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Process Costing – steps with examples
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Process Costing Overview
- Process costing is used when output is produced in a continuous process system and it is difficult to separate individual units of output.
- It is not possible to have abnormal loss and gain on the same account in the same period.
- Whatever the complications, the task that sits at the heart of process costing is always to allocate the costs collected on the debit side of the account to possible output on the credit side.
- Basically we will need to:
1. Identify the losses and output units.
2. Calculate the cost of good output, losses and WIP.
3. Use the costs calculated to assign to good output, losses and WIP (i,e units x cost)
4. Complete the process account.
Losses

Total Losses

Normal Losses
- It is the expected loss in processing and is usually expressed as a percentage of input units of materials.
- It is inherent in the process and is unavoidable.
Normal loss = material input – expected output

Normal loss with recovery/scrap value
- when losses in a process has scrap value then the company is able to recover some of input costs.
- The scrap value reduces overall cost of the process.
- In process account Normal loss is measured at scrap value.
Cost of output = Total process cost – scrap value
Expected output
Expected output = material input – normal loss

Normal loss without recovery/scrap value
- The cost of lost units is part of the cost of obtaining the good output.
- All of the cost should be assigned to the good output and none to the normal loss.
- It is given a NIL value when the loss has no scrap value.
- Disposal cost of normal loss is an addition to costs to the process and debited to process account. It is added to total process costs when calculating cost of good output.
Cost of output = Total process cost – scrap value
Expected output

Abnormal Losses
- The difference between total actual loss and normal loss is ‘abnormal loss’.
- Abnormal loss is not expected and given a cost.
- If it is assumed that losses occur at the end of process, units of abnormal loss are costed exactly as finished output units i,e cost per units of abnormal loss is same as cost of units of good output
Cost of output = Total process cost – scrap value
Expected output
- Abnormal loss is treated as an expense and charged in Income Statement.
Abnormal Gain

Abnormal Gain
- The difference between normal loss and the total actual loss, where the actual loss is less then normal loss.
Abnormal Gain = Normal loss – Actual loss
- Abnormal gain is a benefit rather than a cost.
- Abnormal gain is an adjustment the increases the profit for the period.
- It is recorded as a debit entry.
Abnormal Gain where loss has NO scrap value
- If it is assumed that all losses occur at the end of the process, the cost per unit of finished output and the value/cost of abnormal gain is calculated as the cost per expected unit of output.
- The cost per unit of abnormal gain is therefore the same as the cost of units of good output.
Cost of output = Total process cost – scrap value
Expected output

Abnormal Gain where loss has a scrap value
- When loss has a scrap value, the value of abnormal gain is actually less than the amount shown in the process account. As the balance on the abnormal gain account is netted off by the scrap value.
- The balance is transferred as a net benefit to the Income Statement.
Losses and Gains at different stages in the Process
- If it is assumed that losses occur at the end of the production process, units of abnormal loss or gain are given a cost or value as if they are fully completed units and so one equivalent unit each. But is no relevant for normal loss.
- However, if losses occur at a different stage in the process, this assumption of differing degrees of completion is used for direct material and conversion, instead the concept of equivalent unit is used to decide the cost of abnormal loss/gain.
Valuation

of Abnormal loss

When loss occurs part-way through a process, the cost of any abnormal loss is calculated:
- establishing the equivalent units of direct material and conversion costs for loss.
- calculating a cost per equivalent units.
- using the calculations of equivalent units and cost per equivalent units to obtain a cost for finished output and abnormal loss in period.
of Abnormal Gain

The same principles apply to the valuation of abnormal gain, where the gain occur part-way through the process as abnormal loss.

However there is one important difference, equivalent units of abnormal gain are given a Negative value and subtracted from the total equivalent units of output in the period.

Work in Progress Balance

Work in Progress Balance

Opening Work in Progress
- When there is opening WIP there are two types of costs on the debit side. The opening WIP and the cost incurred in current period.
- The issue is whether these type of costs should be treated together or separately. The question is addressed in the accounting policy adopted for opening WIP. The following are two policies adopted:
weighted average cost method
- When this is used the assumption is that all units produced during the period and all units in closing inventory should be valued at the same cost per equivalent units for materials and conversion i,e an average cost per equivalent unit is calculated for all units of output and closing inventory.
- A three stage calculation is used:
1. Prepare statement of equivalent units.
2. Prepare statement of cost per unit equivalent units
3. Prepare statement of evaluation.
FIFO cost method
- Based on the assumption that the opening WIP are the first units completed. It is necessary to calculate the number of equivalent units for:
- - WIP opening
  - Finished output
  - WIP closing
- The three stage calculation is used for equivalent units and cost allocation.
- The three stage calculation is similar as weighted average with the exception that in statement of evaluation finished output consists of:
- - The finished cost of opening WIP is the sum of: costs in opening WIP value at start of period PLUS cost incurred in current period to complete these units PLUS the cost of finished output started and finished in the period.
Closing Work in Progress
- Closing WIP means some units have been started and finished in the year and others have been started but not finished.
- It stands to reason that cost/value of an unfinished unit is less than the cost of a completed unit. The cost of the process must be shared between finished output and unfinished WIP. In order to do this the concept of equivalent is used.
- A three stage calculation:
1. Prepare statement of equivalent units.
2. Prepare statement of cost per unit equivalent units.
3. Prepare statement of evaluation.
Joint Products and By-Products

Process costing

Joint Products and By-Products

Joint Products

Joint products are two or more products generated simultaneously, by a singe manufacturing process, using common input, and being substantially equal in value.

Apportioning common processing costs
- The costs of the common process that produces the Joint products are common costs. They must be apportioned between Joint products.
One of the following methods is used:

Units Basis

Common costs are apportioned on basis of total number of units produced.

Sales value at split-off point

Common costs are apportioned on basis of the sales value of Joint product produced when they are separated in process.

Net realizable value

Common costs are apportioned on basis of the sales value of Joint product produced when they are separated in process.

By-Products

When two or more different products are produced. Any product that does not have a substantial sales value and relatively minor in quantity is called a by-product.

Treatment of By-Product

Any of following method is used:
- Adding it to revenue from sales. No cost is allocated to by-product.
- As other income. No cost is allocated to by-product.
- As a deduction from Joint process costs (the most common method used).
- - By-product is measured at scrap value, similar to normal loss.
October 2, 2019
Variances – Formulas with examples
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Variances analysis Overview
- Difference between expected results and actual results are known as variances. Variances can be either Favorable (F) or Adverse (A).
- Variances are calculated by comparing actual results with flexed budget.
- Variances are reported in a statement for the accounting period that reconciles the budgeted profit with the actual profit for the period. The statement is known as an Operating statement.
- - Large adverse variances indicate poor performance
  - Large favorable variance indicate unexpected good performance.
Variances: A summary

Variances

Sales variances
- Sales variances are not recorded in a standard costing system of cost accounts/cost ledger.
- Included in variance report (operating statement) to management.
- They help to reconcile the actual profit with budgeted profit.
Types
1. Sales Price Variance
2. Sales Volume Variance
Cost Variances
- The method of calculating cost variances is similar for all variable production cost items (Direct material, Direct labour, Production overheads). A different method of calculating fixed production overhead.
- The total cost variance is the difference between actual and standard variable cost of production. However, total cost variance is not usually calculated. Instead it is calculated in TWO parts.
- Cost variances are adjustments to the profit in an accounting period:
- - Favorable variances INCREASE profit.
  - Adverse variances REDUCES profit.
Types

Direct cost Variance
- Direct material Variance
- Direct labour Variance
Indirect cost/overhead Variance
- Variable Production overhead Variance
- Fixed Production overhead Variance
Cost Variances

Direct material Variance

Total cost variance

The total direct material cost variance is the difference between actual material cost of actual units and the standard material cost of actual costs.

Standard material cost of actual production:
- Actual units produced x standard kg/units x standard price per kg/unit XX
Actual material cost of actual production:
- Actual units produced x Actual kg/units x Actual price per kg/unit XX
Price variance

A price variance measures the difference between the actual paid for material and the price that should have been paid.

Standard material cost of actual production:
- Actual Kgs purchased x standard price per kg/unit XX
Actual material cost of actual production:
- Actual Kgs purchased x Actual price per kg/unit XX
Usage variance
- A usage variance measures the difference between material that were used in production and materials that should have been used.
- The difference is measured as a quantity of materials. This is converted into a money value at the standard price for material.
= Standard Price (standard quantity – Actual quantity)

Usage variance is further analysed into:

1. Material Mix Variance

= Standard Price (Total actual quantity x standard mix) – (Total actual quantity at actual mix)

2. Yield Variance

= Standard cost (standard output at actual mix) – (Actual output of actual mix)

Direct labour Variance

Direct labour Variance

Total cost variance

The total direct labour cost variance is the difference between actual labour cost in producing units and the standard labour cost of producing those actual costs.

Standard actual cost of actual production:
- Actual units produced x standard hrs/units x standard rate per hour XX
Actual labour cost of actual production:
- Actual units produced x Actual hours per unit x Actual rate per hour (XX)
Rate Variance

A rate variance measures the difference between the actual wage rate paid to per labour hour and the rate that should have been paid.

It looks at the hours paid.
Calculated as:

= Actual hrs (standard rate – actual rate)

Efficiency Variance

An efficiency variance or productivity variance measures the difference between the time taken to make the production output and the time that should have been taken.

The difference is measured in hours and converted into a money value at the standard direct labour rate per hour.

It looks at the hours worked.

Calculated as:

= Standard rate per unit (standard hrs – actual hrs)

Idle time variance
- Idle time variance is a part of Efficiency variance.
- Sometimes idle time might be a feature of a production process, in that case the expected idle time might be built into the standard cost. If idle time is not built into the standard cost, the idle time variance is always adverse.
- Calculating the idle time variance will affect the calculation of the direct labour efficiency variance, if idle time occurs but is not recorded.
Idle time not part of standard cost

If idle time is not included in standard cost any idle time is unexpected and leads to an adverse variance.

Idle time included in standard cost

Include idle time as a separate element of standard cost so that standard cost of idle time is a part of total standard cost per unit ; or

Allow for a standard amount of idle time in standard hours per unit for each product. The standard hours per unit therefore include an allowance for expected idle time.

Variable Production Overhead variance

Variable Production Overhead variance

Total cost variance

Standard Cost
- Actual units x standard hours per unit x standard rate per hour X
Actual Cost
- Actual variable production overheads (X)
Expenditure variance

It is the difference between actual variable overhead spending in hours worked and what the spending should have been (standard rate)

Similar to a material price variance or a labour rate variance.

= Actual hours (standard rate – actual rate)

Efficiency variance

The variable overhead efficiency variance in hours is same as the labour efficiency variance in hours (excluding any idle time variance) and is calculated in a very similar way.

= Standard Rate (standard hour – actual hours)

Fixed Production Overhead variance

Fixed Production Overhead variance
- The amount of fixed production overheads represents production overheads absorbed into production cost at a standard cost per unit produced.
- The amount of fixed production overhead absorption rate is a function of the budgeted fixed production overhead expenditure and volume.
- The total fixed overhead variance is the total amount of under-absorbed or over-absorbed overheads.
Total cost variance

Budgeted Cost
- Actual units produced x F.OH rate X
Actual Cost
- Actual overheads incurred (X)
Expenditure variance

= Budgeted F.OH – Actual F.OH

Volume variance

Can be measured in either units of output or standard hours.

= Standard cost (Budgeted Production – Actual Production)

Volume variance is further analyzed into:

Efficiency variance

Same as labour and variable production overhead variance in hours (worked/allowed).

= Standard Rate (standard hours – actual hours)

Capacity variance

= Standard Rate (budgeted hour – actual hour)
Excluding idle time.

Sales Variance

Sales variance

Total sales variance

= Budgeted contribution – Actual Contribution

Price variance

= Actual units sold (budgeted contribution – actual contribution)

Volume variance/ Volume profit variance

= Standard contribution or profit per unit (budgeted volume – Actual volume)

Reconciliation of Budgeted and Actual Profit (OPERATING STATEMENT)
- Operating statement reconciles profit between Budgeted and Actual by reporting all the variances to management , showing the difference between Budgeted and actual profit. Arises because of sales variance and cost variance.
Format

Absorption costing
- Absorption costing operating statement begins with Budgeted Profit.
- The sales variance are Next.
- The cost variance are listed next sales variance.
- Separate columns for the favorable and adverse variance.
- - Adverse — Reduces profit
  - Favorable — Add to profit.
- Actual profit is shown as final figure.
Marginal costing
- Marginal costing operating statement – All the formatting is same as absorption costing format expect there is no fixed production overhead volume variance.
- Where as fixed cost expenditure variance are presented in a separate part of the statement.
- In marginal costing ‘Budgeted contribution’ is used instead of ‘Budgeted profit’.
October 2, 2019
Standard Costing – Types, Meaning and Objectives
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Standard Costing Overview

Standard cost
- A standard cost is an estimated/predetermined unit cost of performing an operation or producing a good or services under normal conditions.
- The predetermined unit cost (standard cost) is based on expected direct materials quantities and expected direct labour time and priced at a predetermined rate per unit of direct materials and rate per direct labour hour and rate per hour of overhead.
- Overheads are normally absorbed at direct labour hour.
Standard costing
- Standard costing is a control technique that report variances by comparing actual cost to pre-set standards. Standard costing may use; absorption or marginal costing.
Types of Standard

Types of Standard

Ideal Standard

This assumes perfect operating conditions.

No allowance for wastage is made.

Unlikely to be achieved.
Reported variance is always adverse

Attainable Standard

This assumes efficient but not perfect operating conditions.

An allowance for wastage is made.

Attainable targets.

Current Standard

These are based on current working conditions.

Includes an allowance for the expected wastage or idle time.

Basic Standard

This remains unchanged over a long period of time.

Variances are calculated by comparing actual results with basic standard.

Idle Time
- Idle time are the hours for which the direct labour employees are paid for no work.
- Idle time is recorded and the hours lost due to idle time are measured.
Methods of including idle time in standard costs

As a separate elements of standard cost
- Standard of idle time is a part of Total standard cost per unit.
Allowance for expected idle time
- Allows for a standard amount (pre-set amount) of idle time in standard hours per unit of each product, therefore including an allowance for expected idle time.
Budget
- Budget: A budget is a formal plan (for a specified time period) covering all the activities of the entity.
- It is a statement of what the entity is going to strive to achieve in future.
- Standard costing is a component of budgeting.
- Standard costs for a unit are often set out in record called a standard cost card.
Types of Budget

Fixed Budget
- It is the original budget prepared at the beginning of a budget period.
- It is prepared for a specific volume of output and sales activity.
- It is the master plan for the financial year that company tries to achieve.
- Variances are NOT calculated by comparing actual results to fixed budget directly.
Flexed Budget
- It is drawn-up at the end of the period.
- It is based on the actual levels of activity and standard revenue and standard costs.
- This shows the amount that the company would have received for the actual number of units sold if they had been sold at the budgeted revenue per item.
- Variances are calculated by comparing actual results with flexed budget.
October 2, 2019
Cost Volume Profit analysis – Formulas
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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.
October 2, 2019
Job Batch and Service costing – Methods
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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
October 2, 2019

Absorption Costing | Absorption of Overheads | Formula

Absorption costing Overview

Meaning: Definition

It is a system of costing which measures cost of a product or a service as its direct costs and variable production overheads plus a share of fixed production overhead costs.

Reporting profit with Absorption

Inventory is valued at the full cost of production (full costing) i,e which consists of direct material + direct labour cost + absorbed production overheads (fixed and variable production overheads), also known as ‘Full absorption costing’.
Fixed production overheads may be under absorbed or over absorbed because the overhead absorption rate is predetermined.

Absorption costing format

Advantages of absorption and Disadvantages of absorption costing:

Advantages	Disadvantages
Inventory values include an element of fixed production overheads. Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.	More complex costing system than marginal costing. It does not provide information that is useful for decision making

Comparison between Absorption and Marginal costing

The profit calculated with marginal costing is different from the profit calculated with absorption.
The difference in profit is due to entirely to the differences in the inventory valuation; as in absorption 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.

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 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 overhead absorption rate.

Fully absorbed cost PDF

The above explained notes is the most simplified version. Moreover, click here to Download PDF

October 2, 2019

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
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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

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

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Losses

Abnormal Gain

Losses and Gains at different stages in the Process

Work in Progress Balance

Joint Products and By-Products

Process costing

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Variances: A summary

Cost Variances

Direct labour Variance

Variable Production Overhead variance

Fixed Production Overhead variance

Sales Variance

Reconciliation of Budgeted and Actual Profit (OPERATING STATEMENT)

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Types of Standard

Budget

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Break-Even Analysis

Multi-Product CVP analysis

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Job Costing

Batch Costing

Service Costing

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Reporting profit with Absorption

Comparison between Absorption and Marginal costing

Profit Reconciliation: Between Absorption and Marginal costing

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Reporting profit with Marginal Costing

Comparison between Absorption costing and Marginal costing​

Profit Reconciliation: Between Absorption and Marginal costing​

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Fixed Production Overheads

Accounting for overheads: Overhead Absorption Rate

Accounting for overheads pdf

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Economic Order Quantity (EOQ)

Inventory Valuation

Inventory Reorder level and other warning levels

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

Comparison between Absorption costing and Marginal costing

Profit Reconciliation: Between Absorption and Marginal costing