Category: Cost and Management Accounting

Cost Accounting involves the calculation and measurement of the resources used by a business in undertaking its various activities and is concerned with

Marginal Costing – with simple examples

Marginal Costing Overview

In marginal costing fixed production overheads are not absorbed into products costs.
The main uses are; planning, forecasting and decision making.

Assumptions in marginal costing:

The variable cost per unit is a constant value.
Fixed cost are costs that remain same in total in each period.
Costs are either fixed or variable costs. Mixed costs can be separated into a variable cost per unit and a fixed cost per period.

Contribution:

It is a key concept in marginal costing.
Contribution therefore means; contribution towards covering fixed costs and making a profit.
If total contribution fails to cover fixed costs there is a loss.

Contribution = Sales – variable costs

Total contribution – fixed costs = Profit

Reporting profit with Marginal Costing

In a marginal cost system the opening and closing inventory is measured at its marginal cost. The cost per unit only includes the variable costs of production.
Profit is measured by comparing revenue to the cost of goods sold in the period and then deducting other expenses.

Advantages	Disadvantages
Easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated as period costs and written off in full as an expense when incurs. No under/over-absorption. Contribution per unit is constant unlike profit per unit which varies as the volume of activity varies.	It does not value inventory in accordance with requirements of financial reporting. Marginal costing can be used to measure the contribution per unit of product or total contribution earned by a product, but this is not sufficient to decide whether the product is profitable enough.

Comparison between Absorption costing and Marginal costing

The profit calculated with marginal costing is different from the profit calculated with absorption costing.
The difference in profit is due to entirely to the differences in the inventory valuation; as in absorption costing inventory cost includes a share of fixed production overheads i,e opening inventory contains fixed production overheads incurred in last period which is written off in the current period and closing inventory contains fixed production overheads that was incurred in this period but carried forward to be written off in the next period.
When there is no change in the opening and closing inventory, exactly same profit will be reported using marginal costing and absorption costing.

When there’s an Increase in inventory

When there’s a Decrease in inventory

(i,e closing inventory is greater than opening)

It reduces cost of sales and increases profit.
The absorption profit will be higher.

(i,e closing inventory is greater than opening)

It reduces cost of sales and increases profit.
The absorption profit will be higher.

Profit Reconciliation: Between Absorption and Marginal costing

To calculate the difference between reported profit using marginal costing and the reported profit using absorption costing make follow simple calculations:

Step I

Calculate increase/decrease in inventory during the period in units:(opening inventory absorption & marginal minus closing inventory absorption marginal).

Step II

Calculate fixed production overhead cost per unit.

Step III

The difference in profit is the increase or decrease in inventory quantity multiplied by the fixed production cost per unit.

October 2, 2019

Accounting for overheads | Fixed Variable | Absorption rate

Accounting for overheads Overview

What constitutes part of inventory value?

Part of Inventory

Direct costs

Direct material
Direct labour
Direct expenses

Indirect Costs (Overheads)

Variable Production/manufacturing overheads
Fixed Production (Depends on costing system used):

In Absorption costing charged to cost unit i,e Absorbed.

Not Part of Inventory

Indirect Costs (Overheads)

Variable non-Production
Fixed Overheads:
1. Production (Depends on costing system used): In marginal costing treated as period cost and charged as an expense in the period in which they incur
2. Non-Production

Fixed Production Overheads

Fixed production overheads and

Fixed production absorption rate

Absorption costing requires a company to calculate a fixed overhead absorption rate, which is then used to measure the fixed overhead that relates to each unit of production.
A company must undertake a series of steps in order to arrive at meaning full rates:

- Identify fixed manufacturing overhead.
- Share the fixed production overhead to departments.
- Estimate fixed overhead absorption rate based on usage of resources in each department.

To reach an absorption rate, a company needs to find something which varies with production(this maybe total number of units or no. of hours worked) and divide the total fixed production overheads by that figure.

Identifying and Methods of charging

fixed production overheads to cost centers

Allocation

Overheads are allocated to cost centres. If a cost center is responsible for entire cost of an item, the entire cost is charged directly to the cost centre.
Many items of indirect cost cannot be charged directly to a cost unit but can be charged directly to a cost centre, in that case charge items of expense in full to the cost centre.
Fixed production may be allocated to:

- Production department/centre
- Service department/centre (that provide support to production department but not directly engaged in production).

Apportionment

Overhead costs that cannot be directly allocated to a cost centre must be share/apportioned between two or more cost centres.

Shared costs maybe divided between:

administration cost centres,
selling and distribution cost centres,
production cost centres,
service cost centres.

Apportionment of production overheads costs goes in TWO stages:

sharing general cost between production and services centres and; then
sharing cost of service centres between production centres (secondary apportionment)

After this has been done. The total overheads costs of each production centre should be:

Cost allocated directly to the production centre, plus
Share costs to production centres, plus
Shared cost of service department apportioned to production centres.

The purpose of doing this is to calculate an absorption rate.

Apportionment of service department costs

to production departments

After production overheads have been allocated and apportioned to production departments and service departments, then the total for each service department is re-apportioned to the production department.
The basis of re-apportionment of the overheads from each service department is some measure of how much its service is used by other departments.

This is called secondary apportionment.

Secondary Apportionment

where one service department use another service department

A service department might be used by production department and by another service department. In that case the secondary apportionment proceeds in TWO stages:

the cost of service department used by other are apportioned first; and
then the new total for the second service department is apportioned to production departments.

where one service department use each other

A situation may arise where both service department do work for the other service department as well as the production departments. In that case apportionment can be done in either of two methods below, each gives the same result:

Repeated Distribution,
Simultaneous Equation.

Repeated distribution method

Taking each service department in turn, the overheads of that department are apportioned to all departments that use its service (i,e to the other service department as well as to the production department).
This leaves the first service department with no overheads.
The overheads of the second service department are then apportioned to all department that use its services (i,e to the other service department as well as to the production department).
Repeat this process until all the overheads from service departments are apportioned to production departments leaving service departments with NIL balance.

Simultaneous equation method

This method is to create two equations for the apportionment of service department overheads. These are simultaneous equations.
The solution to the simultaneous equation can then be used to calculate the overhead apportionment to each production department.
The following steps involves:

Step I

establish two simultaneous equations, one for each service department. Each equation should state the total amount of overheads that will be apportioned from service department plus the proportion of the costs of the other service department that will be apportioned to it.

e.g:

X= F.O.H + %Y
Y= F.O.H + % X

Step II

solve the equations to find value for X and Y.

Step III

use the values of X and Y to establish total costs to apportion from service department to each production department.

*The purpose of doing this is to calculate an absorption rate.

Accounting for overheads: Overhead Absorption Rate

Overhead Absorption Rate

The overhead absorption rate is known by different names; Predetermined overhead absorption rate, the fixed overhead rate or fixed overhead applied.
Budgeted data is used rather than data about actual costs and output.
Predetermined overhead absorption rates are calculated from;

- Budgeted/planned overhead expenditure, and
- the budgeted volume/activity levels.

Total allocated and apportioned overheads
volume of activity in the period

An overhead absorption rate can be calculated for each production department separately or a single rate for all the production department in the factory (also known as Blanket Rate).

Actual overhead expenditure and actual production volume will almost be different from planned expenditure and production volume. This means that production overheads absorbed in product costs will be higher or lower than actual production overhead expenditure.
This means there is some over absorption or under absorption.

Over Absorption	Under Absorption
means expenses in comprehensive income are overstated. is added to profit in the cost accounting system. increases profit.	is deducted from profit. reduces the reported profit.

*There is no adjustment to the value of closing inventory to allow over/under absorption in costing.

Accounting for overheads pdf

The above is the most summarized version of accounting for overheads. Moreover, click here to Download the accounting for overheads pdf summary.

October 2, 2019

Inventory Management – Techniques and methods
Read more
Inventory Management Overview

Costs associated with inventory:
- Purchase Price.
- Re-order costs:
- - cost of delivery of purchase items.
  - cost associated with placing order.
  - cost associated with checking the inventory after delivery.
- Inventory holding costs:
- - capital tied-up.
  - insurance costs.
  - cost of warehousing.
  - obsolescence, deterioration and thief.
- Shortage costs/Stock-out costs.
Changing inventory levels will affect variable holding costs but not fixed cost

Trade-off

There is a trade-off between ordering costs and holding costs:
- The holding costs reduces , as when average inventory falls as order size falls, thus increases order cost as there will be more number of orders. The inverse is also correct.
Economic Order Quantity (EOQ)

Economic Order Quantity

EOQ is a mathematical model used to calculate the quantity to order each time an order is made, in order to minimize the annual inventory costs.

Assumptions of EOQ
- There are no bulk purchases discount. All units purchased cost the same unit price.
- The order lead time/Re-order period (the time between placing an order and receiving delivery) is constant. and known.
- Annual demand is constant throughout the year.
Based on the assumptions; the relevant costs are the annual holding cost per item per annum and the annual ordering costs.

Formula to be used:

Economic order quantity

Q= 2COD
CH

Where;
Q = Quantity purchase in each order.
CO= Cost per order
CH= holding cost per item per annum
D = Annual Demand
- At EOQ total annual ordering costs and holding costs are always same.
- EOQ precludes safety inventory.
Other formulas: (if maximum inventory held is ‘Q’ i,e EOQ)
- Average inventory = Q/2
- Total holding costs = (Q/2) x CH
- No. of orders = D/Q
- Total ordering cost = (D/Q) x Co
Optimum order quantity with price discount for large orders
- EOQ formula uses to calculate purchase quantity and assumes purchase cost constant. Therefore purchase cost irrelevant.
- If a supplier offers a discount on the purchase price above a certain quantity. The purchase price becomes relevant.
- In this situation in order to minimize costs, compare;
- - EOQ ; and
  - Minimum ordering quantity necessary to obtain price discount.
The total costs must be calculated for both:

EOQ Quantity if discount obtained

Annual ordering cost x x

Holding costs x x

Purchase costs x x

Total costs xx xx

Decision: should be which order quantity minimizes total costs.

Inventory Valuation

Valuation of Inventory

Basic Rule:

Inventory must be measured at lower of;
- Cost; or
- Net realizable value (NRV)
Valuation of Inventory

It would be impossible to identify the actual cost for all inventory items because of the large numbers of such items.

Therefore, cost formulas are used for determining cost of group of similar items.

The following cost formulas are used:

First in, first out (FIFO)
- Large and expensive items are readily recognizable but cost of similar items are impossible to identify.
- To establish the cost of inventory using FIFO it is necessary to record:
Received Issued

Date Units Price Date Units Price
- This approach assumes that the first inventory sold is always the inventory bought earliest date.
This means closing inventory is always assumed to be the most recent purchase.

Weighted Average cost (AVCO)
- This approach assumes that all units are issued at the current weighted average cost per unit.
- A new average cost is calculated whenever more items are purchased and received in stores as:
Cost in store + New items cost
No. of units in stores + New units

Inventory Reorder level and other warning levels

When certain lead time and constant demand

When the demand is constant and lead time is certain, the Re-order level can be calculated as:

= Demand for material per day/week (multiply-by) lead time in days/weeks.

UN-certain demand and supply lead-time

Three warning levels of inventory

Maximum inventory level

Inventory held above this would incur extra holding cost without adding benefit to company.

It can be calculated as:

[Reorder level + Reorder quantity]

minus

[maximum demand per day/week x maximum supply lead time]

Re-order level

Re-order level

[maximum demand per day/week x maximum supply lead time]

Safety Inventory
- If supply lead time and demand is uncertain there should be a safety level of inventory (also called safety stock, Buffer stock):
- It is actually the average amount of inventory held in excess of average requirements.
It can be calculated as:

[maximum demand per day/week x maximum supply lead time]

minus

[average demand x average lead time]

Minimum inventory level

When inventory falls below this amount, management should check that a new supply will be delivered before all the inventory is used up.

It can be calculated as:

[Reorder level]

minus

[average demand per day/week x average supply lead time]
October 2, 2019

Accounting for Inventory | Periodic, Perpetual inventory

Accounting for Inventory Overview

Inventory costing methods

There are two methods of recording inventory (Inventory accounting):

Periodic inventory method/period end system
Perpetual inventory system

Each method uses a ledger account for inventory but these have different roles.

Methods for Recording Inventory

Methods for recording Inventory

Periodic inventory method

This system is base on the use of two ledger accounts:

Purchase Account:

It is used to record all purchases during the year. the balance on purchase account is transferred to cost of sales, clearing the purchases account to zero.

Inventory Account:

It is used to record value of inventory at the beginning/end of the year.
Opening inventory is last year’s unused purchases.

Perpetual inventory system

In cost accounting system:

A separate record is kept for each inventory item, in an inventory account. There is no purchase account.
Inventory account is used to record all purchases and other costs associated with inventory and all issue/transfers out of inventory. These transfers might be into work in progress(if inventory account is for raw material) or cost of sales (if inventory account is for finished goods).
Each issue/transfers are given a cost. This is the actual cost or cost obtained from valuation method (i,e FIFO/AVCO method).

With perpetual inventory account any time the balance on inventory account is the value of inventory currently held.

Summary of journal entries under Perpetual accounting and Period end system

Particular	Perpetual Inventory method	Periodic Inventory method
Opening inventory	Closing inventory as brought forward from last period.	Closing balance on the inventory account at the end of previous period.
Purchase of inventory	Purchases Debit Payable/cash Credit	Inventory Debit Payable/cash Credit
Freight paid	Carriage inwards Debit Payable/cash Credit (NO ENTRY IN PURCHASE A/C)	Inventory Debit Payable/cash Credit
Return of inventory to supplier	Payable Debit Purchase returns Credit (NO ENTRY IN PURCHASE A/C)	Payable Debit Inventory Credit
Sale of inventory	Receivables Debit Sales Credit (NO ENTRY IN PURCHASE A/C)	Receivables Debit Sales Credit AND Cost of goods sold Dr. Inventory Cr.
Return of goods by a customer	Sales returns Debit Receivables Credit (NO ENTRY IN PURCHASE A/C)	Sales returns Debit Receivables Credit AND Inventory Dr. Cost of goods sold Cr.
Issue of Inventory	(NO ENTRY IN PURCHASE A/C)	WIP Debit Inventory Credit
Return of unused inventory from production	(NO ENTRY IN PURCHASE A/C)	Inventory Debit WIP Credit
Normal loss	(NO ENTRY IN PURCHASE A/C)	Cost of goods sold Dr. Inventory Cr.
Abnormal loss	Abnormal loss Debit Purchases Credit	Abnormal loss Debit Inventory Credit
Closing Inventory	SOFP Dr. Cost of good sold Cr.	Balance on Inventory account (subject to physical count).

Accounting for Inventory: Inventory Valuation

Valuation of Inventory

Basic Rule:
Inventory must be measured at lower of;

Cost; or
Net realizable value (NRV)

Cost Formulas

It would be impossible to identify the actual cost for all inventory items because of the large numbers of such items.

Therefore, cost formulas are used for determining cost of group of similar items.

The following cost formulas are used:

First in, first out (FIFO)

Large and expensive items are readily recognizable but cost of similar items are impossible to identify.
To establish the cost of inventory using first in first out inventory method (FIFO) it is necessary to record:

Received			Issued
Date	Units	Price	Date	Units	Price

This approach assumes that the first inventory sold is always the inventory bought earliest date.

This means closing inventory is always assumed to be the most recent purchase.

Weighted Average cost (AVCO)

Weighted Average cost (AVCO)

This approach assumes that all units are issued at the current weighted average cost per unit.
A new average cost is calculated whenever more items are purchased and received in stores as:

Cost in store + New items cost
No. of units in stores + New units

Costing of Issues from inventory and Inflation

Inflation

As a general rule, during a period of high inflation the different methods of inventory valuation will give significantly different values for cost of sales and closing inventory.

First in, first out (FIFO)

With FIFO during a period of high inflation cost of sales will be lower than current replacement cost of materials used and the closing inventory should be close to current value, since they are the units bought most recently.
The inverse is also correct when prices are falling.

Weighted Average cost (AVCO)

With AVCO during a period of high inflation, the cost of sales will be higher and value of closing inventory lower than FIFO valuation.

Accounting for inventory

Inventory costing methods pdf

The above accounting for inventory notes are most simplified version. Moreover, click here to Download the accounting for inventory pdf summary

October 2, 2019

Target Costing – with simple examples
Read more
Target Costing Overview
- Target costing is a method of strategic management of costs and profits.
- Target costing involves; setting a target or objective for the maximum cost of a product/service and then working how to achieve this target.
- Target costing is used mainly for new product development.
- - Having identified a target price and target profit, a target cost of the product can be established.
Target cost = Target sales price – Target profit
- The opportunities for cutting costs to meet a target cost are much greater during the product design stage than after the product development has been completed and production process has been set up.
- The estimated costs of a product design can be compared with target cost.
- If the expected cost is higher than target cost then there is a ‘Cost Gap’.
  The cost gap must be closed by finding ways at the product design stage without losing any of the features, so that target cost is achieved.
Cost Gap

Expected costs xx

Target cost (xx)

Cost Gap x

Target costing method
- Target costing is based o the idea that when a new product is developed a company will have a reasonable idea about;
- - The sales price,
  - The sales volume over its expected life.
  - There may also be estimates of capital investment required and any incremental fixed cost.
- Taking the estimates of above it should be possible to calculate target cost.
- The target cost for a product might be the maximum cost for the product, which provide the minimum required return.
Elements in Estimated cost and Target costs

Raw materials costs:

The target cost should allow for expected wastage rates/loss in processing.

The price of materials should also allow for any possible increase up-to the time when the new product development has been completed.

Direct labour:

The target cost should allow for any expected idle time that will occur during manufacturing of product.

Production overheads:

A target cost could be a target marginal cost. However it is more like that target cost will be a full cost (i,e includes a share of fixed production overheads)

Target costing and Services
- Target costing can be used for services as well as products.
- Services vary widely in nature and differ from manufacturing as follows;
- - some service industries are labour intensive and direct materials costs can are only a small part of total costs.
  - overheads costs in many services are very high.
Implication of using target costing
- The use of a target costing system has implication for pricing, cost control and performance measurement.
- A company might decide on a target selling price for either a new or an existing product, which it considers necessary in order to win market share or target volume of sales.
Advantages of target costing
- It helps to improve understanding within a company of product costs.
- It recognizes, that the most effective way of reducing costs is to plan and control costs from the product design stage onward.
- It helps to create a focus on the final customer for the product/services because the concept of ‘value’ is important; target costs should be achieved without loss of value for the customer.
- Target costing can be used together with recognized methods for reducing costs; such as Just-in-time, Total Quantity management.
Closing the Target Cost Gap
- Target costs are rarely achievable.
- Target costing should involve a ‘multi-disciplinary approach’ to resolving the problem of How to close the cost gap.
- Ways of reducing costs might be in; product design and engineering, manufacturing processes used, selling methods and raw materials purchasing.
- Other common methods of closing the target cost gap are;
- - To re-design products.
  - To discuss with key suppliers methods of reducing materials cost.
  - To eliminate non value added activities or non value added features of the product design.
  - To train staff.
October 2, 2019

	EOQ	Quantity if discount obtained
Annual ordering cost	x	x
Holding costs	x	x
Purchase costs	x	x
Total costs	xx	xx

Expected costs	xx
Target cost	(xx)
Cost Gap	x

Category: Cost and Management Accounting

Marginal Costing – with simple examples

Read more

Reporting profit with Marginal Costing

Comparison between Absorption costing and Marginal costing​

Profit Reconciliation: Between Absorption and Marginal costing​

Accounting for overheads | Fixed Variable | Absorption rate

Read more

Fixed Production Overheads

Accounting for overheads: Overhead Absorption Rate

Accounting for overheads pdf

Inventory Management – Techniques and methods

Read more

Economic Order Quantity (EOQ)

Inventory Valuation

Inventory Reorder level and other warning levels

Accounting for Inventory | Periodic, Perpetual inventory

Read more

Methods for Recording Inventory

Summary of journal entries under Perpetual accounting and Period end system

Accounting for Inventory: Inventory Valuation

Costing of Issues from inventory and Inflation

Accounting for inventory

Target Costing – with simple examples

Read more

Target costing method

Target costing and Services

Closing the Target Cost Gap

Comparison between Absorption costing and Marginal costing

Profit Reconciliation: Between Absorption and Marginal costing