EAST AFRICA UNIVERSITY (EAU) COST ACCOUNTING

Course Name: Cost Accounting Course Code: ACT 2030 Semester: Feb to May 2010 Sophomore Classes Credit hours: 3
Course Description: This course focuses on costing methods for service and manufacturing businesses; other topics include activity based costing, job order costing, responsibility accounting, budgeting, standards, variables vs. full costing, joint and by products, process costing, spoilage, project control, and capital budgets. Course Outlines: 1. Introduction to Cost accounting 2. Classification and Coding Elements of Costs: 3. Purchasing procedure and issue of materials, Storekeeping and stock control 4. Labour costing 5. Allocation and apportionment of overheads and Absorption of overheads 6. Job costing 7. Process costing-an introduction 8. Process costing-work in progress 9. Process costing-Joint and By products

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Chapter One
Introduction to Cost Accounting: Definitions:
Cost accounting is the process of tracking recording and analysing cost associated with the products or activities of an organization. Cost accounting can be also defined as a kind of management accounting that relates to the supply chain (the series of events in the production process that in concert, results in a production to a financial values). Managers use cost accounting to support decision making to reduce a companys cost and improve its profitability. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated the industrial revolution, when the complexities of running large scale business led to the development of systems for recording and tracking costs to help business owners and managers make decisions.

Purpose of Cost Accounting

Cost ascertainment The costs of producing different commodities or providing services must be ascertained accurately. These costs consist of material cost, labour cost and overheads and these costs must be kept at minimum level.

Disclosure of Wastes

The costs incurred for production of any commodity can be determined in advance in view of the past experience. If actual costs are higher than the expected or standard costs then this excessive cost can be analysed. This excessive cost may be due to wastage of raw material or idle labour time. Cost accounting is an important aid to disclose wastes.

Decision making

The management is responsible to make decision regarding what goods should be produced and in how much quantity. Cost accounting provides necessary information to the management for making the decisions.

Cost control

Cost control is an important function of the management. Material cost, labour cost and overheads must be maintained at desirable levels. Cost accounting principles are used to eliminate unnecessary costs.

Planning

The management prepares plans for the expansion of business activities. The past experience and cost data are used to prepare and implement future plans

Measurement of efficiency

Cost data are used to measure the efficiency of an organization. If there are various departments of a business enterprise then it is important to determine the relative performance of these departments. More efficient departments must be given greater

incentives and appropriate steps must be taken to improve the performance of less efficient departments.

Setting selling prices

It is difficult for a business concern to set selling prices of its products. Selling price of a product must be reasonable. If selling price is too high then due to competition from rivals, a firms sale can be affected adversely. Similarly, if selling price is too low then a firm can go into loss. It is more advisable that a business concern should ascertain its cost and then add its profit into cost of sales. The cost data are also helpful to set a selling price.

Evaluation of profitability

Profitability measurement is an important purpose of cost accounting. Profitability can be measured in a number of ways; e.g. profit as percentage of sale, profit to capital employed, profit per unit of output etc. the profitability information serves as guide to the management to make some strategic decisions regarding the introduction of new products and increasing or decreasing the volume of production.

Conditions for Effective Costing System

The purposes of cost accounting can be achieved only when an effective costing system is established. The costing system should be simple, economical and predictable. The main conditions for an effective and successful costing system are described below: 1. there must be a proper system of stores and stock control 2. there must be co-operation and co-ordination among staff members of the organization 3. the wages procedure must be proper and satisfactory. The labour cost should be charged to the respective jobs accurately. 4. some standardised printed forms must be used for recording the receipts of materials and issue of materials, recording the labour hours worked and wages calculations and other activities of an organization 5. the overheads must be recorded accurately and these must be charged to the respective production departments and absorbed to the units produced 6. the costing department must established. The responsibilities and duties of cost accountant should be clearly defined 7. the cost accounts and financial accounts should be maintained in such a way that their results can be reconciled easily. The information available from both sets of accounts should be correct and adequate

Some Important Cost terms

Cost: is the amount of expenditure (actual or notional) incurred on, or attributable to, a specified thing or activity. At the simplest level costs includes two components, quantity used and price, i.e. Cost = quantity used X price

Cost units: A unit of product or service in relation to which costs are ascertained. Fore example, in a factory manufacturing typewriter the following cost units might be used in the cost accounting system Cost unit A typewriter Kilowatt-hours Computer minutes of operation Tonne-miles Canteen meals Used for Production cost ascertainment Electricity cost ascertainment computer running cost asct. transport cost ascertainment catering cost ascertainment

Cost centre: a production or service location, function, activity or item of equipment whose costs may be attributed to cost units. Profit centre: a profit centre is that centre which not only incurs costs but also yields revenue Cost allocation: that part of cost attribution which charges a specific cost to a cost centre or cost unit Cost apportionment: That part of cost attribution which shares costs among two of more cost centres or cost units in proportion to the estimated benefit received, using a proxy e.g. square meters. Cost behaviour: means the pattern of change in cost as a result of change in level activity or production. When production increase cost also increases and vice verse.

Cost Classification
Direct Vs Indirect Direct costs is that cost which can be identified for the production of some specific goods. Raw materials and labour cost are direct costs because these can be charged and identified to the production of some specific output of goods. Indirect cost is that cost which ca not be identified to the production of some specific goods. These costs are incurred for the activities as a whole in case any department or organization. E.g. indirect materials, indirect labour, electricity, water charges, rent and rates etc. Having defined direct and indirect costs, the framework of cost build-up can be shown, thus: Direct materials indirect materials + + Direct labour = PRIME COST Indirect labour = Overheads + + Direct Expenses Indirect Expenses Direct Mat. + Direct Labour = Prime Costs Prime cost + Overheads = Total Costs Direct labour + Overheads = Conversion Costs Fixed Vs Variable

Fixed cost is the cost which remains the same at various levels of output; this cost does not change with the change in output and incurred mostly in periodic basis. Variable cost is that cost which changes with the level of production, when production increases variable cost also increases and the vice verse. Classification by function a) Production: consists of raw materials cost, labour cost and factory overhead b) Administration: consists of office rent, postage and telephone, salaries of office staff, depreciation of office machines etc c) Selling and distribution: are those costs which are incurred to promote the sale of goods and deliver these goods to the customers, these include advertisement, salesmans commission, depreciation of delivery vans etc.

Classification and Coding Classification can be defined as the arrangement of items in logical groups having regard to their nature (subjective classification) or purpose (objective classification). The first part of the definition relates to the nature of the expenditure, e.g. expenditure on raw materials and the later part indicates where the expenditure is to be charged, e.g. in case of raw materials, direct to the cost units. Coding is defined as a system of symbols designed to be applied to a classified set of items, to give a brief accurate reference facilitating entry, collation and analysis. Features of good coding systems a- uniqueness: each item should have one , and only one code b- clear symbolisation: codes should consist of either all numeric or all alphabetic characters c- distinctive: codes which represent different items should, so far as practicable, look distinctive. Errors may occur if virtually identical codes describe different items d- Brevity: codes should be as brief as possible consistent with meeting the requirements of the classification system e- Uniformity: codes should be equal length and for the same structure. This makes it easy whether any characters are missing f- Exhaustivity: coding structure should be exhaustive which means that it should encompass the full range of the classification as it exists and, of equal importance to be able to cope with new items as they arise g- Non ambiguity: the notation used for coding system should avoid ambiguity. If there is alpha/numeric system, the letters I an O should not be used because of possible confusion with the numerals 1 and 0 h- Significance: where possible the coding system should be significant. This means that the actual code should signify something about item being coded. i- Mnemonic: on occasion when an alphabetic system is used the actual code derived from the items description or name

THE ELEMENTS OF COSTS: DIRECT MATERIALS, DIRECT LABOUR AND FACTORY OVERHESDS:
CHAPTER Two: Materials: Purchasing procedure and Issue of Materials AND storekeeping and Stock Control. Purchasing Procedure There is a purchasing department in large organizations which is headed by purchasing manager. The importance of the purchasing department varies according to the nature of the business. In manufacturing concerns, a purchasing department will be responsible for obtaining raw materials, components, consumable stores and spare parts of machineries. Purchases control is exercised to ensure that goods are purchased at the right time, of the right quality and in the right time. In addition, the responsibility of the purchasing function includes price, quality and delivery all of which are crucial factors. Late or non-delivery, poor and substandard materials, incorrect specifications etc. are all likely to have at least as great impact on profitability as paying an unnecessary high price. The avoidance of production delays, excessive scarp caused by incorrect materials and avoidance of excessive stocks are among aims of an efficient purchasing function. The below figure shows the purchasing procedure:

Storekeeping Storekeeping means the keeping the store of materials and keeping the store records. The stores department is responsible to receive the materials and hold these materials until they are required by the production department. Stores records are also maintained by the stores department adequately. These records provide the information regarding the receipts, issue and balances of materials. The location of the stores department should be proper and it should be nearer to the production department. The layout of the store requires careful planning. The main effective features and good storekeeping are the following: 1. Efficient and speedy issue of required materials, tools etc 2. Receipt of parts and materials from goods reception(external items) and from production (internal items) 3. Organizing storage in logical sequences, thus ensuring items can be found speedily, that all items can be precisely identified and storage space is used effectively 4. Organizing stock checks on a continuous or periodic basis so as to be able to provide accurate stock figures when required 5. Protecting items in store from damage and deterioration 6. Securing the stores from pilfering, theft and fire Storage- Types of stores The main types of stores are: 1. Centralized stores 2. Decentralized stores 3. Imprest system Centralized Stores When materials are kept in one central warehouse and these are issued from one central point only then it is called centralized stores Decentralized Stores When materials are held and issued by sub stores in each department or branch then it is called as decentralized stores. Imprest System In this case, the materials are received by the central stores but some items of these materials are issued to some sub stores on the basis of imprest system. A specific quantity of each item of material is issued to the storekeeper of a specific department at the start of the period. At the end of the period the storekeeper will inform about the number of items of any materials used for production, and then the specific number of materials will be replaced at the start of the next period.

Storage- Issues and returns

The issue of materials must be appropriately authorized and amount issued recorded so that the appropriate charge can be made to production or to the receiving cost centre. The usual way this is done is by a materials requisition (MR). A MR would contain: QtyPart NoDescription--Job or centre to be chargedAuthorization On presenting an MR to the storeman, it would be checked for correctness and authorization and if satisfactory, the issue would be made. The MR would be retained by the stores who would insert date of issue and forward the MR to store records (for updating the stock records) and hence to the cost department (for pricing and charging). The procedure of goods returned to store is similar to that outlined above except that the document involved is termed a material return note and, of course, the goods are taken into store rather than issued. Storage- Stocktaking There are two approaches to the task of stocktakingPeriodic (usually annual) and Continuous or Perpetual. Periodic stocktaking The objective of periodic stocktaking is to find out the physical quantities of materials of all types (raw materials, finished goods and W-I-P) at a given date. The following factors need to be considered: 1. Adequate number of staff should be available who should receive clear and precise instructions on the procedures 2. Ideally the stocktake should be done at a week end or overnight so that not to interfere with production 3. The stocktake should organized into clearly defined physical areas and the checkers should count or estimate all materials in the area 4. Adequate general assistance should be available to identify materials, part nos etc. far greater errors are possible because of wrong classification than wrong counting 5. Great care should taken to ensure that only valid stock items are included and that all valid items are checked 6. The completed stock sheets should have random, independent checks to verify their correctness 7. The quantities of each type of materials should checked against the stock records to expose any gross errors which may be due to stocktaking errors or faults or errors in the recording system 8. The pricing and extension of stock sheets, where manually, should be closely controlled. Frequently the pricing and value classifications are done computer

Continuous Stocktaking Continuous stocktaking is absolutely essential when an organization uses what is known as perpetual inventory system. This is a stock recording system whereby the stock balance is

shown on the record after every stock movement, either issue or receipt. With this system the balances on the stock record represent the stock on hand and balances would used in monthly and annual accounts as the closing stock. Under this system, proportion of stock items is checked daily so that over the year all stock is checked at least once and many items particularly the major value or fast moving items would be checked several times. Stock recording Stock records refer to documents which give information regarding the movement of stock. However sophisticated the inventory or stock control system is in the firm, a basic prerequisite is that stock movements (issue and receipt) are accurately recorded. The most frequently encountered records of stock in manual system are bin cards and stock record cards/ stores ledger. Bin cards A bin card is stiff card which is kept where the relevant stock item is stored. Goods or materials are stored in drawers, shelve or racks. A separate card is used for each kind of goods. This bin card shows the details of all receipts, issues and stock in hand as it records only the quantities of receipts and issues. The money value of the stock items are not recorded on the bin cards. Stock record card/stores ledger It shows the quantities and monetary values of the stock items. There are three main columns in this ledger; these are for receipts, issues and stock balance in hand and every column has three sub columns for showing quantities, price and value. The stock record card can be kept by the stores department or costing department. Stock Control This can be defined as the system used in a firm to control the firms investment in stock as stock of goods represents money and hence must be controlled effectively. This includes; the recording and monitoring of stock levels, forecasting future demands, and deciding when and how many to order. The overall objective of inventory control is to minimise, in total, the costs associated with stock. These costs can be categorized into three groups: 1. Carrying or holding costs a. Interest on capital invested in stock b. Stores charges (rent, lighting, heating, refrigeration etc) c. Stores staffing, equipment, maintenance and running costs d. Materials handling costs e. Audit, stocktaking, stock records etc f. Insurance and security g. Deterioration and obsolescence h. Pilferage, evaporation and vermin damage

2. Costs of obtaining stock/ ordering costs a. Clerical and administrative costs of purchasing, accounting and goods reception b. Transport costs c. Where goods are manufactured internally, the set and tooling costs associated with each production run plus the planning, production control costs associated with the internal order 3. Costs of being without stock ( Stockout costs) a. Lost contribution through the lost sale caused by the stockout b. Loss of future sales because customers may go elsewhere c. Cost of production stoppages caused by the stockouts of WIP and raw materials d. Extra costs associated with urgent, often small quantity, replenishment orders. Inventory control (stock levels) Stock levels should be determined in view of the requirements of the enterprise based on past experiences. The main factors which affect the stock levels are given as under: a. Availability: if a particular item of material is easily available through out the year; the stock level should be low and vice verse b. Lead or procurement time: the period of time between ordering (externally) and replenishment i.e. when goods are available for use. If the lead time is more then the stock level should be maintained at higher level and vice verse c. Stock holding costs: cost of keeping the materials into stores. If the stockholding costs are high then stock level should low and vice verse d. Consumption: if any item of material is consumed in greater quantity then stock level should maintained at higher level and vice verse e. Trade discount: sometimes, the suppliers offer higher discounts for large quantity, if the benefit of the trade discount is greater than stockholding costs then stock level must be higher f. Durability: the stock level of the durable goods can be maintained at higher level but in case of perishable goods like fish and fruits it should be kept at low level Setting stock levels The following factors should be given into consideration when setting the stock levels: a. Maximum stock level: a stock level calculated as the maximum desirable which is used as an indicator to management to show when stocks have risen too high b. Minimum, buffer or safety stock level: the level below which should not be allowed to fall. If stock falls below this level then there is possibility of production stoppages due to lack of materials. c. Reorder level: the level of stock at which a further replenishment order should be placed. The reorder level is dependent on the lead time and the rate of demand during the lead time d. Reorder quantity: the quantity of the replenishment order; this is the quantity for a purchase order is placed e. Average stock level: this is the average of maximum and minimum stock levels

Average stock level = maximum stock level + minimum stock level/ 2 Formulas of stock levels Mathematical formulas have been developed to establish stock levels; these are: 1. Reorder level = Max: C x Max RP 2. Minimum stock level = RL - (NC x NRP) 3. Maximum stock level = Min: SL + RQ + (Min: C x Min: RP) 4. Reorder quantity = Max: SL Min: SL (Min: C x Min RP) Where: Max : C = Maximum Consumption Min: C = Minimum Consumption NC = Normal Consumption = average of Max C and Min C Max RP = Maximum reorder period or lead time Min RP = Minimum reorder period NRP = Normal reorder period RQ = Reorder qunatity Min SL = Minimum stock level Max SL = Maximum stock level Example 1: The following information is provided for material PQ 251: Maximum Consumption = 6,000 units per week Minimum Consumption = 4,000 units per week Reorder period (Lead time) = 4-6 weeks Reorder quantity = 30,000 units Required: Calculate: a. b. c. d. Reorder level Minimum stock level Maximum stock level Average stock level

Answer: a. Reorder level = Max C x Max RP 6,000 x 6 = 36,000 units b. Minimum stock level = RL (NC x NRP) 36,000 (5,000 x 5) = 11,000 units c. Maximum stock level = Min SL + RQ + (Min C x Min RP) 11,000 + 30,000 + (4,000 x 4) 41,000 + 16,000 = 57,000 units d. Average stock level = Max SL + Min SL/2 = 57,000 + 11,000/2 = 34,000 units CHAPTER THREE: LABOUR COSTING

Labour cost refers to the direct wages of factory workers; direct labour cost consists of

wages paid to workers directly engaged in converting raw materials into finished products. These wages can be conveniently identified with a particular product, job or process.
Labourers must be paid a fair remuneration for their services and some incentives must be given to them to motivate for had work. Labour cots must be also analysed against the jobs completed by labourers. It must be ensured that the labourers have really worked for the hours paid to them. It means the labourers should not sit idle during the working hours and they should not contribute effectively to increase the production. A labour cost consist of: a. basic pay i.e. daily, weekly, or monthly wages b. labour related costs i.e. holiday pay, overtime premium ect Methods of computing wages 1. Time rate method: under this method, payment is made on the basis of time that may be an hour, a day, a week, or a month. A certain sum of money is set for each of the above unit of time. Mostly, the workers are paid according to the number of hours worked during particular week or month. Hourly rate is decided in advance at the time a worker is employed. This hourly rate is multiplied by the number of hours working during a particular month and the resultant figure is the wage for that month. Advantages: a. it is a convenient method and wages can be calculated easily b. employees can forecast their income and they are ensured to receive this income c. this method eliminates the need to measure the performance of the worker Disadvantages: a. it discourages to more efficient workers because they receive the same amount which is received by inefficient and lazy employees b. it requires close supervision of employees otherwise they do not show interest in their work c. this is more suitable for such jobs where work cannot be divided into smaller units 2. Piece rate method: under this method, an employee is paid per unit of product, article or job completed. This method is only used if the work can be divided into uniform pieces as is often possible for factory jobs. Advantages: a. It provides an incentive to more efficient workers. They are paid according to the work done so that they get more income b. It does not require close supervision of employees c. It provides the employers an easy way of determining labour cost per unit of a product Disadvantages:

a. the worker can produce inferior or poor quality products in order to produce greater quantity in short time b. this method cannot be applied to those jobs which are not easy to divide in small pieces c. it does not ensure a stable monthly income of workers 3. Other methods of computing wages a. High time rate for overtime: under this method, normal working hours are paid at the normal time rate but for overtime worked during week days and at weekend, a higher rate is paid in order to induce to the workers to for more hours. Assume that Alis hourly rate is $10; during a particular week, he worked for 60 hours including 8 hours on holidays. His wage for this particular week would be assuming normal working hours per week are 45 hours: Wages Normal hours Overtime: Weekend Holiday Total wages 45 x 410 7 x $15 8 x $20 $105 $160 $715 $450

b. Piece rate with guaranteed time rate: under this method, a specific amount is paid to the worker on daily or monthly basis irrespective of units produced by him during that period but if his output exceeds beyond a minimum limit then he is paid according to piece rate method. Assume that the guaranteed wage of Ali is $1,500 and he is paid $5 per unit produced. Find out his monthly wage on the assumption that he produced in a month a. 500 units b. 270 units Answer; 500 units Total wages for 500 units is 500 x $5 = $2,500; this wage is more than guaranteed wage so he will receive $2,500. 270 units Total wage for 270 units is 270 x $5 = $1,350; this wage is less than guaranteed wage, so he will receive $1500. c. Differential piece rate: under this method, piece rate varies at different levels of output. If the worker produces more units then he gets higher piece rate beyond a specific level of output. Assume that Ali is paid $5 per unit up to 100 units, $6 per unit up for 101 to 200 units and $7 per unit produced in excess of 200 units.

We further assume that he produced 250 units during a particular month. His wages for this month will be: $ 100 units at $5 per unit 500 100 units at $6 per unit 600 050 units at $7 per unit 0350 Total $1,450 WAGES CONTROL The system of paying wages is of great importance in any organization. Correct amount of wages must be paid to the employees at the right time. If wages are not paid in right manner then employees will not work hard and as a result income will fall. Wages should be paid according to the terms and conditions of employment of each worker. If wages are paid without work then this is unnecessary costs and it is a loss to the organization. The main purpose of wages control is to ensure the payment of wages in such a way that both the employees and employer are benefited. Sometimes, wage payments are shown on the payroll to nonexistent employees. These wages are called dummy wages. Similarly, when wages are paid according to the hours worked, some employees may try to show more hours in order to extra wages. In order to prevent the wages frauds, the following steps should be taken: a. the names of the workers employed should be checked with the names of the workers to whom wages are paid b. personnel records should be checked from time to time c. time records and piece work records must be maintained accurately d. The various stages of wages preparation assigned to different employees e. The wages sheets should be compared with original estimate of costing department f. Receipts of wages should be duly signed by the workers the amount drawn from the bank should tally with the actual amounts required g. Any unpaid wages should be deposited in the bank immediately Wages procedure The procedure of calculation and payment of wages is established in all organizations. The main purposes of establishing wages procedure are the following: a. to calculate the wages earned by each employee in view of terms of employment and number of hours worked. It also includes payment of bonus, allowances, overtime premium and holiday pay b. to fulfill the legal requirements like deductions of income tax, national social security fund and national hospital fund c. to take into account other deductions like pension contribution, repayment of loans etc d. to provide the adequate information to the cashier to enable him to pay the amount due to workers e. to complete the accounting records of the business regarding the wages paid f. to ensure the proper use of amounts deducted for various reasons

wages are paid mostly to the workers on hourly basis. Their hours of work are recorded on clock cards issued to them. These clock cards contain the information regarding name, clock number, hours worked on different dates of the month and so on. From these cards the number of hours showing normal time and overtime are transferred to the payroll. Payroll is a list of all employees showing the details of their gross wages, deductions and net wages due to them. It also called as wages sheet. The gross pay of labourers is calculated on the basis of the following documents. a. Clock cards: these give the number of hours worked by each employee b. Piece tickets: these provide information regarding the number of items produced by each worker. These are used for those workers who are paid according to work completed c. Employees personal cards: these provide the information regarding the wages rates etc. Example:

Allocation of costs Labour cost is allocated to respective jobs or products. Labour cost being a direct cost, can be identified and charged to the products which are produced by a specific worker. The allocation of labour cost to the right jobs or products is required to ascertain the total cost of those jobs or products Example. Ali worked 180 hours during the month of September and he was paid at the rate of $10 per hour. During the month, he completed three jobs. The following additional information was also given: Job A B C No of hours worked 80 60 40

Calculate the labour cost chargeable to these three jobs on the assumption that these jobs were completed only by Ali. Answer Total wages of Ali 180 hours x $10 = $1,800 The labour cost must be apportioned among these jobs at their proportions ( 4: 3: 2) Job A Job B Job C 4/9x$1,800 3/9x$1,800 2/9x$1,800 = $800 =$600 = $400

CHAPTER Four: OVERHEADS Allocation and Apportionment of overheads

Overhead can be defined as the total cost of indirect materials, indirect labour and indirect expenses. Indirect costs are those costs which cannot be identified to the production of some specific goods. These costs are incurred for the activities as a whole in case of any department or organization. Overheads can be classified as: a. production overhead: these include indirect materials, indirect wages, factory rent and rates, depreciation of factory plant and other indirect expenses b. administration overhead: these include office salaries, office rent, depreciation of office equipment and other office expenses c. selling and distribution overheads: these include advertisement, salaries of salesman, rent of sales warehouses, depreciation of delivery van and other selling and distribution expenses. Overheads may be also classified as: a. Fixed overheads: rent and rates b. Semi-fixed overheads: supervisors salary c. Variable overheads: indirect materials, indirect labour etc Ways of charging overheads to cost centers: There are two ways of charging overheads to the cost centers, these are: a. allocation of overheads b. apportionment of overheads a. Allocation of overheads: means to charge those overheads to a cost center which result solely from the existence of that cost center. Fore example, all indirect materials used in department A must be charged to this department only. Similarly, the salaries of supervisors of department A are expenses of this department and these must be allocated to this cost center only. This means that the overheads which are incurred for one cost center only, the charging of these overheads to that cost center is known as allocation of overheads. The overheads are allocated when the following conditions are fulfilled: o The cost center must have caused the overhead to be incurred o The exact amount of the overhead must be known b. Apportionment of overheads: means to charge a cost center a fair share of an overhead. The overheads which are incurred for the organization as a whole must be charged to various cost centers of that organization. An example can be, an organization having four department and pays rent on monthly basis for the whole of the organization, this rent expenses must be shared to the four departments and the process of sharing the rent expenses among the four departments is known as apportionment of overheads.

Basis of apportionment For the apportionment of overheads to cost centers, various bases are applied. The following are the most common bases of apportionment: No Basis of apportionment Overheads to which basis applies 1 Area Rent, rates, heat and light, depreciation of building, maintenance and insurance of building 2 Book value Depreciation of plan and machinery, insurance of plant, repairs and maintenance 3 Number of employees Expenses of personnel office 4 Weight of materials or cost Material handling expenses, storekeeping packages etc of materials used 5 Technical assistances Power consumption, water usage, steel consumption etc 6 Sales revenues Advertisement, selling and distribution expense etc 7 Direct wages Staff training, provident contribution etc 8 Machine hours or labour General overhead items hours Choosing the appropriate apportionment base The factors to be considered the choice of an appropriate base are given below, but it must be emphasized that the final choice is a matter of judgment and common-sense. There are no absolute rules or formulas. 1. Direct labour hour basis: most appropriate in a labour intensive cost center and providing the time booking system is good, easy to use 2. Machine hour basis: most appropriate in a mechanized cost center. In such a cost center many of the overheads are related to the machinery (power, repairs, depreciation etc) 3. Direct wages: this is a frequently used rate in practice and is easy to apply. Direct wages paid are related to time, but because of varying rates paid to different personnel, piecework and bonus systems, there is not an exact correlation between wages paid and time elapsed. Example 1. the following information relates to a factory which has four departments: a. Overhead Rent Repairs to plant Depreciation of plant Light and heat Supervision Repairs to building $ 80,000 50,000 40,000 20,000 60,000 30,000

b.information in respect of department

Area sq metres Number of employees Value of plant

Dept A 1,500 35 $500,000

Dept B 1,200 25 $300,000

Dept C 800 25 $200,000

Dept D 500 15

Prepare an overhead analysis sheet showing clearly the bases of apportionment Overhead analysis sheet Overhead Basis Amount Rent Repairs to plant Depreciation of plant Light and heat Supervision Repairs building Area Value plant Value plant Area 80,000 of 50,000 of 40,000 20,000 Units 4,000 sqm 1,000,000 1,000,000 4,000 sqm Rate/unit Dept A $20 $0.05 $0.04 $5 30,000 25,000 20,000 7,500 21,000 Dept B 24,000 15,000 Dept Dept C D 16,000 10,000 10,000

12,000 8,000 6,000 4,000 2,500

No of 60,000 100 $600 employees employees to Area 30,000 4,000 sqm $7.50 $280,000

15,000 15,000 9,000

11,250 9,000 6,000 3,750 114,750 81,000 59,000 25,250

OVERHEADS OF SERVICE DEPARTMENTS Service department to non-service departments only This is the simplest and is somewhat unlikely, and total service departments costs are easily arrived at by the usual process of allocation and primary apportionment from the raw data. Service department working for other service departments Where a service department provides a service to another service department, fore example stores to maintenance, it is necessary to apportion the providing department costs before that of receiving department. In this case, stores costs would be apportioned to maintenance (and appropriate production centers), then the maintenance departments costs would be apportioned between the various production cost centers. The reason for this is that the total cost of the maintenance department must include an appropriate charge for stores issue received. Finally, the overheads charged to service departments must be further charged to production departments. Reciprocal A particular problem arises where two or more service departments work for each other as well as for production departments. Fore example, assume that maintenance department do work for stores and stores supply items to maintenance. The total cost of maintenance department cannot be ascertained until the charge for stores service is known, and similarly the total costs of service cannot be found until the charge for maintenance work is known. Someway has to be found to break into this circular problem so as to be able to ascertain service department costs. This can be done by three methods, these are: 1. Repeated distribution method 2. Simultaneous equation method 3. elimination method Example: a manufacturing company has three production department and two service departments. Overheads of these departments for a period are as follows: Production departments A B C Service departments X Y $ 150,000 270,000 190,000

30,000 50,000 $690,000 A technical assessment for the apportionment of the costs of the service departments shows:

X Y

A 40% 50%

B 20% 20%

Departments C X 30% -20% 10%

Y 10% --

You are required to show the total overheads chargeable to the three production departments. Solution 1. Repeated distribution (continued allotment) A 150,000 12,000 26,500 2120 265 21 3 190,909 Departments B C 270,000 190,000 6,000 10,600 1,060 106 11 1 287,778 9,000 10,600 1,590 106 16 1 211,313 X 30,000 (30,000) 5,300 (5,300) 53 (53) -0 Y 50,000 3,000 (53,000) 530 (530) 5 (5) 0

Overheads OH of X Apportioned OH of Y Apportioned OH of X Apportioned OH of Y Apportioned OH of X Apportioned OH of Y Apportioned

The principle involved in this method is that the appropriate proportion of the costs of the first service department are allotted to the second, then the appropriate portion of the second department is allotted back to the first department and so on until the amounts allotted to and fro become insignificant.

2. Elimination Method

Overheads

A 150,000

Departments B C 270,000 190,000 10,000 10,000

X 30,000 5,000

Y 50,000 (50,000) --0

Apportion total Of Y and eliminate Y 25,000 Apportion total of X and eliminate X 0 15,555

7,778 11,667 ---190,555 287,778 211,667

This is a simpler method which apportions in turn service department costs to users. Once a service department costs have been apportioned the department is eliminated from further apportionments. This means that return charges from other service departments do not arise. The sequence in which departments are eliminated can be related to either the amounts involved or the number of departments serviced. 3. Simultaneous equation method A company has three production departments and two service departments. Overheads of these departments for a specific period are as follows: Production Departments P Q R Service departments A B $ 25,000 20,000 15,000

10,000 07,800 $77,800 The overheads of service centres are charged out as under: P 30% 40% Q 30% 30% Departments R 20% 20% A -10% B 20% ---

A B

Required; show the total overhead chargeable to three production departments. Answer: Let X = And Y = Then: Total overheads of department A Total overheads of department B

X Y

= 10,000 + 0.1 y = 7,800 + 0.2x

Let us multiply both equations by 10 in order to eliminate decimals: 10x= 100,000 + y 10y= 78,000 + 2x OR 10x y = 100,000 -2x + 10y = 78,000 Let us multiple equation (4) by 5 and add the result to equation (3) -10x + 50y = 390,000 10x y = 100,000 49y = 490,000 Y = 490,000/49 Y = 10,000 Let us substitute the value of y into equation (3) 10x -10,000 =100,000 10x = 100,000 + 10,000 10x = 110,000 X= 110,000/10,000 X = 11,000 Now let us apportion the value of x =11,000 and y = 10,000 to the production departments on the basis of agreed percentages: Production Departments Org. Overhead Dept A Dept B P 25,000 3,300 4,000 32,300 Q 20,000 3,300 3,000 26,300 R 15,000 2,200 2,000 19,200 Total 60,000 8,800 9,000 77,800

ABSORPTION OF OVERHEADS Absorption of overheads means the charging of overheads to cost units. After determining the overheads of a cost centre, these overheads are charged to cost units. It means that the total overheads of a cost center are distributed to all cost units produced by that cost centre. In order to charge overheads to cost units, overhead absorption rate (O.A.R) is calculated. OAR is that rate at which overheads are charged to each cost unit. Overhead Absorption methods Overhead absorption methods are also called as bases of absorption. There are seven common methods of overhead absorption. These are: Sno 1 2 3 4 5 6 7 Method Units of output Direct labour hours Direct machine hours Percentage of materials cost Percentage of direct wages Percentage of prime cost Standard hours Formula to calculate OAR Overhead/units of output Overhead/total direct labour hours Overhead/total direct machine hours Overhead/total DM cost x 100 Overhead/total DW x 100 Overhead/total prime cost x 100 Overhead/standard hours

Application of Absorption rates The OAR are used to calculate the total cost of any particular job or cost unit. Overhead absorption method is indicated in order to find out the total cost of a cost unit. Example: the following information relates to the activities in a production department for a certain period: Direct wages 100,000 Direct materials 200,000 Labour hours worked 20,000 Machine hours used 5,000 Total overhead chargeable to the department is $150,000. On job No 1234 produced in the department during the period the relevant data was: Direct wages 5,000 Direct materials 12,000 Labour hours 900 Machine hours 250 Calculate the total cost of Job No. 1234 by five different methods of absorption Answer:

First calculate OARs Method 1. Direct labour hours 2. Direct machine hours 3. Direct material percentage 4. Direct wages percentage 5. Prime cost percentage 1. Total cost of Job No.1234 Direct labour hour method: Direct materials Direct wages Prime cost Overhead (900x7.50) Total Cost

OAR 150,000/20,000 =7.50 per direct labour hour 150,000/5,000 = 30 per direct machine hour 150,000/200,000 x100 = 75% of DM cost 150,000/100,000x100 = 150% of DW cost 150,000/300,000x100 = 50% of PC

12,000 5,000 17,000 6,750 $23,750

2. Direct Machine Hours Method Direct materials 12,000 Direct wages 5,000 Prime cost 17,000 Overhead (250 x30) 7,500 Total Cost $24,500 3. direct materials percentage method Direct materials 12,000 Direct labour 5,000 Prime cost 17,000 Overhead (12,000x75%) 9,000 Total 26,000 4. Direct wages percentage method Direct materials 12,000 Direct wages 5,000 Prime cost 17,000 Overhead (5,000 x 150%) 7,500 Total cost 24,500 5. Prime cost percentage method Direct materials 12,000 Direct wages 5,000 Prime cost 17,000 Overheads (17,000x50%) 8,500 Total cost 25,500 Under or Over absorption of overheads

Overheads are absorbed on predetermined rates in most of the cases. These predetermined rates are based ob estimated production and estimated overheads. The actual overheads may be different than the estimated overheads. As a result, there may be under or over absorption of overheads. If absorbed overheads are less than the actual overheads, this is known as under absorption. On the other hand, if the absorbed overheads are greater than actual overheads, this is known as over absorption. The amount of under absorption of overheads should be added to the total costs before the profit is calculated. On the other hand, the amount of over absorbed overheads should be subtracted from the total cost in order to find out correct profit. Example: equator Garments Ltd. Manufactures custom-made suits tailored to the requirements of each customer. They use predetermined OARs in allocating overheads to each job. In the cutting department, the rate is based on direct labour hours and in the stitching department the rate is based on machine hours. The management of Equator company wants to set overhead absorption rates to help in determining prices in the next financial year. The cost accountant has provided the following budgeted data for the financial year: Direct labour cost Factory Overhead Direct labour hours Machine hours Cutting 1,200,000 1,500,000 60,000 Stitching 750,000 1,620,000 30,000 40,000

Required a. Calculate the overhead absorption rates for each department b. The following data relates to Job No. A 4 Cutting Stitching Direct materials 500 750 Direct labour hours 30 10 Machine hours 20 Administration overheads are absorbed at 25% on factory costs. Profits mark up is 33.33% on cost Required: prepare a cost statement for Job No.A 4 showing the price that will be charged to the customer c. At the end of the year, the following data was obtained: Cutting Stitching Hours actually worked Direct labour hours 68,000 30,000 Machine hours 17,000 Factory overhead cost incurred 1,600,000 760,000

Required: calculate the amount of under or over absorption of overhead for each department. Solution a. Overhead Absorption Rates Cutting Department OAR = overhead/direct labour hours 1,500,000/60,000 = $25/direct labour hour Stitching Department b. Job No A 4 Materials Cost: Cutting Stitching Labour cost: Cutting ($20 x30) Stitching ($25x 10) 250 Factory Overhead: Cutting (25x30) Stitching ($40.50x20) Total Manufacturing cost Administration overhead (25% of 3,660) Total cost Profit (33.33% on cost) Selling price OAR = Overhead/Direct machine hour 1,620,000/40,000 = $40.50/machine hour Cost Statement 500 750 600 850 2,100 750 810 915 4,575 1,525 6,100 1,560 3,660 1,250

C.Under or over absorption of overheads Cutting department Overhead charged Overhead incurred Overabsorbed of overhead Stitching department Overhead charged O.A.R x labour hours worked $25 x68,000 1,700,000 1,600,000 100,000

O.A.R x machine hours worked $40.50 x 17,000 hours 688,500 Overhead incurred 760,000 Under absorption of overhead 71,500