 or £10.00 per machine hour. There would then be 3 possible product costs: Prime cost Production overhead: 4.5 hrs × £15.00 4.5 hrs × £12.50 4.5 hrs × £10.00 Production cost £ 36.00 £ 36.00 £ 36.00 67.50 56.25 103.50 92.25 45.00 81.00 Point out that the highest production cost is when the machine hours are expected to be low. This is the time when we would like to attract more work to increase machine hours. The danger is that, if the higher cost is allowed to influence the price that we quote to the customer, we may discourage orders. One way around this problem is to always set absorption rates on normal machine hours – a sort of average over a number of years. For example, we might always use 12,000 machine hours to set the absorption rate at £12.50 per machine hour, even though the budgeted machine hours for a particular year may be as low as 10,000 machine hours, or as high as 15,000 machine hours. Make sure that the class see the implications for budgeted under- or over- absorptions of production overhead. ▲ Take the class through pages 218-223 of the textbook, particularly working carefully through Example 4. ▲ In the final part of this lesson, give the class a better understanding of the causes of under- or over-absorbed production overheads. Use the following data: Normal machine hours Budgeted machine hours Budgeted production overheads: Variable Fixed Actual machine hours Actual production overheads: Variable Fixed 10,000 8,000 £ 28,000 20,000 9,100 £ 32,098 19,750 Tell the class that we are going to find the under- or over- absorbed overhead, and explain why it has occurred. 80 More advanced aspects of costing for overheads Remind them that the over- or under-absorbed overhead is found by comparing the actual overhead with the absorbed overhead – not by comparing the actual overhead with the budgeted overhead! The actual overhead is clearly £32,098 + £19,750 = £51,848. To get the absorbed overhead, we need an absorption rate. Ask the class what it would be. Some may say (£28,000 + £20,000)/8,000 = £6 per machine hour. This would be incorrect. Tell the class that when normal machine hours are provided, it gives the clue that fixed overheads are to be absorbed on this basis. The absorption rate is therefore (£28,000/8,000) + (£20,000/10,000) = £5.50 per machine hour. This could be split into £3.50 per hour for variable and £2.00 per hour for fixed. The absorbed overhead is then 9,100 + £5.50 = £50,050. This is compared with the actual overheads of £51,848 to get the under-absorption of £1,798. How much of this is due to overspending the overhead budget? The answer is that the variable overheads should have been 9,100 × £3.50 (£28,000/ 8,000) = £31,850. In fact it was £32,098, an overspending of £248. The fixed overheads should have been £20,000, but were £19,750 – an underspending of £250. Taking the variable and fixed together, there was an underspending of £2. Since the under-absorption was £1,798, £1,800 of this must be caused by a loss of output. Although the normal machine hours were 10,000, only 8,000 were budgeted. However, 9,100 were worked, 900 fewer than normal, which at £2 per hour is £1,800. This illustration will need to be carefully explained to the class. It is not an easy concept. They will need to consider each step slowly. ▲ Now take the class through pages 223-226 of the textbook, particularly noting Example 5. Reminders At the end of the lesson, re-state the main points again: Fixed overheads can distort absorption rates when output levels vary from year to year. Normal capacity is used as a basis for absorbing fixed overheads even though budgeted output may be more or less than this in a particular year. As a result of this there may be a budgeted under- or over-absorption of fixed overhead. If cost behaviour is considered it is possible to analyse the under- or overabsorption to its spending and volume parts. 81 Cost Accounting – Teacher’s Guide LESSON 21 Main subject More advanced aspects of costing for overheads Textbook reference Chapter 7: Page 210 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topic Activity Based Costing Extended syllabus reference 1.12 Calculate and apply absorption rates based upon ABC principles Required for Candidates for Third Level only Aim of the lesson • To describe the features of ABC and to explain the ways in which it might improve traditional absorption methods. The lesson ▲ Begin by looking at the CIMA definition of ABC on page 226 of the textbook. It is a long definition and needs to be explained a phrase at a time: ‘It . . . involves tracing resource consumption . . .’ is saying that we need to find out exactly where, and exactly why, resources are consumed. ‘Resources are assigned to activities . . .’ leads on from the first sentence, and is saying that distinct activities need to be matched with the resources used. For example, the traditional approach to overhead absorption might identify overhead with a particular cost centre, to be absorbed (for example) on a basis of process hours. But within that cost centre, there may be different distinct identifiable activities. For example, process preparation, processing, and process cleaning may be 3 distinct activities each of which consumes its own resources. ‘. . . and activities to cost objects based on consumption estimates.’ The cost of resources consumed by each activity must be related in the end to the ‘output’ which benefits from the existence of the activity. To do this, we must estimate the consumption level from the activity. For example, how many purchase orders will the purchasing function handle? ‘The latter utilise cost drivers to attach activity costs to output’ 82 More advanced aspects of costing for overheads To explain this, refer also to the CIMA definition of a cost driver, at the top of page 227 of the textbook. Put simply, what factor causes the cost of an activity to change? For example, would the cost of running a personnel department be increased by higher numbers employed in the company, or by higher labour turnover, or by the level of disputes, or by the amount of new labour legislation, etc.? The ABC definition is saying that the cost driver(s) for an activity are then related to the cost of the activity, to give a basis for charging outputs. For example, if the cost of a purchasing function is £200,000, and it is decided that the number of orders placed and progressed is the single cost driver for this cost, then the two can be linked by using the activity volume (say 10,000 orders) to give £20 per order. ▲ Take the class through Example 6 on pages 227-228 of the textbook. ▲ It is important to draw attention to the section at the top of page 229. The class must see ABC as just one of the ways that we constantly question the basis of cost accounting methods. Technological change is just one of the reasons that must make us ask if a different approach – e.g. to product costing – is needed. ▲ Example 7 is an important one, because it contrasts an absorption method using a single rate (although based upon both labour hours and machine hours) with absorption rates based upon cost drivers, for each pool. Make sure that the class understands the meaning of a ‘cost pool’. Reminders At the end of the lesson, re-state the main points again: Cost accounting methods and techniques cannot remain unchanged when so much change is taking place in technology, manufacturing methods, pressure of competition etc. ABC has evolved to provide an expanded way of looking at where costs are incurred, what causes them to be incurred, and how they should be reflected in the cost of a product or service. There are terms which must be understood. These are Activity Based Costing, cost driver, and cost pool. 83 Cost Accounting – Teacher’s Guide LESSON 22 Main subject Job, batch and contract costing Textbook reference Chapter 8: Page 237 Syllabus reference Second Level 5 Costing methods for specific orders – job (costing) Lesson topic Job costing Extended syllabus reference 5.1 5.2 Distinguish between job costing, batch costing and process costing Prepare a simple job cost Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the meaning of ‘job costing’ • To show how job costing relates to earlier lessons on material, labour and overhead costing • To show how job details are recorded in the costing system The lesson ▲ Begin by explaining that job costing is a subdivision of specific order costing. Jobs are completed to specific customer requirements. Each job will differ from other jobs, although a number of units might be made to complete a job. For example, customer A might order 1 unit of a particular product made specially for him, whereas Customer B might order 8 units of a product made specially for him. Often, the orders for all customers will be made in the same material, and using the same production facilities, but the jobs will be quite different. For example, a furniture maker will make all his products in wood. For all pieces of furniture made, he will use the same skills, techniques and equipment. But each job will be different, making one or a number of pieces of furniture to the design specified by the customer. Emphasise that each job must be identified, so that costs can be booked to it. Remind the class that this will be for prime costs – to book the materials used, the direct labour used on the job, and any direct expenses incurred. Overhead will be charged to the job using pre-determined absorption rates. Jobs are usually identified by a job number, allocated when the order is received. 84 Job, batch and contract costing ▲ Explain why the cost of a job is needed. The reasons are given on page 238 of the textbook. ▲ Candidates in the examination are often asked to calculate a job cost. Since this revises the work of material, labour and overhead costing, it would be sensible to do some calculations as part of this lesson: Tell the class that XT Ltd is a jobbing firm: Job number 2374 was produced in 2 cost centres. The order was for 8 units of the product. The hours booked to the order were 4 machine hours in cost centre X97 and 12 labour hours in cost centre X34. In X97 one labour hour is needed for each machine hour. The pre-determined production overhead absorption rates for the 2 cost centres are: Cost centre X97 £9.40 per machine hour Cost centre X34 £6.20 per direct labour hour Direct labour rates for X97 and X34 are £7.35 and £4.10 per hour respectively. Material is priced out on a weighted average basis. When the job was made the price was £3.90 per kilogram. 24 kilograms were issued at the start of the job. Ask the class to prepare the job cost for the 8 units. The answer should be: Job number 2374 8 units of product Material 24 kg × £3.90 Cost centre X97 Direct labour 4 hours × £7.35 Overhead 4 hours × £9.40 Cost centre X34 Direct labour 12 hours × £4.10 Overhead 12 hours × £6.20 Production cost Cost per unit £ 93.60 29.40 37.60 160.60 49.20 74.40 284.20 £35.525 Remind the class of the benefit of the presentation of the job cost in such a way that the £160.60 is brought out (the accumulated cost at the end of cost centre X97). Point out how these figures relate to the accounts in the costing system. The £284.20 is debited to work-in-progress. Ask the class where the corresponding credit will be. 85 Cost Accounting – Teacher’s Guide The answer is that the credit entries are in different places: The £93.60 will be credited to the material stock account. The £29.40 and the £49.20 will be credited to the wages control account. They are part of the payroll analysis. The £37.60 and the £74.40 will be credited to the production overhead account. These figures are part of the absorbed production overhead, which is always credited to the production overhead account and debited to work-in-progress. Now ask the class how the job cost would appear if, although 8 units were made, 1 unit was not up to standard, and was rejected, and scrapped. Only 90% of its material value can be recovered. The answer is: Job number 2374 8 units of product made Material 24 kg × £3.90 Cost centre X97 Direct labour 4 hours × £7.35 Overhead 4 hours × £9.40 £ 93.60 29.40 37.60 160.60 Cost centre X34 Direct labour 12 hours × £4.10 49.20 Overhead 12 hours × £6.20 74.40 Production cost 284.20 Less: Material cost recovered from 1 scrapped unit (£93.60/8) × 90% 10.53 273.67 Cost per good unit £39.096 The class must understand that the cost of each unit has risen from £35.525 to £39.096, because the net cost of the scrapped unit must be recovered on the 7 good units. The cost of the scrapped unit is £35.525 - £10.53 = £24.995. Therefore each of the 7 good units must carry £24.995/7 = £3.571 of additional cost. This makes £35.525 + £3.571 = £39.096, which agrees with the answer calculated above. Make sure that the class understands this way of looking at the costs incurred on the job. ▲ Point out the practical problems of job costing. The customer ordered 8 units. We now only have 7 available to deliver. This is always a problem. Should we have made 9 in the first place, so that when 1 was found to be below standard, we would still have had the 8 that the customer wanted? You will find this problem discussed in the Notes to the solution to Example 2, which begins on page 242 of the textbook. 86 Job, batch and contract costing ▲ Now refer the class to page 239 of the textbook. They must understand that the raw material stock account, the work-in-progress account, the finished stock account, and the production overhead account are all control accounts. So, for example, the work-in-progress account summarises all jobs in progress whether there are 3 or 1,003! As work on a job commences, the costs incurred will be added (debited) to the work-in-progress account. Only when the job is completed will those costs come out of work-in-progress and go to finished stock or, perhaps, straight to cost of sales. Explain that the examiner sometimes pretends that in a jobbing firm there are only (say) 3 jobs in progress, because this allows for an examination question of manageable size yet can still test knowledge and understanding. ▲ To end this lesson, use the following figures to illustrate the point just made: On 1 May, there were 3 jobs in progress. Up to that date, the following costs had been incurred: Job 1261 £’00 27 Job 1272 £’00 12 Job 1273 £’00 8 Job 1272 £’00 19 12 Job 1273 £’00 21 14 Costs incurred in May were: Job 1261 £’00 Materials 14 Direct labour 20 Job 1274 £’00 5 4 Production overhead is absorbed at 250% on direct labour. During May, Job number 1272 was completed and sent to the customer. Ask the class what the cost of each job is to date, or of the completed job in the case of Job number 1272. The answer is: Job 1261 £’00 27 Job 1272 £’00 12 Job 1273 £’00 8 Job 1274 £’00 14 20 50 111 19 12 30 73 21 14 35 78 5 4 10 19 Balance b/f May: Materials D Labour O/hd absorbed Finally, ask the class what the work-in-progress account will look like. Remind them that it is a control account and will not show the detail of individual jobs. Only total entries will appear. 87 Cost Accounting – Teacher’s Guide The correct answer is: Opening balance Materials Direct labour Absorbed overhead Work-in-progress £’00 47 Cost of sales 59 Closing balance 50 125 281 £’00 73 208 281 ▲ Now take the class through Examples 1 and 2 in the textbook. Reminders At the end of the lesson, re-state the main points again: Jobs are identified by job numbers. Job costs are calculated by adding actual prime cost details to absorbed overhead, using pre-determined absorption rates. Reject products present a particular problem in job costing. A distinction must be made between the cost of individual jobs and the total cost of all jobs which appears on control accounts in the costing system. 88 Job, batch and contract costing LESSON 23 Main subject Job, batch and contract costing Textbook reference Chapter 8: Page 237 Syllabus reference Second Level 5 Costing methods for specific orders – batch (costing) Lesson topic Batch costing Extended syllabus reference 5.1 5.3 Distinguish between job costing, batch costing and process costing Prepare a simple batch cost Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the meaning of ‘batch costing’ • To show how batch costing relates to earlier lessons on material, labour and overhead costing • To explain factors relevant to the batch size The lesson ▲ As with the preceding lesson, begin by pointing out that batch costing is a form of specific order costing. However: Units manufactured may not be identified with a particular job for a particular customer. The continuous aspect of production associated with process costing might not be present. Nevertheless, a firm might make a particular product in batches, which can then be put into stock and used to satisfy the demands of a number of customers. Two important considerations are: Fixed costs may be incurred specific to the batch, such as setting up machines ready for a production run. The larger the batch size, the more of the batch output will be carried in stock before use or sale. Point out that there are, therefore, features of batch production which are the same as those we met earlier, when trying to decide whether to purchase materials in larger quantities. 89 Cost Accounting – Teacher’s Guide ▲ Use the following data to illustrate your lesson: A company uses 6,000 components evenly over each year. These are made by the company in batches of 500 components and there are no rejections. Material costs for each batch are £1,500. However, in addition to this, material costing £200 is used in setting up the machine ready to produce the batch. This setting up also uses 5 labour hours which are charged at the labour-only rate of £10.00 per hour. To produce the batch takes 8 hours, and the combined labour and overhead rate is £18.00 per hour. Ask the class to calculate the cost of a batch, and the average cost per component. The answer is: £ Setting up machine: Material Labour 5 hours × £10 Production of the batch: Material Labour and overhead 8 hours × £18 Batch cost Average cost per component 200 50 1,500 144 1,894 £3.788 Point out that these components could be used in jobs made to customers’ requirements, so that in one business both job costing and batch costing could be in use. For the production of the components, each batch made will be given its own batch number, to which the costs incurred can be booked. Explain that in some businesses batch numbers are important because they are used to trace faulty components back to the batch in which they were made. Make sure the class can see that the setting costs are fixed to the batch, and that if we make the components in bigger batches than 500, this fixed cost per component will fall. Ask the class what the average cost per component would be if the batch size was doubled to 1,000. The answer is: £250 + (£1,644 × 2) = £3,538/1,000 = £3.538. Ask the class if this is a good idea. Hopefully – as a result of earlier lessons, and earlier comments which you made in this lesson – someone will mention stock-carrying costs. You can tell the class that stock-carrying costs are 10% per annum. Can the class attempt a solution? The annual saving would be 6,000 × (£3.788 - £3.538) = £1,500. 90 Job, batch and contract costing Another way of calculating this saving is to say that the fixed setting up costs of 6 batches would be saved, ie 6 × £250 = £1,500. The average stock for a batch of 500 would be 250 × £3.788 = £947, for which the annual stock-carrying costs would be £95. The average stock for a batch of 1,000 would be 500 × £3.538 = £1,769, for which the annual stock-carrying costs would be £177. Since £1,500 is greater than £82 (£177 – £95) the batch size of 1,000 would be worthwhile. ▲ Third Level students might like to apply the EOQ model to this example, to see if a further increase of the batch size is justified. ▲ Take the class carefully through Examples 3 and 4 on pages 245-248 of the textbook. Reminders At the end of the lesson, re-state the main points again: Batches are identified by batch numbers to which costs can be booked. Costs are expressed as an average cost per unit made in the batch. Batch production may give rise to fixed costs such as setting up costs, which means that optimal batch size calculations may be required. 91 Cost Accounting – Teacher’s Guide LESSON 24 Main subject Job, batch and contract costing Textbook reference Chapter 8: page 237 Syllabus reference Second Level 5 Costing methods for specific orders – contract (costing) Third Level 1 Further aspects of the Second Level Cost Accounting syllabus Lesson topic Contract costing Extended syllabus reference 5.1 5.13 5.14 5.15 5.16 Distinguish between job costing, batch costing and process costing Distinguish job costing from contract costing Prepare a simple contract account Appreciate the prudence approach to contract profits and losses Calculate the profit to be taken in an accounting period based upon an estimate of profits earned on completion of the contract. Balance sheet entries will not be required Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the circumstances in which contract costing is used • To explain the source of entries in the contract account • To explain how contract profit is determined The lesson ▲ If you are taking a Second Level class, point out that pages 254-262 in this chapter are for Third Level students only. ▲ Begin by explaining that contract costing is a specific order costing method, which was also true of job costing and batch costing. A contract can be thought of as a large job. For example, a garage may perform a service on a customer’s car. A job number would be issued to that customer’s service, and all parts used, and all of the mechanic’s time can be booked to that order. The job would probably be finished in 2 or 3 hours. 92 Job, batch and contract costing On the other hand, a builder may build a new swimming pool for a customer. He would ‘contract’ to do this, usually for a fixed contract price, and by a certain date. The completion of this contract may take 6 months. Some contracts will take much longer to complete, for example, building a motorway, or a new hotel, or a new airport. Explain to the class that there is a problem with long-term contracts. Because some of them may take years to complete, we won’t know whether or not a profit has been made until the contract is completed – or even later, if we have a responsibility to repair any faults that develop in (say) the first 2 years after completion of the contract. The problem is that if we undertake a contract that will take 4 years to complete, we can’t say that no profit is made for 3 years, and then suddenly a profit is made in Year 4. Tell the class that this is a problem that you will return to later in the lesson. ▲ Now explain some of the terms that are used in contract costing, and which appear in questions on this topic: 1 Contractor The business that will complete the contract. If XY Builders is the firm that will build a new school, then XY Builders is the contractor. 2 Contractee The customer who has asked for the work to be done is the contractee. 3 Contract price The amount that the contractee has agreed to pay the contractor for satisfactory completion of the work. 4 Site The location of the contract is called the contract site. Questions may refer to ‘site labour’ or to ‘materials delivered to the site’. 5 Progress payments Amounts of money paid to the contractor by the contractee as the contract proceeds. These are agreed in the contract terms. They are made because it is unreasonable to expect the contractor to pay for all costs of the contract, with no money coming in until the contract is completed – perhaps in 3 or 4 years’ time. 6 Work certified An old term. It just means that someone has to say how the contract is progressing, so that progress payments can be made. This will be done by an expert acting for the contractee. Questions may refer to the ‘architect’ or the ‘engineer’. 7 Retention money Even when the contract has been completed, part of the contract price may not be paid to the contractor. This balance may not be paid to the contractor for perhaps 2 years – until the contractee is satisfied that the work is good and no faults in the work have appeared. 93 Cost Accounting – Teacher’s Guide ▲ Now go through the 6 points on page 249 of the textbook. Particularly emphasise points 1, 2, and 3: There will be an account for each contract No profit will be taken on a recently started contract The profit we do take on an unfinished contract will be part of the profit we expect to make when the contract is finished. ▲ Now use this illustration: Budd Ltd is a building company. Its financial year end is 31 December. On 1 Jan Year 9 it started work on a contract for an agreed price of £850,000. The contract was given the number B1274. Contract costs were estimated at £800,000 and completion of the contract was expected by December. Budd Ltd completed the contract on 31 December Year 9. The contractee was completely satisfied with the work. Contract costs incurred amounted to £795,000. Show the class what the contract account would look like: Contract B1274 £ Costs incurred Contract profit £ 795,000 55,000 850,000 Contract price 850,000 850,000 Point out that some knowledge of double entry book-keeping is needed for this topic. Ask the class where the corresponding entry is for the debit of £795,000. They should recognise that the £795,000 will include the cost of all materials used, all labour paid and any other overheads incurred on the contract. For materials used, for example, the corresponding credit could be on suppliers’ accounts, or on stock accounts. It would be the latter if bricks, cement, etc, were purchased for central stock by the company, and then issued as required to various contract sites. Ask where the corresponding entry can be found for the £850,000 credit on the contract account. The answer is that it will be on the contractee’s account. The contractee’s account will be cleared when the contract price is paid. Ask where the corresponding entry can be found for the £55,000 debit on the contract account. The answer is, of course, that it is credited to the Profit and Loss Account. 94 Job, batch and contract costing ▲ Make sure that the class understands the following points: The £55,000 has been credited to the Profit and Loss Account for the year ended 31 December Year 9. This is acceptable because the contract has been completed (started and finished) within the financial year. We also know that ‘the contractee was completely satisfied with the work’, so there seems to be no reason to make any provision for future repairs to the work done. (However, prudence might suggest that we should do so – just in case!) Now ask the class what would have happened if the financial year end of Budd Ltd had been 31 March, and that by 31 March Year 9, £162,000 had been spent on the contract. The class should recognise that only 3 months’ work has been done on the contract, and that another 9 months’ work was expected. Only £162,000 had been spent, which is 20.25% of budgeted expenditure. It is too early in the contract to take any profit in the Profit and Loss Account for the year ended 31 March Year 9. All of the profit will be taken in the Profit and Loss Account for the year ended 31 March Year 10. ▲ Now take the class through Example 5 on pages 250-252 of the textbook. Emphasise, particularly, the way that central company overheads have been absorbed to each contract. ▲ Now tell the class that you are going to change the information for Budd Ltd slightly. Budd Ltd is a building company. Its financial year end is 31 December. On 1 Jan Year 9 it started work on a contract for an agreed price of £850,000. The contract was given the number B1274. Contract costs were estimated at £800,000 and completion of the contract was expected by March Year 10. Contract costs incurred up to 31 December Year 9 amounted to £654,000. The contractor estimated that £115,000 would be incurred in completing the contract. Completion date was now estimated as the end of February Year 10. The contractee’s representative assessed the contract as 85% complete on 31 December Year 9. How much profit should be taken into the Profit and Loss Account for the year ended 31 December Year 9? Point out to the class that the contract is expected to be completed early, and that costs are expected to be £654,000 + £115,000 = £769,000. This compares to estimated costs of £800,000. Point out that the contract seems to be going well, and the contractee’s representative considers it 85% complete. 95 Cost Accounting – Teacher’s Guide Contract price Estimated final contract costs Estimated final profit 85% of £81,000 £ 850,000 769,000 81,000 68,850 If the 85% had not been given, the calculation could have been done on a costs-todate/expected final costs basis, as follows: £654,000/£769,000 × £81,000 £68,887 Budd Ltd would probably round down to the nearest £’000, bringing £68,000 into the P & L account for Year 9. ▲ Now take the class carefully through Example 6. Remind the class about losses, referred to in Note 4 to the solution on page 254. ▲ If you are taking a Third Level class, you should also take the class through Example 9 on pages 259-262 in the textbook. Reminders At the end of the lesson, re-state the main points again: Contract costing is a form of specific order costing. Some book-keeping knowledge is required for this topic, as the preparation of accounts is usually required. Profits expected on a contract not yet completed, should only be taken when the contract is reasonably advanced. This is done by taking a proportion of the profits forecast on completion. 96 Continuous process costing (1) LESSON 25 Main subject Continuous process costing (1) Textbook reference Chapter 9: Page 268 Syllabus reference Costing methods for – continuous processes Lesson topics Process accounts and process statements Normal and abnormal losses and gains By-product treatment Extended syllabus reference 5.1 5.4 5.5 5.6 5.7 Distinguish between job costing, batch costing and process costing Prepare a process account or process statement Show the treatment of normal losses, abnormal losses and gains, and scrap values Understand the distinction between by-products and joint products Correctly treat by-products in the process in which they arise Required for Candidates for Second Level and Third Level Aim of the lesson • To explain process costing as a costing method, and to ensure that the students can record inputs to, and outputs from a process, and can place a value upon losses and gains arising from the process, and upon any by-product arising from the process. The lesson ▲ Begin by referring to the CIMA definition on page 268 of the textbook. Particularly emphasise the last sentence – costs are initially charged to the process, and costs are then averaged over the output. Illustrate this with the following: For the month of January, costs booked to Process X73 were: £ Materials 400 tonnes 108,000 Processing costs 68,700 176,700 70,680 sacks of finished product resulted from the process in January. 97 Cost Accounting – Teacher’s Guide (Don’t worry about debits and credits for the moment.) Ask the students where the figure of £108,000 would have come from. They should say that it is either the total of the invoices sent by suppliers for the materials delivered to the process for immediate use in production – just-in-time deliveries, or it is the total value of all the materials issued and priced from stock, where the material is carried in stock for a period before its use. This means that a pricing method must have been used such as FIFO, average, etc. to get the £108,000. Next ask the students what the £68,700 would be. They should describe the figure as conversion costs, including (direct) process labour as well as overheads. Some will have been allocated to the process, some apportioned. Ask for examples of each. Emphasise that the cost of the process for January is £176,700, and that it is important to know this. Then explain that this cost is averaged over the output of 70,680 sacks of product: £176,700/70,680 sacks = £2.50 per sack. Make sure the students understand that in process costing we do not try to find the cost of each individual sack of product. Many identical sacks are produced month after month, and it is sufficient to calculate the average cost per sack for a period. In this case the period is a month (January). It could be a week, or even 3 months. Contrast this with job costing where each job is different. The cost of many different jobs could not be averaged. The result would be meaningless. Similarly, contrast process costing with batch costing, which you have taught in an earlier lesson along with job costing. ▲ Now explain that the data can be presented in a process account or in a process statement: Materials Processing costs Process X73 account £ 108,000 Finished stock 68,700 176,700 £ 176,700 176,700 Explain how this process account conforms to normal debit and credit principles. Explain where the credits are for the debits to the process account, and where the debit is for the credit to the process account. The amount of explanation needed will depend on whether students have already studied the principles of book-keeping. Explain how a process statement is presented in vertical form, with credits shown in brackets. The solutions to Examples 1 and 2 on page 270 of the textbook can be used to illustrate the different presentations. Explain that quantity columns were not shown in the initial example for Process X73, because the quantities could not be balanced – it started with tonnes but finished with sacks. 98 Continuous process costing (1) Use the following figures as a class example. Process X Material issued 2,400 tonnes at a cost of £12,300. Process labour £1,700. Process overhead is to be absorbed at 480% on process labour. Process Y 2,400 tonnes transferred from Process X. 120 tonnes of new material added at a cost of £900. Process labour £1,400. Process overhead is to be absorbed at 380% on process labour. 2,520 tonnes of finished product was passed to the packing department. Ask the students to show (a) an account for each process and (b) a process statement. The solutions are: (a) accounts Material Process labour Overhead Tonnes 2,400 2,400 Trans. from X Material Process labour Overhead Tonnes 2,400 120 2,520 Process X £ Tonnes 12,300 2,400 1,700 8,160 22,160 2,400 Process Y £ Tonnes 22,160 2,520 900 1,400 5,320 29,780 2,520 Cost/tonne £9.233 £ 22,160 22,160 Cost/tonne £11.817 £ 29,780 29,780 99 Cost Accounting – Teacher’s Guide (b) as a process statement: Process X Tonnes Cost/tonne 2,400 Material Process labour Overhead 2,400 Additional material Process labour Overhead £9.233 Process Y Tonnes Cost/tonne 120 2,520 £11.817 £ 12,300 1,700 8,160 22,160 £ 900 1,400 5,320 29,780 Emphasise the strengths and weaknesses of each presentation. ▲ Now teach the treatment of losses in process accounts (or statements), whether normal or abnormal, and whether or not the losses have any value. This topic is on pages 269-274 of the textbook. Note that the £890 should be a credit entry to the first Abnormal gain account on page 274, and not a debit entry as printed. To introduce the topic, use the following figures: Process Z for January, Year 4 Materials used in the process: 1,200 litres at a cost of £9,600 Processing costs for the month: £16,008 Normal loss 3% of material input. The loss has no value. Show the Process Z account to the class: (a) If the good output is 1,164 litres Process Z Litres Material 1,200 Processing costs 1,200 £ 9,600 16,008 25,608 N Loss Output Litres 36 Cost/litre – 1,164 1,200 22.000 Emphasise that the £22.000 per litre has accounted for the normal loss. 100 £ – 25,608 25,608 Continuous process costing (1) (b) If the good output is 1,152 litres. Process Z Litres Material 1,200 Processing costs 1,200 £ 9,600 N Loss 16,008 Ab loss Output 25,608 Litres 36 Cost/litre – 12 1,152 1,200 22.000 22.000 £ – 264 25,344 25,608 Emphasise that the normal cost per litre, £22.000, must be calculated before the cost of the abnormal loss can be known. Make sure the students understand where the debit is located to record the abnormal loss of £264. Show them the abnormal loss account, and explain how the balance on that account is dealt with. (c) If the good output is 1,176 litres Process Z Material Processing costs Ab gain Litres 1,200 £ 9,600 12 1,212 16,008 264 25,872 N Loss Litres 36 Cost/litre – Output 1,176 22.000 1,212 £ – 25,872 25,872 Again, emphasise the importance of the normal cost per litre, as the starting point for the calculation of the abnormal gain. Show the students what the abnormal gain account would look like, and what would happen to the balance on that account. ▲ Explain that process losses might have a value. For example, perhaps the material can be sold as scrap, or as a ‘lesser product’ – a by-product. Refer to page 275 of the textbook to explain the nature of a by-product. You could ask the students to re-do the previous 3 illustrations, assuming that normal loss has a saleable value of (say) £3 per litre. This would be a useful exercise, particularly where the abnormal gain arises. NB The normal cost per litre will not now be a neat figure. It will be £21.907 correct to 3 decimal places. Now use the following example to illustrate these points: 101 Cost Accounting – Teacher’s Guide Process Z44 Materials used: 1,400 tonnes at a cost of £137,600 Processing costs: £89,984 Normal losses: 1% of input is lost and has no value. 2% of input is saleable as scrap for £20 per tonne. 5% of input is a by-product, saleable for £70 per tonne, after spending £10 per tonne on packing. Prepare a process statement Process Z44 Process statement for __________________ Tonnes £ Materials 1,400 137,600 Processing 89,984 227,584 Loss (14) – Scrap (28) (560) (70) (4,200) By-product 1,288 222,824 The final product has a cost per tonne of £222,824/1,288 = £173 per tonne. Reminders At the end of the lesson, re-state the main points again: The examiner might ask for a process account or for a process statement. It is important to establish the normal cost of production. Abnormal losses and abnormal gains can then be established by reference to normal output. Any value that a by-product might have is used to reduce the cost of the normal production. 102 Continuous process costing (1) LESSON 26 Main subject Continuous process costing (1) Textbook reference Chapter 9: Page 268 Syllabus reference Costing methods for – continuous processes Lesson topic Cost accounting for joint products Extended syllabus reference 5.8 5.9 Understand the arbitrary nature of joint cost apportionment Apportion joint costs on a basis of physical units, sales value, and net sales value 5.10 Interpret the results obtained from 5.9 5.11 Evaluate a simple further processing proposal Required for Candidates for Second Level and Third Level Aims of the lesson • To explain the nature of joint products, and the arbitrary nature of the apportionment of common or joint costs between the products. • To introduce the further processing decision, and show the effect of further processing costs upon the basis of common or joint cost apportionment. The lesson ▲ Begin by contrasting the definition of a by-product on page 269 of the textbook with that for a joint product on page 280. Explain that a process could produce 1 by-product and 1 main product, and that the by-product is a usefully saleable product accidentally produced in trying to produce the main product. Further explain that a process could produce two equally important main products, which are then called joint (main) products. Explain also that a product is labelled as a joint product or a by-product by reference to its sales value and not its quantity. Use Aye, Bee and Cee on page 280 to illustrate this. 103 Cost Accounting – Teacher’s Guide ▲ Now use the following examples to explain the principles of by-product and joint product costing to the students. Normal monthly input: 1,000 tonnes of material at a cost of £22,430 Normal monthly processing costs: £9,400 Normal output for one month: Main product RT, 800 tonnes saleable at £45 tonne By-product QS, 130 tonnes saleable at £11 tonne Loss in processing with no value: 70 tonnes. Show the process costs in the form of a process statement. Process statement Materials Processing costs Normal loss By-product QS Main product RT Tonnes 1,000 Cost/tonne 1,000 (70 ) (130) 800 £31.83 £11.00 £38.00 £ 22,430 9,400 31,830 –– (1,430) 30,400 Point out that the average input cost is £31.83 but the normal loss, and the low selling price of the by-product, push the cost of the main product up to £38.00. Ask the class how much profit is made by the process each month. The answer is (800 × £45) – £30,400 = £5,600. This example hasn’t illustrated joint product costing because there is only one main product, RT. Now tell the students that you are going to change the example a little. Let us make the output of 800 tonnes an output of two products, which are to be regarded as joint (main) products. These are: 300 tonnes of RT saleable at £60 per tonne, and 500 tonnes of MJ, saleable at £36 per tonne. All other figures remain the same. Ask the class how much profit the process would now make in one month. This would be: 300 tonnes of RT x £60 per tonne 500 tonnes of MJ x £36 per tonne Less net costs of process Profit £ 18,000 18,000 36,000 30,400 5,600 If any student has tried to work out the profit made by RT and MJ respectively, tell them that you didn’t ask for that – only for the process profit. 104 Continuous process costing (1) ▲ Now ask the students to imagine that, at the financial year end, there is a finished stock of 8 tonnes of RT and 2 tonnes of MJ. How should these be valued – for example, to include in stocks on the balance sheet? They cannot be valued at selling price, so now we do need a cost per tonne for each of the two products. Therefore the common or joint costs of £30,400 must somehow be apportioned over the two products. See if the class can suggest how this apportionment might be done. The two suggestions you want to hear are (1) based on the quantity of each product made, and (2) based on the value of the quantity of each product made: Quantity or physical units basis Total output is 800 tonnes, of which 300 tonnes is of RT and 500 tonnes is of MJ. Therefore the cost is apportioned: RT 300/800 × £30,400 = MJ 500/800 × £30,400 = £ 11,400 19,000 30,400 Point out that this means that the cost per tonne for both products is £38. Ask the class if this can be used for valuing the stocks referred to earlier. The answer is ‘Yes’ for RT which can be sold for £60 tonne, but ‘No’ for MJ which can only be sold for £36 tonne. The stock of MJ would have to be valued at £36 tonne i.e. at cost or net realisable value, whichever is the lower. Show the profit statement for a month: RT Sales Costs Profit/(Loss) £ 18,000 11,400 6,600 MJ £ 18,000 19,000 (1,000) Total £ 36,000 30,400 5,600 It is most important to ask the class what can be done about the loss making product MJ. The answer is nothing. One product cannot be made without the other. The important thing is that there is an overall profit. Value basis Make clear to the class that this is just a different way of apportioning the common, or joint, costs between the two products. It does not change the overall position. Both products generate total sales of £18,000 per month. Therefore the joint cost can be equally shared, £15,200 per product. This is £15,200/300 = £50.667 per tonne for RT and £15,200/500 = £30.40 per tonne for MJ. 105 Cost Accounting – Teacher’s Guide Emphasise that both of these figures could be used to value the stocks referred to earlier, because both costs are below the respective selling prices. Show the profit statement for the month: Sales Costs Profit RT MJ Total £ 18,000 15,200 2,800 £ 18,000 15,200 2,800 £ 36,000 30,400 5,600 Now ask the class why they imagine that product RT sells at a much higher price than MJ – £60 tonne compared with £36 tonne. They might suggest that market conditions are more favourable for RT. However, some might suggest that more work has to be done on RT before it can be sold. In other words, MJ is sold as it leaves the process in which RT and MJ are separated, whereas RT has to go into further processes to make it ready for sale. Explain to the class that if these further costs are a cause of the higher selling price for RT, then it is unfair to give RT a higher proportion of the joint costs on this basis. Therefore we use a theoretical net selling price at the point of separation. For example, suppose that after separation, £12 per tonne is spent in further processing RT to the point where it can be sold for £60 tonne. Explain that at the point of separation its theoretical net selling price is £48. Sales are then: RT 300 tonnes × £48 MJ 500 tonnes × £36 Joint costs are shared: RT 14,400/32,400 × £30,400 MJ 18,000/32,400 × £30,400 Cost per tonne: RT £13,511/300 MJ £16,889/500 Profit: RT £60 – (£45.037 + £12) = £2.963 × 300 = MJ £36 – £33.778 = £2.222 × 500 = £ 14,400 18,000 32,400 £ 13,511 16,889 30,400 £45.037 £33.778 £ 889 1,111 2,000 Get the class to compare the results from the two value-based approaches. Explain that the £2,000 is, of course, £5,600 less the additional processing cost of 300 tonnes × £12 tonne. 106 Continuous process costing (1) ▲ Finally explain that the theoretical net selling price of £48 need not be used if it is known that RT can be sold for £45 at the point of separation, or for £60 after further processing. The class can be asked, as an exercise, to re-apportion the joint costs using £45. Explain also, that this additional information proves the worth of further processing. This is because the additional cost is 300 × £12 = £3,600, but the additional revenue is 300 × (£60 – £45) which is £4,500. ▲ The class should carefully work through Examples 8 and 9 on pages 281-286 in the textbook. Reminders At the end of the lesson, re-state the main points again: The net benefit of a by-product is used to reduce the cost of the main product or products. Two or more main products are referred to as joint products. The material and processing costs incurred prior to the point of separation are called common or joint costs. These can be apportioned to joint products on a quantity basis or a value basis. The value basis uses selling prices which might be a theoretical net selling price at the point of separation. Both methods are arbitrary. The important point is whether the whole process is profitable. The test for further processing is whether the additional revenue exceeds the additional cost. 107 Cost Accounting – Teacher’s Guide LESSON 27 Main subject Continuous process costing (1) Textbook reference Chapter 9: Page 268 Syllabus reference Costing methods for – continuous processes Lesson topic Valuing work-in-process using equivalent units Extended syllabus reference 5.12 Use equivalent units to place a value upon work-in-process. Candidates should be able to use either a FIFO or an average approach to the opening stock. At Second Level only the first process will be examined in respect of workin-progress valuation Required for Candidates for Second Level and Third Level Aim of the lesson • To explain the nature of equivalent units and how they are used to place a value on unfinished work The lesson ▲ Explain that the terms work-in-process and work-in-progress can be used interchangeably. Explain that if £128,800 is spent on materials and processing costs, and 1,400 units of finished product result, then the cost per unit is £92. Ask the class what would happen if 1,400 units of finished product resulted, but that, in addition, there were 200 units of work-in-progress. Some might suggest re-calculating the unit cost as £128,800/(1,400 + 200) = £80.50 The finished output could then be valued at £112,700 and the work-in-process at £16,100. You should point out that this would be unfair, because it values unfinished work at the same cost per unit as finished work, i.e. £80.50. 108 Continuous process costing (1) You should also point out that work-in-progress can be ignored if it is insignificant in relation to the finished output. An example would be if finished output had been 1,400 units and work-in-progress had been 10 units. It can also be ignored if work-in-progress is always constant at the start and end of a period – for example, if processing is continuous, then at every month-end there may be 40 units in the course of processing. If £16,100 gives an unfair valuation to work-in-process, how could a fair valuation be obtained? Explain that we need to know the degree of completion of the work-in-progress. Are the units just started or nearly finished. Once this is known, the work-in-progress units can be expressed as equivalent finished units. Refer the class to the definition of equivalent units given on page 286 of the textbook. Emphasise the word ‘notional’. They are not real units. 600 real units 30% complete = 180 units 100% complete.This means that in the process there are 600 real unfinished units but, notionally, this is equivalent to 180 completed units. Now take the class carefully, step by step, through Examples 10 and 11 on pages 286288. ▲ Use the following new figures to illustrate the calculations: Process 1 for January There was no opening stock of work-in-process. 500 litres of material were put into process at a cost of £2,680. Processing costs for the month were £8,658. Normal loss is 4% of input, saleable at £2 per litre. Finished output was 410 litres. Work-in-process is 60 litres, 100% complete as to material and 40% processed. Prepare the Process account for January Remind the class of the 5 steps to an answer to a question of this kind, as listed at the bottom of page 289 in the textbook. Step 1 Materials Processing Process account – January Litres £ 500 2,680 Normal loss 8,658 Finished stock WIP Abnormal loss ooo 500 Litres 20 410 60 10 500 £ 40 Point out that the abnormal loss is the balancing quantity figure on the account i.e. 500 - (20 + 410 + 60). 109 Cost Accounting – Teacher’s Guide Step 2 Material equivalent units: 410 + 10 + (100% of 60) = 480 litres Processing equivalent units: 410 + 10 + (40% of 60) = 444 litres Step 3 Material (£2,680 - £40)/480 litres = £5.50 per litre Processing £8,658/444 litres = £19.50 per litre Therefore the total cost of a finished litre of product is £25. Step 4 Finished output 410 litres × £25 = £10,250 Abnormal loss 10 litres × £25 = £250 WIP (60 litres × £5.50) + (24 litres × £19.50) = £798 Step 5 Materials Processing Process account – January £ 2,680 Normal loss 8,658 Finished stock WIP Abnormal loss 500 11,338 Litres 500 Litres 20 410 60 10 500 £ 40 10,250 798 250 11,338 Ask the class where the corresponding entries are for each entry in the process account: Materials £2,680: Credited to Material stock account, or to Supplier’s account for justin-time deliveries Processing £8,658: Various sources e.g. payroll analysis, cash book, suppliers’ accounts, material stock, etc. Normal loss £40: Debited to the normal loss account. This account will then be credited with the proceeds of the sale of the material. Finished stock £10,250: Debited to the finished stock account ready for sale WIP £798: Carried down as a debit balance on the Process account to be the opening WIP for February Abnormal loss £250: Debited to the abnormal loss account. This account will be credited with any proceeds from the sale of the abnormally lost material. The net balance will then be debited to the profit and loss account. Take the class through Example 12 on pages 289-291 of the textbook. 110 Continuous process costing (1) ▲ Now explain that you are going to show the class how to deal with an opening stock of work-inprocess. Remind them that there was no opening stock in January so the problem didn’t arise. However, the closing work-in-process for January must automatically become the opening work-in-process for February. Give the class the figures you are going to use for February: Opening WIP: 60 litres, 100% for material, and 40% processed, valued at £798 550 litres of material were put into the process at a cost of £2,948. Processing costs were £9,450. Normal loss is 4% of new input, saleable at £2 litre. Finished output 508 litres. Work-in-process, 80 litres, 100% complete as to materials and 70% processed Before continuing with your illustration, explain the alternative views of the opening workin-process, as explained at the bottom of page 291 and the top of 292 of the textbook. The FIFO assumption would be that the 60 litres of work-in-process has been finished and is included in the 508 litres of finished output. The average assumption says this might not be the case. The 60 litres of work-inprogress at the start of February might still be included in the 80 litres of work-inprogress at the end of February. Therefore it would be sensible to average the costs. ▲ Tell the class that you are going to illustrate the FIFO principle first. Step 1 Op WIP Material Processing Process account – February Litres £ 60 798 Normal loss 550 2,948 Finished stock 9,450 Cl WIP 610 13,196 Litres 22 508 80 610 £ 44 13,196 Step 2 This is the step that you should take particular care to explain. It deals with the completion of the opening stock, and its separation from units entirely made in February. Material (508 litres - 60 litres) + (80 litres × 100%) = 528 litres Processing (508 litres - 60 litres) + (60 litres × 60%) + (80 litres × 70%) = 540 litres Step 3 Material (£2,948 - £44)/528 litres = £5.50 per litre. Point out to the class that this is the same as the material cost in January. Processing £9,450/540 litres = £17.50 Point out to the class that processing has been cheaper in February than in January – £17.50 per litre compared with £19.50 per litre. 111 Cost Accounting – Teacher’s Guide Step 4 Ask the class to note particularly how the transfer to finished stock is valued when using the FIFO approach. Do this first. Finished stock (448 litres × £23) + £798 + (36 litres × £17.50) = £11,732 WIP (80 litres × £5.50) + (56 litres × £17.50) = £1,420. Step 5 Op WIP Material Processing Process account – February Litres £ 60 798 Normal loss 550 2,948 Finished stock 9,450 Cl WIP 610 13,196 Litres 22 508 80 610 £ 44 11,732 1,420 13,196 To confirm that the class understands the FIFO approach, take the students through Example 13 on pages 292-295 in the textbook. ▲ Now tell the class that you are going to illustrate the average cost approach. Emphasise that this can only be done if the opening stock value is given by the examiner in its component parts. In this case we do know the component parts because of our earlier calculations – the £798 comprised £330 for materials and £468 for processing. Show the calculation of the average costs per unit: Material (£330 + £2,948 - £44)/(508 litres + 80 litres) = £5.50 Processing (£468 + £9,450)/(508 litres + 56 litres) = £17.585 Explain that the material cost remains at £5.50 because the material cost for January and for February was the same – £5.50 per litre. Value the output: Finished stock 508 × (£5.50 + £17.585) = £11,727 WIP (80 litres × £5.50) + (56 litres × £17.585) = £1,425 Now complete the process account: Op WIP Material Processing Process account – February Litres £ 60 798 Normal loss 550 2,948 Finished stock 9,450 Cl WIP 610 13,196 Litres 22 508 80 610 £ 44 11,727 1,425 13,196 To confirm that the class understands the average approach, take the students through Example 14 on pages 295-297 in the textbook. 112 Continuous process costing (1) Reminders At the end of the lesson, re-state the main points again: Equivalent units are used to apportion actual costs between completed output and work-in-process. Equivalent units are notional, not real, units. There are 5 steps to be taken. (Remind the class of what they are.) Opening work-in-process can be treated on a FIFO basis. This method clearly separates the costs of the current period from those brought down from the previous period. Alternatively, an average cost approach can be taken, in which the costs brought down from the previous period and those of the current period are averaged. 113 Cost Accounting – Teacher’s Guide LESSON 28 Main subject Continuous process costing (2) Textbook reference Chapter 10: Page 303 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topic Joint cost apportionment Extended syllabus reference 1.13 Apportion joint process costs using physical units as the basis for the variable costs and contribution as the basis for the fixed costs Required for Candidates for Third Level only Aim of the lesson • To explain the use of contribution for joint cost apportionment The lesson ▲ Begin by emphasising the work done in Lesson 26 as a foundation for this Lesson. The relevant sections of Chapter 9 in the textbook must also be understood before coming to this lesson. Point out the basic principles: 1 Any apportionment method is arbitrary. There can be no ‘accurate’ way of sharing common or pre-separation costs. 2 The profitability of individual products arising in a common or joint process cannot be ‘accurately’ assessed. Only the whole process and its total output can be assessed. 3 Products arising from a joint process can be looked at individually, only when each has separated from the other products. Further point out that although many of the principles of by-product and joint product costing have been set out in a previous lesson (Lesson 26/Chapter 9), Third Level students must be able to apply the principles to more difficult questions. 114 Continuous process costing (2) ▲ Remind the class that they have already studied joint cost apportionment based upon (1) physical units and (2) Sales value or net sales value. Tell the class that you are now going to illustrate and explain a third method, which will be done in 2 parts. First, the variable costs of the common or joint process will be apportioned between the joint products on a physical units basis. Second, the contribution from each product can then be determined, and used to apportion the fixed costs of the common or joint process. Explain that you are using the terms ‘variable costs’ and ‘fixed costs’ as they were explained in an earlier lesson which introduced cost behaviour. For example, the cost of material introduced to the process is clearly a variable cost. If material input is doubled, its cost is doubled – and output from the process will double. On the other hand, the depreciation cost for the process might be a fixed cost – unaffected in total by the rise and fall in the amount of material processed Now explain that you have also used the term ‘contribution’. Members of the class who have already passed the Second Level examination will recognise this term, but any member of the class who has not previously studied for Second Level may not recognise it. Explain that it will be dealt with in more detail when Chapter 11 is considered, but that for now it is sufficient to define it as Sales value minus the variable cost of sales. ▲ Continue your lesson using the following figures. Process 1 Material introduced, 1,000 tonnes Processing costs – Variable Fixed £ 138,000 49,000 63,000 250,000 Halfway through processing, 400 litres of a by-product is drawn from the process, and this is sold at £100 per litre. At the end of the process, the normal output from 1,000 tonnes of input is 400 tonnes of JX1 and 300 tonnes of JX2. These products are regarded as joint products and are sold immediately on leaving the process for £360 per tonne for JX1 and £480 per tonne for JX2. Before illustrating the new method, ask the class to calculate the profit made by each product, using the methods they are familiar with: physical units basis and sales value basis. 115 Cost Accounting – Teacher’s Guide Physical units basis Joint costs Less by-product sales Net cost Output Cost per tonne Profit JX1 (400 × £360) – (400 × £300) = JX2 (300 × £480) – (300 × £300) = £ 250,000 40,000 210,000 700 tonnes £300 £ 24,000 54,000 78,000 Sales value basis Joint net costs (as before) Sales value JX1 400 × £360 JX2 300 × £480 £ 210,000 144,000 144,000 288,000 Therefore, since the total sales value of each product is the same, the joint costs are shared equally. Profit JX1 (400 × £360) – £105,000 JX2 (300 × £480) – £105,000 £ 39,000 39,000 78,000 Remind the class that the total profit is £78,000, and this could have been calculated: (400 × £360) + (300 × £480) – £210,000 Point out that the apportionment of cost to product, to get individual product profits, is an arbitrary exercise. ▲ Now illustrate the third method: First, what are the variable costs? They are £138,000 + £49,000 – £40,000 = £147,000 Explain to the class that the by-product income is treated as variable, because the more materials that are processed, the greater the number of by-products that should arise from the process. These variable costs are to be apportioned on a physical units basis. Therefore £147,000/ 700 tonnes = £210 per tonne. 116 Continuous process costing (2) This allows for the calculation of the total contribution earned by each product: JX1 (400 × £360) – (400 × £210) = JX2 (300 × £480) – (300 × £210) = £ 60,000 81,000 141,000 Finally, the fixed costs of £63,000 are apportioned in proportion to these contributions: JX1 60,000/141,000 × 63,000 JX2 81,000/141,000 × 63,000 £ 26,809 36,191 63,000 The profits can now be calculated: JX1 £60,000 – £26,809 = JX2 £81,000 – £36,191 = £ 33,191 44,809 78,000 Point out again that the overall profit is still £78,000, but that there are now 3 possible answers to the question: ‘How much profit has each product made?’ Encourage the class to discuss what the figures mean, and whether any one method produces the ‘correct’ result so that, therefore, the other 2 methods produce an ‘incorrect’ result. You will need to carefully control this discussion. ▲ Now take your lesson a step further. Tell the class that in addition to the data already provided, we are now told that whilst Product JX1 is sold immediately on leaving the joint process, Product JX2 is further processed at a cost of £20 per tonne of input. During further processing, 10% of the input weight is lost and has no value. The selling price of JX2 after further processing is £550 per tonne. Tell the class that we want to reconsider the apportionment of joint costs using the new method taught in this lesson. It would be wrong to use £360 a tonne for JX1 and £550 per tonne for JX2 as the basis of apportioning pre-separation costs, if the selling price of the latter is higher than that for JX1 – partly because it is further processed. The 300 tonnes of JX2 that leaves the common process becomes 270 tonnes of saleable product. This is sold for 270 × £550 = £148,500. However, this is after incurring further processing costs of 300 × £20 = £6,000. The theoretical net sales value of 300 tonnes of JX2 at the point of separation is therefore £148,500 – £6,000 = £142,500. 117 Cost Accounting – Teacher’s Guide The contribution for each product is then: JX1 £144,000 – (400 × £210) = JX2 £142,500 – (300 × £210) = £ 60,000 79,500 139,500 The fixed costs are then apportioned: JX1 (60,000/139,500) × £63,000 = JX2 (79,500/139,500) × £63,000 = £ 27,097 35,903 63,000 The profits then are: £ JX1 144,000 – (84,000 + 27,097) = 32,903 JX2 148,500 – (63,000 + 35,903 + 6,000) = 43,597 76,500 ▲ Now take the class through Examples 1, 2, and 3 on pages 304-312 of the textbook. Example 2 is particularly important because it shows how, at Third Level, topics can be combined in one question. The question is about joint products that are processed after the separation point. However, the further processing costs are not given, but have to be calculated, using equivalent units. Example 3 is similar to the question used in this lesson. Losses are incurred after the separation point. However, again, the further processing costs have to be calculated. You are advised to make sure that the class gives adequate time to working through and understanding these 3 Examples. Reminders At the end of the lesson, re-state the main points again: All joint cost apportionment methods are quite arbitrary. Because of this, the product costs and product profits arrived at by this process must be treated with care. The overall profit from the process is the only valid figure for assessing the profitability of joint product manufacture. Only after products have separated, can costs sensibly be attributed to individual products. 118 Continuous process costing (2) LESSON 29 Main subject Continuous process costing (2) Textbook reference Chapter 10: Page 303 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topic The further processing decision Extended syllabus reference Third Level 3.19 Use marginal costing to evaluate proposals Required for Candidates for Third Level only Aim of the lesson • To explain and illustrate how a further processing proposal should be evaluated The lesson ▲ Begin by pointing out that the extended syllabus reference comes under the heading ‘Marginal costing’. It says ‘Use marginal costing to evaluate proposals’ Tell the class that much more will be considered under this heading when Chapters 11, 12 and 13 are looked at later. Further processing is looked at here specifically in the context of process costing. Remind the class that an understanding of further processing does require a basic knowledge of cost behaviour – the distinction between variable and fixed costs. This was looked at in an earlier Lesson when classification of costs was considered, and classification by cost behaviour was suggested as a possible classification. Explain that the term ‘further processing’ implies that there is a choice between processing material only to condition A, and doing some more work on it to take it to condition B. The options must be evaluated by comparing the costs incurred to reach condition B rather than condition A, with the benefits of having the material in condition B instead of condition A. 119 Cost Accounting – Teacher’s Guide At its simplest: 20 kilograms of material costs £100. It costs £30 to process it to condition A, in which it sold for £145. There is no loss in processing. The same material can be processed beyond condition A to condition B for an extra £20. It can then be sold for £173. There is still no loss of material in processing. The increase in revenue is £173 – £145 = £28. The increase in cost is £20. It is worth processing the material to condition B. This has been answered by first calculating the extra revenue. This is £28, and we call this the marginal revenue (i.e. the extra revenue). The extra cost is given as £20. This is called the marginal cost (i.e. the extra cost). The difference, £8, is the extra profit we will make. This is generally the best approach to further processing questions, but point out that another approach is to look at each total position separately: Present sales Present costs Present profit £ 145 130 15 Proposed sales Proposed costs Proposed profit 173 150 23 Therefore the profit for the proposal is £8 more. This approach gives the same answer. Emphasise that generally it wastes some time. ▲ Point out that one thing that made this introductory example easy, was that the additional processing did not cause any loss of the material being processed. The 20 kg remained 20 kg. Take the class through Examples 4 and 5 on pages 313-314 of the textbook. Example 5 explains how lost material affects the problem. Use the following data to illustrate how losses in further processing are dealt with in a more detailed question: Each year a company processes 15,000 tonnes of material X in batches of 500 tonnes. Material X costs £160 per tonne. It takes 80 hours to process each batch in Process 19. Processing costs are £240 per hour. From each batch, processing results in 50 tonnes of worthless residue, which must be safely disposed of at a cost of £2,050. 450 tonnes of Product PR3 are also produced and can be sold for £260 per tonne. 120 Continuous process costing (2) Two proposals are now being considered: 1 The residue could be re-processed by another company at a cost of £48 per tonne. Each 50 tonnes would yield 38 tonnes of material X, which could be used again in the process. 2 Product PR3 could be further processed in Process 23 to make PR4. Each 450 tonnes from Process 19 would be passed through Process 23. It would take 40 hours and the hourly rate for Process 23 is £170 per hour. This includes £90 per hour for the absorption of fixed process overheads, although no additional fixed overheads would be incurred. Process 23 has been underutilised for some time. 10 tonnes would be lost, and the remaining 440 tonnes of PR4 could be sold for £280 per tonne. Advise the management on these 2 proposals Explain to the class that because the question just says ‘Advise the management ...’ it would be up to the candidate to decide the best approach. This is something you may wish to discuss with the class. You should also point out that in this case, the proposals are unrelated: The company can continue to sell Product PR3 and can continue to dispose of the residue or The company can continue to sell Product PR3 and can send the residue for reprocessing or The company can further process PR3 to make and sell PR4, and can continue to dispose of the residue or The company can further process PR3 to make and sell PR4, and can send the residue for re-processing. ▲ Before continuing, make sure that the class understands each alternative open to the company. Emphasise that at Third Level the approach taken by the candidate must be clear to the examiner. This is because there are often a number of equally acceptable ways to the answer, and the examiner needs to be sure of the candidate’s reasoning. Unfortunately, different acceptable approaches are often made unacceptable because they are mixed up! 121 Cost Accounting – Teacher’s Guide ▲ One approach to the question is to look at a year’s output: 15,000 tonnes = 30 batches of 500 tonnes. Material 15,000 tonnes × £160 Processing: 80 hours × £240 × 30 batches Disposal of residue 30 × £2,050 Sales 450 × 30 × £260 Present annual profit £ 2,400,000 576,000 61,500 3,037,500 3,510,000 472,500 Point out that others may look at one batch, because then figures are smaller, and less prone to error as a result: Material 500 tonnes × £160 Processing: 80 hours × £240 Disposal of residue Sales 450 × £260 Present batch profit £ 80,000 19,200 2,050 101,250 117,000 15,750 £15,750 × 30 = £472,500, which agrees with the answer calculated on an annual basis. ▲ Continuing with the batch approach, what would the profit be if the residue were recycled? Each batch produces 50 tonnes of residue which can be re-processed to give 38 tonnes of material X. Explain that to obtain this, we have to pay another company 50 × £48 = £2,400. Tell the class that the revised profit statement is: Material 462 tonnes × £160 Material 38 tonnes 500 Processing: 80 hours × £240 Sales 450 × £260 Proposed batch profit £ 73,920 2,400 76,320 19,200 95,520 117,000 21,480 Point out that if the residue is re-processed, the batch profit rises from £15,750 to £21,480, an increase of £5,730. This means that we can recommend the proposal to re-process the residue. 122 Continuous process costing (2) ▲ Now explain that there is a quicker approach, which does not require the preparation of 2 profit statements – either for a batch or for a year. The quicker approach just looks at the things that change. £ Additional costs 50 tonnes × £48 = 2,400 Savings Disposal costs not paid Material that won’t have to be bought 38 tonnes × £160 2,050 6,080 8,130 Net savings 5,730 Point out to the class that this is the same as the difference between the 2 profit statements. ▲ Apply the same approaches to the proposal to further process PR3 into PR4: Use the profit statement approach first. The class should be able to do this one for you! The present position is the same, of course, giving a profit of £15,750. The revised profit statement will be: £ Material 500 tonnes × £160 Processing: Process 19 80 hours × £240 Disposal of residue Processing: Process 23 40 hours × £80 (£170 – £90) Sales 440 × £280 Proposed batch profit 80,000 19,200 2,050 3,200 104,450 123,200 18,750 Point out that if PR3 is further processed to give PR4, the batch profit rises from £15,750 to £18,750 – an increase of £3,000. This means that we can recommend the proposal to further process PR3. Remind the class that there is a quicker approach, which does not require the preparation of 2 profit statements – either for a batch or for a year. This quicker approach just looks at the things that change. 123 Cost Accounting – Teacher’s Guide Proposed sales 440 × £280 Present sales 450 × £260 Extra income Extra cost 40 hours × £80 hour (£170 – £90) Extra profit per batch £ 123,200 117,000 6,200 3,200 3,000 Again, emphasise that this agrees with the £3,000 difference between the 2 profit statements, but has been obtained by a quicker and neater approach. Point out that £80 per hour has been used to get the extra processing cost in process 23. The fixed costs are not included because there will be no increase in fixed costs and because the process is under-utilised. ▲ Finally, take the class carefully through Example 6 on pages 314-317 of the textbook Reminders At the end of the lesson, re-state the main points again: Further processing proposals are evaluated by comparing the additional revenue that will arise with the additional costs of obtaining it. Because there are often different ways of presenting the figures, the candidate’s approach should always be made clear to the examiner. 124 Continuous process costing (2) LESSON 30 Main subject Continuous process costing (2) Textbook reference Chapter 10: Page 303 Syllabus reference Third Level Further aspects of the Second Level Cost Accounting syllabus Lesson topic Stock valuations for later processes, using equivalent units Extended syllabus reference Third Level 1.14 Value completed production and work-in-process using equivalent units, and using a FIFO or average approach to the flow of costs. Candidates could be asked to prepare an account or a statement for the first process or any subsequent process Required for Candidates for Third Level only Aim of the lesson • To explain how equivalent units are used for valuing stock in any process which has a preceding process. The lesson ▲ Begin by reminding the class that they have previously been taught how to use equivalent units in a single process or in Process 1 where other processes follow. Remind them also that 2 approaches were shown – one that used a FIFO approach and one that used an average cost approach. Take the class through Example 7 on pages 317-320 of the textbook as a reminder of these principles. 125 Cost Accounting – Teacher’s Guide ▲ Now explain that you are going to introduce successive processes – a sequence of processes through which the work passes to completion. Begin by clarifying 2 terms that often confuse students: 1 Previous or preceding period This is concerned with the calendar. If equivalent units are used to give a value of £2,367 to work-in-process at 31 March Year 6, that is the closing stock value for March. Remind the class that £2,367 is also the opening stock value for April. The use of the FIFO approach to stock valuation assumes that work that is in process at the end of March will be the first to be completed in April, and passed to the next process, or to finished stock. March is therefore the period that precedes April. If a product is made in a single process, there will always be a period which precedes the current period. If the examiner asks for the Process account for the month of July (as in Example 7 on page 317), then we must ask what has been brought forward from June, because that is the preceding period. The answer is 80 tonnes 30% complete, and valued at £11,616. 2 Previous or preceding process One or more products may be made by a succession of processes. These may be continuous. This means that the material is introduced at the start of processing and automatically passes through a number of stages before emerging as a finished product. Although continuous, each ‘stage’ may be regarded as a distinct process. On the other hand the part-processed product may be removed at the end of each process, and later introduced to the next process. If there are 3 distinct stages, they may be called Process 1, Process 2 and Process 3. Process 1 is the previous or preceding process to Process 2. Process 2 is the previous or preceding process to Process 3 Emphasise that this means that any work that is still in process in Process 3 at the end of a period, must nevertheless be fully complete in respect of the work done in Processes 1 and 2. If it isn’t, then what is it doing in Process 3? ▲ Make these important distinctions clear with the following: A product is made in 2 consecutive processes, A and B On 1 January Year 4 the following was the work-in-process: Process A 400 tonnes, fully complete for materials, and 30% processed. It carried a value of £10,900. Process B 700 tonnes, fully complete for materials, and 45% processed. It carried a value of £28,600. 126 Continuous process costing (2) In both cases, the preceding period is December of Year 3. Processing of the 400 tonnes of work-in-process in Process A was certainly started before 1 January Year 4, sometime in Year 3. This is also true of the 700 tonnes in Process B. There is no preceding process to Process A. Process A is the first process. Process A is the preceding process to Process B. Therefore any work that is in, or has passed through, Process B, must have previously passed through Process A. Because of this, the valuation of the work-in-process in Process B, £28,600, must include cost to reflect the work done in Process A. ▲ Use the following data to illustrate your lesson: A chemical product is made in 2 consecutive processes, A and B. Process A precedes process B. Process A At 1 January: Work-in-process was 1,200 litres, 100% complete in respect of materials, and 30% processed It carried a cost of £3,732. During January: 48,000 litres of material, costing £121,680, were put into the process. Processing costs were £77,452. 42,000 litres were transferred to Process B. 1,200 litres were lost in processing, but this was considered normal. At 31 January: Work-in-process was 5,200 litres, 100% complete in respect of material and 60% processed. Process B At 1 January: Work-in-process was 2,700 litres, 40% processed. It carried a cost of £9,840. During January: 42,000 litres were received from Process A. At the start of processing, 14,000 litres of material were added at a cost of £14,000. 51,000 litres of finished chemical product were transferred to finished stock. There were no losses, either normal or abnormal in this process. Processing costs were £66,834. At 31 January: Work-in-progress was 75% processed. 127 Cost Accounting – Teacher’s Guide Because Process A has no previous process, you may want to ask the class to do Process A themselves. If, however, you decide to work it through with them, it will give you the opportunity to revise key points, such as: balance the physical units (litres) to detect losses, and start to prepare the process account or statement: WIP Material Processing Process A account – January Litres £ 1,200 3,732 Normal loss 48,000 121,680 Process B 77,452 WIP Abnormal loss 49,200 Litres 1,200 42,000 5,200 800 49,200 £ – Point out that the abnormal loss was not mentioned in the question. It was detected by balancing the input and output of litres. Now take the class through the calculation of the equivalent units. You can use the table format as illustrated in an earlier lesson and in the textbook. The competent student can do it as follows: Material equivalent units: Remind the class that we are using FIFO because the opening stock value has been given as one figure. (42,000 – 1,200) + 5,200 + 800 = 46,800 litres Processing equivalent units: (42,000 – 1,200) + (70% of 1,200) + (60% of 5,200) + 800 = 45,560 litres Now calculate the cost per equivalent unit: Materials £121,680/46,800 litres = £2.60 per equivalent litre Processing £77,452/45,560 litres = £1.70 per equivalent litre Total cost = £2.60 + £1.70 = £4.30 per equivalent litre Now value the items for the completion of the Process account: Process B (40,800 × £4.30) + (840 × £1.70) + £3,732 = £180,600 Abnormal loss 800 × £4.30 = £3,440 WIP (5,200 × £2.60) + (3,120 × £1.70) = £18,824 128 Continuous process costing (2) Now complete the Process A account or statement. WIP Material Processing Process A account – January Litres £ 1,200 3,732 Normal loss 48,000 121,680 Process B 77,452 WIP Abnormal loss 49,200 202,864 Litres 1,200 42,000 5,200 800 49,200 £ – 180,600 18,824 3,440 202,864 ▲ Remind the class that, next, we have to do the account for Process B. For this process there is both a previous period (the opening WIP was started before 1 January), and a previous process (any work that has passed through or is still in, Process B must have already passed through Process A). Tell the class that the answer starts in exactly the same way as for Process A. The account must be prepared as far as possible, and any losses or any other missing figure, detected. Process B account – January Litres £ Litres WIP 2,700 9,840 Finished stock From Process A 42,000 180,600 WIP Material added 14,000 14,000 Processing 66,834 58,700 271,274 £ 51,000 7,700 58,700 271,274 Remind the class that the WIP figure of 7,700 litres is detected as the balancing figure, because we are told that no losses of any kind have occurred. Point out, in addition, that the new material is added as processing starts in Process B. Therefore the opening WIP must already have been diluted with new material prior to 1 January i.e. in the previous period. Now take the class through the calculation of the equivalent units. They can be set out in a table as shown on page 322 of the textbook, or can be calculated as we did earlier for Process A: Input from Process A equivalent units: (51,000 – 2,700) + 7,700 = 56,000 equivalent litres. Point out that this is the calculation that ensures that the output from Process B will bear cost for the work done in Process A. Process B equivalent units: Material added equivalent units: (51,000 – 2,700) + 7,700 = 56,000 equivalent litres Processing equivalent units: (51,000 – 2,700) + (60% × 2,700) + (75% of 7,700) = 55,695 equivalent litres 129 Cost Accounting – Teacher’s Guide Now calculate the cost per equivalent unit: Input from Process A cost £180,600/56,000 = £3.225 per equivalent litre Process B: Material added cost £14,000/56,000 = £0.25 per equivalent litre Processing £66,834/55,695 = £1.20 per equivalent litre Total cost = £3.225 + £0.25 + £1.20 = £4.675 per equivalent litre Now value the items for the completion of the Process account: Finished stock (48,300 × £4,675) + (60% × 2,700 × £1.20) + £9,840 = £237,586.5 (say £237,587) WIP (7,700 × £3.475) + (75% × 7,700 × £1.20) = £33,687.5 (say £33,687) Now complete the process account: Process B account – January Litres £ WIP 2,700 9,840 Finished stock From Process A 42,000 180,600 WIP Material added 14,000 14,000 Processing 66,834 58,700 271,274 Litres 51,000 7,700 £ 237,587 33,687 58,700 271,274 Make sure the class understands this example in all respects before going on. ▲ You may also wish to use the example to go through the average cost approach. To do this you will need the breakdown of the opening stock values. You should use: Process A Material Processing £ 3,120 612 3,732 Process B Input from Process A cost Process B cost: Material Processing £ 8,320 604 916 9,840 ▲ Now take the class carefully through Example 8 on pages 320-324 of the textbook. ▲ Finally, ensure that the class reads and works through Example 9 on pages 324-327, although specific lesson time has not been allocated to this. It might be worth returning to these pages later, when the class is more aware of standard costing. 130 Continuous process costing (2) Reminders At the end of the lesson, re-state the main points again: The difference between a previous period and a previous process must be clearly understood. Any work completed in Process B must include, in its valuation, an amount to reflect the work done in the previous process, Process A. This also applies to a work-in-process valuation in Process B. 131 Cost Accounting – Teacher’s Guide LESSON 31 Main subject Marginal costing (1) Textbook reference Chapter11: Page 334 Syllabus reference Second Level 6 Marginal costing Elementary knowledge of the use of contribution for decisions and the effect on stock values and reported profits Lesson topics The behaviour of variable costs and fixed costs in relation to output change The meaning of, and calculation of, contribution per unit and total contribution Extended syllabus reference 6.1 6.2 6.3 Appreciate marginal costing as a technique Understand the terminology of marginal costing – marginal cost, variable cost, out-of-pocket cost, fixed cost, contribution, break-even point, contribution/sales (CS) ratio Calculate contribution per unit and total contribution Required for Candidates for Second Level and Third Level Aims of the lesson • To explain terms used in marginal costing • To explain contribution and how it is calculated The lesson ▲ Begin by reminding the class that in an earlier Lesson the subject of cost classification was looked at. Costs can be classified by element, by function, by controllability, by normality and – important to the class now – by behaviour. Continue by reminding the class that to define cost behaviour we asked the question, ‘If output increases by 10%, what happens to a particular cost?’ If the total amount of that cost also rises by 10% we say that the cost is a variable cost. If the total amount of that cost is unchanged then we say that the cost is a fixed cost. 132 Marginal costing (1) An example of a variable cost is direct material cost. If it takes £20 of material to make 1 product, then to make 15 products we would need £300 of material, and to make 130 products we would need £2,600 of material. We can tabulate this: Units of output 1 15 130 Total material cost £ 20 300 2,600 Cost per unit £ 20 20 20 Emphasise that a cost is described as variable if, as output increases, the total of that cost rises in proportion to output. The cost per unit is constant. Now contrast this with a fixed cost. An example of a fixed cost is the salary paid to a supervisor or manager. If he is paid £500 per week, he will be paid this if his department produces (say) 1,000 units of output in the week. But what if, because of machine breakdown or shortage of orders, his department only produces 500 units in a particular week. Will the manager only be paid half his normal salary? Of course not! But nor will he be paid more when his department produces 1,200 units in a week. If we tabulate this: Units of output 500 1,000 1,200 Total salary cost £ 500 500 500 Cost per unit £ 1.00 0.50 0.42 Emphasise that a cost is described as fixed if, as output increases, the total of that cost remains constant. The cost per unit is not constant. Point out that because the fixed cost (in this case, salary) per unit fluctuates in this way, and can be confusing, some prefer not to express fixed costs as a cost per unit. This will be explained shortly. As the meaning of variable and fixed costs is so important to later work, please don’t continue until you are satisfied that the class understands clearly the points being made. 133 Cost Accounting – Teacher’s Guide ▲ Now explain that for most examination questions, prime cost per unit of output should be considered to be a variable cost. Remind the class that prime cost is the sum of direct material, direct labour and direct expense. For a business that makes just one product, the cost per unit might be: £ Direct material 3 kilograms @ £4 per kg 12.00 Direct labour 6 hours @ £8 per hour 48.00 Direct expense 10.00 Prime cost 70.00 Remind the class that the direct expense might be paid to another company for (say) polishing each product. Now tell the class we will suppose that the overheads of the business are all considered fixed, and amount to £18,000 per month. Ask the class to tabulate the costs for monthly outputs of 200 units, 300 units and 350 units. Their answers should be: £ 2,400 9,600 2,000 14,000 18,000 32,000 Direct material Direct labour Direct expense Prime cost Fixed overheads Total cost £ 3,600 14,400 3,000 21,000 18,000 39,000 £ 4,200 16,800 3,500 24,500 18,000 42,500 Point out to the class that prime cost has been treated as a variable cost. The total amount of prime cost has been increased in line with the increase in output. Because of this, the figures can be summarised: Variable cost Fixed cost Total cost £ 14,000 18,000 32,000 £ 21,000 18,000 39,000 £ 24,500 18,000 42,500 £ 70.00 60.00 130.00 £ and cost per unit shown as: £ Variable cost Fixed cost Total cost 70.00 90.00 160.00 70.00 51.43 121.43 Once again, don’t leave these 2 tables until the class is clear on the distinction between total cost and unit cost, for each of variable cost, fixed cost and total cost. 134 Marginal costing (1) ▲ Now tell the class that, at this level of study, other terms that mean the same as variable cost are marginal cost, avoidable cost, and out-of-pocket cost. Refer the class to the CIMA definition of marginal cost on page 335 of the textbook. Marginal cost is the amount of cost that we avoid by not producing a unit of output. It is the amount of extra cost that we incur by producing one more unit of output. Remind the class of the total cost of producing 300 units: Direct material Direct labour Direct expense Prime cost Fixed overheads Total cost £ 3,600 14,400 3,000 21,000 18,000 39,000 Now ask them to put alongside, the total cost of producing 299 units and 301 units. Units 299 £ Direct material Direct labour Direct expense Prime cost Fixed overheads Total cost 3,588 14,352 2,990 20,930 18,000 38,930 300 £ 3,600 14,400 3,000 21,000 18,000 39,000 301 £ 3,612 14,448 3,010 21,070 18,000 39,070 Point out clearly to the class that the cost of producing 1 extra unit is £39,070 – £39,000 = £70. This is the marginal cost. The cost avoided by producing 1 unit fewer is £39,000 – £38,930 = £70. Note that this figure, £70, is the variable cost of 1 unit of output. It is also called the out-of-pocket cost because to produce 1 more unit, the business has to ‘dip into its pocket’ for another £70, whereas no more is needed for fixed costs. ▲ Now introduce contribution. Refer the class to the CIMA definition on page 337 of the textbook. Point out the 3 ways of referring to contribution: as total contribution, as unit contribution or as contribution as a % of sales. Tell the class that you are going to use a selling price of £150 per unit for the product referred to earlier. Point out that the definition of contribution refers to the variable cost of sales. In this example, we only have prime cost as a variable cost because all the overheads are fixed. In another question there could be variable production overheads, and variable selling and distribution overheads. These must be taken into account in calculating the contribution. 135 Cost Accounting – Teacher’s Guide Using the same figures: Contribution = £150 – £70 = £80. This is the unit contribution. Total contribution depends upon how many units are made and sold. We looked at 3 possibilities: 200, 300 and 350. Units Direct material Direct labour Direct expense Prime cost/Variable cost Sales value Total contribution 200 £ 2,400 9,600 2,000 14,000 30,000 16,000 300 350 3,600 14,400 3,000 21,000 45,000 24,000 £ 4,200 16,800 3,500 24,500 52,500 28,000 £ Point out that the total contribution is simply obtained by multiplying the units by the unit contribution: 200 × £80 = £16,000; 300 × £80 = £24,000; and 350 × £80 = £28,000. Contribution as a % of sales is £80/£150 = 53.33% This is known as the C/S ratio, the Contribution to Sales ratio. The same answer would be obtained from £16,000/£30,000, or £24,000/£45,000, or £28,000/£52,500. ▲ Finally, take the class through pages 334-341 of the textbook. Example 3 is very important because it contrasts absorption costing and marginal costing. Point out, particularly, that variable overhead has to be considered in arriving at the variable product cost, and therefore at the contribution. Reminders At the end of the lesson, re-state the main points again: Total variable cost increases in line with output increases, but unit variable cost is a constant. Total fixed cost remains constant as output increases, but unit fixed cost rises and falls with output change. Variable cost is also known as marginal cost, avoidable cost and out-of-pocket cost. Contribution is selling price minus variable cost of sales. 136 Marginal costing (1) LESSON 32 Main subject Marginal costing (1) Textbook reference Chapter 11: Page 334 Syllabus reference Second Level 6 Marginal costing Elementary knowledge of the use of contribution for decisions and the effect on stock values and reported profits Lesson topics The effect of stock valuations on reported profits Simple break-even calculations Extended syllabus reference 6.4 6.5 6.6 6.7 Make simple break-even calculations using F/C unit or F/CS ratio. Break-even charts and profit graphs will not be examined at Second Level Calculate require sales for a given profit using (F + P)/CS ratio Prepare profit statements valuing stock on either a marginal cost or a full absorption cost basis Explain the profit variation resulting from 6.6 Required for Candidates for Second Level and Third Level Aims of the lesson • To explain how reported profits are affected by decisions about stock valuation • To explain the use of break-even formulae The lesson ▲ Begin by reminding the class that we have identified two types of cost: (1) Those that are incurred because the product is made: the direct costs, and the variable overheads. As more output is produced, the total amount spent on these costs increases. We called these the variable costs. (2) Those that are incurred in providing the facilities to make and distribute the product. As more output is produced, the total amount spent on these facilites is unchanged. We called these fixed costs. 137 Cost Accounting – Teacher’s Guide ▲ Explain that in an earlier lesson, the subject of overhead absorption was studied. Using an absorption method such as a machine (or process) hour rate, all production overheads were absorbed into the cost of each unit of production. Point out that we didn’t ask whether the production overheads were fixed or variable. All of the overheads were included in the absorption rate. Therefore both variable and fixed production overheads were absorbed into the unit product cost. In addition, Administration, Selling and Distribution overhead (all of it) was absorbed in some examples. Make it absolutely clear to the class that we were using absorption costing, and make sure that they understand clearly what this is. Go back again to Example 3 on page 337 of the textbook. Point out that at the top of page 338, it makes clear that the budgeted overheads are £47,360 variable and £87,040 fixed, totalling to £134,400. Then point to the first paragraph of the Solution, where the last sentence says: ‘The fixed overheads as well as the variable overheads will be absorbed into the unit cost of the product.’ Also, refer the class to Note 1 to the solution at the foot of page 338. ▲ So, we know what absorption costing means. What about marginal costing? Refer the class back to the CIMA definition of marginal costing on page 334 of the textbook: ‘The accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate contribution.’ Here then is the difference. Make sure that the class sees the distinction: With absorption costing, all costs are absorbed into the cost unit. With marginal costing, only variable costs are absorbed into the cost unit. So what do we do with the fixed costs under marginal costing? The answer is that we work out the total (aggregate) contribution earned by our product or products, and then deduct the fixed costs to get the profit. Because under absorption costing fixed overheads are absorbed into the unit cost, any unsold units will be valued inclusive of fixed overheads. However, these are only fixed production overheads. Under marginal costing, any unsold stocks will be valued at variable cost only. Again, however, this will only be variable production cost, since – if the unit is still in stock – the variable distribution cost has not yet been incurred. Take the class through the paragraphs on pages 339-340 that contrast absorption and marginal costing. 138 Marginal costing (1) ▲ Now use the following data to illustrate your lesson: Company X starts production on 1 January Year 1 It makes one product and budgets to make and sell 1,000 units during Year 1. The product will be sold direct to the public from its factory premises – so there will be no distribution costs. A selling price of £200 per unit has been set. Prime costs have been forecast as: Material 40 kg @ £0.50 kg Direct labour 20 hours @ £5 hour £ 20 100 Overheads (all fixed) are budgeted at £50,000 for the year. Tell the class that you will begin with an absorption costing approach. The budgeted hours are 1,000 units × 20 hours per unit = 20,000 hours. The absorption rate is therefore £50,000/20,000 hours = £2.50 per direct-labour hour. The unit product cost is: Material 40 kg @ £0.50 kg Direct labour 20 hours @ £5 hour Prime cost Fixed overhead 20 hours × £2.50 hour Total cost £ 20 100 120 50 170 Therefore, on an absorption basis, the budgeted profit for the year is: £200 – £170 = £30 × 1,000 units = or Sales 1,000 units × £200 Costs 1,000 units × £170 Profit £30,000 £ 200,000 170,000 30,000 ▲ Now tell the class that you will illustrate the marginal costing approach. Point out that, so far, contribution has not been mentioned. Now it should be calculated: Selling price Variable cost Contribution £ 200 120 80 Remind the class that the definition of marginal costing, on page 334 of the textbook, stated that profit is found by deducting the fixed costs from the aggregate contribution. The aggregate contribution is 1,000 units × £80 per unit = £80,000 139 Cost Accounting – Teacher’s Guide The profit is therefore found: Contribution Less fixed costs Profit £ 80,000 50,000 30,000 Point out that the figures could be shown in full: Sales Variable costs £120 × 1,000 units Contribution Fixed costs Profit £ 200,000 120,000 80,000 50,000 30,000 Tell the class that the absorption approach and the marginal approach have both reported a profit of £30,000. This is because 1,000 units are to be made and 1,000 units are to be sold. There is no stock at the year end. We will change this in a minute. ▲ First let us look at simple break-even calculations. Break-even is where neither a profit nor a loss is made. The aggregate contribution must just be enough to cover the fixed costs. It can be calculated: Fixed costs/Contribution per unit, which gives an answer in units sold or Fixed costs/CS ratio, which gives the answer in sales value. Using F/Cunit, £50,000/£80 = 625 units Using F/CS ratio, first calculate the CS ratio which is £80/£200 = 40% Break even sales is then £50,000/40% = £125,000 625 units × £200 unit = £125,000. Show the class that this is correct: Sales 625 units × £200 Variable cost 625 × £120 Contribution Fixed costs Profit/Loss £ 125,000 75,000 50,000 50,000 Nil Tell the class that sometimes the question is asked, ‘What do the sales need to be, to make a profit of (say) £40,000?’ 140 Marginal costing (1) This answer is found by using F + P instead of just F. (F + P)/Cunit = (£50,000 + £40,000)/£80 = 1,125 units or (F + P)/CS ratio = (£50,000 + £40,000)/40% = £225,000 1,125 units × £200 unit = £225,000 sales. ▲ Now, after that little diversion, tell the class that you are returning to the question of reported profits. Using the earlier example, explain that we are now going to assume that – although the firm plans to make 1,000 units in its first year – it only expects to sell 900 units. First, look at absorption costing: Sales 900 units × £200 Cost of sales: Material 1,000 × £20 Direct labour 1,000 × £100 Fixed overhead Less stock 100 units × £170 Profit £ 180,000 20,000 100,000 50,000 170,000 17,000 153,000 27,000 Now look at marginal costing: Sales Variable cost of sales 900 × £120 Contribution Fixed costs Profit £ 180,000 108,000 72,000 50,000 22,000 It would also help class understanding if you showed the marginal costing approach in its longer presentation: Sales Variable cost of sales: Material 1,000 × £20 Direct labour 1,000 × £100 Less stock 100 × £120 Contribution Fixed costs Profit £ 180,000 20,000 100,000 120,000 12,000 108,000 72,000 50,000 22,000 141 Cost Accounting – Teacher’s Guide Explain to the class that we now have different profits. The absorption approach says £27,000. The marginal approach says £22,000. This is a £5,000 difference. Point out that this is entirely due to a difference in the value of stocks: absorption £17,000; marginal £12,000. The £5,000 difference is 100 units × fixed overhead per unit £50. ▲ I would suggest that you now continue this example into Year 2. Tell the class that the planned production is still 1,000 units but planned sales are 1,040 units. ▲ Finally, to revise the work of this lesson, take the class through the Examples on pages 342-353 of the textbook. Reminders At the end of the lesson, re-state the main points again: Reported profits will depend on whether absorption or marginal principles are used. Using absorption costing, stocks are valued at full production cost, inclusive of fixed production overheads Using marginal costing, stocks are valued at variable production cost. Which method reports the higher profits depends upon whether stocks are rising or falling. Break-even is the point where fixed costs are just covered by contribution. 142 Marginal costing (1) LESSON 33 Main subject Marginal costing (1) Textbook reference Chapter 11: Page 334 Syllabus reference Second Level 6 Marginal costing Elementary knowledge of the use of contribution for decisions and the effect on stock values and reported profits Lesson topic Contribution analysis for simple business decisions Extended syllabus reference 6.8 Apply contribution analysis to simple business decisions, relating to additional output, effect of price change and the use of a scarce resource Required for Candidates for Second Level and Third Level Aim of the lesson • To explain how marginal costing helps to make better business decisions The lesson ▲ Begin by referring the class to the definition of marginal costing which appears on page 334 of the textbook. Emphasise the last sentence: ‘Its special value is in recognising cost behaviour, and hence assisting in decision making.’ This is saying, that because cost behaviour can be recognised, it is possible to identify variable and fixed costs, and to calculate contribution. This allows for better decisions, because the cost data is not confused with the treatment of fixed costs. Now tell the class that you are going to illustrate the lesson by using the Company X data from the previous lesson. However, we will now say that we are looking at Year 3, and the company plans to make 900 units of its first product (now called X1), for which the prime costs are still: Material 40 kg @ £0.50 kg Direct labour 20 hours @ £5 hour Prime cost £ 20 100 120 143 Cost Accounting – Teacher’s Guide In addition, the company plans to make 400 units of a second product (called X2), for which the prime costs will be: £ 50 25 75 Material 100 kg @ £0.50 kg Direct labour 5 hours @ £5 hour Prime cost X1 will continue to be sold for £200 per unit, and X2 will be sold for £135 per unit. Fixed costs in total will be £50,000 for the year. ▲ Before using this data in the marginal costing sense, ask the class to prepare a product cost for each of X1 and X2, using absorption costing principles. The first thing the class should do, is to establish an absorption rate based upon direct labour or direct labour hours. Any student attempting to calculate an absorption rate based upon direct material or prime cost should be reminded of the weaknesses of such an approach. Budgeted direct labour hours: X1 900 units × 20 hours = X2 400 units × 5 hours = Total 18,000 hours 2,000 hours 20,000 hours Fixed overhead absorption rate £50,000/20,000 hours = £2.50 per hour Point out to the class that this rate is the same as that for Year 1 in the previous lesson. This is because, although fewer units of X1 are to be made, there are units of X2 being made instead. The overall 20,000 hours is the same as in Year 1. The class can now prepare the product costs: Direct material Direct labour Fixed overhead: 20 hours × £2.50 5 hours × £2.50 Total cost Selling price Profit per unit X1 £ 20.00 100.00 X2 £ 50.00 25.00 50.00 _____ 170.00 200.00 30.00 12.50 87.50 135.00 47.50 Now explain that if a manager asks how much profit will be made in Year 3, the answer is: X1 900 units × £30.00 per unit = X2 400 units × £47.50 per unit = Total profit 144 £ 27,000 19,000 46,000 Marginal costing (1) The class should find this fairly clear to this point. Now tell the class that the manager comes back and says, ‘I am a bit unsure of the market and how many of each product we will sell. Am I right in thinking, that if we make and sell 10% more of each product than we have budgeted, we will make a profit of £50,600? And that if we make and sell 800 of X1 and 500 of X2, we will make a profit of £47,750?’. Before going on, make sure that the class can see where the manager has got these figures from. When you have shown where the figures have come from, tell the class that both of his statements are unsound. They illustrate the confusion produced by absorption costing, when we try to make decisions. ▲ Now take the class into marginal costing routines. First, calculate the contribution per unit for each product: Direct material Direct labour Variable cost Selling price Contribution X1 £ 20 100 120 200 80 X2 £ 50 25 75 135 60 Now remind the class how the profit statement is produced using marginal costing: Contribution per unit Units Total contribution Fixed costs Profit 80 900 72,000 60 400 24,000 96,000 50,000 46,000 Point out to the class that this agrees with the profit under absorption costing. However, under absorption costing, no attempt is made to put fixed costs against each product. Now deal with the two questions that the manager came back with: If the output of both products increases by 10%, then contribution will rise by 10%. The new profit will be: £46,000 + (10% of £96,000) = £55,600 (not the £50,600 suggested by the manager). If we make and sell 800 units of X1 and 500 units of X2, then the profit will be: (800 × £80) + (500 × £60) – £50,000 = £44,000 (not £47,750 as suggested by the manager). Emphasise to the class how neat and quick the contribution approach is, and how dangerous it is to use costs based upon absorption costing. 145 Cost Accounting – Teacher’s Guide Now show how easily selling price changes can be incorporated: The manager says ‘Compared with the original budget for Year 3, we could sell 20% more units of X1 if we reduced the selling price by 5%. Should we do this?’ This should be answered: £ Present selling price Reduced selling price Revised contribution per unit £190 – 120 = 200 190 70 Revised total contribution 900 (1.20) × £70 = 75,600 Original contribution 72,000 Extra contribution 3,600 Yes, we should do it. ▲ Now take the class through Examples 11 and 12 on pages 355-359 of the textbook. ▲ Finally, show the class how contribution can be used to make sure that we make the most profit we can, when a resource – e.g. materials, or a skill of labour – is in short supply, so that it is not possible to make all of the budgeted output. Tell the class that you will be using the budget for Year 3, which was to make 900 units of X1 and 400 units of X2. This resulted in a budgeted profit of £46,000. First tell the class that we now know that only £30,000 of material will be available for the whole year. What is the best profit that we can make? To answer this we need the contribution per £ of material: Contribution per unit Material used per unit Contribution per £ of material X1 £ 80 20 4 X2 £ 60 50 1.2 Explain to the class that this clearly shows that product X1 gives the best contribution in relation to the scarce material used. It is preferred, and therefore we should allocate scarce material to X1 first: X1 needs £20 material per unit. Therefore, 900 units needs 900 × £20 = £18,000 worth. This leaves £30,000 – £18,000 = £12,000 for product X2. This will make £12,000/£50 = 240 units of X2. The best (or optimal) profit is therefore: (900 × £80) + (240 × £60) – £50,000 = £36,400. 146 Marginal costing (1) Now explain that we can get as much material as we need, but direct labour hours will be limited to 16,000 hours. What is the best profit that we can make? To answer this we need the contribution per direct labour hour (or per £ of direct labour cost): Contribution per unit Direct labour hours per unit Contribution per direct labour hour X1 £ 80 20 4 X2 £ 60 5 12 Explain to the class that this clearly shows that product X2 gives the best contribution in relation to the scarce labour used. It is preferred, and therefore we should allocate scarce labour to X2 first: X2 needs 5 labour hours per unit. Therefore, 400 units needs 400 × 5 = 2,000 hours. This leaves 16,000 – 2,000 = 14,000 for product X1. This will make 14,000/20 hours = 700 units of X1 The best (or optimal) profit is therefore: (700 × £80) + (400 × £60) – £50,000 = £30,000. ▲ Now take the class through Examples 13 and 14 on pages 359-362 of the textbook. Reminders At the end of the lesson, re-state the main points again: Unit product costs which include fixed overheads are difficult to use in decisionmaking. Contribution per unit of product can easily be adjusted to reflect change, for example a change in selling price. Total contribution is easily adjusted to reflect change, for example a change in output. Contribution in relation to a scarce resource can be used to allocate that resource most profitably. 147 Marginal costing (3) LESSON 37 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: make/buy and route selection Extended syllabus reference 3.18.a Choose between in-house manufacture and subcontracting (make or buy), where in-house resources are without limit 3.18.b As 3.18.a, but where in-house resources are limited in supply Multiple resource limitations requiring a graphical or linear programming solution will not be set 3.20 Use marginal costing to choose between alternative internal methods of manufacture Required for Candidates for Third Level only Aims of the lesson • To show how marginal costing can be used to decide between in-house manufacture and subcontracting • To show how marginal costing can be used to select the most economical route for manufacture The lesson ▲ Begin by pointing out that many decisions are made with the aim of minimising cost. For a constant level of sales, minimising costs is equal to maximising profit. But – remind the class – ‘cost’ has different meanings. For example, it could be variable cost or total cost. One view might be that we should aim to minimise the extra cost arising from a decision. Remind the class that the word ‘marginal’ could be used instead of ‘extra’. Revise the motoring example again. This was first used as an illustration of a principle in Chapter 11 of the textbook: 163 Cost Accounting – Teacher’s Guide A motorist may normally travel 16,000 kilometres each year. His petrol bill for the year might be £800. His cost per kilometre for petrol (a variable motoring cost) is £0.05. Explain that he has fixed motoring costs for depreciation and insurances. These are £3,600 and £400 respectively for a year. Therefore, His cost per kilometre for fixed motoring costs is £0.25. The total cost of his motoring is £0.30 per kilometre. Tell the class that he has to make a journey of 160 kilometres to his destination, and then make the return journey of 160 kilometres. He can make the journey by rail for £82. What should he do? By car the ‘cost’ is 320 kilometres × £0.30 = £96. By rail the cost would be £82. This seems to say, ‘Use the train.’. Can the class remember the argument? The ‘marginal or variable cost’ of using the car is 320 kilometres × £0.05 = £16. It isn’t worth spending £82 to save £16. Remember the fixed costs will not be saved. The car is still depreciating, and is still insured, even whilst he is sitting on the train! What you should now emphasise is that this is a ‘make or buy’ decision: Shall I use my own available facilities, or shall I purchase in the service of another business, the railway company? ▲ Continue using the following data per unit: Product A £ Material 10 Other variable costs 12 Fixed cost 19 Total cost 41 Selling price 50 Profit 9 Annual production and sales (units) 1,200 B £ 8 28 26 62 70 8 C £ 4 15 14 33 40 7 D £ 7 17 17 41 45 4 1,200 100 50 Ask the class: Should we be making and selling these products? The answer is: Yes – because each makes a profit on an absorption basis, and each therefore makes a contribution. More able members of the class may ask whether any problem exists with resources. Point out that if there is, these products may displace others that cannot then be made. 164 Marginal costing (3) In which case, should we let another firm make these products for us? This depends on whether another firm could make them, and what they would charge etc. Suppose a firm could, and quotes per unit: A £ 40 B £ 63 C £ 18 D £ 26 Can the class now apply the principles of the motor car illustration to this example? Product A Total internal cost of manufacture £41. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £22. It isn’t worth paying £40 to save £22. Carry on with internal manufacture. Product B Total internal cost of manufacture £62. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £36. It isn’t worth paying £63 to save £36. Carry on with internal manufacture. Product C Total internal cost of manufacture £33. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £19. It is worth paying £18 to save £19. Subcontracting Product C will minimise cost and will maximise profit. Ask the class about the dangers of subcontracting. For example, your customer and your supplier could make contact and cut you out. Also important will be the subcontractor’s ability to meet delivery dates, product quality and whether the price will hold for a reasonable period of time. Product D Total internal cost of manufacture £41. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £24. It isn’t worth paying £26 to save £24. Carry on with internal manufacture. Suggest now that a special gauge has to be purchased, at a cost of £250, to check each completed Product D. The gauge loses accuracy after being used to test 50 products, and a new gauge has then to be purchased. The gauge cost is included in fixed costs. If an outside firm makes the product, it will have to purchase its own gauges. Does this change the decision? 165 Cost Accounting – Teacher’s Guide Yes – this is a directly attributable fixed cost. It would have to be purchased, even if the customer only ordered 10 products. It would be usable for orders totalling 50 products but, after that, additional orders could not be guaranteed. The cost only relates to Product D. The fixed costs will include £250/50 = £5 per unit. This will be saved if Product D is subcontracted. It is worth paying £26 to save £24 + £5. Draw the conclusion that, on cost considerations alone, internal manufacture of Products A and B should be continued, but Products C and D should be subcontracted. ▲ Now tell the class that even if this is done, a problem remains with a particular machine used to make all four products. Other machines are used as well, but they do not have the capacity problem of this particular machine. This machine has an annual capacity of 1,500 hours and this cannot be increased. The hours used on this machine are: Product Hours A 0.5 B 1.0 C 1.0 D 2.0 C 100 D 100 Therefore, the annual hours needed are: Product Hours A 600 B 1,200 Total 2,000 2,000 hours are needed but only 1,500 hours are available. Remind the class that the problem has been partly solved by the decision to subcontract the manufacture of Products C and D. This reduces the need to 1,800 hours. Explain that, therefore, the manufacture of some of Product A, or of Product B, or some of each, will have to be subcontracted. How do we decide which? Draw the attention of the class to the ‘boxed’ rule on page 407 of the textbook. So, if extra cost is to be incurred through subcontracting, it should be as little as possible for each hour of limited capacity released. Show the class the calculation: Product Variable cost Subcontract price Excess cost Limited capacity hours Excess cost per hour A £ 22 40 18 B £ 36 63 27 0.5 £36 1.0 £27 Take care in explaining the meaning of these figures and how they are interpreted. 166 Marginal costing (3) Although Product B has the highest excess cost (£27 compared to £18), it has the lowest excess cost per machine hour. This is the decision criteria. It is Product B that should be subcontracted. 300 units of Product B should be subcontracted, so saving the 300 hours. ▲ Now take the class through Examples 1 and 2 on pages 404-409 of the textbook. These are important questions, and each step in the solutions should be carefully explained. ▲ Next, remind the class that the same principle of minimising additional cost can be applied to any course of action for which alternatives exist. For example, If we have to deliver goods to a customer, should our delivery vehicle use Route A or Route B? If a product can be made on either Machine A or Machine B, how do we decide which? Use the following illustration: An operation on a product can be done on either of 2 machines, TR5 or SK4. The operation would take 6 hours on TR5, or 4.5 hours on SK4. Conversion cost rates per hour for each machine are: Variable Fixed TR5 £ 3.70 4.65 8.35 SK4 £ 4.30 7.20 11.50 At the end of the operation, the product is inspected. 20% of those made on TR5 have to go back onto TR5 for 1 hour each, to be rectified. They are then acceptable. 10% of those made on SK4 have to go back onto SK4 for 2 hours each, to be rectified. They are then acceptable. Both machines have adequate available time. First, work out the hours to allow for rectification work. The class may find it easier to work on 10 products. TR5 10 products take 10 × 6 = 2 (20%) will need rectifying × 1 SK4 10 products take 10 × 4.5 = 1 (10%) will need rectifying × 2 60 hours 2 hours 62 hours 45 hours 2 hours 47 hours 167 Cost Accounting – Teacher’s Guide Total costs TR5 62 hours × £8.35 SK4 47 hours × £11.50 £ 517.70 540.50 This suggests that Machine TR5 should be used. This would be an incorrect conclusion since fixed costs will be incurred anyway. On the assumption that both machines are being kept and both are available, only the variable costs should be looked at: TR5 62 hours × £3.70 SK4 47 hours × £4.30 £ 229.40 202.10 Machine SK4 should be used. ▲ Take the class carefully through Example 3 on pages 410-412 of the textbook. Reminders At the end of the lesson, re-state the main points again: The application of the marginal costing technique allows decisions to be made on the basis of lowest additional cost. If a subcontractor can carry out an operation or make a product at less than the internal variable cost, then allowing the subcontractor to do the work will minimise cost and maximise profit. If subcontractors have to be used because of internal capacity problems, then a decision should be made which minimises the additional cost in relation to the release of the scarce internal resource. 168 Marginal costing (3) LESSON 38 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: further processing and product and service pricing Extended syllabus reference 3.16 Calculate value added 3.17 Use marginal costing to assist product and service pricing 3.17.a Calculate a selling price to recover long run average costs 3.17.b Calculate a selling price to recover short run marginal costs 3.17.c Explain why a selling price might be set at a level below marginal cost 3.17.d Explain why a selling price might be set to match that of a competitor 3.17.e Calculate a selling price to achieve a target rate of contribution or value added Required for Candidates for Third Level only Aims of the lesson • To show how marginal costing can be used to assess the value of further processing • To show how marginal costing can be used, with other measures, to assist in setting prices for goods or services The lesson ▲ Begin by pointing out to the class that the term ‘further processing’ is usually associated with process costing. For example: Andor Limited produces 18,000 litres of Product XP6 each month. XP6 is sold for £22 per litre. It is proposed to further process XP6 to make XP6 (Superior). Further processing will cost £6.50 per litre of input, and there will be additional fixed costs of £15,000 each month. 169 Cost Accounting – Teacher’s Guide 10% of input material will be lost in further processing. This will have no value. XP6 (Superior) is expected to sell for £34 per litre. Remind the class that this example is a typical Third Level problem. Should XP6 be further processed into XP6 (Superior)? Ask the class to work out some figures for you, as this is really revision. They should start with extra revenue figures as follows: The present monthly revenue is 18,000 × £22 The monthly revenue for XP6 (Superior) will be (18,000 × 90%) × £34 Extra revenue £ 396,000 550,800 154,800 Remind the class that we do not know the cost of producing XP6. We do not need to. We have calculated the increase in revenue from XP6 to XP6 (Superior). All we now need is the extra cost: The extra cost is: Variable 18,000 × £6.50 Fixed £ 117,000 15,000 132,000 It is worth producing XP6 (Superior) because marginal revenue of £154,800 exceeds the marginal cost of £132,000 by £22,800. Emphasise what was said in an earlier lesson: The fixed costs of £15,000 are relevant to the decision, as they will only be incurred if XP6 (Superior) is made. So, in this case, the fixed costs are relevant and are part of marginal costs. Point out that these principles apply in any situation where ‘one more step’ is being considered, such as working overtime, putting on an additional shift, increasing advertising, etc. Another example is: ABC Limited sells 12,000 units each month for £14 per unit. At present, the company spends £10,000 per month on advertising. The variable cost per unit is £6 per unit. It is considered that if the amount spent on advertising were to be increased to £13,000 per month, 13,500 units could be sold per month, although the average selling price would fall to £13.80. 170 Marginal costing (3) What would the class recommend? Present Monthly sales 12,000 × £14 Variable costs per month 12,000 × £6 Monthly contribution £ 168,000 72,000 96,000 Proposed Monthly sales 13,500 × £13.80 Variable costs per month 13,500 × £6 Monthly contribution £ 186,300 81,000 105,300 Extra contribution £105,300 – £96,000 Additional advertising £13,000 – £10,000 Additional profit 9,300 3,000 6,300 The proposal is worth doing. ▲ Now take the class through Example 4 on pages 412-414 of the textbook. ▲ Next, turn to the setting of selling prices for goods and services. Begin with a single-product firm, whose budget for Year 6 is: Product SR5 Units of production and sale Manufacturing hours Direct material cost Variable conversion costs Fixed conversion costs Total cost Total cost per unit 8,000 12,000 £ 10,000 9,000 13,000 32,000 £4.00 If the firm wants to breakeven it will set its selling price at £4 per unit. If the firm wants to make £4,000 profit, it will set its selling price at £4.50 per unit. If competitors are selling at £3.70 per unit, it may be decided that this lower price should be matched, to avoid the loss of business. This will result in a loss of £0.30 per unit, and an overall loss of £2,400. Discuss these possibilities with the class. Emphasise, particularly, that a firm which makes one product only must sell at a price which, in the long term, covers its average costs. In this case the average costs are £4.00 per unit. Ask the class how this figure of £4.00 per unit could be reduced. For example, if it could be reduced to £3.50, then even a selling price of £3.70, to match competitors, would make a profit. 171 Cost Accounting – Teacher’s Guide The class should suggest: Lower material prices from suppliers Better use of material in production – reduce wastage etc Lower wage rates Improve productivity – labour could earn more but still reduce the unit labour cost Control and reduce spending on overheads Hopefully, the class will also mention increased volume of output, so that the fixed conversion cost per unit falls from its present level of £1.625 per unit. Point out, also, that once the fixed costs are committed, each additional unit made and sold has a marginal cost of £19,000/8,000 = £2.375. Ask the class if the firm would ever sell some or all of its output at £2.600 per unit. The answer is: Yes – a price of £2.600 gives a contribution of £0.225 per unit. This is better than no contribution at all. Ask the class if the firm would ever sell some or all of its output at £2.100 per unit. The answer is: Probably no, but possibly yes. A price of £2.100 is below the marginal cost and, therefore, offers a negative contribution of £0.275. This would not seem sensible. However, a firm might do this if the £0.275 could be more than made up on the sale of other products to the same customer. A supermarket might adopt such a ‘loss-leader’ pricing strategy on a few products but, obviously, not on many! Now tell the class that the firm becomes a 2-product firm in Year 7, by adding SR6. The budget is: SR5 8,000 12,000 £ Direct material cost 10,000 Variable conversion costs 9,000 Fixed conversion costs have increased to £16,250. Units of production and sale Manufacturing hours SR6 2,000 1,000 £ 2,000 1,000 Traditional absorption costing would lead us to: Material cost per unit Variable conversion cost per unit Variable cost per unit 172 £ 1.250 £ 1.000 1.125 2.375 0.500 1.500 Total 10,000 13,000 £ 12,000 10,000 Marginal costing (3) From earlier studies, the class should know that time-based absorption rates are preferred if absorption costing is to be practised at all. Fixed conversion cost is £16,250/13,000 manufacturing hours = £1.25 per hour. This makes the product costs per unit: £ 1.250 1.125 2.375 1.875 4.250 Material cost Variable conversion cost Variable cost Fixed cost (£1.25 per hour) Total cost £ 1.000 0.500 1.500 0.625 2.125 Point out to the class that the fixed conversion costs have been absorbed into the product costs on a basis of 1.50 manufacturing hours for SR5 and 0.50 hours for SR6. It is worth noting that, on this basis, Product SR5 bears 8,000 × £1.875 = £15,000 of the fixed conversion costs. It could be argued that this is unreasonable since, presumably, the increase in fixed conversion costs from £13,000 to £16,250 was due to the introduction of SR6. Suppose the firm wants to make £5,750 profit in Year 7. Remind the class that the budgeted total costs are: £ 12,000 10,000 16,250 38,250 5,750 44,000 Direct material cost Variable conversion cost Fixed conversion cost Total cost Profit required Sales revenue required The total profit of £5,750 as a % of total cost of £38,250 is 15.033%. Many businesses make a first attempt at pricing by adding this target %, known as mark-up, to the total absorption cost for each product, as follows: Total cost per unit Add mark up 15.033% Target selling price SR5 £ 4.250 .639 4.889 SR6 £ 2.125 .319 2.444 As discussed on page 414 of the textbook, this is only a starter because – in the real commercial world – final selling prices are largely decided by competition and other factors. Cost is only one of the factors to be considered. Another approach is to say that the required contribution is £5,750 + £16,250 = £22,000. As the planned hours are 13,000, this gives a required contribution per hour of £22,000/ 13,000 = £1.692. 173 Cost Accounting – Teacher’s Guide This would give required selling prices of: Material cost per unit Variable conversion cost per unit Variable cost per unit Contribution at £1.692 per hr Selling price Contribution Hours to make Contribution per hour SR5 SR6 £ 1.250 £ 1.000 1.125 2.375 2.538 4.913 0.500 1.500 0.846 2.346 2.538 1.50 1.692 0.846 0.50 1.692 Another approach would be to say that the required added value is £44,000 less material of £12,000 = £32,000. This gives an added value per hour of £32,000/13,000 = £2.462 per hour. This would give required selling prices of: Direct materials Added value @ £2.462 hr Target selling price SR5 £ 1.250 3.693 4.943 SR6 £ 1.000 1.231 2.231 Help the class to compare and understand these results. ▲ Now take the class through Example 5 on pages 415-416 of the textbook. Reminders At the end of the lesson, re-state the main points again: Further processing decisions are made by comparing marginal cost with marginal revenue. Remember that marginal costs can include fixed costs. Selling prices are set with many factors being considered. These include total absorption cost, target mark-up, marginal cost, target contribution, target value added, limited resources, product mix and – perhaps most important of all – competition from other suppliers in the market. 174 Marginal costing (3) LESSON 39 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: closure decisions and maximising the return from scarce resources Extended syllabus reference 3.18 Use marginal costing to maximise the return from a resource that in the short term is limited in supply 3.19 Use marginal costing to evaluate proposals e.g. to expand output or contract output, to change the product mix, to mount an advertising campaign, to close a department, to remove a product from the range etc Required for Candidates for Third Level only Aims of the lesson • To show that the marginal costing technique can be used to evaluate any proposed change. • To show that it can also be used to show the decision that will maximise profits when resources are limited. The lesson ▲ Begin by reminding the class that a decision results in change. For example: It could be decided to close one of a company’s retail outlets. What change will this cause. Costs will be saved – rent, rates, insurances, telephones, heating and lighting, and wages and salaries. Remember that wages and salaries will be saved unless the employees are retained and transferred to other branches. However, sales will also be lost, although it is possible that customers may go instead to another of the company’s retail outlets. The decision to close will be because it is believed that the costs savings will exceed the gross margin on the lost sales revenue. 175 Cost Accounting – Teacher’s Guide Use the following illustration: The management of Company X are considering the closure of Branch 10. Annual sales of this branch are £860,000. An average gross margin of 60% is earned. £345,000 is paid for staff wages and salaries. In addition, sales staff are paid a commission of 2% of sales turnover. Staff with salaries totalling £75,000 would be absorbed in other branches. The remaining staff would be made redundant. This would involve one-off redundancy costs of £36,700. An amount of £80,000 is apportioned to Branch 10 from Head Office costs, which would be unaffected in total by the closure of Branch 10. Other expenses amount to £55,000, and these would be saved by the closure of Branch 10. It is estimated that sales of £340,000 normally made at Branch 10 would be picked up at other branches. The rest of the sales would be lost. How should this closure proposal be evaluated? First, look at the sales revenue and gross margin. Lost sales from Branch 10 Sales picked up at other branches Net lost sales Gross margin 60% £ 860,000 340,000 520,000 312,000 Now look at the cost savings Staff wages and salaries Less wages and salaries not saved Other expenses Commission 2% on £520,000 Net saving from closure of Branch 10 One-off redundancy payment Net loss from closure £ 345,000 75,000 270,000 55,000 10,400 335,400 23,400 36,700 13,300 Point out that this suggests Branch 10 should not be closed – however, it reflects a point which is included in many questions of this type: the redundancy payment is only paid once. In all future years the company will be £23,400 better off if Branch 10 is closed. Point out, also, that it has been assumed that the staff transferred to other branches are additional staff. If they are being placed in jobs for which people would otherwise have to be recruited, then the £75,000 should not be deducted. 176 Marginal costing (3) ▲ Alternatively, it could be decided to reduce the amount of advertising done by a company. Would this result in the loss of sales to competitors? Could anything be done to retain sales? Use the following illustration: A company makes two products for which the unit product costs are: Product Direct material Variable conversion cost Fixed conversion cost Advertising Selling price Profit Annual units of production and sale A B £ 27.50 22.00 36.00 37.50 123.00 125.00 2.00 800 £ 29.00 42.00 58.00 60.00 189.00 200.00 11.00 500 The company plans to cut its total advertising bill by 80%. The marketing manager thinks that if this decision is made, the selling price of A and B would have to be reduced by 4% and 5% respectively. Even then he believes that volume for both products will fall by 12%. Ask the class for their recommendation. They should approach it along these lines. Advertising Total advertising must be (800 × £37.50) + (500 × £60) = £60,000. 80% of this will be saved, which is £48,000. Lost contribution Present contribution Product A 800 × (£125 – £49.50) = Product B 500 × (£200 – £71) = Expected contribution Product A (800 × 88%)(£120 – £49.50) Product B (500 × 88%)(£190 – £71) Lost contribution Saving in advertising cost Net benefit £ 60,400 64,500 124,900 £ 49,632 52,360 101,992 22,908 48,000 25,092 ▲ Now take the class through Example 6 on pages 417-420 of the textbook. 177 Cost Accounting – Teacher’s Guide When you come to maximising the return from scarce resources (page 420), you should point out that this topic was introduced to Second Level students in Chapter 11 and in the corresponding lessons. ▲ Third Level questions do not introduce any new principles with regard to this topic. However, differences of application arise. Begin with the following budgeted data: Product Material Variable conversion @ £6 per hour Fixed conversion @ £8 per hour Total cost Selling price Units X Y £ 40.00 36.00 48.00 124.00 130.00 500 £ 25.00 54.00 72.00 151.00 155.00 1,000 Ask the class what the budgeted profit is. The answer is (500 × £6) + (1,000 × £4) = £7,000. Now tell the class that only £35,000 of material is available for the budget period. Ask them to calculate the optimal profit or loss The answer is calculated: Product Material needed Material available Shortage Contribution per unit Material used Contribution per £ of material Ranking X £ 20,000 Y £ 25,000 54 40 1.35 2 76 25 3.04 1 Total £ 45,000 35,000 10,000 £10,000 of material would make £10,000/£40 = 250 units of X. These units would earn 250 × £54 = £13,500 contribution. Therefore, optimal profit or loss is £7,000 – £13,500 = £6,500 loss. Now tell the class that material is freely available, but production hours are limited to 10,000 hours in the budget period. Ask them to calculate the optimal profit or loss. 178 Marginal costing (3) The answer is calculated: Product Production hours needed Hours available Shortage Contribution per unit Hours used Contribution per hour Ranking X 3,000 Y 9,000 54 6 £9.00 1 76 9 £8.44 2 Total 12,000 10,000 2,000 2,000 hours would make 2,000/9 = 222 units of Y. These units would earn 222 × £76 = £16,872 contribution. Therefore, optimal profit or loss is £7,000 – £16,872 = £9,872 loss. ▲ Explain that the illustrations have been quite simple so far, but they do show the principles that Second Level should be able to apply. Third Level questions on the same topic areas are likely to contain more detail. As an example: Tell the class that the variable rate per hour, £6 per hour, includes £4.80 for labour cost. 990 hours of overtime could be available but productivity will fall in overtime, and 10% more time will be needed for each unit. Overtime will be paid at time and a third. Ask the class to calculate the optimal profit or loss. Explain that since the production time is rising, and the hourly rate is rising, the contribution per hour must fall. The original preference for X therefore remains. What would be the contribution per hour for units made in overtime? Product Material Variable conversion @ £7.60 per hour Variable cost Selling price Contribution Hours Contribution per hour X £ 40.00 Y £ 25.00 50.16 90.16 130.00 39.84 6.6 £6.04 75.24 100.24 155.00 54.76 9.9 £5.53 Of course, X remains the best product. However, all units of X are being made in normal time. 990 hours of overtime allows 990/9.9 = 100 units of Y to be produced. The additional contribution will be 100 × £54.76 = £5,476. The optimal contribution becomes a loss of £9,872 – £5,476 = a loss of £4,396. Now take the class carefully through Example 7 on pages 421-423 of the textbook. 179 Cost Accounting – Teacher’s Guide Reminders At the end of the lesson, re-state the main points again: Marginal costing is a useful technique when considering closures. It identifies the costs and revenue changes that result from the closure. In such decisions many costs normally considered to be fixed become relevant. The ‘closure’ principle is applied to other similar situations – for example, ‘closing’ advertising expenditure. Maximising scarce factors means looking at the contribution earned in relation to the consumption of the scarce factor. At Third Level some adjustment of the basic contribution per unit is likely to be necessary. 180 Marginal costing (3) LESSON 37 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: make/buy and route selection Extended syllabus reference 3.18.a Choose between in-house manufacture and subcontracting (make or buy), where in-house resources are without limit 3.18.b As 3.18.a, but where in-house resources are limited in supply Multiple resource limitations requiring a graphical or linear programming solution will not be set 3.20 Use marginal costing to choose between alternative internal methods of manufacture Required for Candidates for Third Level only Aims of the lesson • To show how marginal costing can be used to decide between in-house manufacture and subcontracting • To show how marginal costing can be used to select the most economical route for manufacture The lesson ▲ Begin by pointing out that many decisions are made with the aim of minimising cost. For a constant level of sales, minimising costs is equal to maximising profit. But – remind the class – ‘cost’ has different meanings. For example, it could be variable cost or total cost. One view might be that we should aim to minimise the extra cost arising from a decision. Remind the class that the word ‘marginal’ could be used instead of ‘extra’. Revise the motoring example again. This was first used as an illustration of a principle in Chapter 11 of the textbook: 163 Cost Accounting – Teacher’s Guide A motorist may normally travel 16,000 kilometres each year. His petrol bill for the year might be £800. His cost per kilometre for petrol (a variable motoring cost) is £0.05. Explain that he has fixed motoring costs for depreciation and insurances. These are £3,600 and £400 respectively for a year. Therefore, His cost per kilometre for fixed motoring costs is £0.25. The total cost of his motoring is £0.30 per kilometre. Tell the class that he has to make a journey of 160 kilometres to his destination, and then make the return journey of 160 kilometres. He can make the journey by rail for £82. What should he do? By car the ‘cost’ is 320 kilometres × £0.30 = £96. By rail the cost would be £82. This seems to say, ‘Use the train.’. Can the class remember the argument? The ‘marginal or variable cost’ of using the car is 320 kilometres × £0.05 = £16. It isn’t worth spending £82 to save £16. Remember the fixed costs will not be saved. The car is still depreciating, and is still insured, even whilst he is sitting on the train! What you should now emphasise is that this is a ‘make or buy’ decision: Shall I use my own available facilities, or shall I purchase in the service of another business, the railway company? ▲ Continue using the following data per unit: Product A £ Material 10 Other variable costs 12 Fixed cost 19 Total cost 41 Selling price 50 Profit 9 Annual production and sales (units) 1,200 B £ 8 28 26 62 70 8 C £ 4 15 14 33 40 7 D £ 7 17 17 41 45 4 1,200 100 50 Ask the class: Should we be making and selling these products? The answer is: Yes – because each makes a profit on an absorption basis, and each therefore makes a contribution. More able members of the class may ask whether any problem exists with resources. Point out that if there is, these products may displace others that cannot then be made. 164 Marginal costing (3) In which case, should we let another firm make these products for us? This depends on whether another firm could make them, and what they would charge etc. Suppose a firm could, and quotes per unit: A £ 40 B £ 63 C £ 18 D £ 26 Can the class now apply the principles of the motor car illustration to this example? Product A Total internal cost of manufacture £41. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £22. It isn’t worth paying £40 to save £22. Carry on with internal manufacture. Product B Total internal cost of manufacture £62. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £36. It isn’t worth paying £63 to save £36. Carry on with internal manufacture. Product C Total internal cost of manufacture £33. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £19. It is worth paying £18 to save £19. Subcontracting Product C will minimise cost and will maximise profit. Ask the class about the dangers of subcontracting. For example, your customer and your supplier could make contact and cut you out. Also important will be the subcontractor’s ability to meet delivery dates, product quality and whether the price will hold for a reasonable period of time. Product D Total internal cost of manufacture £41. This is irrelevant, because fixed costs will not be saved if they are all general fixed costs. Internal variable cost of manufacture £24. It isn’t worth paying £26 to save £24. Carry on with internal manufacture. Suggest now that a special gauge has to be purchased, at a cost of £250, to check each completed Product D. The gauge loses accuracy after being used to test 50 products, and a new gauge has then to be purchased. The gauge cost is included in fixed costs. If an outside firm makes the product, it will have to purchase its own gauges. Does this change the decision? 165 Cost Accounting – Teacher’s Guide Yes – this is a directly attributable fixed cost. It would have to be purchased, even if the customer only ordered 10 products. It would be usable for orders totalling 50 products but, after that, additional orders could not be guaranteed. The cost only relates to Product D. The fixed costs will include £250/50 = £5 per unit. This will be saved if Product D is subcontracted. It is worth paying £26 to save £24 + £5. Draw the conclusion that, on cost considerations alone, internal manufacture of Products A and B should be continued, but Products C and D should be subcontracted. ▲ Now tell the class that even if this is done, a problem remains with a particular machine used to make all four products. Other machines are used as well, but they do not have the capacity problem of this particular machine. This machine has an annual capacity of 1,500 hours and this cannot be increased. The hours used on this machine are: Product Hours A 0.5 B 1.0 C 1.0 D 2.0 C 100 D 100 Therefore, the annual hours needed are: Product Hours A 600 B 1,200 Total 2,000 2,000 hours are needed but only 1,500 hours are available. Remind the class that the problem has been partly solved by the decision to subcontract the manufacture of Products C and D. This reduces the need to 1,800 hours. Explain that, therefore, the manufacture of some of Product A, or of Product B, or some of each, will have to be subcontracted. How do we decide which? Draw the attention of the class to the ‘boxed’ rule on page 407 of the textbook. So, if extra cost is to be incurred through subcontracting, it should be as little as possible for each hour of limited capacity released. Show the class the calculation: Product Variable cost Subcontract price Excess cost Limited capacity hours Excess cost per hour A £ 22 40 18 B £ 36 63 27 0.5 £36 1.0 £27 Take care in explaining the meaning of these figures and how they are interpreted. 166 Marginal costing (3) Although Product B has the highest excess cost (£27 compared to £18), it has the lowest excess cost per machine hour. This is the decision criteria. It is Product B that should be subcontracted. 300 units of Product B should be subcontracted, so saving the 300 hours. ▲ Now take the class through Examples 1 and 2 on pages 404-409 of the textbook. These are important questions, and each step in the solutions should be carefully explained. ▲ Next, remind the class that the same principle of minimising additional cost can be applied to any course of action for which alternatives exist. For example, If we have to deliver goods to a customer, should our delivery vehicle use Route A or Route B? If a product can be made on either Machine A or Machine B, how do we decide which? Use the following illustration: An operation on a product can be done on either of 2 machines, TR5 or SK4. The operation would take 6 hours on TR5, or 4.5 hours on SK4. Conversion cost rates per hour for each machine are: Variable Fixed TR5 £ 3.70 4.65 8.35 SK4 £ 4.30 7.20 11.50 At the end of the operation, the product is inspected. 20% of those made on TR5 have to go back onto TR5 for 1 hour each, to be rectified. They are then acceptable. 10% of those made on SK4 have to go back onto SK4 for 2 hours each, to be rectified. They are then acceptable. Both machines have adequate available time. First, work out the hours to allow for rectification work. The class may find it easier to work on 10 products. TR5 10 products take 10 × 6 = 2 (20%) will need rectifying × 1 SK4 10 products take 10 × 4.5 = 1 (10%) will need rectifying × 2 60 hours 2 hours 62 hours 45 hours 2 hours 47 hours 167 Cost Accounting – Teacher’s Guide Total costs TR5 62 hours × £8.35 SK4 47 hours × £11.50 £ 517.70 540.50 This suggests that Machine TR5 should be used. This would be an incorrect conclusion since fixed costs will be incurred anyway. On the assumption that both machines are being kept and both are available, only the variable costs should be looked at: TR5 62 hours × £3.70 SK4 47 hours × £4.30 £ 229.40 202.10 Machine SK4 should be used. ▲ Take the class carefully through Example 3 on pages 410-412 of the textbook. Reminders At the end of the lesson, re-state the main points again: The application of the marginal costing technique allows decisions to be made on the basis of lowest additional cost. If a subcontractor can carry out an operation or make a product at less than the internal variable cost, then allowing the subcontractor to do the work will minimise cost and maximise profit. If subcontractors have to be used because of internal capacity problems, then a decision should be made which minimises the additional cost in relation to the release of the scarce internal resource. 168 Marginal costing (3) LESSON 38 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: further processing and product and service pricing Extended syllabus reference 3.16 Calculate value added 3.17 Use marginal costing to assist product and service pricing 3.17.a Calculate a selling price to recover long run average costs 3.17.b Calculate a selling price to recover short run marginal costs 3.17.c Explain why a selling price might be set at a level below marginal cost 3.17.d Explain why a selling price might be set to match that of a competitor 3.17.e Calculate a selling price to achieve a target rate of contribution or value added Required for Candidates for Third Level only Aims of the lesson • To show how marginal costing can be used to assess the value of further processing • To show how marginal costing can be used, with other measures, to assist in setting prices for goods or services The lesson ▲ Begin by pointing out to the class that the term ‘further processing’ is usually associated with process costing. For example: Andor Limited produces 18,000 litres of Product XP6 each month. XP6 is sold for £22 per litre. It is proposed to further process XP6 to make XP6 (Superior). Further processing will cost £6.50 per litre of input, and there will be additional fixed costs of £15,000 each month. 169 Cost Accounting – Teacher’s Guide 10% of input material will be lost in further processing. This will have no value. XP6 (Superior) is expected to sell for £34 per litre. Remind the class that this example is a typical Third Level problem. Should XP6 be further processed into XP6 (Superior)? Ask the class to work out some figures for you, as this is really revision. They should start with extra revenue figures as follows: The present monthly revenue is 18,000 × £22 The monthly revenue for XP6 (Superior) will be (18,000 × 90%) × £34 Extra revenue £ 396,000 550,800 154,800 Remind the class that we do not know the cost of producing XP6. We do not need to. We have calculated the increase in revenue from XP6 to XP6 (Superior). All we now need is the extra cost: The extra cost is: Variable 18,000 × £6.50 Fixed £ 117,000 15,000 132,000 It is worth producing XP6 (Superior) because marginal revenue of £154,800 exceeds the marginal cost of £132,000 by £22,800. Emphasise what was said in an earlier lesson: The fixed costs of £15,000 are relevant to the decision, as they will only be incurred if XP6 (Superior) is made. So, in this case, the fixed costs are relevant and are part of marginal costs. Point out that these principles apply in any situation where ‘one more step’ is being considered, such as working overtime, putting on an additional shift, increasing advertising, etc. Another example is: ABC Limited sells 12,000 units each month for £14 per unit. At present, the company spends £10,000 per month on advertising. The variable cost per unit is £6 per unit. It is considered that if the amount spent on advertising were to be increased to £13,000 per month, 13,500 units could be sold per month, although the average selling price would fall to £13.80. 170 Marginal costing (3) What would the class recommend? Present Monthly sales 12,000 × £14 Variable costs per month 12,000 × £6 Monthly contribution £ 168,000 72,000 96,000 Proposed Monthly sales 13,500 × £13.80 Variable costs per month 13,500 × £6 Monthly contribution £ 186,300 81,000 105,300 Extra contribution £105,300 – £96,000 Additional advertising £13,000 – £10,000 Additional profit 9,300 3,000 6,300 The proposal is worth doing. ▲ Now take the class through Example 4 on pages 412-414 of the textbook. ▲ Next, turn to the setting of selling prices for goods and services. Begin with a single-product firm, whose budget for Year 6 is: Product SR5 Units of production and sale Manufacturing hours Direct material cost Variable conversion costs Fixed conversion costs Total cost Total cost per unit 8,000 12,000 £ 10,000 9,000 13,000 32,000 £4.00 If the firm wants to breakeven it will set its selling price at £4 per unit. If the firm wants to make £4,000 profit, it will set its selling price at £4.50 per unit. If competitors are selling at £3.70 per unit, it may be decided that this lower price should be matched, to avoid the loss of business. This will result in a loss of £0.30 per unit, and an overall loss of £2,400. Discuss these possibilities with the class. Emphasise, particularly, that a firm which makes one product only must sell at a price which, in the long term, covers its average costs. In this case the average costs are £4.00 per unit. Ask the class how this figure of £4.00 per unit could be reduced. For example, if it could be reduced to £3.50, then even a selling price of £3.70, to match competitors, would make a profit. 171 Cost Accounting – Teacher’s Guide The class should suggest: Lower material prices from suppliers Better use of material in production – reduce wastage etc Lower wage rates Improve productivity – labour could earn more but still reduce the unit labour cost Control and reduce spending on overheads Hopefully, the class will also mention increased volume of output, so that the fixed conversion cost per unit falls from its present level of £1.625 per unit. Point out, also, that once the fixed costs are committed, each additional unit made and sold has a marginal cost of £19,000/8,000 = £2.375. Ask the class if the firm would ever sell some or all of its output at £2.600 per unit. The answer is: Yes – a price of £2.600 gives a contribution of £0.225 per unit. This is better than no contribution at all. Ask the class if the firm would ever sell some or all of its output at £2.100 per unit. The answer is: Probably no, but possibly yes. A price of £2.100 is below the marginal cost and, therefore, offers a negative contribution of £0.275. This would not seem sensible. However, a firm might do this if the £0.275 could be more than made up on the sale of other products to the same customer. A supermarket might adopt such a ‘loss-leader’ pricing strategy on a few products but, obviously, not on many! Now tell the class that the firm becomes a 2-product firm in Year 7, by adding SR6. The budget is: SR5 8,000 12,000 £ Direct material cost 10,000 Variable conversion costs 9,000 Fixed conversion costs have increased to £16,250. Units of production and sale Manufacturing hours SR6 2,000 1,000 £ 2,000 1,000 Traditional absorption costing would lead us to: Material cost per unit Variable conversion cost per unit Variable cost per unit 172 £ 1.250 £ 1.000 1.125 2.375 0.500 1.500 Total 10,000 13,000 £ 12,000 10,000 Marginal costing (3) From earlier studies, the class should know that time-based absorption rates are preferred if absorption costing is to be practised at all. Fixed conversion cost is £16,250/13,000 manufacturing hours = £1.25 per hour. This makes the product costs per unit: £ 1.250 1.125 2.375 1.875 4.250 Material cost Variable conversion cost Variable cost Fixed cost (£1.25 per hour) Total cost £ 1.000 0.500 1.500 0.625 2.125 Point out to the class that the fixed conversion costs have been absorbed into the product costs on a basis of 1.50 manufacturing hours for SR5 and 0.50 hours for SR6. It is worth noting that, on this basis, Product SR5 bears 8,000 × £1.875 = £15,000 of the fixed conversion costs. It could be argued that this is unreasonable since, presumably, the increase in fixed conversion costs from £13,000 to £16,250 was due to the introduction of SR6. Suppose the firm wants to make £5,750 profit in Year 7. Remind the class that the budgeted total costs are: £ 12,000 10,000 16,250 38,250 5,750 44,000 Direct material cost Variable conversion cost Fixed conversion cost Total cost Profit required Sales revenue required The total profit of £5,750 as a % of total cost of £38,250 is 15.033%. Many businesses make a first attempt at pricing by adding this target %, known as mark-up, to the total absorption cost for each product, as follows: Total cost per unit Add mark up 15.033% Target selling price SR5 £ 4.250 .639 4.889 SR6 £ 2.125 .319 2.444 As discussed on page 414 of the textbook, this is only a starter because – in the real commercial world – final selling prices are largely decided by competition and other factors. Cost is only one of the factors to be considered. Another approach is to say that the required contribution is £5,750 + £16,250 = £22,000. As the planned hours are 13,000, this gives a required contribution per hour of £22,000/ 13,000 = £1.692. 173 Cost Accounting – Teacher’s Guide This would give required selling prices of: Material cost per unit Variable conversion cost per unit Variable cost per unit Contribution at £1.692 per hr Selling price Contribution Hours to make Contribution per hour SR5 SR6 £ 1.250 £ 1.000 1.125 2.375 2.538 4.913 0.500 1.500 0.846 2.346 2.538 1.50 1.692 0.846 0.50 1.692 Another approach would be to say that the required added value is £44,000 less material of £12,000 = £32,000. This gives an added value per hour of £32,000/13,000 = £2.462 per hour. This would give required selling prices of: Direct materials Added value @ £2.462 hr Target selling price SR5 £ 1.250 3.693 4.943 SR6 £ 1.000 1.231 2.231 Help the class to compare and understand these results. ▲ Now take the class through Example 5 on pages 415-416 of the textbook. Reminders At the end of the lesson, re-state the main points again: Further processing decisions are made by comparing marginal cost with marginal revenue. Remember that marginal costs can include fixed costs. Selling prices are set with many factors being considered. These include total absorption cost, target mark-up, marginal cost, target contribution, target value added, limited resources, product mix and – perhaps most important of all – competition from other suppliers in the market. 174 Marginal costing (3) LESSON 39 Main subject Marginal costing (3) Textbook reference Chapter 13: page 402 Syllabus reference Third Level 3 Marginal costing Lesson topic Applications of the marginal costing technique: closure decisions and maximising the return from scarce resources Extended syllabus reference 3.18 Use marginal costing to maximise the return from a resource that in the short term is limited in supply 3.19 Use marginal costing to evaluate proposals e.g. to expand output or contract output, to change the product mix, to mount an advertising campaign, to close a department, to remove a product from the range etc Required for Candidates for Third Level only Aims of the lesson • To show that the marginal costing technique can be used to evaluate any proposed change. • To show that it can also be used to show the decision that will maximise profits when resources are limited. The lesson ▲ Begin by reminding the class that a decision results in change. For example: It could be decided to close one of a company’s retail outlets. What change will this cause. Costs will be saved – rent, rates, insurances, telephones, heating and lighting, and wages and salaries. Remember that wages and salaries will be saved unless the employees are retained and transferred to other branches. However, sales will also be lost, although it is possible that customers may go instead to another of the company’s retail outlets. The decision to close will be because it is believed that the costs savings will exceed the gross margin on the lost sales revenue. 175 Cost Accounting – Teacher’s Guide Use the following illustration: The management of Company X are considering the closure of Branch 10. Annual sales of this branch are £860,000. An average gross margin of 60% is earned. £345,000 is paid for staff wages and salaries. In addition, sales staff are paid a commission of 2% of sales turnover. Staff with salaries totalling £75,000 would be absorbed in other branches. The remaining staff would be made redundant. This would involve one-off redundancy costs of £36,700. An amount of £80,000 is apportioned to Branch 10 from Head Office costs, which would be unaffected in total by the closure of Branch 10. Other expenses amount to £55,000, and these would be saved by the closure of Branch 10. It is estimated that sales of £340,000 normally made at Branch 10 would be picked up at other branches. The rest of the sales would be lost. How should this closure proposal be evaluated? First, look at the sales revenue and gross margin. Lost sales from Branch 10 Sales picked up at other branches Net lost sales Gross margin 60% £ 860,000 340,000 520,000 312,000 Now look at the cost savings Staff wages and salaries Less wages and salaries not saved Other expenses Commission 2% on £520,000 Net saving from closure of Branch 10 One-off redundancy payment Net loss from closure £ 345,000 75,000 270,000 55,000 10,400 335,400 23,400 36,700 13,300 Point out that this suggests Branch 10 should not be closed – however, it reflects a point which is included in many questions of this type: the redundancy payment is only paid once. In all future years the company will be £23,400 better off if Branch 10 is closed. Point out, also, that it has been assumed that the staff transferred to other branches are additional staff. If they are being placed in jobs for which people would otherwise have to be recruited, then the £75,000 should not be deducted. 176 Marginal costing (3) ▲ Alternatively, it could be decided to reduce the amount of advertising done by a company. Would this result in the loss of sales to competitors? Could anything be done to retain sales? Use the following illustration: A company makes two products for which the unit product costs are: Product Direct material Variable conversion cost Fixed conversion cost Advertising Selling price Profit Annual units of production and sale A B £ 27.50 22.00 36.00 37.50 123.00 125.00 2.00 800 £ 29.00 42.00 58.00 60.00 189.00 200.00 11.00 500 The company plans to cut its total advertising bill by 80%. The marketing manager thinks that if this decision is made, the selling price of A and B would have to be reduced by 4% and 5% respectively. Even then he believes that volume for both products will fall by 12%. Ask the class for their recommendation. They should approach it along these lines. Advertising Total advertising must be (800 × £37.50) + (500 × £60) = £60,000. 80% of this will be saved, which is £48,000. Lost contribution Present contribution Product A 800 × (£125 – £49.50) = Product B 500 × (£200 – £71) = Expected contribution Product A (800 × 88%)(£120 – £49.50) Product B (500 × 88%)(£190 – £71) Lost contribution Saving in advertising cost Net benefit £ 60,400 64,500 124,900 £ 49,632 52,360 101,992 22,908 48,000 25,092 ▲ Now take the class through Example 6 on pages 417-420 of the textbook. 177 Cost Accounting – Teacher’s Guide When you come to maximising the return from scarce resources (page 420), you should point out that this topic was introduced to Second Level students in Chapter 11 and in the corresponding lessons. ▲ Third Level questions do not introduce any new principles with regard to this topic. However, differences of application arise. Begin with the following budgeted data: Product Material Variable conversion @ £6 per hour Fixed conversion @ £8 per hour Total cost Selling price Units X Y £ 40.00 36.00 48.00 124.00 130.00 500 £ 25.00 54.00 72.00 151.00 155.00 1,000 Ask the class what the budgeted profit is. The answer is (500 × £6) + (1,000 × £4) = £7,000. Now tell the class that only £35,000 of material is available for the budget period. Ask them to calculate the optimal profit or loss The answer is calculated: Product Material needed Material available Shortage Contribution per unit Material used Contribution per £ of material Ranking X £ 20,000 Y £ 25,000 54 40 1.35 2 76 25 3.04 1 Total £ 45,000 35,000 10,000 £10,000 of material would make £10,000/£40 = 250 units of X. These units would earn 250 × £54 = £13,500 contribution. Therefore, optimal profit or loss is £7,000 – £13,500 = £6,500 loss. Now tell the class that material is freely available, but production hours are limited to 10,000 hours in the budget period. Ask them to calculate the optimal profit or loss. 178 Marginal costing (3) The answer is calculated: Product Production hours needed Hours available Shortage Contribution per unit Hours used Contribution per hour Ranking X 3,000 Y 9,000 54 6 £9.00 1 76 9 £8.44 2 Total 12,000 10,000 2,000 2,000 hours would make 2,000/9 = 222 units of Y. These units would earn 222 × £76 = £16,872 contribution. Therefore, optimal profit or loss is £7,000 – £16,872 = £9,872 loss. ▲ Explain that the illustrations have been quite simple so far, but they do show the principles that Second Level should be able to apply. Third Level questions on the same topic areas are likely to contain more detail. As an example: Tell the class that the variable rate per hour, £6 per hour, includes £4.80 for labour cost. 990 hours of overtime could be available but productivity will fall in overtime, and 10% more time will be needed for each unit. Overtime will be paid at time and a third. Ask the class to calculate the optimal profit or loss. Explain that since the production time is rising, and the hourly rate is rising, the contribution per hour must fall. The original preference for X therefore remains. What would be the contribution per hour for units made in overtime? Product Material Variable conversion @ £7.60 per hour Variable cost Selling price Contribution Hours Contribution per hour X £ 40.00 Y £ 25.00 50.16 90.16 130.00 39.84 6.6 £6.04 75.24 100.24 155.00 54.76 9.9 £5.53 Of course, X remains the best product. However, all units of X are being made in normal time. 990 hours of overtime allows 990/9.9 = 100 units of Y to be produced. The additional contribution will be 100 × £54.76 = £5,476. The optimal contribution becomes a loss of £9,872 – £5,476 = a loss of £4,396. Now take the class carefully through Example 7 on pages 421-423 of the textbook. 179 Cost Accounting – Teacher’s Guide Reminders At the end of the lesson, re-state the main points again: Marginal costing is a useful technique when considering closures. It identifies the costs and revenue changes that result from the closure. In such decisions many costs normally considered to be fixed become relevant. The ‘closure’ principle is applied to other similar situations – for example, ‘closing’ advertising expenditure. Maximising scarce factors means looking at the contribution earned in relation to the consumption of the scarce factor. At Third Level some adjustment of the basic contribution per unit is likely to be necessary. 180 Breakeven charts and profit graphs LESSON 40 Main subject Breakeven charts and profit graphs Textbook reference Chapter 14: Page 430 Syllabus reference Third Level 3 Marginal costing Breakeven charts involving traditional, contribution and profit volume (P/V) presentations Lesson topic Traditional breakeven charts Extended syllabus reference 3.22 Breakeven charts (a) Apply principles of good chart construction (b) Construct a traditional breakeven chart (c) Construct a contribution breakeven chart (Lesson 41) (d) Explain and identify relevant range (e) Understand cost and revenue behaviour within the relevant range. Required for Candidates for Third Level only Aim of the lesson • To explain the preparation of traditional breakeven charts. The lesson ▲ Begin by drawing attention to the CIMA definition of a breakeven chart given on page 430 of the textbook. Emphasise the word ‘approximate.’ It indicates that readings from a graph can never have the accuracy of calculations. Point out as well the reference to ‘a limited range.’ Tell the class that this means that – when the graph is completed – only a small part of it may really hold good for the distinctions drawn between variable and fixed costs. Reinforce the comment made at the top of page 431 of the textbook. In the examination, readings from the graph are often called for. When they are, calculations are not an acceptable substitute. 181 Cost Accounting – Teacher’s Guide ▲ Before plotting a single graph or chart, please take the class through points 1-6 on pages 431-432. Emphasise that many errors on breakeven charts come from failing to observe the principles of good chart construction. Please ensure that the class is able to practise the preparation of breakeven charts on proper graph paper. Use the following data to demonstrate a breakeven chart in traditional format: Company X makes one product, which it sells for £40 per unit. The variable cost per unit is £30, and fixed costs in total are £30,000. The maximum output is 5,000 units. Tell the class that the very first step is to plan the use and range of scales appropriate to the particular format required – in this case, the traditional one. Use the x-axis (horizontal scale) to represent units of output. Use the y-axis (vertical scale) to represent £. Choose the maximum values on each scale. The maximum output is 5,000 units. Therefore, scale the x-axis from 0 units (emphasise this!) to 5,000 units, making best use of the full width of the graph paper. The y-axis must therefore allow for the sales revenue from 5,000 units. This will be 5,000 × £40 = £200,000. Therefore, scale the y-axis from 0 (emphasise this!) to £200,000, making use of the full height of the graph paper. Explain to the class that the above procedure should be done for any graph or chart before any plotting commences. For a traditional chart, explain that the fixed costs are plotted first. Find the £30,000 point on the vertical axis, and extend the fixed cost line parallel to the base line. This shows that however many units are made and sold, the fixed costs will still be £30,000. Next, plot the variable costs over the fixed costs. Point out that it is the total cost line that is therefore being plotted. If 0 units are made and sold, the cost will just be the £30,000 fixed costs. Take any other output point. This could be 5,000 units. For 5,000 units the variable cost will be 5,000 × £30 = £150,000. Add this to the fixed costs of £30,000, and the total cost will be £180,000. Draw the total cost line by connecting the points (x-axis 0, y-axis £30,000) and (x-axis 5,000, y-axis £180,000). Finally draw in the sales revenue line. This will connect the points (x-axis 0, y-axis 0) and (x-axis 5,000, y-axis £200,000) This is because if no units are sold there is no revenue and if 5,000 units are sold the revenue is 5,000 × £40 = £200,000. Refer to the CIMA definition of a breakeven point on page 433 of the textbook. Ask the class to read the breakeven point from their graph. It will be in units in this case, because the x-axis is scaled in units. An approximate reading will do. Its accuracy will depend upon having made no errors in drawing the chart, and upon how neatly the chart has been drawn. The reading can be checked. Breakeven is F/Cunit, which in this case is £30,000/(£40 – £30) = 3,000 units. 182 Breakeven charts and profit graphs Tell the class that if the example had said that the company normally makes and sells between 2,500 and 4,000 units, then that would be the relevant range, that is, what happens to the cost and revenue lines outside that range is less important. Explain the meaning of margin of safety. If the company was planning to make and sell 3,800 units this year, the margin of safety would be 800 units ( 3,800 units minus 3,000 units). ▲ Now ask the class to do a second traditional breakeven chart, using the following: Sales Variable costs 48,000 Fixed costs 60,000 Profit The firm makes one product. £ 120,000 108,000 12,000 Point out to the class that units are not mentioned. This means that the x-axis of the chart cannot be in units, even though the firm only makes one product. Sales value has to be used as a measure of output. Explain that both the x-axis and the y-axis will be in £. Suggest that the class takes both scales to £120,000. When drawing the fixed costs line, draw it from £60,000 on the y-axis parallel to the xaxis. Then get the class to draw the total cost line. This needs care. If there is no output, the total cost will be the fixed costs of £60,000. When the output has a sales value of £120,000, the total cost is £108,000. The line is drawn from (x-axis 0, y-axis £60,000) through (x-axis £120,000, y-axis £108,000). The sales revenue line is drawn from (x-axis 0, y-axis 0) to (x-axis £120,000, y-axis £120,000). Now ask the class to read the breakeven point from the graph. This time the reading from the x-axis will be in £, and will be a sales figure. Again, the reading can be checked by calculation. Breakeven sales = F/CS ratio. The CS ratio is (£120,000 – £48,000)/£120,000 = 60%. Breakeven sales = £60,000/60% = £100,000. ▲ The class must practise a number of graphs. They must be able to decide quickly what scales are appropriate. They must then be able to accurately construct the chart, and read information from it. They must also be able to interpret a given chart. 183 Cost Accounting – Teacher’s Guide Reminders At the end of the lesson, re-state the main points again: Care is needed in the choice of a scale for each axis of the chart, and in its construction. A breakeven chart can have an x-axis labelled in units, or in the sales value of output. There are other possible measures of output such as direct labour or machine hours. A traditional breakeven chart plots fixed costs first, and then overlays the variable costs to get the total cost line. 184 Breakeven charts and profit graphs LESSON 41 Main subject Breakeven charts and profit graphs Textbook reference Chapter 14: Page 430 Syllabus reference Third Level 3 Marginal costing Breakeven charts involving traditional, contribution and profit volume (P/V) presentations Lesson topic Contribution breakeven charts Extended syllabus reference 3.22 Breakeven charts (a) Apply principles of good chart construction (b) Construct a traditional breakeven chart (Lesson 40) (c) Construct a contribution breakeven chart (d) Explain and identify relevant range (Lesson 40) (e) Understand cost and revenue behaviour within the relevant range. (Lesson 40) (f) Explain the economist’s breakeven chart Required for Candidates for Third Level only Aims of the lesson • To explain the preparation of contribution breakeven charts. • To explain the economist’s breakeven chart The lesson ▲ Begin by telling the class that the contribution breakeven chart is another way of presenting the same information. However, the term ‘contribution breakeven chart’ has a particular meaning, and if a traditional chart is done when a contribution chart is asked for, all marks may be lost! Emphasise that a contribution breakeven chart has the same x and y axes as a traditional chart, but draws the variable cost line first instead of the fixed cost line. Use the same data as for Company X in Lesson 40. The x-axis and y-axis must be scaled and labelled in exactly the same way. 185 Cost Accounting – Teacher’s Guide Then tell the class that the variable cost line will be drawn first. If no units are made and sold, then the variable costs will be zero. Then choose any other output level. If 5,000 units are made and sold the variable costs will be 5,000 × £30 = £150,000. The plotting points for the variable cost line are therefore (x-axis 0, y-axis 0) and (xaxis 5,000, y-axis £150,000). Next draw the sales revenue line. If no units are sold, the sales revenue is zero. If 5,000 units are sold the sales revenue is £200,000. The plotting points are therefore (x-axis 0, y-axis 0) and (x-axis 5,000, y-axis £200,000). Joining these points will give the sales revenue line. Now tell the class why this unfinished chart is called a contribution breakeven chart. It doesn’t yet show a breakeven point, but it does show the wedge of contribution as the area between the sales revenue line and the variable cost line. Finally, put on the fixed costs to show the total cost line. This time the fixed costs are being added to the variable costs. When output was zero, no variable costs were incurred. However, fixed costs are £30,000, so at zero output the total costs are £30,000. When 5,000 units are made and sold, the variable costs are £150,000. If the fixed costs are added the total cost is £180,000. This gives the plotting points for the total costs line, (x-axis 0, y-axis £30,000) and (xaxis 5,000, y-axis £180,000). If the class now marks the breakeven point, it must be in exactly the same position as on the traditional breakeven chart produced in Lesson 40. However, this time emphasise how the breakeven point is reached when the contribution wedge increases until the contribution = fixed costs. ▲ Now take the class through Example 2 on page 434 of the textbook. ▲ Ask the class to take the second example in Lesson 40, and prepare an answer as a contribution breakeven chart. ▲ Now use the following data to prepare a contribution breakeven chart: Product Sales Variable costs Contribution Fixed costs Profit X Y Total £ 120,000 48,000 72,000 £ 180,000 90,000 90,000 £ 300,000 138,000 162,000 108,000 54,000 Fixed costs are general. That is, no fixed costs are incurred because of any one product. Advise the class that no attempt must be made to produce separate charts for X and Y. It must be one chart for the firm. 186 Breakeven charts and profit graphs Tell the class that no units are given, so the x-axis must be in £ sales, as a measure of output. Emphasise that this will also represent a mix of sales – that any level of sales will consist of 40% X and 60% Y. Tell the class that the x-axis is scaled to £300,000. The y-axis would have to be similarly scaled. Now draw the variable cost line. Plotting points are (x-axis 0, y-axis 0) and (x-axis £300,000, y-axis £138,000). Now draw the sales revenue line. Plotting points are (x-axis 0, y-axis 0) and (x-axis £300,000, y-axis £300,000). Draw the attention of the class to the contribution wedge again. Now draw the total cost line by overlaying the variable costs with the fixed costs. This will give plotting points of (x-axis 0, y-axis £108,000) and (x-axis £300,000, y-axis £246,000). Ask the class to read off the breakeven sales £. When the answer is given, point out that it is only true if the breakeven sales is made up of 40% sales of X and 60% sales of Y. The answer can be checked by calculation: Average CS ratio £162,000/£300,000 = 54%. Breakeven sales £108,000/54% = £200,000. ▲ Now take the class through Example 3 on pages 435-436 of the textbook. Make sure that the class carefully works through the Notes to the solution. ▲ Discuss with the class the factors that may affect the linear assumptions of the traditional and contribution breakeven chart. Make sure that the class can say something about each of selling prices, variable costs and fixed costs. ▲ Take the class through Example 5. ▲ Finally, work through Examples 6 and 7 with the class. Emphasise how important it is to prepare neat graphs when information has to be read from the chart. This is particularly so when more than one situation is to be shown on one chart – as in Example 7. Reminders At the end of the lesson, re-state the main points again: On contribution breakeven charts the variable cost line is drawn first. When the sales revenue line is drawn, the contribution wedge can be seen. Across the entire output range, lines on the breakeven chart would not be linear. Candidates should be able to suggest reasons for this. 187 Cost Accounting – Teacher’s Guide LESSON 42 Main subject Breakeven charts and profit graphs Textbook reference Chapter 14: Page 430 Syllabus reference Third Level 3 Marginal costing Breakeven charts involving traditional, contribution and profit volume (P/V) presentations Lesson topic Profit graphs Extended syllabus reference 3.22 Breakeven charts (g) Understand profit graphs or PV graphs (j) Apply breakeven chart principles to less usual situations e.g. to show overhead incurred and overhead absorbed. Required for Candidates for Third Level only Aim of the lesson • To explain the preparation of profit/volume (PV) graphs The lesson ▲ Begin by explaining that a PV graph or chart is a type of breakeven chart. It allows direct readings of profit or loss. On a traditional or contribution breakeven chart, profit has to be read as a space between the total cost line and the total revenue line. ▲ The class should practise the preparation of PV graphs. This is the only way to gain confidence and increase the speed of accurate graph preparation. Begin with the following example: A company makes one product. Its results for the current year show: Sales Variable costs Fixed costs Profit £ 180,000 72,000 90,000 162,000 18,000 Prepare a profit graph for these figures. 188 Breakeven charts and profit graphs Emphasise that, as with traditional and contribution breakeven charts, care is needed in starting the graph. Scales must be carefully chosen and marked on the graph before any plotting begins. Explain that the profit graph has an x-axis which represents output. Output can be measured in units (for a one-product firm), or in sales value, or in machine hours, or in any other measure of output. Point out that units or sales £ are the most usual. Emphasise that this horizontal scale must start at zero. Next, explain that the profit graph has a y-axis which represents profit or loss. Above the x-axis it represents profit and below the x-axis it represents loss. Now explain to the class what will determine the choice of scale for this example. First, no units have been mentioned, although the firm does only make one product. Therefore, the x-axis will be scaled in Sales £. It will begin at zero. The sales given are £180,000, so the x-axis should be taken to this figure. For the y-axis, the maximum loss must be equal to the fixed costs. In this case that is £90,000. Below the x-axis, the y-axis must go from zero to £90,000. The y-axis above the x-axis is for profit. The given profit is £18,000, so the y-axis above the x-axis could go to £20,000. Emphasise that the intervals on the y-axis scale must be identical for the loss area and the profit area. Point out that the x-axis and the y-axis should be labelled and scaled neatly, so that when the graph is drawn, readings can easily be made. Now draw the line. The plotting points are (x-axis 0, y-axis £90,000 loss) and (x-axis £180,000, y-axis £18,000 profit). Tell the class that the breakeven point is where the drawn line crosses the x-axis. This is in £ sales. Ask the class to read the figure from their graph. The figure can be checked by calculation: The CS ratio is £108,000/£180,000 = 60%. The breakeven sales = £90,000/60% = £150,000. Tell the class that the gradient (slope) of the line reflects the CS ratio of 60%. Remember that this means that as £1 is added to sales, £0.60 is added to contribution. Eventually, there is enough contribution to meet the fixed costs, and at this point the line crosses the x-axis. The margin of safety in this case is £180,000 – £150,000 = £30,000. ▲ Now take the class through Examples 8 and 9 on pages 445-449 of the textbook. In particular, spend some time on Example 9. It shows how 2 situations can be presented on one graph. Emphasise that this means that both situations must be considered when choosing the scales. For example the y-axis must allow for fixed costs of £400,000 for Alternative 1, even though scaling it just to £200,000 would have been sufficient for Alternative 2. Also, emphasise the importance of neatness when 2 lines are to be drawn on one graph, from which 3 readings have to be accurately made. 189 Cost Accounting – Teacher’s Guide Point out that, in an examination question, the information can be given in a number of ways. As an example, ask the class to produce a profit graph for the following company: £ Sales 240,000 Total costs 220,000 Profit 20,000 The company breaks even at sales of £190,000. At first sight, the class may think that not enough information has been given. Where are the fixed costs? Where are the variable costs? We only appear to know the total costs of £220,000. Point out that we have, however, been given the breakeven sales of £190,000. This is a plotting point because we know that this point must lie on the x-axis (because there is neither a profit nor a loss). As the class tries this example, they will realise that one problem is scaling the graph. How much needs to be allowed on the y-axis at the loss end. We don’t know the fixed costs. The way round this is to put the x-axis first, scaled in £ sales from 0-£240,000. Next, tentatively put in the scale on the y-axis for profit. This must go from 0-£20,000. Now put the ruler through the 2 plotting points. These are (x-axis £240,000, y-axis £20,000) and (x-axis £190,000, y-axis 0). The extension of this line to the y-axis will point to the fixed costs. Remind the class that the second plotting point is the breakeven point – hence 0 on the y-axis! The fixed costs can be calculated, of course: Sales Profit £ 190,000 Nil £ 240,000 20,000 Therefore an increase in sales of £240,000 – £190,000 = £50,000, has resulted in an increase in profit (and therefore contribution) of £20,000. (Profit has moved from zero to £20,000). This means the CS ratio is £20,000/£50,000 = 40% When sales are £190,000, the contribution must be 40% × £190,000 = £76,000. Since sales of £190,000 are breakeven sales, the fixed costs must be £76,000. ▲ Finally, work through Examples 10 and 11 with the class. These are on pages 449-452 of the textbook. Example 11 illustrates a slight variation in presentation of a PV graph. Example 12 shows how the basic structure of a breakeven graph can be applied to a different problem, in this case to illustrate incurred and absorbed overhead. 190 Breakeven charts and profit graphs Reminders At the end of the lesson, re-state the main points again: PV graphs are a version of the breakeven chart. They make direct profit/loss readings possible. The gradient (slope) of the line drawn on the graph reflects the CS ratio. The preparation of PV graphs requires the same attention to scale choice, neatness etc as was the case for traditional and contribution breakeven charts. It is easier to plot and compare alternative situations on a PV graph than on either a traditional or contribution breakeven chart. NB Tell the class that a pocket ruler is not usually adequate for questions on breakeven charts and profit graphs. Candidates should take a full 12-inch or 30-centimetre ruler into the examination. 191 Cost Accounting – Teacher’s Guide LESSON 43 Main subject Budgeting and budgetary control Textbook reference Chapter 15: Page 459 Syllabus reference Optional techniques – Elementary knowledge of budgeting Lesson topic Introduction to budgeting and its organisational framework Extended syllabus reference 7.1 7.2 7.3 Understand the difference between budgeting and budgetary control Explain the benefits expected to accrue from the use of budgets Understand the meaning and importance of the principal budget factor Required for Candidates for Second Level and Third Level Aim of the lesson • To explain the purpose and place of budgeting and budgetary control in an organisation, whose responsibility it is, how it is organised, and what budgets will be needed The lesson ▲ Begin by pointing out that in the Second Level syllabus, this subject is under ‘7 Optional Techniques’. This allows you to remind the class of the difference between a costing method – such as process costing – and a costing technique such as budgeting. If a particular firm makes its product repeatedly, in a sequence of processes, then it needs a system of process costing; this is the costing method applied. However, it doesn’t have to use budgets or budgetary control. This is an option. Point out that it would be difficult not to use some budgeting. For example, predetermined production overhead absorption rates need a budget for the production overheads. ▲ Point to the definition of a budget on page 459 and emphasise ‘defined period of time’ and ‘planned’. Tell the class that the defined period of time could be a year, but that shorter periods might be used. A business experiencing cash difficulties might prepare monthly cash flow budgets. Explain why this is. 192 Budgeting and budgetary control Emphasise that the word ‘planned’ shows that, by definition, a budget is forward looking. This gives you a chance to explain that assumptions made when budgeting may not turn out to be valid, and continuous adjustment may be needed. To illustrate this, ask the class to imagine that a business is about to prepare its sales budget for the coming year. (You might want to use a particular local business to help the students.) Ask them to suggest assumptions which will affect the sales budget, but which could later turn out to be invalid. These could include: Growth rates in the market Strength of the currency if there are export sales Efficiency of sales staff Strength of competition Production capacity and so on. Now explain that we can budget for sales for the coming year, for the wages and salaries to be paid in the coming year, for the cash inflows and outflows for the coming month, etc. Although this is budgeting, it isn’t budgetary control. Budgetary control implies two things: comparison of actual and budget; action to correct unacceptable deviations. Explain that like must be compared with like. If the sales budget is £10,000 and the actual sales are £3,000, what does this mean? If the budget is for one month and the actual is for one week, then the figures mean nothing. ▲ You should now take the class through the points on page 460 of the textbook, and in particular, those points dealing with the choice of short-term control period. Discuss with the class the 6 important points under the heading ‘Why does a business prepare budgets?’ on page 461. ▲ Now ask the class whose job it is to prepare budgets. They may suggest that it is the accountant’s job. Point out that whilst this could happen in some firms, it isn’t really the correct answer. Point to the first paragraph on page 461 under the heading ‘Budget organisation’ and emphasise the words ‘starting’, ‘progressing’ and ‘supervising’. Explain that the starting point for budgeting depends upon the ‘principal budget factor’ (page 462). Explain this. Then get the class to see the usual order of budgeting: A sales budget, to show what the Sales Department believes it can sell A production budget, to show what the production department will have to make in order to provide the planned sales and allow for any planned stock changes A materials usage budget, to show the materials needed to make the production budget 193 Cost Accounting – Teacher’s Guide A capacity budget, to show what manpower, machine, process time, etc, is needed to meet the production budget A labour budget, for direct and indirect labour An overhead budget etc etc At this point – without involving any numbers – the idea is to get the class to understand the nature of budgeting and budgetary control, and the broad direction in which the budgeting process goes. Reminders At the end of the lesson, re-state the main points again: The terms that must be known. The difference between budgeting and budgetary control. The organisation for budgeting. The normal order in which budgeting takes place. 194 Budgeting and budgetary control LESSON 44 Main subject Budgeting and budgetary control Textbook reference Chapter 15: Page 459 Syllabus reference Optional techniques – Elementary knowledge of budgeting Lesson topic The preparation of budgets (excluding cash budgets) Extended syllabus reference 7.4 Prepare a sales budget analysed where necessary by product, area, salesman etc 7.5 Prepare a production budget which takes into account planned product sales and planned finished stock changes 7.6 Prepare a materials usage budget based upon the production budget 7.7 Prepare a materials purchasing budget based upon the materials usage budget and planned material stock movements 7.8 Prepare a machine or process utilisation budget based upon the production budget 7.9 Prepare a direct labour budget 7.10 Prepare a production overhead budget and calculate the budgeted production overhead absorption rates 7.11 Summarise budgets to establish the budgeted profit, making stock adjustments where necessary Required for Candidates for Second Level and Third Level Aim of the lesson • To explain how individual budgets can be prepared, then summarised to obtain the budgeted profit or loss. The lesson ▲ Remind the class that budgeting is an orderly process. There has to be a starting point which is determined by the principal budget factor, which usually is sales. The budgeting process therefore begins with the sales budget. 195 Cost Accounting – Teacher’s Guide Emphasise that other budgets then follow in a logical sequence: Sales budget – what are we planning to sell? Production budget – what, therefore, have we got to make? Materials budget – to make this output, what materials do we need? Purchasing budget – how much material do we need to purchase? Capacity budget – what machine and manpower do we need to make the production budget? and so on. Each budget depends on the preceding budget. In other words, there is an order. Point out that the examiner may only ask for the preparation of one or two budgets – for example, the materials usage budget and the purchasing budget. This is because the time constraints of an examination prevent the examiner from setting a question requiring all budgets. However, tell the class, you are going to illustrate the whole sequence for understanding. In addition you should point out the importance of understanding the Fenner Limited examples in the textbook, which begin with Example 1 on page 463. ▲ Start with a very simple situation. Tell the class: A business makes only one product, XP1. It is made in 2 departments, taking 1 hour in Department A and 1 hour in Department B. It is made with 3kg of material which costs £2 per kg. The sales budget for Year 6 has been prepared: 4,000 units of XP1 are to be sold for £30 per unit. Labour is paid £5 per hour in Department A: £6 per hour in Department B. The overhead cost is £3 per hour + £16,000 fixed cost for Department A; £2 per hour + £8,000 fixed cost for Department B. No stock changes are planned. Now take the class steadily through the sequence of budget preparation in this situation. Sales Budget 4,000 units × £30 £120,000 Production budget No stock changes are planned so we must produce 4,000 units. This is the production budget. Materials usage budget 4,000 units × 3kg = 12,000 kg. This will cost 12,000 × £2 = £24,000. Because there are no planned stock changes, this is also the Purchasing budget for the year. 196 Budgeting and budgetary control Labour budget Department A: 4,000 units × 1 hour = 4,000 hours. This is the budgeted utilisation of Department A. The labour will cost 4,000 hours × £5 = £20,000. Department B: 4,000 units × 1 hour = 4,000 hours. This is the budgeted utilisation of Department B. The labour will cost 4,000 hours × £6 = £24,000. Overhead budget Department A: (4,000 hours × £3) + £16,000 = £28,000 Department B: (4,000 hours × £2) + £8,000 = £16,000 All the budgets have been prepared. Explain to the class that because there are no planned stock changes, the sales budget and all cost budgets are based upon 4,000 units. Therefore the budgeted profit is simply the budgeted sales minus the budgeted costs. £ Sales £ 120,000 Material Department A production costs: Labour Overhead 24,000 20,000 28,000 48,000 Department B production costs: Labour Overhead 24,000 16,000 40,000 Total cost Budgeted profit 112,000 8,000 Make sure the class understands this example before continuing. Point out, also, that the budget must be approved as a plan of action by the manager or managers who will be responsible for the overall achievment of this plan. ▲ Now add two more pieces of information, and ask the class how they will change the budgets already prepared. The additional information is: 1 By the end of Year 6, finished stocks of XP1 are to be increased by 500 units. 2 By the end of Year 6, stocks of material are to be decreased by 1,000 kg. Let the class discuss this, and then ask which budgets will change. The answers are: Sales budget – no change. Production budget – this will now be 4,500 units. We must make 4,000 units to sell and a further 500 units to increase the finished stock levels. Materials usage budget – this will now be 4,500 units × 3kg = 13,500 kg. Its cost will be 13,500 kg × £2 = £27,000. 197 Cost Accounting – Teacher’s Guide Materials purchasing budget – this will not now be the same as the material usage budget. Although 13,500 kg are needed for production, 1,000 kg will be drawn from stock, so purchases will be 12,500 kg × £2 = £25,000. Labour budget: Department A. We now have to make 4,500 units. This will take 4,500 × 1 hour = 4,500 hours. It will cost 4,500 × £5 = £22,500. Labour budget: Department B. To make 4,500 units will take 4,500 hours. The cost will be 4,500 × £6 = £27,000. Overhead budget: Department A. This will now be (4,500 hours × £3) + £16,000 = £29,500. Overhead budget: Department B. This will now be (4,500 hours × £2) + £8,000 = £17,000. Ask the class to note that every budget has changed, with the exception of the sales budget. ▲ Now ask the class to summarise the budgets, to get the new budgeted profit or loss. Give them some time to think about this. £ Sales £ 120,000 Material Department A production costs: Labour Overhead 27,000 22,500 29,500 52,000 Department B production costs: Labour Overhead 27,000 17,000 44,000 Total cost Budgeted loss 123,000 (3,000) Some of the class might also include the purchasing budget. You can explain that it would be wrong to have both the material usage budget and the materials purchasing budget included. Many are likely to say that we are now budgeting to make a loss of £3,000. You should point out that this is wrong, because it comes from a comparison of the sales revenue of 4,000 units and the cost of producing 4,500 units. This is not comparing like with like. Explain that the 500 units haven’t been lost – they are in stock ready for sale. They must be valued. Ask the class how the 500 units might be valued. Some might say that since the cost of producing 4,000 units was budgeted at £112,000 and the cost of producing 4,500 units is budgeted at £123,000, then it is reasonable to say that the difference, £11,000, must be the cost of producing the extra 500 units. If this is done, the unsold 500 units, valued at £11,000, would turn the budgeted £3,000 loss into a budgeted £8,000 profit – exactly as it was before! You can suggest that this is reasonable, since 4,000 units are to be sold irrespective of how many are produced. (You could take the opportunity, here, to revise some earlier work on marginal costing, and in particular, absorption versus marginal cost stock valuations.) 198 Budgeting and budgetary control Make sure the class understands that if the 500 units are valued at £11,000, this valuation does not include any of the departmental fixed costs. Some members of the class might suggest valuing the 500 units at 500/4,500 × £123,000 = £13,667. This, of course, includes 500/4,500 of the departmental fixed overheads of £24,000 (£16,000 + £8,000). The effect of this, and how reasonable it is, can be discussed. Finally, point out that if the examiner asks for only one budget, rather than all of them, it is likely to involve more than one product. ▲ Ask the class to imagine that we are now budgeting for Year 7, and that it has been decided to introduce another product, XP2. The production budget for Year 7 has been prepared and we are going to make 3,800 units of XP1 and 700 units of XP2. Tell the class that each unit of XP2 will need 4kg of material (the same material as XP1). To make a unit of XP2 will need 0.5 hours in Department A and 0.8 hours in Department B. Tell the class to suppose that the examiner asked for the materials usage budget and the labour budget for Department B: Materials usage budget XP1 3,800 units × 3 kg = XP2 700 units × 4kg = This will cost 14,200 × £2 = 11,400 kg 2,800 kg 14,200 kg £28,400 Labour budget for Department B XP1 3,800 units × 1 hour = XP2 700 units × 0.8 hrs = 3,800 hrs 560 hrs 4,360 hrs These will cost 4,360 × £6 = £26,160 Encourage the class to pay particular attention to working through pages 462-473 of the textbook, and to work carefully through each Example. Reminders At the end of the lesson, re-state the main points again: Budgets are prepared in a logical order. The starting point is determined by the principal budget factor. Usually the principal budget factor will be sales, so that the sales budget is the starting point Care needs to be taken over stock increases/decreases of finished products and/ or materials. These will usually be part of any budgeting question. 199 Cost Accounting – Teacher’s Guide LESSON 45 Main subject Budgeting and budgetary control Textbook reference Chapter 15: Page 459 Syllabus reference Optional techniques – Elementary knowledge of budgeting Lesson topics The preparation of cash budgets The use and interpretation of flexible budgets Extended syllabus reference 7.12 Prepare a simple cash budget 7.13 Understand the reasons for preparing a cash budget and what can be done to overcome cash difficulties 7.14 Prepare a simple flexed budget and make a comparison with actual costs and/or income Required for Candidates for Second Level and Third Level Aims of the lesson • To explain why and how a cash budget is prepared • To explain why flexible budgets are useful aids for the control of cost, and how they are prepared and interpreted The lesson ▲ Simple cash budgets Explain that the budgets prepared in the preceding lesson were mainly budgets for income and expenditure, and that they were summarised to give the budgeted profit. One exception was the material purchasing budget which was not used in the summary to determine the profit. Remind the class that a business can be budgeting to make a profit, yet could still experience cash flow difficulties. Ask the class why this could be. They should mention timing differences on normal operations – for example, profit is recognised at the moment of sale when an invoice is raised. However, it may be several months before the customer actually pays and the cash comes in. 200 Budgeting and budgetary control They might also mention large one-off payments not directly related to current operations, for example, capital expenditure in acquiring facilities to expand output in the future, but not immediately. Draw attention to the textbook: the second half of page 473 and the first half of page 474, and in particular points 1 and 2 under the heading ‘Cash budgets’. Point out the pro-forma layout of a cash budget on page 474. This is the preferred presentation, and students should be encouraged to use it from the start. On no account should a cash budget be presented as a sequence of ‘T’-accounts. Go through the pro-forma with the class, explaining each line, and referring to the Notes at the top of page 475. ▲ Use the following figures to show the class how to prepare a cash budget: A trader plans to commence in business on 1 January Month 1. On that date he will open a business bank account with £5,400 taken from his private bank account. He budgets his sales for the first 4 months as £3,000, £3,800, £4,500 and £5,000 respectively. He budgets for a 40% gross margin. Both sales and purchases are made on an immediate cash basis. No stocks are carried. He budgets monthly expenses (to be paid in cash) as £1,800. This includes £100 a month depreciation of a motor van, which he intends to buy for cash in Month 1 for £4,800. Cash budget for Months 1-4 Month Opening balance Receipts from customers Payments: Suppliers Expenses Motor van Net inflow/(outflow) Closing balance 1 £ 5,400 3,000 1,800 1,700 4,800 8,300 (5,300) 100 2 3 4 £ £ £ 100 3,800 (80) 4,500 20 5,000 2,280 1,700 2,700 1,700 3,000 1,700 3,980 (180) (80) 4,400 100 20 4,700 300 320 Explain that an overdraft facility will have to be arranged with the bank for Month 2. Ask the class if they can suggest any other solution to the problem. They may suggest buying the motor van on HP (Hire Purchase) terms instead of making an outright cash purchase. Point out that it is, however, a temporary cash problem. By Month 3 the cash is in surplus. 201 Cost Accounting – Teacher’s Guide ▲ Now continue. In Month 5, the trader plans to buy some goods to carry as a constant level of stock. These goods will cost £950. From Month 5, the trader plans to give all customers 1 month’s credit. Sales for the 4 months starting with Month 5 are budgeted as £5,500, £6,000, £6,200 and £6,500. Because he will be buying more goods from his supplier, the trader budgets to negotiate better prices – with the result that his gross margin can be budgeted as 45% instead of 40%, starting with the purchases made and paid for in Month 5. Cash budget for Months 5-8 Month Opening balance Receipts from customers Payments: Suppliers Purchase of stock Expenses Net inflow/(outflow) Closing balance 5 6 7 8 £ 320 – £ (5,355) 5,500 £ (4,855) 6,000 £ (3,965) 6,200 3,025 950 1,700 5,675 (5,675) (5,355) 3,300 3,410 3,575 1,700 5,000 500 (4,855) 1,700 5,110 890 (3,965) 1,700 5,275 925 (3,040) Point out that this cash problem has been caused by planning to give 1 month’s credit to all customers, and to carry level of stocks. You should also point out that the deficit is steadily reducing. Ask the class if the trader is planning to make a profit in Month 5. They may be tempted to say, ‘No’, because a large deficit appears at the end of the month. However, you should show the class these figures: Sales Cost of sales 55% Expenses Depreciation on van Budgeted profit £ 5,500 3,025 1,700 100 4,825 675 Make sure that the implications of this are understood. ▲ Finally, with the class, work carefully through Example 6 on page 475 of the textbook. Note that the net cash inflow for March on page 476 should be 14, not 13 as printed. 202 Budgeting and budgetary control ▲ Flexible budgets Emphasise the definition of a flexible budget which appears on page 478 of the textbook. Also emphasise that there is no budget which controls cost – only people do that. However, budgets may help. Department A has a budget for one month amounting to £18,800. When actual costs are recorded they amount to £17,300. Is this a good cost performance by the departmental manager? Ask the class. They should say that there is insufficient information to decide! We need to know both the budgeted and actual level of production, and the expected behaviour of the departmental costs. Now tell the class that budgeted output was 1,500 hours of work, the actual output was 1,200 hours of work, and that £8,000 of the budgeted cost is regarded as fixed, the balance being variable. The question asked can now be answered: The output of the department was 80% of budget, (1,200/1,500), so the costs should have totalled (80% × £10,800) + £8,000 = £16,640. Since the costs incurred were £17,300, the flexible budget (not the original budget!) has been overspent by £660. This should encourage the departmental manager to investigate the reason(s) for the overspending, and to identify the cost, or costs, that need particular attention. Corrective action can then be taken. Reminders At the end of the lesson, re-state the main points again: Cash budgets are about the timing of cash flows. Presentation in columns is important. Cash budgets are needed to identify possible shortages or surpluses of cash at future short term intervals – often monthly. Management can take appropriate action now to cover for these future shortages/ surpluses. Flexible budgets are needed to make a correct assessment of cost control by managers. Flexible budgets are output-adjusted budgets and therefore give a good comparison with the actual costs. 203 Cost Accounting – Teacher’s Guide LESSON 46 Main subject Budgeting (2) Textbook reference Chapter 16: page 484 Syllabus reference Third Level 4 Variance accounting – Preparation and co-ordination of functional, cash and master budgets. Limiting factor. Fixed, flexible and rolling budgets. Human behavioural considerations. Lesson topic Human behavioural considerations Extended syllabus 4.5 Recognise the importance of management style: autocratic or participative budgeting 4.6 Outline behavioural aspects of budgeting – planning and control aspects 4.31 Discuss the attitude of managers to variance reporting 4.32 Understand the purpose of budget padding in this context Required for Candidates for Third Level only Aim of the lesson • To introduce the relationship between budgets and people. The lesson ▲ Begin by referring to the reasons for preparing budgets given on page 461 of the textbook. Emphasise particularly points 4, 5, and 6. These show how an individual manager is affected by the existence of budgets: 1 He/she may (should) take part in the preparation of budgets 2 He/she may be motivated to achieve and improve the standards built into his/her budget 3 His/her actual performance will be compared with his/her budget 4 His/her budget performance may be one way in which he/she is judged as a manager. Note to the teacher: There is a lot of research material on the relationship between budgets and people. Candidates are not expected to know this material. For the LCCI Third Level examination the awareness required is of a more general nature. 204 Budgeting (2) Setting budgets Emphasise the difference between an autocratic budget process and a participative budget process. With the former, budgets may be set by senior managers and ‘handed down’ to lower levels of management. In this way, a manager could be asked to be responsible for achieving a budget which he/she has had no part in preparing. With participative budgeting, managers at all levels are involved in setting budgets. Point out that participative budgeting tends to be a more time-consuming process. Explain why this is. Ask the class for their views on each approach. Remind them that budgeting is a process which settles the claims made by different managers on the limited resources available. Does a more ‘aggressive’ manager get a larger share of the resources – and should this be the case? Motivation Some people suggest that budgets can motivate a manager to better performance. One view is that even where budgets are imposed upon managers, they accept and are challenged by the standards of achievement built into the budgets. Another view is that there has to be self-motivation. Managers accept ownership of budgets that they have had a part in setting. They will not accept imposed budgets. It may also be that different managers have different attitudes. Some will accept or give themselves difficult targets to achieve, knowing that they cannot all be met. Others would be depressed by targets which are difficult to achieve, and particularly when these targets are not met. Again, ask the class to discuss these points in a simple way. Comparisons with actual cost Some managers may see this as a threatening situation. If actual costs are to be compared with budget – why is it being done? Some managers fear that it is so that they can be reprimanded for spending over budget. They may feel that praise for underspending the budget is less likely. Whether this fear exists will depend partly upon the environment created by senior management. Fear of this kind is one reason for budget ‘padding’. A manager may feel that if he can obtain approval, at the budgeting stage, for more resources than he really needs, then he has a safeguard against higher than expected actual costs. When incremental budgeting is practised instead of ZBB (Zero-Base Budgeting – see next lesson), this padding leads to budgetary drift. Budget performance A manager knows that he will be appraised either continuously or at specific times. As a result of the appraisals, he knows that he will be judged, fairly or unfairly, as good or bad, competent or incompetent, effective or ineffective, and so on. 205 Cost Accounting – Teacher’s Guide If he considers that performance against a budget will be one basis for appraisal, then he will want to influence not only the setting of the budget, but also the collection of actuals, any comparisons made and their interpretation. Ask the class to look again at Example 1 on pages 485-488 of the textbook. Some of these points are considered briefly from the viewpoint of the manager, R Jinks. Reminders At the end of the lesson, re-state the main points again: Budgets affect people and people affect budgets. Attitudes to budgets and the measurement of performance against budgets will differ from manager to manager. Where managers perceive threats, they will want to influence the budgeting and budgetary control system, to minimise the dangers to themselves personally. 206 Budgeting (2) LESSON 47 Main subject Budgeting (2) Textbook reference Chapter 16: page 484 Syllabus reference Third Level 4 Variance accounting – Preparation and co-ordination of functional, cash and master budgets. Limiting factor. Fixed, flexible and rolling budgets. Human behavioural considerations. Lesson topic Zero Base Budgeting Extended syllabus reference 4.8 Explain Zero Base Budgeting Required for Candidates for Third Level only Aim of the lesson • To explain the nature of Zero Base Budgeting and how it may be applied. The lesson ▲ Begin by emphasising the CIMA definition of ZBB given on page 489 of the textbook. Explain some of the key elements of the definition: Managers must justify each element of expenditure. A manager might have spent £15,000 last year for a particular cost heading, for example, advertising. He might consider that his budget for this year should at least be £15,000 + an allowance for inflation. This approach is called incremental budgeting. (Last year + an increment). ZBB says the expenditure must be justified for this year, whatever was spent last year. The definition says: think of this year’s budget as relating to an activity being done for the first time. So there is no last year which can be referred to. If expenditure is not justified for this year, then the resource allocation is zero. Explain to the class that almost all businesses have limited resources. Many individual managers with budget responsibility are competing for those limited resources. Some managers will be disappointed. ZBB says to each manager, ‘Your resource allocation is zero unless you can justify your claim for resources, and your claim is preferred to those of other managers.’. 207 Cost Accounting – Teacher’s Guide ▲ Take the class carefully through Note 2 on page 489. Emphasise the word ‘activity’ as used in the CIMA definition in its plural form. Get the class to think of a number of activities which could be approached in this way. For example, one could think of maintenance, advertising, quality control, manufacturing, credit control – and so on. Point particularly to 3(e). Even if the activity is thought to bring benefits to the firm, those benefits could perhaps be obtained in a different way. The ‘different way’ might be more economical, more reliable, for instance. For example, the credit control activity would be considered beneficial. It seems sensible to record what customers owe, and to chase them for outstanding debts. However, this could be done by a specialist agency outside the firm. Emphasise that part of the benefit of ZBB is that it encourages managers to challenge assumptions. ‘Because we’ve always’ done something is no reason to carry on doing it, and – even if we do – it doesn’t have to be in the same way. Note that the textbook has not concentrated on the steps involved in ZBB. Candidates only need to know what it means, and what advantages it might bring when compared with traditional or incremental budgeting. This lesson gives you the opportunity to remind the class of the traditional approach, and how ZBB contrasts with this. ▲ Finally, take the class carefully through Example 2 on pages 489-492 of the textbook. Again, this is a detailed practical example. It will benefit the class to understand the steps taken. It is, however, a longer example than would be expected as an examination question. Reminders At the end of the lesson, re-state the main points again: ZBB is an approach to budgeting. It tells managers that their resource allocation is zero, unless their claim for resources for this year is justified. Last year’s allocation and actual spending are not relevant. 208 Budgeting (2) LESSON 48 Main subject Budgeting (2) Textbook reference Chapter 16: page 484 Syllabus reference Third Level 4 Variance accounting – Preparation and co-ordination of functional, cash and master budgets. Limiting factor. Fixed, flexible and rolling budgets. Human behavioural considerations. Lesson topic Budget preparation Extended syllabus reference 4.9 4.10 4.11 4.12 4.13 4.14 4.15 4.16 4.17 4.18 4.19 4.20 4.21 4.22 Prepare a sales budget analysed where necessary by product, area, salesman etc Prepare a production budget which takes into account budgeted product sales, budgeted WIP and finished stock changes, and finished and part finished product rejections Prepare a materials usage budget based upon the production budget Prepare a materials purchasing budget based upon the materials usage budget and planned material stock movements Use the EOQ model to determine the order size and the number of orders to be placed based upon the budgeted annual material requirement Prepare a scrap sales budget Prepare a capacity (machine, labour, process) utilisation budget based upon the production budget Compare the capacity needed with the capacity available for each department, cost centre etc Recognise a ‘bottleneck resource’ and whether it is long-term or shortterm Suggest possible solutions to a shortage of capacity Suggest possible actions to deal with excess or under-utilised capacity Measure capacity utilisation Prepare a direct labour budget based upon the production and capacity utilisation budgets Prepare a production overhead budget and calculate budgeted production overhead absorption rates 209 Cost Accounting – Teacher’s Guide 4.23 Combine 4.21 and 4.22 to budget conversion costs and to calculate conversion cost absorption rates 4.24 Summarise budgets to establish the budgeted profit, making stock adjustments where necessary 4.25 Prepare a cash budget. Questions will normally involve greater complexity in the terms of credit than found at Second Level 4.26 Make proposals to deal with a short-term cash deficit or surplus 4.27 Apply the rolling budget principle – particularly, but not exclusively, to cash budgets 4.28 Contrast fixed budgets versus flexible budgets for control 4.29 Suggest a basis or bases of flexing 4.30 Prepare a flexed budget and make a comparison with actual costs/income, and interpret the variances Required for Candidates for Third Level only Aim of the lesson • To explain some of the major areas of budgeting which are important for the Third Level candidate. The lesson ▲ Remind the class that the ‘principal budget factor’ – usually sales – determines the order of the budgeting process. Explain that some examination questions ask for sales data to be presented as a budget in different ways: perhaps analysed by product, by area, by sales staff, for example. Use the following figures to illustrate this: Sales for Year 12 have been budgeted as: Product X 4,800 units to be sold at £65 each Product Y 1,900 units to be sold at £120 each Product Z 2,800 units to be sold at £90 each. There are 4 sales staff, A, B, C, and D. A only sells Product X and Product Y. He plans to sell 2,400 units of X and 700 units of Y. B only sells Product Z. She plans to sell 2,100 units. C only sells Product Y. He plans to sell 1,100 units. D plans to sell Products X, Y and Z. Prepare a sales budget for Year 12 analysed by (i) product and (ii) sales staff. Explain to the class that this kind of analysis needs to be done quickly and accurately. In practice, it would be done using a simple computer programme. 210 Budgeting (2) (i) by product Product X Product Y Product Z (ii) by sales staff Sales person A Product X Product Y Sales person B Product Z Sales person C Product Y Sales person D Product X Product Y Product Z 4,800 × £65 1,900 × £120 2,800 × £90 £ 312,000 228,000 252,000 792,000 2,400 × £65 700 × £120 £ 156,000 84,000 240,000 2,100 × £90 £ 189,000 1,100 × £120 £ 132,000 2,400 × £65 100 × £120 700 × £90 Total £ 156,000 12,000 63,000 231,000 792,000 Explain the use of the control Total to the class, the fact that both analyses total £792,000. ▲ The production budget This was introduced for Second Level students in the lessons which accompanied Chapter 15 of the textbook. The production budget is in quantity terms. It states the production needed in each production cost centre. In a single-product firm, it will be in units of output. In the multi-product firm, it will usually be in budgeted standard hours of production. Emphasise the difference between the production budget which shows the quantity of output, and the production cost budget, which shows the production cost of that output. If the examiner asks for the production budget, he does not want material cost and conversion cost! Point out that the Third Level candidate must be able to deal with work-in-progress, and rejected products in the production budget. 211 Cost Accounting – Teacher’s Guide Use the following figures in illustration: X Limited makes a single product. Sales budget for Year 9 230 units Finished stock at the start of Year 9 12 units Planned stock at the end of Year 9 22 units What is the production budget for Year 9? The answer is 230 – 12 + 22 = 240 units. Alternatively it can be expressed as 230 + stock increase of 10 = 240 units. Ask the class what the production budget would be if, in addition to the finished stock, there were 18 units of work-in-progress at the start of Year 9, which were 331/3% complete, and work-in-progress at the end of Year 9 was to be increased to 32 units, 50% complete. What is the production budget for Year 9? The class should now call upon their process-costing knowledge. The production budget is: Sales budget Stocks at end of Year 9: Finished stock Work-in-progress 32 × 50% Stocks at start of Year 9: Finished stock Work-in-progress 18 × 331/3% Production budget 230 22 16 12 6 38 268 18 250 Now go back to the illustration before work-in-progress was introduced. The production budget was 240 units. Ask the class what this would become if a 20% reject rate was expected. The finished products are inspected at the end of the production process. Rejected products cannot be recovered. The answer is 240/80% = 300 units. Make sure that the class understands this. The most common incorrect answer is 288 units i.e. 240 + 20%. This is wrong. Emphasise that we must say if 240 units = 80%, what is 100%? 212 Budgeting (2) Now use this example: Y Limited makes one product. It is made in 2 departments. It goes first into Department A and then into Department Y. The sales budget for Year 12 is 520 units. At the start of Year 12 there is a stock of 40 finished units ready for sale. At the end of Year 12, it is planned to have 60 finished units ready for sale. When the work in Department A is completed, the products are inspected and 10% are rejected. They cannot be recovered. When the work in Department B is completed, the products are inspected and 20% are rejected.. They cannot be recovered. What is the production budget? Point out that there is a catch in this question. In fact there are 2 production budgets – one for Department A and one for Department B. Tell the class that we must begin with the completed products and work backwards. We do Department B first. Sales budget Finished stock – end of year Finished stock – start of year Good units to be produced 520 60 580 40 540 540 = 80%. Therefore, production in Department B must be 675 675 = 90%. Therefore, production in Department A must be 750 Emphasise to the class that there are 2 production budgets. For Department A it is 750 units. For Department B it is 675 units. Finally, use these figures: Sales budget: Product A 200 units Product B 340 units Product C 130 units Planned finished stock increase: Product A 30 units Product C 10 units What is the production budget? 213 Cost Accounting – Teacher’s Guide The answer is: Product A Product B Product C 200 units + 30 units = 230 units 340 units 140 units 130 units + 10 units = This is cumbersome. The units cannot be added together to say 710 units because they are 3 different products. We cannot read out a list of products. Although there are only 3 products in this example, there might be 103 products! We need a common denominator. The one that is usually used is hours. If the standard production hours to make 1 unit are: Product A Product B Product C 2.5 hours 4.0 hours 5.5 hours then we can say: (230 × 2.5) + (340 × 4) + (140 × 5.5) = 2,705 The production budget is 2,705 standard hours. ▲ Production cost budgets Point out that the production cost budgets depend upon what is to be produced. Production cost budgets must follow the production budget(s). Remind the class that production cost is direct materials + production conversion cost. The direct material budget depends upon the products made. The conversion cost depends upon how long it takes to make the products in departments and cost centres. To illustrate this, use the figures from the earlier production budget: 750 units to be worked on in Department A 675 units to be worked on in Department B Suppose each unit needs £45 material, and takes 40 hours in Department A and 36 hours in Department B Point out that the direct material budget must be based on 750 units, as that is the number of units which are initially made. They do not all reach finished stock, of course. Direct material cost budget 750 × £45 = £33,750 Before the conversion cost (direct labour + production overhead) can be completed, explain that we first need the budgeted utilisation hours. These are: Department A 750 × 40 =30,000 hours Department B 675 × 36 =24,300 hours 214 Budgeting (2) Explain that if participative budgeting is in use, the manager of Department A will be asked to budget his costs, one by one – labour, electricity, consumables, etc – for 30,000 hours of work from his department. The manager of Department B will be asked to do the same thing for 24,300 hours of work from his department. Emphasise that this budgeting process will also provide the budgeted costs against which the actual costs will be compared. Point out that the manager will also be expected to define his costs as variable or fixed – in case fewer than, or more than, 30,000 hours are worked. This will then be used as the basis of flexible budgets. Now take the class carefully through Example 3 on pages 493-498 of the textbook. ▲ Cash budgets Remind the class that cash budgets were introduced in Chapter 15 and in one of the lessons relating to that chapter. This means that it is a Second Level topic, and that Third Level questions will include a greater degree of difficulty. Explain that this ‘greater difficulty’ usually relates to 2 areas of the cash budget: first, in working out the receipts from customers, and second, in working out the payments to creditors (suppliers). Use the following figures to show how receipts from debtors are calculated: Month Cash sales Credit sales 1 £’000 65 120 2 £’000 45 130 3 £’000 58 140 4 £’000 69 160 5 £’000 72 150 6 £’000 58 140 40% of credit sales by value are received in the month of sale. This attracts a 2% discount. 30% by value will be received after 1 month, 20% after 2 months and 8% after 3 months. The remaining 2% will not be received at all. Ask the class to schedule the cash receipts expected from the sales of each month. Explain that cash receipts should be scheduled on a working (spread) sheet: 215 Cost Accounting – Teacher’s Guide Month Cash sales Credit sales 1 £’000 65 120 Cash receipts schedule: Month 1 £’000 Cash sales 65.00 Credit sales: 40% received in month of sale 48.00 2% discount (0.96) 30% received after one month 20% received after 2 months 8% received after 3 months 2 £’000 45 130 3 £’000 58 140 4 £’000 69 160 5 £’000 72 150 6 £’000 58 140 2 £’000 45.00 3 £’000 58.00 4 £’000 69.00 5 £’000 72.00 6 £’000 58.00 52.00 (1.04) 56.00 (1.12) 64.00 (1.28) 60.00 (1.20) 56.00 (1.12) 36.00 39.00 42.00 48.00 45.00 24.00 26.00 28.00 32.00 9.60 209.32 10.40 217.20 11.20 201.08 Emphasise to the class 1 This is a working sheet to get the 3 final figures for months 4, 5, and 6. These are then taken into the cash budget. 2 Because it is a working sheet, it needs to be done neatly, but above all, quickly. 3 Cash receipts for Months 1, 2, and 3, cannot be completed because no information was given as to the sales of Months 10, 11, and 12 (i.e. the months before Month 1). 4 Expected bad debts are simply left out. The cash will not be received. ▲ Payments to suppliers depend upon purchases made. Purchases made depend, not only upon materials needed for production, but also upon planned changes in material stock levels. Use the following figures to illustrate this: Month Budgeted sales 1 £’000 170 2 £’000 230 3 £’000 310 4 £’000 280 5 £’000 260 6 £’000 200 Selling prices are set so that value added is 70% of selling price. Production in any month comprises 50% of the current months sales requirements and 50% of the next months sales requirements. Purchases in any month comprise the material production requirements of the next month. Suppliers are paid two months after purchase. 216 Budgeting (2) Ask the class to calculate the amounts payable to creditors The answer should be: Month Budgeted sales Material content 30% Production materials Purchases of materials Payments to creditors 1 £’000 170 51.00 60.00 81.00 2 £’000 230 69.00 81.00 88.50 3 £’000 310 93.00 88.50 81.00 81.00 4 £’000 280 84.00 81.00 69.00 88.50 5 £’000 260 78.00 69.00 6 £’000 200 60.00 81.00 69.00 Again, you should point out why parts of this table cannot be completed. Emphasise that it is a working sheet, and that it has given us the payments for months 3, 4, 5, and 6 which can now be entered in the cash budget. Now take the class through Examples 4 and 5 on pages 499-503 of the textbook. Reminders At the end of the lesson, re-state the main points again: Production budgets are prepared in quantity terms (units of product) or in a term that can represent a number of products (standard hours). A clear distinction must be drawn between the production budget and the production cost budget. Cash budgets at Third Level are usually more complex than those at Second Level. Because of this, workings become important and need to be prepared quickly and accurately. 217 Cost Accounting – Teacher’s Guide LESSON 49 Main subject Standard costing (1) Textbook reference Chapter 17: Page 510 Syllabus reference Elementary knowledge of budgeting and standard costing restricted to prime cost variance analysis Lesson topics The nature and purpose of standard costing The preparation of a standard cost Extended syllabus reference 7.15 7.16 7.17 7.18 Understand the meaning of standard cost, standard costing and variance Distinguish between an ideal standard and an attainable standard Explain the uses to which a standard cost can be put Prepare a simple standard cost Required for Candidates for Second Level and Third Level Aim of the lesson • To explain what a standard cost is, what it is used for, how it is prepared, and how a standard cost relates to standard costing The lesson ▲ Begin by reading out the CIMA definition of standard costing on page 511 of the textbook. Emphasise the first three words: ‘a control technique’. Explain how this works: actual costs are compared with standard costs to get a variance, or difference. The analysis of this variance should result in managers taking action to stimulate better performance. For example: Standard cost to make 1 product 150 products made Therefore standard cost for 150 good products Actual cost for making 150 good products Therefore variance 218 £230 £34,500 £36,750 £2,250 Adverse Standard costing (1) Ask the class to suggest why this overspending might have occurred. They could suggest: The material price has gone up. More materials have been used than should have been used. Some products had to be scrapped – because they were not up to standard. A more expensive grade of labour was used. Direct labour took longer than expected to produce the output. and so on. If analysis of the variance is used to stimulate better performance, ask the class to suggest what a manager could do. For example, if the variance is because the purchase price of the materials has risen, he could look for another supplier, or he could suggest purchasing in larger amounts to get a lower price. (Hopefully, the class might recognise that this will increase stockcarrying costs). He could consider if an alternative, cheaper material could be used. Students might correctly suggest that this might not be satisfactory to the customer, or might reduce the quality of the product. If the variance is because too much material has been used, the manager could investigate to find out if this was because of poor supervision of employees, inadequate training of employees, machine faults, and so on. Emphasise that a variance can only be calculated if a standard cost has already been set. So what is a standard cost? Read out the CIMA definition of a standard cost. This is on page 513 of the textbook. Emphasise that it is a planned unit cost. It is set before the product is made. Emphasise, also, that it can be for a product, a component or a service. As examples: A standard cost can be set for a loaf of bread, but one can also be set for an audit. A bakery can set a standard cost for producing a loaf of bread. It can then compare actual costs to this standard. An accountant can set a standard cost for conducting an audit for a client, and can then compare actual costs to this standard. The bakery makes a product. The accountant gives a service. ▲ Draw the attention of the class to some other uses of a standard cost, given in the definition: Stock valuation If 450 of the product already referred to are made at a cost of £110,700, but only 421 are sold, then 29 remain in stock. At the period end when a profit and loss account is prepared, unsold stock must be valued. On an actual cost basis, the valuation could be £110,700 × (29/450) = £7,134. Where a standard cost exists it is easier to value the unsold stock at 29 × £230 = £6,670. 219 Cost Accounting – Teacher’s Guide Once the standard cost has been prepared, the £230 can be stored in a database. At each period (month) end, the number of unsold units can be input, and multiplied by the stored £230 to give the stock valuation. The establishment of selling prices Emphasise to the class that cost alone rarely determines selling prices. Ask them why. Ask them if a product that costs £230 to make would ever be sold for (say) £210. The class should say ‘Yes, it might be’ and should mention strong competition, trying to get a foothold in an export market, and so on. A standard cost – an indication of what the product or service should cost in standard circumstances – is helpful to a manager who has to set the selling price for a product, but he will consider other things as well. The level of attainment This is covered on pages 517-518 of the textbook. Ask the class if it will be easy to make a product for the £230 set as standard. Hopefully, they will say that this depends upon how tightly or generously the standard has been set. A very tight standard might challenge employees, but might almost always give rise to adverse variances. Draw the attention of the class to the CIMA definitions on page 518 of the textbook and contrast them. ▲ Preparing a standard cost This is covered on pages 513-517 of the textbook Emphasise that all elements of a standard cost are a standard quantity multiplied by a standard price. For example, a standard material cost might be 10 kg × £14 per kg = £140. The standard labour cost might be 3 hours × £8 per hour = £24. The 10 kg and the 3 hours are both standard quantities. The £14 kg and the £8 per hour are both standard prices (even though as we shall see later, the standard price for labour is usually called a standard rate). Put a simple standard cost on the whiteboard, blackboard or overhead projector: Direct material Direct labour Production overhead Production cost 10 kg × £14 3 hours × £8 3 hours × £12 £ 140 24 36 200 Ask the class where each of the six numbers in bold would have been obtained from, and what problems might exist in getting them. Relate this to the 8 points at the bottom of page 513 and the top of page 514 in the textbook. 220 Standard costing (1) Explain that, these days, direct labour might not be given separately. It could be merged with production overhead to give production conversion cost, and the standard cost would just show: Direct material Production conversion cost Production cost 10 kg × £14 3 hours × £20 140 60 200 Remind the class that the term conversion cost means the cost of converting the material into a product. Show how a standard cost could be presented where the product is made in more than one department or cost centre: To make one unit of product XRP: 30 kg of material costing £13 per kg is issued to Department J 4.50 hours work is done on the product in Department J The product is then passed to Department K 12 kg of material costing £5 per kg is added to the product 6.75 hours work is done on the product in Department K, and the product is then finished. Cost rates are: Department J: £8.30 for direct labour and £10.20 for production overhead Department K: £6.40 for direct labour and £7.60 for production overhead The standard cost should be presented as: Quantity Rate Material £ Department J Material 30 kg £13 kg Labour 4.50 hrs £8.30 hr Overhead 4.50 hrs £10.20 hr Overhead £ 390.00 37.35 51.30 97.20 60.00 43.20 51.30 627.75 43.20 80.55 £ 45.90 45.90 60.00 450.00 Total 390.00 37.35 45.90 473.25 37.35 390.00 Department K Material 12 kg £5 kg Labour 6.75 hrs £6.40 hr Overhead 6.75 hrs £7.60 hr Labour £ Emphasise that this is a practical presentation, because it not only shows the cost of the product after each department’s work – for example, the cost after Department J’s work is £473.25, and after Department K’s work it has risen to £627.75 – but it also accumulates each cost element separately. For example direct labour in the finished product is £80.55. 221 Cost Accounting – Teacher’s Guide Compare this with the Solution to Example 2 on page 515 of the textbook.The cost is shown after the work of each cost centre, but the cost is not accumulated by element. However, the examiner would be happy with that Solution, and it is far superior to that given in Note 2 on page 516. Make sure that the students understand the differences in presentation, and why the one on page 516 is poor. Reminders At the end of the lesson, re-state the main points again: Standard costing is a technique concerned principally with control. Variances are differences between actual cost and standard cost – and they should be analysed and used by managers as the basis for prompt appropriate action. Standard costs can be set at an ideal level or at an attainable level. Standard costs should be presented to show the build up of cost by cost centre or department, and possibly by cost element. Standard costs have a number of uses. These include the valuation of stocks and guidance in the fixing of selling prices. 222 Standard costing (1) LESSON 50 Main subject Standard costing (1) Textbook reference Chapter 17: Page 510 Syllabus reference Elementary knowledge of budgeting and standard costing restricted to prime cost variance analysis Lesson topic The calculation of prime cost variances Extended syllabus reference 7.19 Calculate a direct material total variance 7.20 Analyse the direct material total variance to direct material price variance and direct material usage variance 7.21 Calculate direct material price variance whether based on purchases or on issues 7.22 Calculate a direct labour total variance 7.23 Analyse the direct labour total variance to direct labour rate variance and direct labour efficiency variance 7.24 Understand the measure ‘standard hours of the actual output.’ Required for Candidates for Second Level and Third Level Aim of the lesson • To explain how to calculate 6 specific variances. These are: For direct material – total, price and usage variances For direct labour – total, rate and efficiency variances The lesson ▲ Please note that variance interpretation is not part of this lesson. However, begin by reminding the class that a variance means nothing in itself – it must be interpreted and used by management to stimulate action. Emphasise that a variance is either favourable or adverse. In this lesson, we are only concerned with cost variances. Therefore, in this context, a variance is adverse if the actual cost exceeds the standard cost, and favourable if the actual cost is less than the standard cost. Tell the class they should use F to indicate a favourable variance and A to indicate an adverse variance. 223 Cost Accounting – Teacher’s Guide ▲ The direct material total variance Emphasise that this is the difference between the standard material cost of the actual production, and the actual material cost of the actual production. Also emphasise that the phrases used are standard material cost, actual material cost and actual production. There is no mention of budgeted material cost or budgeted production because they are not relevant. Illustrate these points with the following: Standard material cost for one unit of product YPR Budgeted production of YPR Actual production of YPR Actual material cost £6.80 1,200 units 1,350 units £9,390 What is the direct material total variance? What figures do we have to choose from? Budgeted material cost 1,200 units × £6.80 Standard material cost 1,350 units × £6.80 Actual material cost £8,160 £9,180 £9,390 The direct material total variance is the difference between £9,390 and £9,180 = £210. Since the actual cost exceeds the standard cost it is £210 A. Make sure the class understands that the budgeted cost of £8,160 is irrelevant. A common error would be to say that the direct material total variance is the difference between the budgeted material cost of £8,160 and the actual material cost of £9,390, i.e. £1,230A. The class must appreciate why this would be a bad error to make. Point out that the £9,180 is sometimes called the standard material cost of the actual output or production. Ask the class why this variance of £210 A has occurred. The class should suggest that either the price of the material has changed from the standard, or the quantity of material used has changed from the standard. If they say that the price might have increased, you should point out that the price might have decreased, but that the quantity of materials used has been much more than standard, so eliminating the price savings and leaving an overall variance of £210 A. ▲ Now consider the need for further analysis of the direct material price and direct material usage variances Emphasise that price and usage variances are sub-variances of the total variance and will therefore add up to the total variance, provided that the price variance is to be based on the materials used in production. The meaning of this latter point will be clearer later. Ask the class what additional information they think we need to know before any subvariances can be calculated. 224 Standard costing (1) The answer is we need to know what quantity of material had an actual cost of £9,390, and what quantity of material was needed to make each unit of YPR according to the standard. Now give this additional information: Each unit of YPR needs 4 kg of material. This means that the standard price per kg must be £1.70 so that 4 kg × £1.70 = £6.80. The actual cost of £9,390 was for 5,300 kg of material actually used to produce 1,350 units of YPR With this additional information we can show the class how to calculate the price and usage variances. But first, ask how the £9,390 for the 5,300 kg of materials used has been obtained. Where has the figure come from? Give the class a few moments to think about this. Usually, they will fail to relate this question to earlier work. The answer is: 1 If JIT purchasing is in use, then £9,390 will be the total of the supplier’s invoices for the 5,300 kg delivered for immediate use in production, i.e. because no stocks are carried, then kgs purchased = kgs used. 2 If the material is purchased and carried in stock, then £9,390 will be the total cost of the 5,300 kg issued from stock to work-in-progress. The £9,390 will have been arrived at using the pricing method adopted by the company. It might be FIFO, LIFO, average etc. ▲ You should now explain the calculation of price and usage variances. Price variance This compares the standard cost of the materials used in production with the actual cost of the materials used in production. When calculating this variance the number of units of YPR produced is not relevant. How much material has been used? Answer 5,300 kg What should this have cost? Answer 5,300 × £1.70 = £9,010 What did it cost? Answer £9,390 The material price variance is therefore £9,390 – £9,010 = £380 A. Emphasise the warning given in Note 2 on page 522 of the textbook, with regard to an unsatisfactory method of calculation. Here it would mean the actual cost per kg was £9,390/5,300 kg = £1.77 (This is how the student normally rounds the figure!) The price variance is then given as (£1.77 – £1.70) × 5,300 kg = £371 A This is incorrect! Usage variance Make sure your students know the correct spelling: usage not useage. This variance is calculated by comparing the standard material usage for the actual production with the actual usage, and multiplying the difference by the standard price. 225 Cost Accounting – Teacher’s Guide How much material should have been used for the actual production of YPR? Answer 1,350 units × 4 kg = 5,400 kg How much material was actually used to make 1,350 units of YPR? Answer 5,300 kg We have therefore used 100 kg fewer than standard. This has saved us 100 kg × £1.70 = £170. This is the usage variance and it is favourable. Because both the price variance and the usage variance have been based upon the materials issued, they should add up to the material total variance calculated earlier. Thus, price £380 A and usage £170F, add up to £210 A, which agrees with the material total variance calculated earlier. ▲ The direct labour total variance Emphasise that this variance is the difference between the standard direct labour cost of the actual production and the actual direct labour cost of the actual production. As with direct material, the budgeted direct labour cost is irrelevant. Use these figures to illustrate the direct labour variances: Budgeted output of product YPR Standard direct labour cost 5 hours × £8.20 Budgeted direct labour cost Actual output of product YPR Actual direct labour hours Actual direct labour cost 1,200 units £41 £49,200 1,350 units 6,300 hours £52,200 After giving this information to the class, tell them that the principles to be applied to labour variances are identical to those applied to material variances: There are 3 labour variances, just as there were 3 material variances. There is a direct labour total variance, and this subdivides to two other variances: the labour rate variance, corresponding to the material price variance; and the labour efficiency – or productivity – variance, corresponding to the material usage variance. Ask the class to try to calculate the 3 labour variances by applying the same principles as those used to calculate the 3 material variances. What should they have done? Direct labour total variance Standard labour cost of actual output 1,350 × £41 Actual labour cost of actual output Direct labour rate variance Actual hours at standard rate 6,300 × £8.20 Actual labour cost 226 £ 55,350 52,200 3,150 F £ 51,660 52,200 540 A Standard costing (1) Direct labour efficiency variance Standard labour cost of the actual output – as above Actual hours at standard rate – as above £ 55,350 51,660 3,690 F ▲ Tell the class that there is an expression ‘standard hours produced’ or ‘standard hours of the actual output.’ Explain that this is the number of hours that should have been taken, to produce the actual output of 1,350 units. In this case it is 1,350 × 5 = 6,750 standard hours Go on to remind the class that actually only 6,300 hours were needed. This saved 450 hours which at the standard rate of £8.20 meant £3,690 labour cost saved. This shows another way of calculating the labour efficiency or productivity variance. ▲ Only continue when you feel that all students understand how to calculate each of the 6 variances covered. You should emphasise the word ‘understand’. Sometimes a question may be asked which gives variances and asks the candidate to work back to the standard cost. Such questions present a real test of understanding, not because they are particularly difficult, but because the approach is unusual. For example: In Period 9, a department produced 365 units of a product. The actual material cost was £4,768. A price variance of £298 A occurred on the issue of the 1,490 kg of material used from stock. A total of 30 kg of material were used in excess of standard. Prepare the standard material cost card for the product. If the actual material cost was £4,768 and the price variance was £298 A, we can deduce that £4,470 was the standard cost of the actual material used. 1,490 kg were used, so the standard cost per kilogram must have been £4,470/1,490 = £3 per kilogram. The 30 kg of excess material (the usage variance) indicates that 1,490 – 30 = 1,460 kg should have been used. For 365 units, this is 4 kg per unit. The standard cost card is therefore 4 kg × £3 = £12 per unit. ▲ For a similar example, take the class through Question 2 on page 532. The Solution appears on page 535 of the textbook. ▲ Now consider material price variance based upon purchases instead of upon issues from stock. This is explained on pages 524-526 of the textbook under ‘Material price variance: issue or purchase?’. Remind the class that the price variance calculated earlier compared the actual materials used from stock at standard price, with the actual materials used from stock at actual price. We emphasised that this actual cost could be based upon FIFO, LIFO, average or any other pricing method. 227 Cost Accounting – Teacher’s Guide There is a way around the bother of actual issue pricing, and that is to keep all material stocks at standard. To do this the material price variance must be immediately calculated when materials are purchased. Use the following information to illustrate this: Standard material per unit of product HYT Standard price per kg of material Purchases of material 20,000 kg for £78,200 Output of HYT Material used 2 kg £4 5,400 units 10,950 kg A direct material total variance cannot be calculated, as price must be based on materials purchased, whereas usage must be based on materials used. Price variance Standard cost of purchases 20,000 kg × £4 Actual cost of purchases Usage variance Standard usage of material 5,400 × 2 kg Actual usage of material Excess usage at standard price £ 80,000 78,200 1,800 F £ 10,800 10,950 150 £4 600 A Reminders At the end of the lesson, re-state the main points again: For Second Level candidates, 3 material variances and 3 labour variances must be known. For material, there is a total variance which can be subdivided to price and to usage, except when the price variance is based upon purchases. If the examiner says so, the price variance can be based on purchases, and stocks of unused material will then be valued at standard. For labour, there is a total variance which can be subdivided to rate and efficiency (or productivity). The expression ‘standard hours produced’ must be understood. Variances may be given in some questions; candidates must be able to use them to work back to other basic information. Give the class plenty of practice by making up your own short questions using different figures. 228 Standard costing (1) LESSON 51 Main subject Standard costing (1) Textbook reference Chapter 17: Page 510 Syllabus reference Elementary knowledge of budgeting and standard costing restricted to prime cost variance analysis Lesson topics Accounting entries for actual costs, standard costs, and variances Elementary variance interpretation Extended syllabus reference 7.25 Make accounting entries for standard prime costs and prime cost variances in an integrated accounting system 7.26 Make simple interpretations of prime cost variances Required for Candidates for Second Level and Third Level Aims of the lesson To explain how to make entries in the integrated ledger to record standard prime costs, actual prime costs and variances To encourage students to suggest simple explanations for specific prime cost variances Note: In itself, this is a comparatively short lesson, particularly in comparison to Lesson 50. You may find that some of Lesson 50 will run over into this lesson, or that time is available for some revision of the material in Lessons 49 and 50. The lesson ▲ Second Level candidates are only concerned with integrated accounting systems. This topic will be dealt with more fully in Lessons 55, 56 and 57, which relate to Chapter 19. This lesson is only concerned with a few of the accounts in the ledger system. First introduce materials. Remind the class that materials are purchased, are stocked, and then are issued to be used in production. The output achieved from a given amount of material issued to production may, or may not, be in line with standard. 229 Cost Accounting – Teacher’s Guide Also remind the class that materials may be carried in stock at standard cost (in which case the price variance is removed on purchase) or at actual cost (in which case the price variance is removed a bit at a time as the materials are used). Begin with the following example: 2,400 kg of Material X is purchased on credit for £12,480 in March Year 9. No stock of Material X existed prior to this purchase. At the start of Year 9, the standard price for Material X was set at £5 per kg. Tell the class that the recording of this transaction will be in ‘T’ account form so that the debit and credit entries are clear. ▲ First, show the entries if the price variance is taken on purchase: Suppliers account Material stock Suppliers account Material stock account £ 12,000 Suppliers account Price variance account £ 480 £ 12,480 Emphasise that the debits of £12,000 + £480 equal the credit of £12,480. Also, that the entry in the material stock account is at standard price, i.e. 2,400 kg × £5 = £12,000. Emphasise that the price variance is adverse and that it is a debit on the variance account. This means that if the price variance account was given by the examiner, the candidate must immediately recognise the £480 as an adverse variance, simply because it is a debit on the variance account ▲ Next, show the entries if the price variance is to be taken on issue (use) of the materials: Suppliers account Material stock Suppliers account £ 12,480 Material stock account £ 12,480 Explain that the stock is now carried in the material stock account at actual cost, and that no variance account will be needed until some of the material is used. 230 Standard costing (1) Make sure the class understands that it is a matter of debate as to when the variance is recognised in accounting terms. In the first illustration the price variance is recognised when the materials are purchased. In the second illustration the price variance will be recognised a bit at a time as the material is used. ▲ Issues of material to production Explain that the account to record production activities will be the work-in-progress account. Suppose that 1,800 kg of the material is issued to production in April to make 450 units of a product. That is, according to the standard product cost 4 kg of material should make 1 unit of product. In the first illustration, the material is held in stock at £5 per kg because the price variance was removed at the moment of purchase. Explain that because of this the 1,800 kg must now be issued at standard price, making £9,000. This is credited to material stock and debited to work-in-progress: Material stock account £ Suppliers account 12,000 Work-in-progress £ 9,000 Work-in-progress £ Material stock 9,000 Remind the class that in the second illustration, the material is held in stock at its actual cost of £5.20 per kg, (£12,480/2,400 kg). The price variance of £0.20 per kg must be removed from the material stock account for the kilograms issued to work-in-progress. This is 1,800 kg × £0.20 = £360. This is an adverse price variance. The entries are: Suppliers account Material stock account £ 12,480 Material stock Work-in-progress £ 9,000 Material stock Price variance £ 360 Work-in-progress Price variance £ 9,000 360 Ask the class to explain the balance on the material stock account. The balance is £3,120 i.e. 12480 – (9000 + 360). There are 2,400 – 1,800 = 600 kg of material left. These were purchased for £5.20 per kg, and 600 × £5.20 = £3,120. 231 Cost Accounting – Teacher’s Guide ▲The usage variance Explain that this variance will only be known when production is complete and we see how many units of product have actually been made with the 1,800 kg of material issued. Remind the class that 1,800 kg should have made 450 units of product. Now tell the class that the production records show that only 440 units of product have been made from the material issued. Ask the class to calculate the material usage variance. The answer given should be £200 A. If a student says the usage variance is £200, say, ‘No, that is not correct. It is only correct if given as £200 Adverse’. 440 units should only have needed 1,760 kg of material, but 1,800 kg have been used. This wastage of 40 kg is costed at standard price, i.e. £5 per kg. This is credited to work-in-progress, along with the standard cost of the good finished output. The standard cost for 1 unit of product is 4 kg × £5 = £20. The standard cost of 440 units is therefore £8,800. The entries are: Work-in-progress Material stock Work-in-progress £ 9,000 _____ 9,000 Finished stock Usage variance £ 8,800 200 9,000 Usage variance account £ 200 Finished stock account £ Work-in-progress 8,800 Remind the class, once more, that the usage variance is an adverse variance, and this has correctly ended up as a debit balance on the variance account. ▲ Now teach the entries for wages, which are more straightforward than those for materials. Remind the class that the amount of wages paid for output will come from the payroll analysis. In line with the answer to Example 10 (b) on page 530 of the textbook, the work-inprogress account will be debited with the actual direct labour cost, and all labour variances will come out of work-in-progress. 232 Standard costing (1) Tell the class that in a particular month, we have only made one type of product, for which the standard labour cost is 6 hours × £8 hour = £48 per unit. 130 units were made in 750 hours for which the labour cost was £6,180. Ask the class to calculate the labour variances. They should get: Total: (130 units × £48) – £6,180 = £60 F Rate: (750 hours × £8) – £6,180 = £180 A Efficiency: (130 units × 6 hrs) – 750 = 30 hours × £8 = £240 F If the class can remember the rule about variance postings they should be able to suggest the entries needed. They are: Wages payable (See textbook p 592) Efficiency variance Work-in-progress £ 6,180 240 6,420 Work-in-progress Finished stock account £ 6,240 Work-in-progress Rate variance account £ 180 Finished stock Rate variance £ 6,240 180 6,420 Efficiency variance account Work-in-progress £ 240 ▲ Elementary prime cost variance interpretation Ask the class to briefly discuss, and then reply to, the following questions: Question: If, month after month, all variances are adverse, what does this suggest? Answer: It suggests that the standard cost has been prepared as an ideal standard, which is therefore impossible to achieve. Question: If a material price variance is adverse, what could be the reason? Answers: The material is in short supply, which has caused the market price to rise. Smaller quantities have been purchased each time causing the loss of quantity discounts. It has been necessary to change the supplier, and less favourable terms apply. The customer has specified a substitute material which is more expensive. 233 Cost Accounting – Teacher’s Guide Question: If a material usage variance is adverse, what could be the reason? Answers: If it is a natural material, for example, timber, the material supplied may be of a poorer quality. The production equipment could have broken down causing a loss of material. Trainee operatives may be more wasteful with material than would be the case with experienced operatives. Question: If a labour rate variance is adverse, what could be the reason? Answers: A scarcity of skilled labour could have caused the market rate of pay to rise. A more expensive grade of labour might have been used in a particular period. If overtime premium is treated as part of direct labour cost, then expensive weekend working could increase the average hourly rate of pay. Question: If a labour efficiency variance is adverse, what could be the reason? Answers: Poor supervision. A difficult job or difficult materials to work with, meaning slower working is necessary. Difficulties with equipment. Question: Can any of these variances be inter-related? Answer: Yes. For example, the buyer may find a cheaper source of supply for materials, resulting in a favourable material price variance. However, the materials may be of a lower quality, and cause production difficulties which could result in adverse variances on both material usage and labour efficiency. Reminders At the end of the lesson, re-state the main points again: Students should feel ‘comfortable’ about the book-keeping aspects of variance accounting. Adverse variances must be debit entries on the variance accounts. Favourable variances will be credit entries on the variance accounts. Students should be imaginative in trying to suggest why particular variances might have occurred, and to recognise possible inter-relationships, for example, the effect of purchasing poorer quality material at a lower price. 234 Standard costing (2) LESSON 52 Main subject Standard costing (2) Textbook reference Chapter 18: Page 537 Syllabus reference Third Level 4 Variance accounting Comprehensive sales and production cost variance analysis, including mixture variances Lesson topic Analysis of material usage and labour efficiency variances Extended syllabus reference 4.33 Calculate ratios of production volume, efficiency or productivity, and capacity 4.43 Analyse the material usage variance to material mix variance and material yield variance 4.44 Understand the effect of losses and scrap on the usage variance and its analysis 4.46 Understand the effect of idle time treatment on labour variances Required for Candidates for Third Level only Aim of the lesson • To explain the sub-variances of the material usage variance and of the labour efficiency variance The lesson ▲ Remind the class that they should already know how to calculate a material usage variance. The calculation is always based upon standard price. For example, if the standard material cost per unit of output is 4 kg × £3 kg = £12, and 1,520 units of output are made using 6,190 kg of material, then the usage variance is 110 kg × £3 = £330 A. Point out that because only one material is used in the manufacture of this product, there can be no further sub-division of the usage variance. 235 Cost Accounting – Teacher’s Guide ▲ Once you are satisfied that the class is competent at calculating total, price and usage variance, you can introduce material mix variance. By definition, material mix variance can only arise when more than one material is combined to make a product, and where the proportion of each material can be varied without unacceptably affecting the quality of the product. As an example, point out that a motor car is assembled from many different parts, but mix doesn’t arise because an extra wheel cannot be substituted for a battery! Emphasise at the start that mix is a variance of input. We do not need to know output figures to calculate it. Start with this example: Standard cost to produce a chemical product, XM. Material A Material B tonnes 60 40 100 price/tonne £900 £900 £ 54,000 36,000 90,000 In Period 9, 300 tonnes of A and 240 tonnes of B are used. Ask the class to calculate the mix variance. Material A Material B Std mix tonnes 324 216 540 Act mix tonnes 300 240 540 Variance tonnes ( 24 ) 24 Std price £900 £900 Mix var. £ 21,600 F 21,600 A Nil Point out to the class that: 1 The overall mix variance is Nil. This is only because both materials, A and B, have a standard cost of £900 per tonne. 2 No information was given on whether any loss of material was expected in production – i.e. whether 100 tonnes of product XM arises from 100 tonnes of input materials. This information was not required to calculate a mix variance! 3 No information was given on the actual production of XM. This information was not required to calculate a mix variance. Now tell the class that you are changing the standard price of material B to £750. Everything else remains the same. Immediately we know that there will be a mix variance! Material A Material B 236 Std mix tonnes 324 216 Act mix tonnes 300 240 Variance tonnes (24) 24 Std price £900 £750 Mix var. £ 21,600 F 18,000 A 3,600 F Standard costing (2) Ask the class why the change in mix might have occurred, and whether it is good for the business. It might have occurred because of a shortage of Material A. The company might have had no choice. Material B has been substituted for Material A. It seems to be good for the business. Favourable variances are welcomed. They increase profits. But we need to know more: The change in material mix could have affected the output, and this is a figure which we haven’t got. The change could also have affected the quality of the output. Emphasise that up to this point, the mix variance was calculated using 60/40 as the standard mix i.e. it was based on the standard quantity, the mix of tonnes. Tell the class that another approach is where materials are mixed in a standard batch size. For example, in a bakery this could be be a mix of dough, from which a certain number of loaves should be made. To use another example, the examiner might say that 200 litres of X at a standard price of £60 per litre and 40 kg of Y, at a standard price of £200 per kg, is considered to be a standard batch. He might also say that the 1,900 litres of X and 420 kg of Y was the actual material used for 10 batches. It seems as if less of X has been used in relation to Y. Perhaps Material Y was not as dry as normal when purchased, and required less of the liquid, Material X, to make the mix ready for production. The mix variance can be calculated as follows: Standard cost of 1 batch: Material X Material Y £ 12,000 8,000 20,000 Standard cost of 10 batches: Material X Material Y £ 120,000 80,000 200,000 Standard cost of materials used: Material X 1,900 litres × £60 litre Material Y 420 kg × £200 kg £ 114,000 84,000 198,000 Therefore, mix variance: Material X Material Y £ 6,000 F 4,000 A 2,000 F 237 Cost Accounting – Teacher’s Guide Before continuing, emphasise to the class that these mix variances have all been calculated with no information on the actual cost of the material used, nor on the output of product made with the materials. This information is not needed to calculate a material mix variance. ▲ Now go through Examples 1 and 2 with the class. These are on pages 538-540 of the textbook. ▲ Now introduce the calculation of the material yield variance. Tell the class that it is a subvariance of the material usage variance. Tell them, also, that it measures the relationship between the total input of materials and the output of product. Use the following data for this part of your lesson: To make 1 tonne of product YT4, the standard cost is: Material S Material T Tonnes 0.60 0.40 1.00 Std price £120 £300 £ 72 120 192 9.5 tonnes of YT4 were made, using: 5.8 tonnes of material S at a cost of £710, and 4.0 tonnes of material T at a cost of £1,179. First, ask the class to calculate the total, price and usage variances. Their answers should be: Total (9.5 × £192) – (£710 + £1,179) = £65 A Price S (5.8 × £120) – £710 = £14 A Price T (4 × £300) – £1,179 = £21 F Usage (9.5 × £192) – ((5.8 × £120) + (4 × £300)) = £72 A Now work through the material mix variance with the class. Total material input was 5.8 + 4 = 9.8 tonnes 60% should be S = 5.88 tonnes 40% should be T = 3.92 tonnes Therefore mix variance: S = (5.88 – 5.80) × £120 = £9.6 F T = (3.92 – 4.00) × £300 = £24 A Overall mix variance = £14.4 A Emphasise again that for the mix variance, we weren’t concerned with output. But for yield variance we are! What should the output have been from 9.8 tonnes of input? The answer is 9.8 tonnes of YT4, because the standard did not allow for any loss of material. 238 Standard costing (2) What was the output from 9.8 tonnes of input? The answer is 9.5 tonnes of YT4. The yield variance is 9.8 tonnes – 9.5 tonnes = 0.3 tonnes. In value the loss of output is 0.3 tonnes × £192 per tonne (from the standard). This is £57.6 A. Emphasise to the class that the mix variance of £14.4 A and the yield variance of £57.6 A adds up to £72 A, and this agrees with the usage variance. Point out that no attempt should be made to calculate the yield variance separately for material S and material T. It would have no meaning. Yield variance measures the gain or loss of production – and we produce YT4, not Material S and Material T. Point out, also, that if the material mix variance is calculated differently – for example, on batches, then the calculation of the yield variance will be different. Suppose that we look at the earlier example: Material X Material Y 200 litres 40 kgs £60 £200 £ 12,000 8,000 20,000 and suppose that we now say that this 1 batch should produce 25 kg of finished product, and that the output of finished product from the 10 batches referred to earlier was 240 kg. Ask the class what the material usage variance would be. The answer should be: (240 kg × £800) – £198,000 (earlier calculation) = £6,000 A. Point out that earlier, using the batch approach, the mix variance was calculated as £2,000 F. Tell the class that the yield variance is calculated as: 1 batch should produce 25 kg of output. Therefore, 10 batches should produce 250 kg of output. Actual output was 240 kg. Therefore, the shortfall was 10 kg, which × £800, is £8,000 A. The mix variance £2,000 F + yield variance £8,000 A = £6,000 A, which agrees with the usage variance. ▲ Now take the class through Examples 3, 4, 5, and 6 on pages 541-549 of the textbook. Give particular attention to Examples 5 and 6 which also illustrate variances relating to losses. ▲ Finally, remind the class that when interpreting the meaning of variances, interrelationships must be considered. A mix variance may be favourable if a greater proportion of cheaper material has been used. However, this may cause a fall in output, giving an adverse yield variance which is greater than the favourable mix variance. 239 Cost Accounting – Teacher’s Guide ▲ With regard to direct labour variances, remind the class that they have already studied the calculation of total, rate and efficiency variance. ▲ Point out that Examples 7 and 8 on pages 550-551are concerned with the effect of idle time on the calculation of the efficiency variance. Reminders At the end of the lesson, re-state the main points again: Material mix and material yield variances are sub-variances of the material usage variance. A material mix variance can be calculated for each input material. The calculation of mix variances require no information on output. The material yield variance looks at output in relation to input. It is not calculated for each input material. If idle time is treated as part of direct labour cost, it must be removed before (pure) efficiency is measured. 240 Standard costing (2) LESSON 53 Main subject Standard costing (2) Textbook reference Chapter 18: Page 537 Syllabus reference Third Level 4 Variance accounting Comprehensive sales and production cost variance analysis, including mixture variances Lesson topic Overhead variances Extended syllabus reference 4.33 Calculate ratios of production volume, efficiency or productivity, and capacity 4.47 Calculate the total variable overhead variance and analyse this to variable overhead expenditure variance and variable overhead efficiency variance 4.48 Calculate the total fixed overhead variance and analyse this to fixed overhead expenditure variance, and, where using absorption costing, to fixed overhead volume variance 4.49 Analyse the fixed overhead volume variance to fixed overhead efficiency variance and fixed overhead capacity variance 4.50 Understand how a budgeted fixed overhead volume variance can arise 4.51 Explain each variance in simple terms 4.52 Understand the importance of cumulative variance, trend of variance etc 4.53 Suggest possible inter-relationships between variances Required for Candidates for Third Level only Aim of the lesson • To explain how overhead variances are calculated and interpreted The lesson ▲ Begin by telling the class that overhead variances are not part of the Second Level syllabus. Therefore this lesson assumes no prior knowledge. Explain that the lesson will first consider variable overhead variances, and will then consider fixed overhead variances. 241 Cost Accounting – Teacher’s Guide Remind the class that overhead is incurred by a cost centre and not by a product. Overhead is absorbed into a product cost on a pre-determined method based on budgets. The one-product firm is quite rare in practice, although common in examinations. Nevertheless, overhead must always be thought of as indirect costs, although in the single-product firm it is incurred because of the one product. Now ask the class to tell you the meaning of variable overhead. They should reply that it is a term which covers those items on which more is spent as output increases. Double the output and the spending on those items will double. Give the class this product cost: Direct material 3 kg × £12 kg Direct labour 2 hrs × £8 hr Prime cost Variable overhead £ 36 16 52 9 61 Suppose that we are told that 620 units of this product have been made (no other product is made), and £5,930 of variable overhead was incurred. Point out to the class that it says that £9 should be spent on variable overhead for every unit of product made. Like any total variance, the total variable overhead variance is: Standard cost for the output 620 × £9 Actual cost £ 5,580 5,930 350 A Point out that no further analysis is possible and that this is also the variable overhead expenditure variance. Now point out that a cost can be variable, but may not vary with output. For example, electricity varies with machine hours. The more machine hours that are operated, the greater the amount that will be spent on electricity. There may be a close link between machine hours and output. However, it is quite possible for machines to be running but not producing output. If the class find this difficult to understand, use the illustration of a motor car. We have a motor car to take us from one place to another and this uses petrol. However, a car engine can be running, and using petrol, but the car may be stationary, and not taking us anywhere. It may be caught in a traffic jam! Petrol – a variable cost of motoring – is being incurred, but the cost is being used inefficiently. It is not producing output. 242 Standard costing (2) Tell the class that the standard cost is now being changed slightly. It becomes: £ 36 16 52 9 61 Direct material 3 kg × £12 kg Direct labour 2 hrs × £8 hr Prime cost Variable overhead 2 hrs × £4.50 Point out the difference. It now says that every direct labour hour worked should incur variable overhead cost of £4.50, and that because it should take 2 hrs to make the product, £9 is absorbed into the standard cost of the product. Suppose we are now told that 620 products were made, 1,280 direct labour hours were used, and £5,930 of variable overhead was incurred. Point out that the only additional information is that 1,280 direct labour hours have been used. Now show the class what the variances become: Variable overhead total variance Calculated exactly as before £ 350 A Variable overhead expenditure variance The allowed cost is 1,280 hrs × £4.50 = Actual cost Variable overhead efficiency variance Standard hours 620 × 2 = 1,240 1,280 Actual hours Excess hours 40 × £4.50 5,760 5,930 170 A ooo 180 A Point out to the class that the expenditure variance of £170 A and the efficiency variance of £180 A add up to the total variance of £350 A. It would also be worth asking the class to calculate the direct labour efficiency variance (£320 A), so that they can understand the relationship between the efficiency variances. Finally, explain that it only really makes sense to consider variable overhead in a multiproduct environment. However, the principle can be illustrated with 2 products, as follows: Product Prime cost Variable overhead: 4 hrs × £7 3 hrs × £7 A £ 40 B £ 60 28 ooo 68 21 81 243 Cost Accounting – Teacher’s Guide Tell the class that in Period 3: 2,200 units of product A and 1,100 units of product B, were made. 12,500 hours were worked and £86,450 of variable overhead was incurred. Take the class carefully through the variances: Variable overhead total variance Standard cost (2,200 × £28) + (1,100 × £21) = Actual cost Variable overhead expenditure Allowed cost 12,500 × £7 Actual cost Variable overhead efficiency Standard hrs (2,200 × 4) + (1,100 × 3) = 12,100 Actual hrs 12,500 Excess hrs 400 × £7 £ 84,700 86,450 1,750 A £ 87,500 86,450 1,050 F £ 2,800 A Again, point out that the expenditure and efficiency variances add up to the total variance. ▲ Now take the class through Example 9 on pages 552-554 of the textbook. Note the reference to the efficiency ratio and its relationship with the efficiency variance. Students often experience difficulties with overhead variances. You may wish to stop at this point and work through the next section (fixed overhead variances) in another lesson, after the class has practised and become familiar with variable overhead variances. ▲ Fixed overhead variances. Refer to the CIMA definition of a fixed cost on page 554 of the textbook. Emphasise that this introduces the simplest of the fixed overhead variances – the fixed overhead expenditure variance. Tell the class that the question is simply, ‘How much did we budget to spend, and how much have we actually spent?’ The difference is the fixed overhead expenditure variance. Then tell them that if we are using marginal costing, there are no other fixed overhead variances. This is because, under marginal costing, fixed overheads are not attributed to products. For this reason, fixed overhead variances other than the expenditure variance, relate only to absorption costing. Remind the class that this means that pre-determined absorption rates must have been established using budgeted fixed overheads and a budgeted level of output. 244 Standard costing (2) Tell the class that you will now add fixed overhead to the earlier examples: £ 36 16 52 9 16 77 Direct material 3 kg × £12 kg Direct labour 2 hrs × £8 hr Prime cost Variable overhead 2 hrs × £4.50 hr Fixed overhead 2 hrs × £8hr The £8 per hour for fixed overheads was arrived at as follows: Budgeted output Standard hours per unit Budgeted (standard) hours Budgeted fixed overhead Fixed overhead absorption rate 800 units 2 hours 1,600 hours £12,800 £8 hour Now tell the class that in addition to the information given earlier, we are told that the actual fixed overhead incurred was £12,470. The fixed overhead total variance is: Standard cost of the actual output 620 units × £16 = Actual fixed overhead £ 9,920 12,470 2,550 A Make sure the class understands that the principle being used here (to calculate this total fixed overhead variance) is exactly the same as that used to calculate the variable overhead total variance. The fixed overhead total variance is £2,550 A. This is quite a large variance. This can happen on fixed overheads, particularly if the output achieved is significantly different to that budgeted. ▲ What does this total variance break down to? Fixed overhead expenditure variance Budgeted fixed overheads Actual fixed overheads £ 12,800 12,470 330 F Tell the class that because absorption costing is in use, there is a volume variance i.e. fixed overheads can be under- or over-absorbed because output differs from that budgeted. Fixed overhead volume variance Budgeted output 800 units Actual output 620 units Shortfall 180 units × £16 unit £ 2,880 A 245 Cost Accounting – Teacher’s Guide Point out that the volume variance £2,880 A and the expenditure variance £330 F, add up to £2,550 A, which agrees with the total variance. Tell the class that the volume variance could have been calculated in hours: Standard hours (620 × 2) = 1,240 Budgeted hours 1,600 Shortfall 360 hours × £8 hour = £2,880 A Now take the class through Example 11 on pages 557-560 of the textbook. Again, particularly note the ratios and how they relate to the variances. ▲ Finally, show the class that it is possible to analyse the volume variance into 2 parts – the volume capacity variance and the volume efficiency variance. Volume capacity This is best worked in hours. Budgeted hours 800 units × 2 Actual hours (given in original data) Lost hours × £8 per hour = 1,600 1,280 320 £2,560 A Volume efficiency Emphasise to the class that the calculation for this variance follows the principles used for direct labour efficiency and variable overhead efficiency: Standard hours Actual hours Excess hours × £8 per hour = 1,240 1,280 40 320 A Point out that the efficiency variance £320 A and the capacity variance £2,560 A add up to £2,880 A which agrees with the volume variance. ▲ Take the class through the remainder of the Solution to Example 11 on pages 560-562 of the textbook. ▲ Finally, take the class through the important Examples 12, 13 and 14 on pages 562-568. 246 Standard costing (2) Reminders At the end of the lesson, re-state the main points again: There are only 2 sub-variances for variable overhead: expenditure and efficiency. The latter occurs when overheads vary with any factor other than output. There are 2 sub-variances for fixed overhead: expenditure and volume. The latter can only occur in absorption costing. There are 2 sub-variances of the sub-variance volume: volume capacity and volume efficiency. Volume capacity can be quite a large variance, because it is possible for actual output to be significantly different from budgeted output. 247 Cost Accounting – Teacher’s Guide LESSON 54 Main subject Standard costing (2) Textbook reference Chapter 18: Page 537 Syllabus reference Third Level 4 Variance accounting Comprehensive sales and production cost variance analysis, including mixture variances Lesson topic Sales variances, cost variances and profit variances Extended syllabus reference 4.39 Compare budgeted profit with actual profit to establish the profit variance – whether using absorption costing or marginal costing 4.40 Calculate how much of the profit variance is due to selling price variance and sales volume profit or contribution variance Further analysis of the sales volume variance to mix and quantity will not be required Required for Candidates for Third Level only Aims of the lesson • To explain sales variances and their impact on profit • To reconcile budgeted and actual profit The lesson ▲ Begin by explaining that a company – which will make one product – has set its standard cost per unit for Year 1, its first year of trading, as: Direct material 3 kg × £9 kg Direct labour 5 hours × £8 hr Variable overhead 5 hours × £2 Fixed overhead 5 hours × £7 £ 27 40 10 35 112 All of the costs are production costs. The firm will not incur any Administration or Selling & Distribution costs. 248 Standard costing (2) In its first year it plans to make and sell 4,000 units. The selling price is expected to be £120 per unit. Point out that the budgeted gross profit (i.e. before administration, selling and distribution overheads) is easily obtained as 4,000 × (£120 – £112) = £32,000. Now ask the class why, at the end of Year 1, the company might find that it has not made a profit of £32,000. Their replies should include: 1 Material cost more than £9 per kg. 2 More than 3 kg of material has been used to make each unit of product. 3 More than £8 per hour has been paid to direct labour. 4 More than 5 hours has been needed to make each unit of product. 5 More than £2 has been spent on variable overhead for each hour worked. 6 More has been spent on fixed overhead than the £140,000 budgeted. 7 Fewer units might have been produced than budgeted. Point out to the class that these are the points that should have occurred to them as a result of their standard costing studies so far. The 7 points made can all be identified with adverse cost variances. Any of them could have been favourable, of course. For example, the company might have been able to purchase material for less than £9 kg. ▲ Now (if they have not already been mentioned) introduce the sales variances: 1 The product might have been sold at a price below £120 unit. 2 Fewer than 4,000 units might have been sold. Emphasise at this point that if budgeted and actual profits disagree, the difference will be explained by both cost variances and sales variances. To illustrate this, now tell the class that in Year 1: 3,800 units were made and sold. The actual sales were £454,000. 11,700 kg of material were used at a cost of £104,800. Direct labour worked 19,200 hours and were paid £152,700. Variable overheads incurred were £38,090. Fixed overheads incurred were £138,800. Point out that because 3,800 units were made and sold there was no stock at the year end. Because of this, cost of sales is the same as cost of production. Therefore, the actual profit for Year 1 is simply £454,000 – (£104,800 + £152,700 + £38,090 + £138,800) = £19,610. The profit variance is the budgeted profit minus the actual profit, which is £32,000 – £19,610 = £12,390 A. 249 Cost Accounting – Teacher’s Guide This adverse variance must be explained by cost variances and sales variances. ▲ Ask the class to calculate the cost variances. This will give them some revision. Their answers should be: £ Material price (11,700 × £9) – £104,800 Material usage ((3,800 × 3) – 11,700) × £9 Labour rate (19,200 × £8) – £152,700 Labour efficiency ((3,800 × 5) – 19,200) × £8 Variable overhead expenditure (19,200 × £2) – £38,090 Variable overhead efficiency 200 excess hours × £2 Fixed overhead expenditure £140,000 – £138,800 Fixed overhead volume (4,000 – 3,800) × £35 500 F 2,700 A 900 1,600 A 310 F 400 A 1,200 F 7,000 A F The volume variance can then be analysed to: £ 5,600 A 1,400 A Volume capacity (20,000 – 19,200) × £7 Volume efficiency 200 excess hours × £7 ▲ Now explain the sales variances to the class. There is a selling price variance. This is because the 3,800 units sold should have produced a revenue of 3,800 × £120 = £456,000, but the actual revenue was £454,000. Therefore, selling price variance is £2,000 A There is a sales volume profit variance. This is (4,000 – 3,800) × (£120 – £112) = £1,600 A ▲ Now summarise the variances to reconcile the budgeted and actual profit. £ Budgeted profit Favourable variances: Material price Labour rate Variable overhead expenditure Fixed overhead expenditure Adverse variances: Material usage Labour efficiency Variable overhead efficiency Volume efficiency Volume capacity Selling price Sales volume profit Actual profit 250 500 900 310 1,200 2,700 1,600 400 1,400 5,600 2,000 1,600 £ 32,000 2,910 34,910 15,300 19,610 Standard costing (2) ▲ Now take the class through Example 15 on pages 569 – 570 of the textbook. ▲ Next, tell the class that for Year 2, the standard cost will not be changed. The budget for Year 2 is to make and sell 4,000 units. When the actual results for Year 2 were summarised, 3,900 units had been made, but only 3,750 units had been sold, for £451,000. The actual costs of production totalled £441,070. Ask the class to tell you the budgeted profit for Year 2. Their answer should be £32,000 because it must be the same as the budgeted profit for Year 1. Now ask them what the actual profit is for Year 2. The answer is: £ Sales Actual costs Less stock (3,900 – 3,750) × £112 Profit 441,070 16,800 £ 451,000 424,270 26,730 Hopefully, no-one gave £9,930 as the answer. If they did, you should remind them that the revenue from 3,750 units cannot be set against the cost of 3,900 units. Stocks must be valued, and when standard costing is in use, stocks are always valued at standard. The profit variance is £32,000 – £26,730 = £5,270 A What has caused this? It is not possible to analyse cost variances for Year 2, because no detail is given, such as material used, hours worked, etc. The total cost variance is: Standard cost of production 3,900 × £112 Actual cost Variance £ 436,800 441,070 4,270 A Point out that there is one variance within this figure that can be calculated: the fixed overhead volume variance. Fixed overhead variance (4,000 – 3,900) × £35 = 3,500 A No other detailed cost variances can be calculated. What about the sales variances? Selling price variance (3,750 × £120) – £451,000 = 1,000 F Sales volume profit variance (4,000 – 3,750) × (£120 – £112) = 2,000 A 251 Cost Accounting – Teacher’s Guide The reconciliation is: £ 32,000 Budgeted profit Selling price variance Sales volume profit variance 1,000 F 2,000 A Cost variances Actual profit 1,000 A 31,000 4,270 A 26,730 Now point out that the actual profit could have been presented in a different way from that used earlier: Sales Less standard cost of sales Standard profit Less cost variances Actual profit £ 451,000 420,000 31,000 4,270 A 26,730 3,750 × £112 Make sure that the class understands why this presentation gives the same result, particularly as there is no mention of selling price variance and sales volume profit variance. ▲ Now take the class carefully through Example 16 on pages 571-573 of the textbook. ▲ Finally, ask the class to consider how the answer would have differed if the company had decided to give up absorption costing, and use marginal costing from the start of Year 2. One additional bit of information is needed: the actual costs in Year 2. These comprised £301,870 variable and £139,200 fixed, making the £441,070 in total. The first point to note is that the budgeted profit for Year 2 would still have been £32,000. This is because there was no opening stock, and no budgeted closing stock – because the plan was to make and sell 4,000 units. However, the actual profit will be different. Sales Actual variable costs Less stock (3,900 – 3,750) × £77 Contribution Actual fixed costs Actual profit £ 451,000 301,870 11,550 The profit variance is now £32,000 – £21,480 = 252 290,320 160,680 139,200 21,480 10,520 A Standard costing (2) This is explained by: Variable production cost variance: (3,900 × £77) – £301,870 = Fixed overhead expenditure £140,000 – £139,200 Selling price – as before Sales volume contribution variance: (4,000 – 3,750) × (£120 – £77) = 1,570 A 800 F 1,000 F 10,750 A 10,520 A Make sure that the class understands the difference between the absorption and marginal costing solutions. Reminders At the end of the lesson, re-state the main points again: Sales variances reflect the difference between the planned and actual selling price of products, and the change in gross profit caused by selling fewer or more units than planned. The overall profit variance is caused by a combination of sales variances and of cost variances. 253 Cost Accounting – Teacher’s Guide LESSON 55 Main subject Costing systems (1) Textbook reference Chapter 19: Page 580 Syllabus reference Second Level 8 Costing systems Simple examples of integrated accounting systems. Basic understanding of uniform costing Lesson topic An introduction to integrated accounting systems (1) Extended syllabus reference 8.1 8.2 Understand the nature and function of an integrated accounting system Understand the function and operation of control accounts, particularly for material stocks, work-in- progress stocks, finished stocks and production overheads Required for Candidates for Second Level and Third Level Aims of the lesson • To describe the features of an integrated accounting system • To reinforce the use of control accounts The lesson ▲ Begin by pointing out that Chapter 19 is the last chapter in the textbook which is specifically for Second Level candidates. Because of this, it uses much of the earlier work already studied – for example, material pricing, payroll analysis, overhead incurred and absorbed, but uses it in a context of formal accounting records. Refer the class to the definition of integrated accounts given on page 580 of the textbook. Emphasise each aspect of the definition: ‘a set of accounting records’ – formal, and based upon basic principles of debit and credit. ‘provides financial and cost accounts’ – within a single system; with some compromise, the users of both financial and cost accounts can be satisfied. ‘using a common input of data’ – the same data is used, although it may be differently analysed; for example, under nominal headings for financial accounting, but under cost centre headings for cost accounting. 254 Costing systems (1) Explain that an integrated ledger can be recognised by the accounts it contains. For example, we would see accounts for fixed assets (land, buildings, motor vehicles, plant and machinery, etc.), for debtors and creditors, for share capital and reserves etc. These would be seen in any set of financial accounts. However, we would also see accounts for raw material stock, other stocks, work-inprogress, finished goods, and production, administration, selling and distribution overheads. These are not typical of financial accounts. They are there to meet cost accounting needs. This reflects a compromise in that the traditional financial accounts’ expense headings of rent, rates, insurance, etc. are not immediately obvious. Ask the class, or individual members of the class, to state the debit and the credit for each of the following transactions. For example, on the first one, simply say, ‘Purchase of fixed assets’. The answer given should be ‘Debit, Fixed asset at cost account; Credit, Bank or creditors’. Some answers will depend upon basic book-keeping knowledge. Other answers will depend upon topics learned in an earlier lesson on this course. 1 2 3 4 5 6 7 Purchase of fixed assets Debit Fixed asset at cost account Credit Bank or creditors Payments received from debtors Debit Bank Credit Debtors Purchase of materials for stock, prior to use Debit Material stock Credit Bank or creditors Purchase of components, delivered for production use on a Just-in-time basis Debit Work-in-progress Credit Bank or creditors Issue of materials from stock, to production use Debit Work-in-progress Credit Material stock Issue of materials from stock, for repair of a production machine Debit Production overhead Credit Material stock Sales of finished output Debit Debtors Credit Sales 255 Cost Accounting – Teacher’s Guide 8 9 10 11 12 Payroll analysis Debit Work-in-progress (Direct wages) Debit Production overhead (Indirect wages) Debit Admin S & D overhead (Indirect wages) Credit Wages control Production overhead absorbed Debit Work-in-progress Credit Production overhead Payment of wages Debit Wages payable – net wages Debit Wages payable – deductions Credit Bank (Net wages) Credit Deductions creditors Depreciation of fixed assets used in production Debit Production overhead Credit Accumulated provision for depreciation of fixed assets Finished production delivered immediately to the customer Debit Cost of sales Credit Work-in-progress You can make up more examples like this if you wish. It is beneficial to ask questions like these, which require an oral answer, without reference to books, notes etc. Emphasise that the answers contain the mix of accounts associated with integrated accounts. ▲ Now take the class through pages 580-584 of the textbook. ▲ Finally, in this lesson, you should reinforce the nature of control accounts. Begin with the comments near the top of page 584. Use the Production overhead (control) account as an example. Remind the class that it is debited with overhead incurred and credited with overhead absorbed. The balance on the account is, then, either an under-absorption or an overabsorption of overhead. Point out that it is a control account because it summarises the many different cost centres that exist in the firm. 256 Costing systems (1) To illustrate this, suppose that a firm has just 3 production cost centres. The details are, for one month: Cost centre Overhead incurred Direct labour hours Machine hours Process hours Absorption basis Absorption rate 1 2 3 £ £ £ 13,200 39,450 21,600 2,400 1,600 1,680 – 3,400 – – – 860 Labour hrs Machine hrs Process hrs £5.75 £10.80 £22.60 These figures provide a good opportunity for revision, before continuing with the control account: For example, you could ask what the term ‘Overhead incurred’ covers. The answer is that it includes overhead allocated, and overhead apportioned, including an apportionment of service department costs. You could ask why there are 3 different bases of overhead absorption. The answer is because, for each cost centre, the most appropriate method has been used. Cost centre 1 is perhaps a hand-assembly department. Cost centre 2 clearly uses machines. It has been decided that many of the overheads incurred relate to the machines, so a machine hour rate is being used. You can also point out that all 3 cost centres are using hourly rates. Remind the class that these are generally considered better than money-based rates. Now continue with the control account: Cost centre Overhead incurred Direct labour hours Machine hours Process hours Absorption basis Absorption rate 1 2 3 £ £ £ 13,200 39,450 21,600 2,400 1,600 1,680 – 3,400 – – – 860 Labour hrs Machine hrs Process hrs £5.75 £10.80 £22.60 Calculate the: Absorbed overhead Under/(Over) absorption £13,800 (£600) £36,720 £2,730 £19,436 £2,164 257 Cost Accounting – Teacher’s Guide Finally, show the class how the Production overhead (control) account would appear in the integrated ledger: Production overhead Overhead incurred £ 74,250 Overhead absorbed Under-absorbed 74,250 £ 69,956 4,294 74,250 Emphasise that the debit of £74,250 would have corresponding credits on bank, creditors, material stock, accumulated depreciation etc. Show that it is the total of the overhead incurred by the 3 cost centres: Show that the £69,956 is the total of the overhead absorbed by the 3 cost centres. Emphasise that the absorbed overhead figure originates on each cost centre. Finally, show that the under-absorbed £4,294 is made up of 2 under-absorptions and an over-absorption. ▲ Now take the class through page 584 to the top of page 588. Reminders At the end of the lesson, re-state the main points again: An integrated accounts system meets the needs of both financial accounts and cost accounts. This topic needs a good basic understanding of debit/credit book-keeping principles. Many accounts in the integrated ledger are control accounts, which summarise detail for jobs, cost centres etc. 258 Costing systems (1) LESSON 56 Main subject Costing systems (1) Textbook reference Chapter 19: Page 580 Syllabus reference Second Level 8 Costing systems Simple examples of integrated accounting systems. Basic understanding of uniform costing Lesson topic Ledger entries for integrated accounts Extended syllabus reference 8.3 Make all entries in the integrated ledger to record the transactions of a period Required for Candidates for Second Level and Third Level Aim of the lesson • To show the preparation of a set of integrated accounts The lesson ▲ Begin by explaining that it is not always possible, within the time available for a single question, for the examiner to ask for a full set of accounts. For this reason, he may ask for a selection of one or two accounts from the integrated ledger. However, doing a full set of accounts is a good way to develop understanding of the subject, so tell the class that this is what you are going to do. Use the following example: 259 Cost Accounting – Teacher’s Guide On 1 April Year 3 the following balances were in the integrated ledger of Simon Jelford: Raw material stock Work-in-progress Finished stock Capital Fixed assets at cost Accumulated depreciation Bank Debtors Creditors £’000 12 8 9 £’000 105 90 36 14 22 155 14 155 During the year ended 31 March Year 4, the following transactions occurred (all figures are in £’000). 1 Material purchased for stock on credit: £142 2 Material issues: £136 of which £122 was direct material, issued to workin-progress. The balance was production overhead. 3 Depreciation was provided as production overhead at 10% on the cost of fixed assets. 4 Cash receipts during the year: £204 from customers. 5 Cash payments during the year: £136 to creditors for material purchases; £29 for net wages; £11 for production overhead purchases. 6 £9 had been deducted from the gross wages, which were analysed to direct wages £30 and indirect production £8 7 Production overhead was absorbed using a rate of 160% on direct labour 8 The cost of completed goods was £187 9 Sales on credit: £206 10 Cost of sales: £190 11 Cash drawings: £12 Explain that accounts must now be opened. The balances 1 April Year 3 must be entered. Then the transactions for the year ended 31 March Year 4 must be posted, accounts balanced, and a trial balance at the end of the year extracted. 260 £’000 1 Apr 3 Balance Raw material stock £’000 12 £’000 1 Apr 3 Balance Work-in-progress £’000 8 Costing systems (1) Finished stock £’000 9 1 Apr 3 Balance £’000 Capital £’000 1 Apr 3 Balance Fixed assets at cost £’000 90 1 Apr 3 Balance £’000 105 £’000 Accumulated depreciation £’000 1 Apr 3 Balance £’000 36 £’000 1 Apr 3 Balance Bank £,000 14 £’000 1 Apr 3 Balance Debtors £’000 22 Creditors £’000 1 Apr 3 Balance £’000 14 Once the accounts have been opened and the opening balances entered, the transactions for the year can then be entered: 1 Apr 3 31 Mar 4 1 Apr 3 31 Mar 4 Balance Purchases Balance Dir material Dir wages O/hd absorbed Raw material stock £’000 12 31 Mar 4 142 Work-in-progress £’000 8 31 Mar 4 122 30 48 WIP Prodn O/hd £’000 122 14 £,000 Finished stock 187 261 Cost Accounting – Teacher’s Guide 1 Apr 3 Balance 31 Mar 4 WIP Finished stock £’000 9 31 Mar 4 Cost of sales 187 Capital £’000 1 Apr 3 1 Apr 3 Balance Balance Fixed assets at cost £’000 90 1 Apr 3 Balance 31 Mar 4 Debtors 1 Apr 3 Balance 31 Mar 4 Sales – P&L Debtors £’000 22 31 Mar 4 206 31 Mar 4 Bank 31 Mar 4 Ind material Depreciation Ind labour Bank 262 £’000 105 £’000 Accumulated depreciation £’000 1 Apr 3 Balance 31 Mar 4 Prod O/hd Bank £,000 14 31 Mar 4 204 £’000 190 £’000 36 9 £’000 Creditors 136 Wages payable 29 Prodn O/hd 11 Drawings 12 Bank £’000 204 Creditors £’000 £’000 136 1 Apr 3 Balance 14 31 Mar 4 Mat purchases 142 Production overhead £’000 14 31 Mar 4 9 8 11 £’000 WIP – O/hd absorbed 48 Costing systems (1) 31 Mar 4 Bank Deduction creditor Wages payable £’000 29 31 Mar 4 Wages control 9 38 £’000 38 38 Deductions creditor £’000 £’000 31 Mar 4 Wages payable 9 31 Mar 4 Wages payable Wages control £’000 38 31 Mar 4 WIP Prodn O/hd 38 £’000 30 8 38 31 Mar 4 Finished stock Cost of sales £’000 190 31 Mar 4 Profit & Loss £’000 190 31 Mar 4 Profit and Loss Sales £’000 206 31 Mar 4 Debtors £’000 206 31 Mar 4 Cost of sales 31 Mar 4 Bank Profit and Loss £’000 190 31 Mar 4 Sales Drawings £’000 12 £’000 206 £’000 The accounts now show the opening balances and the transactions for the year. Make sure that all of the class understand each transaction in terms of its debit/credit entry. You can now complete the example by balancing the accounts, and taking out a trial balance as a test of accuracy. 263 Cost Accounting – Teacher’s Guide Raw material stock £’000 12 31 Mar 4 WIP 142 Prodn O/hd Balance 154 18 1 Apr 3 Balance 31 Mar 4 Purchases 1 Apr 4 Balance 1 Apr 3 Balance 31 Mar 4 Dir material Dir wages O/hd absorbed 1 Apr 4 Balance £’000 1 Apr 3 Balance 31 Mar 4 WIP 1 Apr 4 Balance £’000 31 Mar 4 Drawings Balance 1 Apr 3 Balance £’000 264 Work-in-progress £’000 8 31 Mar 4 Finished stock 122 Balance 30 48 208 21 Finished stock £’000 9 31 Mar 4 Cost of sales 187 Balance 196 6 Capital £’000 12 1 Apr 3 Balance 115 31 Mar 4 P&L net profit 127 1 Apr 4 Balance Fixed assets at cost £’000 90 Accumulated depreciation £’000 1 Apr 3 Balance 31 Mar 4 Prod O/hd £’000 122 14 18 154 £’000 187 21 208 190 6 196 105 22 127 115 £’000 36 9 45 Costing systems (1) 1 Apr 3 Balance 31 Mar 4 Debtors 1 Apr 4 Balance 1 Apr 3 Balance 31 Mar 4 Sales – P&L 1 Apr 4 Balance 31 Mar 4 Bank 31 Mar 4 Balance 31 Mar 4 Ind material Depreciation Ind labour Bank P&L Over abs Bank £’000 14 31 Mar 4 Creditors 204 Wages payable Prodn O/hd Drawings Balance 218 30 £’000 136 29 11 12 30 218 Debtors £’000 22 31 Mar 4 Bank 206 Balance 228 24 £’000 204 24 228 Creditors £’000 136 1 Apr 3 Balance 20 31 Mar 4 Mat purchases 156 1 Apr 4 Balance £’000 14 142 156 20 Production overhead £’000 £’000 14 31 Mar 4 WIP – O/hd 9 absorbed 48 8 11 6 48 48 Wages payable £’000 31 Mar 4 Bank 29 31 Mar 4 Wages control Deduction creditor 9 38 Deductions creditor £’000 31 Mar 4 Wages payable £’000 38 38 £’000 9 265 Cost Accounting – Teacher’s Guide 31 Mar 4 Wages payable Wages control £’000 38 31 Mar 4 WIP Prodn O/hd 38 £’000 30 8 38 31 Mar 4 Finished stock Cost of sales £’000 190 31 Mar 4 Profit & Loss £’000 190 31 Mar 4 Profit and Loss Sales £’000 206 31 Mar 4 Debtors £’000 206 Profit and Loss £’000 31 Mar 4 Cost of sales 190 31 Mar 4 Sales 22 Over abs O/hd Net profit – capital 212 31 Mar 4 Bank Drawings £’000 12 31 Mar 4 Capital £’000 206 6 212 £’000 12 Trial balance at 31 March/1 April Year 4 Material stock Work-in-progress Finished stock Capital Fixed assets at cost Accumulated depreciation Bank Debtors Creditors Deductions creditor £’000 18 21 6 £’000 115 90 45 30 24 189 20 9 189 ▲ Now take the class through Examples 1, 2, 3 and 4 on pages 588-598 of the textbook. 266 Costing systems (1) Reminders At the end of the lesson, re-state the main points again: An understanding of the principles of an integrated accounting system will only come through practice, and through a clear appreciation of the underlying bookkeeping principles. 267 Cost Accounting – Teacher’s Guide LESSON 57 Main subject Costing systems (1) Textbook reference Chapter 19: Page 580 Syllabus reference Second Level 8 Costing systems Simple examples of integrated accounting systems. Basic understanding of uniform costing Lesson topic Uniform costing Extended syllabus reference 8.4 8.5 8.6 Understand the purpose of uniform costing Make simple adjustments to achieve uniformity Interpret simple cost comparisons made where uniform costing has been applied Required for Candidates for Second Level and Third Level Aim of the lesson • To explain the purpose and practice of uniform costing. The lesson ▲ Begin by referring to the CIMA definition on page 598 of the textbook. Point out that the word ‘uniform’ suggests ‘sameness’ or ‘having common elements’. The definition says that it is the costing system that is the same. It goes on to say that this means the same methods, principles and techniques. Take the opportunity to introduce revision into this lesson: Remind the class that costing methods include job costing, process costing, batch costing, contract costing etc., and that these are selected to reflect the business, its products and its customers. For example, a printer may take many, often small, orders for printing. This would suggest the need for a job costing system, with the ability to identify individual jobs, and to book costs incurred to them. Such a printer could also have regular repeat orders from some customers – which would make batch costing suitable for those orders. 268 Costing systems (1) A single firm could, therefore, use both job costing and batch costing methods. Point out that whilst it might be tempting to imagine that similar firms will use the same costing methods, there is a big difference between a small jobbing printer, and a printing company that produces the same magazine every week. Explain that there may be differences in principle between firms. Examples are depreciation policy and the treatment of directors’ salaries. Point out that depreciation methods can be the same, but there can still be differences in assumed asset life, in residual value assumptions and in how to treat a fully-depreciated asset. With respect to directors’ salaries, some firms will treat them all as administration overhead. Others will treat them functionally. The third point in the CIMA definition relates to the ‘same techniques’. An example that you can give the class is whether marginal costing is used – with implications for stock valuations. The list given on page 599, of points to be agreed in developing uniformity, should be discussed with the class. ▲ Now explain to the class that the definition of uniform costing says nothing about the reasons for using it. Make the suggestion that if we know figures have been prepared and presented on a common basis, then there is the opportunity to compare them. Emphasise the benefits of comparison, given at the foot of page 599 and at the top of page 600. Explain the 2 ways in which uniformity may be applied: within a group; within an industry. ▲ Take the class through the procedures of a trade-association-based comparison (pages 600-601). ▲ Finally, take the class through Example 5 on pages 601-603 of the textbook. Reminders At the end of the lesson, re-state the main points again: Uniform costing is used to allow valid comparisons of cost between different organisations. Such comparison should then encourage improved cost performance. 269 Cost Accounting – Teacher’s Guide LESSON 58 Main subject Costing systems (2) Textbook reference Chapter 20: Page 610 Syllabus reference Third Level Accounting Systems Interlocking and integrated accounting systems Use of control accounts. Reconciliation and causes of different profits Notional costs Lesson topic Standard costing entries in the integrated ledger for historical and marginal costing systems. Extended syllabus reference 5.1 5.2 5.3 Distinguish between integrated and non-integrated accounting systems Understand the importance of, and use of, control accounts, with particular emphasis on material stock, work-in-progress, finished goods and production overhead Post entries in an integrated ledger for historical cost and standard cost systems, and for absorption costing and marginal costing systems Required for Candidates for Third Level only Aim of the lesson • To explain the entries needed in the integrated ledger to deal with standard costs and variances The lesson ▲ Remind the class that a previous lesson has explained the nature of an integrated accounts system. The importance of control accounts was also explained. They are total accounts. For example, the production overhead control account summarises the many production cost centres. Each cost centre has its own incurred overhead, its own absorbed overhead – and therefore, its own under- or over-absorbed overhead. 270 Costing systems (2) Third Level candidates must be able to handle more complex questions than would be expected of Second Level candidates. However, you should point to the opening comment on page 610 – it is unlikely that the examination will include a full question with all transactions. This would require far too much within a 20-mark question. It is more likely, therefore, that selected accounts will be asked for. Explain that, nevertheless, the only way to really understand parts of the system is to do questions which are comprehensive. This can be done in the time available in the class, and will be done in this lesson. ▲ First, take the class through Example 1 on pages 611-615 of the textbook. This illustrates the type of selective question that could be asked on the examination paper. This example does not involve standard costing. The class could therefore do it as a revision question. ▲ Now introduce standard costing Emphasise that as a result of their work in earlier lessons, the class should have a working knowledge of all variances. In the examination, variances may have to be calculated before being posted to accounts in the integrated system. Alternatively, variances may be given by the examiner. Either way, time cannot be wasted on thinking how each variance has to be calculated. For this reason, the class needs to come to this topic (integrated accounts) confident of standard costing basics. Now take the class through each element of cost to remind them of the accounting entries. These will be given as journal entries. You might want the class to do them in ‘T’ accounts. Materials Use the following data: Material purchases 200 tonnes @ £180 tonne Standard price fixed at £175 tonne Material issues to production 90 tonnes. Remind the class that there are 3 alternatives: If standard costing does not exist: Material stock account Creditors account ––––––––––––––––––––– Work-in-progress account Material stock account ––––––––––––––––––––– £ 36,000 £ 36,000 16,200 16,200 271 Cost Accounting – Teacher’s Guide If standard costing exists, and the price variance is taken on purchase: Material stock account 35,000 Material price variance account 1,000 Creditors account ––––––––––––––––––––– Work-in-progress account 15,750 Material stock account 36,000 15,750 ––––––––––––––––––––– If standard costing exists, and the price variance is taken on issue: Material stock account 36,000 Creditors account 36,000 ––––––––––––––––––––– Work-in-progress account 15,750 Material price variance account 450 Material stock account 16,200 ––––––––––––––––––––– Make sure the class understands the circumstance in which each answer would be correct. Also, make sure that they fully appreciate that these journal entries are instructions as to which integrated ledger accounts will be debited, and which will be credited. Labour Use the following data: Actual gross wages for Month 4 £34,200. This comprised direct wages 3,200 hours for £25,100, and £9,100 indirect production wages. Net wages paid were £27,150, and deductions creditors amounted to £7,050. First, ask the class to do the journal entries for wages if standard costing is not in use. This should not present a problem. The answer should be: £ 34,200 Wages control account Wages payable account –––––––––––––––––––– Wages payable account 34,200 Bank account Deductions creditors accounts –––––––––––––––––––– Work-in-progress account 25,100 Production overhead account 9,100 Wages control account –––––––––––––––––––– 272 £ 34,200 27,150 7,050 34,200 Costing systems (2) Again, make sure the class understands. Emphasise that these are all control accounts. For example, the £9,100 indirect labour will be analysed to individual cost centres. Now give the class additional information: Standard costing is in use. Standard rate per hour for direct labour £7.50 Standard hours produced 3,310 Emphasise that the class should, if possible, begin to ‘see’ variances as the information is given. For example, as soon as you told them that 3,310 standard hours of output had been produced, they should immediately have realised that there is a favourable efficiency variance, because the actual direct labour hours were 3,200. Point out that it is usual to extract the rate variance prior to work-in-progress, but to bring the efficiency variance out of work-in-progress. The required entries are: £ Wages control account 34,200 Wages payable account –––––––––––––––––––– Wages payable account 34,200 Bank account Deductions creditors accounts –––––––––––––––––––– Work-in-progress account 3,200 hours @ £7.50 24,000 Rate variance account 1,100 Production overhead account 9,100 Wages control account –––––––––––––––––––– Finished stock account 3,310 @ £7.50 24,825 Work-in-progress account Labour efficiency variance account ––––––––––––––––––––– £ 34,200 27,150 7,050 34,200 24,000 825 Remind the class that if they were asked to calculate the labour efficiency variance, they would calculate it: £ Standard hours Actual hours Hours saved 3,310 3,200 110 @ standard rate £7.50 825 F 273 Cost Accounting – Teacher’s Guide Overhead Use the same data as for the labour illustration. Give the following additional data: Standard absorption rate (based upon 4,000 budgeted direct labour hours and budgeted fixed production overheads of £25,000) is £6.25 per hour. Actual fixed production overheads were £24,130, of which £20,130 was paid from the bank, and £4,000 was depreciation of machinery. Immediately the class should see 3 things which you can ask them about: 1 Standard hours and actual hours are well down on budget. This means there will be a large volume variance, because all of the production overheads are fixed. 2 It is already known that the direct labour efficiency variance is favourable. Therefore, there must be a favourable overhead efficiency variance 3 As the budgeted, and the actual, fixed production overheads are both known, the class should be able to see the expenditure variance. (Before taking the class through the overhead entries, point to the textbook author’s preferred method, stated at the top of page 620 of the textbook.) The answer should be: £ Production overhead account 24,130 Bank account Provision for machinery depreciation ––––––––––––––––––––––– Work-in-progress account 3,200 hours x £6.25 20,000 Volume capacity variance account (4,000 – 3,200) x £6.25 5,000 Expenditure variance account (£25,000 – £24,130) Production overhead account ––––––––––––––––––––––– Finished stock account 3,310 x £6.25 20,687.5 Work-in-progress Volume efficiency ––––––––––––––––––––––– 274 £ 20,130 4,000 870 24,130 20,000.0 687.5 Costing systems (2) Emphasise again, that the class needs to be sufficiently confident of variance analysis, so that they can calculate variances as entries are made in the integrated ledger. There is not sufficient time in an examination to calculate the variances and then to do the accounts. They must be done together. ▲ Now take the class through Examples 2-9 on pages 615-626 of the textbook. Example 9 is a very important example. It is more comprehensive than the others as it deals with many variances. It also shows – in (a) – the presentation of the Profit & Loss account using actual costs and a stock movement valuation at standard cost. In (b)(vi) it shows the presentation using standard profit and variances. See also Note 11 to the solution. Make sure that the class is aware of the difference in approach and presentation. ▲ Now take the class through the following example, which will be a complete set of transactions for Binford Ltd. Binford Ltd makes a single product. It commenced trading on 1 January Year 8, and planned to make and sell 3,000 units of output in its first year. The company decided to use standard absorption costing and an integrated system of accounting. The company commenced with £80,000 in ordinary share capital, and this amount was paid into a company bank account. The company operated from rented premises, but used £60,000 to purchase plant and equipment. No vehicles were purchased, because finished products are delivered to customers by external carrier, The standard cost per unit produced for Year 1 was: Direct material 6 kg @ £15 kg Direct labour 6 hours @ £8 hour Fixed production overhead 6 hours @ £12 Production cost £ 90 48 72 210 The standard selling price per unit was £260. Administration, Selling and Distribution costs were budgeted at £125,000. Material stocks were to be valued at standard, i.e. the material price variance is taken on purchase. The transactions for the year ended 31 December Year 8 were: 1 Production was 2,800 units. 2 2,600 units were sold on credit for £685,000. 3 £672,000 was received from debtors. 4 19,000 kg of material were purchased on credit for £292,000. 5 £264,000 was paid to creditors for material supplied. 6 17,000 kg of material was issued and used in production. 275 Cost Accounting – Teacher’s Guide 7 Production wages totalled £177,000. 8 Production wages comprised Direct wages 18,000 hours for £146,000 and Indirect wages £31,000. 9 Net wages paid to production employees totalled £138,000. Deductions were £39,000, of which £31,000 had been paid to deduction creditors by 31 December. 10 Fixed production overheads incurred amounted to £211,000. £31,000 of this was the indirect labour already referred to. A further £165,000 was incurred in cash payments, and £15,000 was for plant and equipment depreciation. 11 Administration, Selling and Distribution overheads incurred, and paid in cash, amounted to £109,000. The solution in ledger accounts will now be shown, but no further explanations will be given for this example. Dates will also be omitted because, except for the opening entries, all dates will be 31 December. Ordinary share capital Bank Capital Debtors Balance c/d Material creditors Balance b/d Bank Balance c/d 276 Bank £’000 80 Fixed assets 672 Material creditors 15 Wages payable Deduction creditors Production overheads Admin S & D 767 Balance b/d Material Stock £’000 285 WIP Balance c/d 285 30 Material creditors £’000 264 Material stock 28 Material price variance 292 Balance c/d £’000 80 £’000 60 264 138 31 165 109 767 15 £’000 255 30 285 £’000 285 7 292 28 Costing systems (2) Material creditors Bank Deduction creditors Wages payable Wages control account Material stock account Wages control account Production overhead: 18,000 x £12 Material price variance £’000 7 Profit & Loss account Wages payable £’000 138 Wages control account 39 177 Wages control £’000 177 WIP (18,000 x £8) Labour rate variance Production overhead 177 Labour rate variance £’000 2 Profit & Loss Account £’000 177 177 £’000 144 2 31 177 £’000 2 Work-in-progress £’000 £’000 255 Finished stock account: 144 2,800 x £210 588 216 Material usage variance Efficiency variance 615 Production overhead £’000 Bank 165 Work-in-progress Wages control 31 Provision for depreciation 15 Expenditure variance 5 216 Work-in-progress £’000 7 Material usage variance £’000 3 Profit & Loss 3 24 615 £’000 216 216 £’000 3 277 Cost Accounting – Teacher’s Guide Provision for depreciation Profit & Loss Work-in-progress Production overhead £’000 15 Expenditure variance £’000 5 Production overhead £’000 5 Efficiency variance £’000 24 Profit & Loss £’000 24 Note: The £24,000 efficiency variance comprises direct labour efficiency of £9,600 and fixed overhead volume efficiency of £14,400. A separate variance account for each could be presented. Work-in-progress Balance b/d Sales Balance b/d Bank 278 Finished stock £’000 588 Cost of sales Balance c/d 588 42 £’000 546 42 588 Debtors £’000 685 Bank Balance c/d 685 13 £’000 672 13 685 Admin. Selling & Distribution £’000 109 Profit & Loss £’000 109 Finished stock Cost of sales £’000 546 Profit & Loss £’000 546 Profit & Loss Sales £’000 685 Debtors £’000 685 Costing systems (2) Cost of sales Admin S & D Material price variance Labour rate variance Material usage variance Efficiency variance Loss b/d Profit & Loss 546 Sales 109 Fixed overhead exp 7 Loss c/d 2 3 24 691 1 685 5 1 691 Note: There is no fixed overhead volume capacity variance because budget and actual hours were both 18,000. Bank Bank Balance c/d Plant & Machinery £’000 60 Deduction creditors £’000 31 Wages payable 8 39 Balance b/d £’000 39 39 8 Finally, to check accuracy, a trial balance can be extracted: £’000 Share capital Bank Material stock Material creditors Plant & Machinery at cost Prov for Plant & Machinery depn Finished stock Debtors Profit & Loss Deduction creditors £’000 80 15 30 28 60 15 42 13 1 146 8 146 Whilst this example will provide you with an excellent teaching aid, the length of the solution shows why a complete question cannot be asked on an examination paper of 20-mark questions. 279 Cost Accounting – Teacher’s Guide Reminders At the end of the lesson, re-state the main points again: Integrated accounts, of the type discussed in this lesson, require that the student has a basic competence in variance analysis before starting. 280 Costing systems (2) LESSON 59 Main subject Costing systems (2) Textbook reference Chapter 20: Page 610 Syllabus reference Third Level Accounting Systems Interlocking and integrated accounting systems Use of control accounts. Reconciliation and causes of different profits Notional costs Lesson topic Interlocking accounts Extended syllabus reference 5.4 As 5.3 but for a non-integrated ledger system Required for Candidates for Third Level only Aim of the lesson • To explain the entries needed in the non-integrated cost ledger to deal with standard costs and variances. The lesson ▲ Begin by referring the class to the CIMA definition on page 627 of the textbook. Note that this definition emphasises that interlocking and non-integrated accounts are the same thing. Emphasise that the cost accounts are a distinct and separate system from the financial accounts. In other words, there are 2 double-entry ledger systems. The financial accountant can record transactions as he wishes. For example, the financial accounts may record gross wages under the nominal account heading. In the cost accounts, the gross wages will be analysed to direct and indirect, charged to jobs and cost centres respectively. Use the wages illustration on pages 627-628 to make this clear. Point out, particularly, the problem of finding a credit entry in the cost ledger to correspond to the debit for the gross wages. Make sure that the class sees the financial ledger control account as the solution to this problem. 281 Cost Accounting – Teacher’s Guide Tell the class that, at any time, the balance on the financial ledger control account is equal to the sum of all other balances on accounts in the cost ledger. It can be thought of as the capital account of the cost ledger. ▲ Explain that sometimes the examiner does not mention the financial ledger control account, but he expects the candidate to know that it exists. For example, the examiner gives balances in the cost ledger at 1 August Year 5 as: Raw material stock Work-in-progress stock Finished stock Production overhead over-absorbed £ 12,650 8,967 10,760 768 Tell the class that the examiner would expect them to deduce that there must be a credit balance of £31,609 on the financial ledger control account. This is because the 3 stock accounts are asset accounts, and therefore must carry debit balances. The production overhead over-absorbed, on the other hand, must be a credit balance. ▲ Now explain that Example 10 on pages 629-632 of the textbook is a complete example in that it begins with a trial balance, records a month’s transactions, and then ends with a trial balance. It is not, however, a standard costing question. The absence of standard costing, together with the fact that it is a non-integrated system, makes the question shorter. Point out that there are transactions which are only recorded in the financial ledger. These include bank entries, payments to creditors, payments by customers etc. Take the class through the Example. Point out that most of the accounts are almost the same as they would be for an integrated system. These are Material stock, Work-in-progress, Finished stock, Wages and salaries control, Production overhead, Cost of sales, Administration, Selling and Distribution overhead and the Profit and Loss account. The only difference is in the narrations, where there is regular reference to the FLC (the financial ledger control account). In addition, point out to the class that there is no bank account, capital account, debtors account or creditors account etc. These are now in the separate financial ledger. Ask the class to note which entries pass through the financial ledger control account. For example, purchases of £47,115 is credited there, because there is no creditors account in the cost ledger to take the entry. Remind the class that it was said earlier that the financial ledger control account could be thought of as the capital account of the cost ledger. Explain that the profit from the profit & loss account in the cost ledger has been credited to the financial ledger control account. This emphasises the similarity. ▲ Finally in this lesson, the standard costing example will be taken from the previous lesson, and illustrated in a non-integrated form: 282 Costing systems (2) Binford Ltd makes a single product. It commenced trading on 1 January Year 8, and planned to make and sell 3,000 units of output in its first year. The company decided to use standard absorption costing and a non-integrated system of accounting. The company commenced with £80,000 in ordinary share capital, and this amount was paid into a company bank account. The company operated from rented premises, but used £60,000 to purchase plant and equipment. No vehicles were purchased, because finished products are delivered to customers by external carrier, The standard cost per unit produced for Year 1 was: Direct material 6 kg @ £15 kg Direct labour 6 hours @ £8 hour Fixed production overhead 6 hours @ £12 Production cost £ 90 48 72 210 The standard selling price per unit was £260. Administration, Selling and Distribution costs were budgeted at £125,000 Material stocks were to be valued at standard, i.e. the material price variance is taken on purchase. The transactions for the year ended 31 December Year 8 were: 1 Production was 2,800 units. 2 2,600 units were sold on credit for £685,000. 3 £672,000 was received from debtors. 4 19,000 kg of material were purchased on credit for £292,000. 5 £264,000 was paid to creditors for material supplied. 6 17,000 kg of material was issued and used in production. 7 Production wages totalled £177,000. 8 Production wages comprised Direct wages 18,000 hours for £146,000 and Indirect wages £31,000. 9 Net wages paid to production employees totalled £138,000. Deductions were £39,000, of which £31,000 had been paid to deduction creditors by 31 December. 10 Fixed production overheads incurred amounted to £211,000. £31,000 of this was the indirect labour already referred to. A further £165,000 was incurred in cash payments, and £15,000 was for plant and equipment depreciation. 11 Administration, Selling and Distribution overheads incurred, and paid in cash, amounted to £109,000. 283 Cost Accounting – Teacher’s Guide The solution in ledger accounts will now be shown, but no further explanations will be given for this example. Dates will also be omitted because – except for the opening entries – all dates will be 31 December. Before taking the class through this example, tell them that the question has been reproduced exactly as it was given in the previous lesson, except for stating that nonintegrated accounts were used. Therefore some of the information is not needed for the preparation of the cost ledger. Ask the class to tell you what information is not needed. They should say: 1 The £80,000 introduced as capital to open the bank account 2 The purchase of fixed assets for £60,000 3 Transaction 3. Receipt of £672,000 from debtors 4 Transaction 5. Payment of £264,000 to creditors 5 Transaction 9. Payment of net wages, and accounting for deductions The entries will be: Material – FLC Balance b/d Material stock Gross wages – FLC Wages control account 284 Material stock £’000 292 WIP Price variance account ___ Balance c/d 292 30 £’000 255 7 30 292 Material price variance £’000 7 Profit & Loss account £’000 7 Wages control £’000 177 WIP (18,000 x £8) Labour rate variance ___ Production overhead 177 £’000 144 2 31 177 Labour rate variance £’000 2 Profit & Loss Account £’000 2 Costing systems (2) Work-in-progress £’000 £’000 255 Finished stock account: 144 2,800 x £210 588 Material stock account Wages control account Production overhead: 18,000 x £12 216 ___ 615 Expenses – FLC Wages control Provision for depreciation – FLC Expenditure variance Work-in-progress Profit & Loss Work-in-progress Work-in-progress Balance b/d Expenses – FLC Material usage variance Efficiency variance Production overhead £’000 165 Work-in-progress 31 15 5 216 Material usage variance £’000 3 Profit & Loss Expenditure variance £’000 5 Production overhead Efficiency variance £’000 24 Profit & Loss Finished stock £’000 588 Cost of sales ___ Balance c/d 588 42 Admin. Selling & Distribution £’000 109 Profit & Loss 3 24 615 £’000 216 ___ 216 £’000 3 £’000 5 £’000 24 £’000 546 42 588 £’000 109 285 Cost Accounting – Teacher’s Guide Finished stock Cost of sales £’000 546 Profit & Loss £’000 546 Profit & Loss Sales £’000 685 FLC £’000 685 Cost of sales Admin S & D Material price variance Labour rate variance Material usage variance Efficiency variance Sales Loss Balance c/d Profit & Loss 546 Sales 109 Fixed overhead exp 7 Loss – FLC 2 3 24 691 Financial Ledger Control Account £’000 685 Material purchases 1 Gross wages 72 Expenses Depreciation ___ Expenses 758 Balance b/d 685 5 1 ___ 691 £’000 292 177 165 15 109 758 72 Finally, to check accuracy, a trial balance can be extracted: Material stock Finished stock Financial Ledger Control £’000 30 42 72 £’000 72 72 You should emphasise how much shorter the non-integrated accounts solution is. However, do point out that work is also being done in a separate financial accounts system. Finally, point out that this example has been answered, in both the previous lesson and in this lesson, as for a standard absorption costing system. This was correct, because the company had chosen this. 286 Costing systems (2) ▲ Now ask the class what would change if it were a standard marginal costing question. The class should know that if standard marginal costing was being used, the fixed production overheads would be treated as a period cost, and not absorbed into the unit cost of the product. In addition, the standard cost would only be calculated as far as the prime cost (there were no variable overheads), and no fixed overhead variances would be calculated. The answer under standard marginal costing would be much easier. It would be: Material – FLC Balance b/d Material stock Gross wages – FLC Wages control account Material stock account Wages control account Material stock £’000 292 WIP Price variance account ___ Balance c/d 292 30 £’000 255 7 30 292 Material price variance £’000 7 Profit & Loss account £’000 7 Wages control £’000 177 WIP (18,000 x £8) Labour rate variance ___ Production overhead 177 £’000 144 2 31 177 Labour rate variance £’000 2 Profit & Loss Account £’000 2 Work-in-progress £’000 £’000 255 Finished stock account: 144 2,800 x £138 386.4 Material usage variance 3.0 ___ Labour efficiency variance 9.6 399 399 287 Cost Accounting – Teacher’s Guide Expenses – FLC Wages control Provision for depreciation – FLC 15 211 £’000 211 211 Work-in-progress Material usage variance £’000 3 Profit & Loss £’000 3 Work-in-progress Labour efficiency variance £’000 9.6 Profit & Loss £’000 9.6 Work-in-progress Balance b/d Expenses – FLC 288 Production overhead £’000 165 Profit & Loss 31 Finished stock £’000 386.4 Cost of sales Balance c/d 386,4 27.6 Admin. Selling & Distribution £’000 109 Profit & Loss £’000 358.8 27.6 386.4 £’000 109 Finished stock Cost of sales £’000 358.8 Profit & Loss £’000 358.8 Profit & Loss Sales £’000 685 FLC £’000 685 Costing systems (2) Cost of sales Admin S & D Fixed overheads Material price variance Labour rate variance Material usage variance Labour efficiency variance Sales Loss Balance c/d Profit & Loss £’000 358.8 Sales 109.0 Loss – FLC 211.0 7.0 2.0 3.0 9.6 700.4 Financial Ledger Control Account £’000 685.0 Material purchases 15.4 Gross wages 57.6 Expenses Depreciation Expenses 758.0 Balance b/d £’000 685.0 15.4 700.4 £’000 292.0 177.0 165.0 15.0 109.0 758.0 57.6 Finally, to check accuracy, a trial balance can be extracted: Material stock Finished stock Financial Ledger Control £’000 30.0 27.6 £’000 57.6 57.6 57.6 Reminders At the end of the lesson, re-state the main points again: Non-integrated accounts are accounts which have a double-entry ledger for each of financial accounts and cost accounts. As with the preceding lesson, the type of accounts discussed in this lesson require that the student already has a basic competence in variance analysis. 289 Cost Accounting – Teacher’s Guide LESSON 60 Main subject Costing systems (2) Textbook reference Chapter 20: Page 610 Syllabus reference Third Level Accounting Systems Interlocking and integrated accounting systems Use of control accounts. Reconciliation and causes of different profits Notional costs Lesson topic Reconciliations Extended syllabus reference 5.5 5.6 5.7 Understand the need for reconciliation in a non-integrated system Understand why certain items cause the need for reconciliation – stock valuations, depreciation treatment, notional items, treatment of under/ over-absorbed overhead etc Prepare a reconciliation statement Required for Candidates for Third Level only Aims of the lesson • To explain the reason fo a reconciliation statement • To explain how a reconciliation statement is prepared The lesson ▲ Begin by looking at the example on page 632 of the textbook. Point out that if separate cost and financial ledgers exist, each will produce a profit and loss account. If the two profits are identical, no-one will be concerned. If they are different, the question may be asked, ‘Which is correct?’. A reconciliation of the two profits is therefore prepared, to show that both profits are correct – but the reconciliation is done in different ways! Take the class through the important notes on pages 633-634. Make sure that they understand the difference between the 3 categories. Explain that a reconciliation statement can start with either the profit from the profit and loss account in the cost ledger, or from the profit and loss account in the financial ledger, unless the examiner tells the candidate which profit to start with. 290 Costing systems (2) Explain this, using the following: The profit in the cost ledger is £45,346. The profit in the financial ledger is £46,120. Investment income of £774 has been credited in the financial profit and loss account. The reconciliation statement can be either: Profit per the financial accounts Less investment income Profit per the cost accounts £ 46,120 774 45,346 Profit per the cost accounts Add investment income Profit per the financial accounts £ 45,346 774 46,120 or Emphasise that the second answer would have been wrong if the examiner had instructed candidates to ‘Prepare a reconciliation statement, starting with the profit per the financial accounts.’ ▲ Continue your lesson with this example: The profit in the cost ledger of Jinks Ltd is £85,786. The profit in the financial ledger of Jinks Ltd is £103,973. Investment income of £1,087 has been credited in the financial profit and loss account. The company’s production buildings are all owned, but a notional rent of £17,100 has been included in production overheads in the cost ledger. The reconciliation statement can be either: Profit per the financial accounts less investment income less notional rent Profit per the cost accounts £ 103,973 1,087 102,886 17,100 85,786 or Profit per the cost accounts Add investment income Add notional rent Profit per the financial accounts £ 85,786 1,087 86,873 17,100 103,973 291 Cost Accounting – Teacher’s Guide ▲ Continue your lesson with this example: The profit in the cost ledger of Hermes Ltd is £346,612. The profit in the financial ledger of Hermes Ltd is £381,334. Investment income of £7,349 has been credited in the financial profit and loss account. The company’s production buildings are all owned, but a notional rent of £28,560 has been included in production overheads in the cost ledger. In the cost ledger, the stocks at the start of the financial year were brought forward at cost £64,356, whereas in the financial ledger, they were brought forward at cost, £73,180. In the cost ledger, the stocks at the end of the financial year, valued at cost, amounted to £46,734, whereas in the financial ledger, they were valued at cost, £54,371. The reconciliation statement can be either: £ 381,334 7,349 373,985 28,560 345,425 Profit per the financial accounts less investment income less notional rent less difference in closing stock values: Financial accounts Cost accounts add difference in opening stock values: Financial accounts Cost accounts Profit per the cost accounts 54,371 46,734 73,180 64,356 7,637 337,788 8,824 346,612 or £ 346,612 7,349 353,961 28,560 382,521 Profit per the cost accounts add investment income add notional rent add difference in closing stock values: Financial accounts Cost accounts less difference in opening stock values: Financial accounts Cost accounts Profit per the financial accounts 292 54,371 46,734 73,180 64,356 7,637 390,158 8,824 381,334 Costing systems (2) Point out to the class that this last example includes one adjustment from each of the 3 categories which cause difference. These are given on page 633. Now explain that the reconciliations illustrated were easy because both profits were given. Not only could the candidate choose which profit to start with (provided the examiner gave no instruction), but could also keep testing his answer until it reconciled one given profit to the other given profit. That makes it too easy! For this reason, the examiner doesn’t usually give both profits. He usually gives only one. Therefore there is no choice of starting profit. This means that the candidate must be able to reason out whether each adjustment is added or subtracted. For this reason, you need carefully to explain the reasoning behind the adjustments made in this lesson. ▲ Now take the class through Example 11. You will see that the profit per the financial accounts is given. However, it only says that this differs from the profit in the cost ledger. We don’t know what that difference is. The answer, therefore, has to start with the profit per the financial accounts. Reminders At the end of the lesson, re-state the main points again: Managers are uneasy about being given 2 different profits for the same accounting period. The reconciliation is produced to give assurance that both sets of accounts are correct. Candidates must be able to reason the adjustment required in working from one known profit to the other – usually unknown – profit. 293
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