Tag: cost accounting

Read More

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Time Value of Money Overview

Discounted cash flow analysis

• It is a technique for evaluating the proposed investments to decide whether thy are financially worthwhile.
• The expected future cash flows (inflows/outflows) from the investment are all converted to a present value by discounting them at the cost of capital ‘r’
• Taking into account the concept of relevant cost.
• It is usually assumed that cash flow early during a year should be treated as a cash flow as at the end of the previous year.

Present value Formulas

Discount factor = 1/(1+r)n

where
r = cost of capital
n = number of periods

Annuity factor = ( 1 – (1+r)-n /r)

Discounted Cash Flow

Time Value of Money

Methods of Discounted Cash Flow



Net Present value (NPV)

• In Net present value (NPV) analysis, all future cash flows from a project are converted into a present value.
• NPV is the difference between present value of all costs incurred and present value of all benefits received.

Approach

1. List all cash flows from the project (initial investments, future cash inflows/outflows).
2. Discount these cash flows to present value using ‘cost of capital’ as discount rate.
3. If present value of Benefits exceeds the present value of costs, the NPV is positive and if present value of benefits is less, then NPV is negative.

• A project is worthwhile if NPV is positive.
• The project commences at time ‘0’ where the cash flows are already at present value.
• Changes in working capital included as cash flows. An increase usually at the beginning of the project in time ‘0’ is a cash outflow and reduction is a cash inflow.

Internal Rate of Return (IRR)

• It is the discounted rate of return on investment.
• It is the average annual investment return from the project.
• The NPV of the projected cash flows is ‘zero‘ when those cash flows are discounted at IRR.
• A company might establish the minimum rate of return that it wants to earn on an investment:

• • If a project’s IRR is equal or higher than minimum acceptable rate of return, it should be undertaken.
  • If IRR is lower than the minimum required return, it should be rejected.
• The following step are involved for calculation of a reliable Internal rate of return (IRR):

1. 1. Calculate NPV of the project at TWO different rates. One of the NPV should be positive and the other should be negative.
   2. Put the NPVs in the formula:

Discounted Cash Flow and Inflation

Time Value of Money

Methods of incorporating Inflation



Real cash flows

• The cash flows expressed in today’s price terms.
• They ignore the expectations of inflation.
• In order to incorporate real cash flows in NPV calculation, real cash flows should be discounted at the real cost of capital.

The following steps are involved:

• Calculate real discount rate

= money cost of capital – 1
inflation rate

• Calculate net cash flows at today’s prices.
• Discount them using real discount rate.

Money cash flows

This is the most common method used.

• Money (nominal) cash flows are cash flows that include expected inflation.
• Money cash flows should be discounted at the money cost of capital.

The following steps are involved:

1. Calculate net cash flows at today’s price.
2. Make adjustment for inflation (by doing this they will be converted into money cash flows).
3. Use money cost of capital as discount rate.

*Both approaches give same solution, with a difference of rounding off.

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Relevant costing and Decision Making Techniques Overview

Definitions:

Relevant cost

• A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision.
• They cannot include any cost occurred in past.
• Costs that occur whether or not a particular decision is taken are not relevant costs.
• Relevant costs are cash flows. Notional costs such as depreciation, interest costs and absorbed fixed cost are not relevant cost.

Incremental cost

• Any incremental cost, if a particular decision is taken, results in cash flow are relevant cost.

Differential cost

• A differential cost is an amount by which future costs will be higher or lower. A differential cost is a relevant cost.

Avoidable and unavoidable cost

• Avoidable costs are relevant costs
• Unavoidable costs are not relevant.

Committed costs

• Committed costs are unavoidable costs, therefore not relevant for decision making.

Sink costs

• Cost that are already incurred/or committed by an earlier decision. Such costs are not relevant costs.

Opportunity costs

• The relevant cost is the benefit that would be lost by switching to other work.

Identifying Relevant costs

Relevant costs of:



Materials

When Material currently in inventory

Are material in regular use?

• Yes

The relevant cost is the current Replacement cost.

• No

The relevant cost is the current opportunity cost.
Opportunity cost is higher of;

1. Net disposal/sales value/scrap value or;
2. Net benefit from alternative use.

When Material not currently in inventory

In this case the relevant cost is simply the purchase value.

Labour

• If the cost of labour is a variable cost and labour is not in restricted supply: The relevant cost is its variable cost.
• If labour is a fixed cost and there is spare labour time available: The relevant cost of using labour is ‘zero‘. The spare time would otherwise be paid for idle time.
• If labour is in unlimited supply: Relevant cost includes the opportunity cost of using the labour time for the decision instead of next most profitable way.

Overheads

• Normal rules of relevant costs are applied i,e Relevant costs are future cash flows.
• Fixed overheads absorption rate are irrelevant. However the variable overhead hourly rate is treated as relevant cost.
• The only overhead fixed costs that are relevant costs are the extra cash spending.

Decision Making Techniques

Types of Decisions

• The concept of relevant costs can be applied for both ‘long term’ and ‘short term’ decisions.
• The application is same for both types of decisions except for long term decisions ‘time value of money’ should be considered.

Such Types of Decisions are:

Limiting Factor Decisions

• Limiting factor are the factors that ‘restricts‘ operational capabilities, sales demand is normally the factor that sets a limit on volume of production. However the availability of scarce resources such as Direct material, skilled labour or machine capacity could be the limiting factor.
• If the company makes just one product and a production resource is in limited supply, profit is maximized by making as many units of product as possible with limited resources.
• However, if the company produces more than one product with same scarce resources then a budgeting problem is to decide how many of each product to make and sell in order to maximize Profit. In Such case select products for manufacture and sale according to the contribution per unit. The following steps are involved:

1. Calculate the contribution per unit of each good produced.
2. Identify scarce resources (e,g labour hours).
3. Calculate the amount of scarce resources used by each good produced (e,g ‘X’ no. of labour hours)
4. Now divide the contribution earned by each good by scarce resources used by that good to give the contribution per unit of scarce resources for that good.
5. Rank each good in order of contribution per unit per scarce resources (highest contribution is ranked 1st).
6. Construct a production plan based on ranking.

Assumptions of limiting factors:

• Profit is maximized by maximizing contribution.
• Variable costs are only the relevant costs.
• Fixed cost will be the same whatever decision is taken. Therefore are not relevant.

One-off contractual decisions

• The contract where the Job is once only and will not be repeated in future.
• The one-off contract is under taken if extra revenue is higher than relevant costs.
• The decision is to whether agree to do the Job at a Price offered by customer or decide a selling price (base on relevant costs).
• Profit = Revenue – Relevant cost
• One-off contract decisions might occur when a company has spare capacity and an opportunity arises to earn some extra profit.

Make-or-Buy decisions

• A decision whether: to make an item internally or buy it externally. The decision should be based on relevant cost, the preferred option from a financial view point is the one with the lowest relevant costs.
• A financial assessment of a make or buy decision involves a comparison of:

• • cost that would be saved; and
  • incremental cost of outsourcing
• A situation may arises where entity is operating in full capacity, in order to overcome some restrictions on its output and sales, the entity may outsource some products.
• The decision is about which item to outsource and which to retain in-house.
• The profit maximizing decision is to which items to outsource.
• Those items are outsource where cost of outsourcing is least.
• To identify the Least-cost of outsourcing, it is necessary to compare:

• • additional cost of outsourcing; with
  • amount of resources need to make product in-house.

Make-or-buy decision non-financial considerations

Non-financial considerations will often be relevant to make-or-buy decision:

• When work is outsourced, the entity loses some control over the work. It will rely on the external supplier. There may be some risk that external supplier will:

• • provide a lower quality.
  • fail to meet delivery on said dates.
• The entity will lose some flexibility. If it needs to increase or reduce supply of the outsourced item at short notice.
• Redundancy of employees may occur as a consequence of outsourcing affecting relations between management and other employees.

Shut-down Decisions

• A shutdown decision is whether or not to shut down a part of the operations of a company.
• From a financial view an operation should be shutdown if the benefits of shutdown exceeds relevant costs.

Example of such costs

• Fixed costs may be saved, Employee redundancy cost.

Joint Product further processing decisions

• Joint products are product manufactured from a common process.
• The entity has a choice whether:

1. 1. selling joint product as soon as it is output; or
   2. processing it further before selling (at a higher price).

• This is a short-term decision and financial assessment should be made using relevant cost and revenues. The financial assessment should compares:

1. 1. Revenue (less) selling cost from joint product as soon as it is output.
   2. The revenue that will be obtained if Joint product is processed further (less) incremental cost of further processing.

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Cost volume profit analysis ​Overview

• CVP analysis is used to show how costs and profit changes with changes in volume of activity.
• CVP analysis is an application of marginal costing concepts.

Assumptions in CVP analysis

• Costs are either fixed or variable.
• Fixed costs are normally assumed to remain unchanged at all levels of output.
• The contribution per unit is constant for each unit sold. Therefore the contribution to sales ration is also a constant value at all levels of sales.

Contribution

• Contribution is a key concept.
• It is measured as sales revenue (Less) variable costs

Contribution per unit = selling price – variable costs

Contribution/sales ratio (C/S) = contribution per unit
                                                         selling price per unit

Break-Even Analysis

• Break-even point is the volume of sales where the profit is ‘zero‘. And the total contribution is exactly equal to the total fixed costs.
• Management wants to know what the break-even point is in order to:

• • Identify the minimum volume of sales in order to avoid a loss.
  • Asses the amount of risk in budget by comparing the budget volume of sales with break-even volume.

• CVP analysis can be used to calculate a break-even point for sales.

Calculating Break-even point



Break-even as No. of units

In this method Break-even is calculated by using the contribution per unit i.e.;

Break Even = Total fixed costs
                        Contribution per unit

Once Break-even is calculated as a number of units it is easy to express it in terms of revenue by multiplying no. of units by selling price.

Break-even as Sales-Revenue

In this method Break-even is calculated by using the contribution to sales ratio (C/S) i.e.;

Break Even = Total fixed costs
                         C/S ratio

Once Break-even is calculated as in Revenue, it is easy to express it in terms of no. of units by dividing the revenue by selling price per item.

Margin of Safety

• The margin of safety is the difference between:

• • Budgeted sales (in units/revenue); and
  • Break-even amount of sales (in units/revenue).
• It is usually expressed as a Percentage of the budgeted sales. However it may be measured as;

• • A quantity of units (difference between budgeted sales volume and break-even sales volume)
  • An amount of sales Revenue (The difference between budgeted sales revenue and total sales revenue required to break-even).
• At margin of safety all fixed cost are ‘0’, any addition would be directly profit.
• It can be positive or negative.
• A high margin of safety indicates a low risk of making a loss.

Target Profit

• The amount sales must be known in order to achieve a target profit.
• CVP analysis can be used to calculate the volume of sales required.
• The volume of sales required must be sufficient to earn a contribution that covers the fixed costs and make the target amount of profit i,e the contribution needed to earn the target profit is target profit PLUS the fixed costs.

Volume target (units) = Total fixed costs + target profit
                                            Contribution per unit

Volume target (Revenue) = Total fixed costs + target profit
                                               Contribution to sales ratio

Multi-Product CVP analysis

Multi-Product CVP Analysis

For ‘multi-product cvp analysis’ there is an assumption that products are sold in set ratio which does not change with volume. This assumption allows to calculate weighted average contribution per unit or per batch and contribution to sales (C/S) ratio.

Break even analysis

Break even in Batches

= Total fixed costs
Contribution per Batch

• Average contribution per unit should be used (multiply sales ratio with contribution per unit of each product and add them)
• Units can be converted into money value by multiplying with sales price.

Break even in Revenue

= Total fixed costs
C/S ratio per Batch

For C/S ratio;

• calculate contribution per Batch.
• calculate average revenue by multiplying sales ratio with selling price of each product.
• now divide contribution per batch by average revenue to have C/S ratio.

Margin of safety

• The margin of safety is calculated in same way as for single product by comparing the budgeted activity level to Break-even activity.
• The Break-even can be compared to the Budgeted activity level using Batches, units, revenues.

Target Profit

• Same as for a single product.
• The necessary contribution to earn the target profit is the target profit PLUS the fixed costs.
• This can be calculated using contribution per unit, batch or C/S ratio.

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Job Costing

• Job costing is used when a business entity carries out tasks or Jobs to meet specific customer orders.
• Jobs are short-time and work is usually carried out in a fairly short period of time.
• A cost is calculated for each individual Job and this cost can be used to establish the profit/loss from doing the Job.
• Each Cost unit is a Job.
• A Job costing system is usually based on absorption costing principles.
• In many cases, Job costs include not just direct material and direct labour but also direct expense;
  • Rental cost for the Job,
  • depreciation of equipment used for Job.
• Production overheads might be absorbed on a direct labour hours basis or any other suitable basis.
• Non – Production overheads might be added;
  • as a percentage of prime cost of the Job; or
  • as a percentage of production cost of the Job.
• Each Job is given a unique identity number or Job number.
• Direct costs and overheads are recorded on a Job sheet or Job card for the Job.
• A Job account is similar to a W.I.P account, except Job account is for only one Job.
• The W.I.P account is the total of all individual Job account.
• When the Job is finished the total cost of Job is transferred to the cost of sales.

Job Account Proforma

Batch Costing

• Batch costing is a system of costing for items that are produced in ‘Batches’ rather than individually. A batch might also be called a Production run.
• In batch costing the total cost is established for each individual batch where each batch consists of a large number of similar units/items.
• Unlike Job costing it is less common to include Non-Production overheads costs within the total batch cost.. Although it is certainly possible to do so.

Cost per unit = Total Batch cost
                        No. of units

• In all other respects batch costing is very similar to Job costing.
• Any ‘Setup costs’ can be charged directly to the cost of the batch.

Batch costing proforma

Service Costing

• The costs of a service are the sum of direct materials, direct labour, direct expenses and a share of operational overheads (unless marginal costing is used).
• Service costing differs from costing in manufacturing industries in several ways:

• • No production system therefore no production overheads.
  • Direct materials are fairly small proportion of total costs.
  • Direct labour costs are high.
  • General overheads costs can be a very high proportion of total costs.

Composite cost units:

• One of the main problem with service costing is that it can be different to identify a suitable cost unit for the service.
• It is often appropriate to use a composite cost unit in service costing. This cost is made from two variables , such as a cost per man per day.

Service unit/composite cost unit = Total costs of services
                                                              No. of units of services

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

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.

*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.

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

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

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.