Cost and Management Accounting

Transcription

1 Cost and Management Accounting

2 Cost and management accounting A publication of Lyceum College, (Pty) LTD, 110 Jorissen Street, Braamfontein. Copyright reserved. Apart from any fair dealing for the purpose of research, criticism or review as permitted under the Copyright Act, no part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, without permission in writing from EDUCOR Holdings LIMITED (Registration No 1999/020356/06) First print 15 March 2002 Second print (revised) 15 September 2004 ii

3 Contents Contents Page Critical outcomes and assessment standards... viii Unit 1 : Introduction to cost accounting Learning outcomes Introduction The origin of cost accounting The purpose of cost and management accounting The role and function of cost accountants The differences between financial accounting and cost and management accounting The function of cost accounting Costing terminology Synopsis Self-evaluation Unit 2 : Material cost Learning outcomes Introduction Purchasing procedures and documents Storage of materials Issuing of material Stock valuation Stocktaking systems Stock levels Accounting entries Synopsis Self-evaluation iii

4 Cost and management accounting Unit 3 : Labour costs Learning outcomes Introduction Personnel department procedures Wage administration Wage systems Calculation of labour costs Accounting entries Learning curve hypothesis Uses of learning curves Synopsis Self-evaluation Unit 4 : Overhead costs Learning outcomes Introduction The nature and classification of overheads Budgeted manufacturing overheads Allocation of manufacturing overheads to products Over-applied and under-applied overheads Accounting entries Allocation of overheads to manufacturing departments Basic assumptions underlying cost behaviour High-low method Synopsis Self-evaluation Unit 5 : Job costing Learning outcomes Introduction Job costing system Accounting entries Synopsis Self-evaluation iv

5 Contents Unit 6 : Process costing Learning outcomes Introduction Differences between job costing and process costing Productions cost reports Methods used to calculate equivalent units Losses Accounting entries Synopsis Self-evaluation Unit 7 : Joint products and by-products Learning outcomes Introduction Common joint costs and additional processing costs Methods for apportionment of joint costs Costing methods for by-products Synopsis Self-evaluation Unit 8 : Contract costing Learning outcomes Introduction Contract cost elements Specific contract terminology Profit determination Disclosure in financial statements Typical costing entries Synopsis Self-evaluation v

6 Cost and management accounting Unit 9 : Marginal and absorption costing Learning outcomes Introduction Classification of costs in the income statement Format used for income statements Example Cost-volume-profit (CVP) analysis Example Synopsis Self-evaluation Unit 10 : Budgets Learning outcomes Introduction Basic principles Operating budgets Preparation of budgets Fixed and flexible budgets Zero-based budgeting Synopsis Self-evaluation Unit 11 : Standard costing Learning outcomes Introduction Types of standard costs Uses and advantages of standard costs Budgets and standard costs Standard costing Reconciliation of actual profit with budgeted profit Synopsis Self-evaluation References Assessment Guide vi

7 Contents Key of icons used in text Learning outcomes NB Example Activity Definition Self-evaluation These are questions that you would typically find in a Cost and management accounting exam. The figures that appear after each question indicate the number of marks that such an answer would carry in an exam. Answer these on a separate sheet of paper after you have worked through each unit. They should help you to assess what you have learned. vii

8 Cost and management accounting Critical outcomes and assessment standards CRITICAL OUTCOMES 1. Problemsolving skills PROGRAMME OUTCOMES Demonstrate logical, critical, reflective and problemsolving abilities with regard to cost and management accounting. ASSESSMENT STANDARD Demonstrate logical, critical, reflective and applied problem-solving skills in the evaluation of personal abilities to apply problemsolving skills. 2. Teamship Act as a member of a professional team on a formal or informal basis in an organisation. Demonstrate the ability to act as a member of a team in an organisation by contributing and taking responsibility for effective planning, and cost accounting. 3. Selfresponsibility 4. Research skills Organise and participate as a competent and selfconfident member of a team in an organisation. Collect, organise, compare, and critically evaluate information, formally and informally within the organisation. Conduct duties and activities responsibly and effectively by complying with the ethical rules and standards of the organisation. Demonstrate the basic ability to execute research and compile statistics for improving budget planning, management and control within the organisation. 5. Communication skills Apply advanced communication abilities and interpersonal skills, verbal, non-verbal and written within the organisation. Demonstrate the ability to apply the principles of communication during interaction with members of the organisation, management, formal and informal groups, and informal groups and customers. " viii

9 Critical outcomes CRITICAL OUTCOMES PROGRAMME OUTCOMES ASSESSMENT STANDARD # 6. Macro-vision 7. Citizenship 8. Cultural and aesthetic sensitivity 9. Technology Solving organisational management and personal problems by considering ethical, social, cultural and environmental influences. Participate and communicate with the groups within the organisation and the community with the necessary responsibility. Demonstrate cultural and aesthetic sensitivity to groups and the community when operating in the organisation. Introduce and use technology to improve management and control skills in an organisation. Demonstrate an understanding of the world as a set of related systems and the ability to effectively address personal, creative, final, management and organisational problems within the organisational context. Demonstrate the ability to effectively address operational problems and communicate within the organisation management groups, subordinates, customers and the community. Demonstrate effective interaction, managerially as well as culturally and aesthetic sensitivity towards the organisational groups and the community when operating in an organisation. Demonstrate the ability to use technology effectively as part of planning, budgeting and cost accounting. ix

10 Cost and management accounting Notes x

11 Introduction to cost accounting Unit 1 Introduction to cost accounting Learning Outcomes After you have completed this unit, you should be able to 1. understand the role of cost and management accounting in organisations, 2. interpret the differences between various types or classification of costs, 3. demonstrate how costs could behave differently depending on the manufacturing process, and 4. show how the costs of products manufactured can be subdivided into three elements for better control. Unit 1 1

12 Cost and management accounting Assessment standards 1. Provide a brief description of the purpose of cost and management accounting as well as the role of the cost accountant. 2. Indicate the differences between the various types of costs. Supply supporting examples. 3. Name the different types of costs and explain these differences by making use of illustrations how the costs will react during the manufacturing process. 4. Discuss the three elements of manufacturing costs and indicate why it is important to distinguish between these three elements. 2 Unit 1

13 Introduction to cost accounting Keywords It is essential that you master the keywords in this unit. Write down a definition or short description in the space provided below. Keywords Definition or brief description Activity 1 Cost accounting Management accounting Financial accounting Cost Expense Cost centre Period cost Product cost Total cost Unit cost Direct cost Indirect cost Sunk cost Opportunity cost Fixed cost Variable cost Semi-variable cost Semi-fixed cost Unit 1 3

14 Cost and management accounting 1. Introduction The aim of cost and management accounting is to provide cost information to managers so that they can improve the effectiveness of the organisation. Cost accounting as part of management accounting is therefore focused on future decisions (as opposed to financial accounting which reports on past results). The importance of studying cost and management accounting is emphasized when the extensive variety of the types of cost is taken into account and, moreover, when it is realised that different types of cost can behave in different ways or show different patterns. 2. The origin of cost accounting The concept of cost accounting was already revealed in Biblical times, according to Luke 14:28: (New International Version): "Suppose one of you want to build a tower. Will he not first sit down and estimate the cost to see if he has enough money to complete it?" With the coming of the Industrial Revolution, and the concentration of manufacturing facilities into factories, it became important to know the cost of producing a product. This has led to the development of costing systems so that the information thus produced could be standardised and accurate in order to be useful in decision-making. Initially, cost accounting was almost entirely related to manufacturing undertakings. However, costing is now widely used by all forms of business entities, including service industries such as banks and insurance companies, as well as manufacturing concerns. 4 Unit 1

15 Introduction to cost accounting 3. The purpose of cost and management accounting The main purpose of cost and management accounting is to provide management with information required for decision-making. It is applied in organisations for planning, decision-making and control. For example, what is the cost of producing Product A and are we able to make a profit on the sale of this product? Cost and management accounting is also used for cost controlling purposes. Cost and management accounting gives management information used for decision-making 4. The role and function of cost accountants On an organisational chart (organogram) the cost accountant is usually found in the financial department. The cost accountant s direct superior is usually either the Accountant or the Financial Manager. The primary function of cost and management accounting is maintaining internal control and planning systems. The cost and management accountant is also responsible for providing relevant cost information to management. These responsibilities include the following duties: Forecasts Cost and management accounting maintains internal control and planning systems Management accountant s responsibilities Budget control Communication Cost calculations Determining selling prices The role of the cost accountant in an organisation, is best summarised by the functions performed: Functions of the cost accountant Documenting internal events Unit 1 5

16 Cost and management accounting Supplying detailed information about specific elements of industry Supplying relevant management information Comparing different alternatives for performing certain tasks, according to costs Supplying and maintaining a cost system for the organisation Responsibilities due to budgets and budgetary control Developing cost standards Determining the most effective and efficient use for production means Determining product cost and selling prices 5. The differences between financial accounting and cost and management accounting Financial Accounting provides organisations with historical information by producing financial statements for use within and outside the organisation. Cost Accounting is a branch of Management Accounting that establishes budgets, standard costs and actual costs in respect of operations, processes, departments or products and the analysis of exceptions. 6 Unit 1

17 Introduction to cost accounting Financial Accounting compared to Cost and Management Accounting Legal requirements Precision Accepted accounting principles Time dimension FINANCIAL ACCOUNTING Statutory requirement for companies to produce financial statements whether or not management regards this information as useful. Must be accurate external parties must have confidence in published accounts. Prepared in accordance with certain guidelines. For external use. What has happened in the past. COST AND MANAGEMENT ACCOUNTING Internal reports prepared for management based on their needs. Information must be available when required for decisions use can be made of approximations and estimates. Use any accounting rules that are appropriate. No need to conform to rules. For internal use only. Future orientation. Decisions need to be made on expected future revenues and costs. 6. The function of cost accounting It has already been stated that cost accounting involves planning, decision-making and control. Planning involves the design of actions for the organisation, which are then submitted to different levels of management. Management then makes decisions regarding these actions and implements them. Typical planning decisions, requiring management accounting information, are: Planning Unit 1 7

18 Cost and management accounting How many units of a specific product must be produced within a certain period? Are the manufacturing facilities sufficient to maintain production? If not, what then? Which products should be produced? How should a new product be marketed? Which products must be bought and which must be selfmanufactured? How does an organisation maximise profits while maintaining available capital? How much must be spent on research and development? The above-mentioned decisions require that the cost accountant makes use of current data that is adapted for future cost estimations. Although decisions involving planning are mainly influenced by management s future expectations, historical data is a good starting point for future estimates. Decision-making Control Good planning is of no value unless it is implemented. A conscious decision has to be made in order to implement decisions. If management refuses to make decisions based on the information supplied to them, chaos and stagnation will reign. It is thus of the utmost importance that management will make decisions. Decisions imply that managers make an assertive effort. All decisions made by managers are not always good decisions, but it is still necessary for them to make decisions. It is true that if a manager does not make decisions, (s)he has in effect decided not to decide. When deciding not to decide, a very bad decision has been made. Control entails comparing actual results to budgeted results and allocating responsibility for deviations from the standards originally set. This function may require further management decisions to ensure that budgeted results are truly met. This is done by adjusting the original planning according to the latest available information. 8 Unit 1

19 Introduction to cost accounting 7. Costing terminology In the sections that follow, important costing terminology is defined. It is essential that you fully understand the concepts discussed as these concepts form the basis for the knowledge required for costing procedures and techniques included in this study material. NB What is a cost? A cost is the value of economic resources used as a result of producing or doing the thing being costed. Usually, this is an amount of money spent. Cost centres: This is the smallest segment of activity or area of responsibility for which costs are accumulated. For example, in the machining department there are lathes and punch presses. Difference between a cost and an expense: A cost becomes an expense when it is recorded in the income statement relating to a specific period. For example, if six units of a particular item are purchased in a certain accounting period and four of these units are sold during the same period, the cost of the four units will be brought into account as an expense against the revenue of the four units in order to determine the gross profit relating to that product for the period. The cost relating to the two remaining items will be capitalised into stock in the balance sheet, to be written off against the revenue resulting from their eventual sale in the accounting period during which they are sold. The term cost therefore refers to the cost of acquiring something. The term expense refers to the portion of the cost that is expended in a particular accounting period according to the matching (as explained above) or prudence concepts. The prudence concept will become applicable, for instance, in the case of advertising expenses which are incurred in anticipation of generating additional revenue. In terms of the prudence concept the full amount of the advertising expenses should be expended in the period during which they are incurred. In other words, the expense should not be postponed in anticipation of revenue which might not materialise. (Training expenses would be treated in the same manner.) Example: Advertising costs Unit 1 9

20 Cost and management accounting 7.1 Classification of costs Costs may be classified into more than one category. For example, a cost could be described as both a variable cost and an indirect cost. It is important that you understand that costs do not fall into only one category. Cost Category Period costs Product costs Total cost Unit cost Clarification Period costs exclude product costs and appear in the income statement in the period during which they are incurred. Period costs may under no circumstances be capitalised into stock. Examples of period costs would include advertising expenses, accounting fees, transport costs, or any costs incurred for administrative or marketing purposes. Product costs are those costs which are associated with the manufacturing function and form part of the stock value, for example, direct materials, direct labour and manufacturing overheads. However, product costs more broadly refer to costs which are incurred in order to obtain a saleable product, whether or not the product is purchased or manufactured. Product costs will include all costs which have been incurred in order to bring products to the location from which, and in the condition in which they can then be sold. The total cost is the cost of running for the whole organisation, a department within the organisation or a cost centre. Using the example of a supermarket, the total cost could be the cost of running the whole supermarket. Or it could be the total cost of operating the dry goods portion of the supermarket and at a lower level the total cost associated with running the in-store bakery. Unit costs are the costs relevant to a single product i.e. how much does it cost to produce a loaf of bread? A unit cost is calculated on the following basis: Total cost Number of units produced = Cost per unit Direct cost It is important to understand the concept and calculation of a unit cost. This term will be used in many instances in this course. A direct cost is directly traceable to a specific product or department. A direct cost would not exist if the item being costed did not exist, for example, materials and labour used in the manufacture of the finished product. 10 Unit 1

21 Introduction to cost accounting Cost Category Indirect cost Overheads Sunk cost Opportunity cost Clarification An indirect cost is a cost that is not direct. An indirect cost will arise even if no production takes place. This is the total of all manufacturing costs excluding direct materials and direct labour. These costs are collectively known as overheads. Examples of indirect costs are, depreciation of fixed assets, electricity and water consumption, building rent and overtime and payments. Overheads represent costs which cannot be traced directly to a specific unit of a particular product or service. However, these costs are essential in order to manufacture or sell a particular product or render a specific service, or perform administrative duties. For example, manufacturing overheads will relate directly to the manufacturing process, but cannot be traced directly to a specific unit of a product. Overhead expenditure can easily get out of control, especially where the enterprise is growing quickly or where multiple products are manufactured using the same infrastructure. Controlling overheads can be done by means of zero-based budgeting (each cost item has to be budgeted for from scratch) or activity-based costing (this is an expensive method of control and will only be done where overhead is a major cost item). These are the costs of resources already acquired and these costs cannot be changed. For example, the cost of raw materials, already purchased but no longer utilised, and fixed assets purchased are sunk costs. These costs cannot be changed by any future decision. An opportunity cost is a cost that measures the opportunity not utilised by choosing one course of action in preference to another. Opportunity costs only apply to the use of scarce resources. If there is spare capacity, an opportunity cost could not exist. An opportunity cost measures the monetary benefit sacrificed when the choice of one course of action requires that another course of action has to be forfeited. Example: Trendwear Manufacturing Ltd has sufficient capacity to manufacture dresses a month. The normal demand for the dresses is per month at a selling price of R200 per dress. Fixed manufacturing costs amount to R per month. Variable manufacturing costs amount to R40 per unit. An opportunity exists to sell dresses at a price of R50 per dress. Delivery of the total quantity within the next month should be guaranteed. Example Unit 1 11

22 Cost and management accounting Discussion: Should the order be accepted, the demand for dresses cannot be met. The opportunity cost relevant to the acceptance of the order will therefore be the marginal income forfeited in respect of dresses. The opportunity cost would therefore be x (200-40) per dress = R Note that if the order for the extra dresses could be delivered over 2 months there would be no opportunity cost as the orders could be delivered within the total capacity of dresses for the two months. 7.2 Cost behaviour Definition Cost behaviour refers to the sensitivity of costs with regard to the production plan. The following costs are defined according to their cost behaviour. " Fixed costs Definition A fixed cost remains constant in total for a given period of time despite changes in the number of units produced. A fixed cost is fixed only in relation to a given relevant range and a given time. Example An example of a fixed cost is the rent paid for the milk distribution depot. If only one litre of milk is sold, the rent of R1 000, for example, has to be recovered by the sale of one bottle of milk. If bottles of milk are sold, the fixed cost per litre of milk is R = 10c per bottle. It is apparent from the example that a minimum turnover is required in order to cover the fixed cost. 12 Unit 1

23 Introduction to cost accounting Graphic illustration of a fixed cost Cost (R) Number of production units " Variable costs A variable cost varies in direct proportion to the number of units produced. The greater the number of units produced, the higher the cost. Examples of variable costs are direct materials and direct labour. Definition Graphic illustration of a variable cost Cost 900 (R) Number of production units If the purchase price of a litre of milk is R3,00, 10 litres would cost R30 and a 100 litres would cost R300. Unit 1 13

24 Cost and management accounting " Semi-variable costs This is sometimes referred to as a mixed cost. These costs include both a fixed and variable component. An example of a semi-variable cost would be your home telephone account. This account is made up of a fixed element, being the monthly rental and a variable element, being the number of telephone calls made. Graphic illustration of a semi-variable cost Cost (R) } Variable costs } Fixed costs 0 Production units Graphic illustration: cost of a telephone account Cost (R) Cost gradients according to cost per call 0 Number of calls made 14 Unit 1

25 Introduction to cost accounting " Semi-fixed costs Semi-fixed costs or step costs are fixed for a given level of activity, but they eventually increase by a constant amount at some critical point. Graphic illustration: semi-fixed costs At some critical point semi-fixed costs increase by a constant amount Cost Production value An example of this may be a supervisor s salary. The supervisor s salary is a fixed cost. As more units are produced another supervisor is required. Example 7.3 Elements of manufacturing costs The calculation of product costs consists of three elements: 1. Direct materials Rxxx 2. Direct labour xxxxx PRIME COST XXX 3. Manufacturing overheads xxxxx TOTAL MANUFACTURING COST RXXX Unit 1 15

26 Cost and management accounting Direct materials Direct labour Manufacturing overheads Elements of manufacturing costs Consist of all materials that may be physically identified with a specific product. Fabric in the sewing of a dress can be identified as a direct material. Is the remuneration paid to production workers for work directly related to production. For example, the wages paid to a machinist who sews the dresses. Are all manufacturing costs other than direct material and direct labour. These are all the indirect costs of manufacture. These costs are used in manufacture, but cannot be directly related to a product, yet are essential in the manufacture of the product. For example, needles and thread used in the manufacture of the garments and rental of the factory buildings. The above three costs elements will be discussed in the following units. Exercise Cost: Distinguish between these opposite terms Expense: Direct costs: Period costs: Total costs: Unit costs: Direct costs: Indirect costs: Sunk costs: Opportunity costs: Fixed costs: Variable costs: Semi-variable costs: Semi-fixed costs: NB Try to get hold of a financial dictionary (International Dictionary of Finance: Graham Bannock: 1995) to look up the meaning of these concepts. They are discussed in this unit, but it will help you tremendously if you consult other sources, so that you end up formulating definitions in your own words. 16 Unit 1

27 Introduction to cost accounting 8. Synopsis The basic terminology always forms the basis of any subject. You must become familiar with the basic cost and management accounting principles set out in this chapter. Before one can use a language, one first has to master the alphabet. The same applies to cost and management accounting. NB With the development of information technology, the cost and management accountant of today has the opportunity to become actively involved in the management of the organisation and in helping determining its future goals. The cost and management accountant who accepts this challenge will have to become familiar with every aspect of the organisation, for example, acquire a detailed knowledge of every activity performed. It will further be important to communicate with as many people as possible, thereby not only identifying what information is needed and in what format, but also communicating to relevant role-players areas of concern and suggesting possible solutions. Unit 1 17

28 Cost and management accounting 1. What are the differences between financial accounting and cost and management accounting? Explain briefly. [06] Self-evaluation 2. Discuss the role and functions of the cost accountant in an organisation. [06] 3. Explain the difference between a cost and an expense. [06] 4. Define the following concepts and provide an example of each: 4.1 Product cost (03) 4.2 Period cost (03) 4.3 Fixed cost (03) 4.4 Variable cost (03) 4.5 Semi-variable cost (03) 4.6 Semi-fixed cost (03) 4.7 Manufacturing cost (03) [21] 5. Classify each of the following as being usually fixed (F), variable (V), semi-fixed (SF) or semi-variable (SV): 5.1 Direct labour (01) 5.2 Depreciation of machinery (01) 5.3 Rental of the factory building (01) 5.4 Cleaning cloths and other indirect materials (01) 5.5 Advertising (01) 5.6 Raw material used in finished goods production (01) 5.7 Insurance paid on the company s motor vehicles (01) 5.8 Salary paid to the marketing director s secretary (01) 5.9 Production manager s salary (01) 5.10 Telephone account for the sales department (01) [10] 18 Unit 1

29 Introduction to cost accounting 6. Classify cost according to the various cost terms as provided in the table below: [09] 1. Wood used in a table (at R100 per table) 2. Labour cost to assemble a table (at R40 per table) 3. Salary of a factory supervisor (at R per annum) 4. Cost of electricity to produce tables (at R2 per machine hour) 5. Depreciation of machines used to produce tables (R per annum) 6. Salary of company president (at R per annum) 7. Advertising expense (at R per annum) 8. Commissions paid to salespersons (at R30 per table sold) 9. Rental income paid on factory space Cost Behaviour Product Cost Variable Fixed Period Direct Direct Manufacturing cost cost (selling materials labour overheads & admin cost) Self-evaluation Unit 1 19

30 Cost and management accounting Notes: 20 Unit 1

31 Material costs Unit 2 Material costs Learning outcomes After you have completed this unit, you should be able to 1. explain procedures and documents that will be used when purchasing materials, 2. identify procedures required for the storage and issuing of materials, 3. explain reasons why materials will be kept in stock, 4. describe how much stock to order and when to order it by using the most appropriate method or formula, 5. calculate the value of material issues and closing stock by making use of the most appropriate method, 6. assist with identifying the appropriate stocktaking method and with the implementation thereof, and 7. understand the accounting entries that will be required for the purchasing, receipt and issuing of materials. Unit 2 21

32 Cost and management accounting Assessment standards 1. Name and explain the procedures and documents used when purchasing materials. Use examples to explain the use of the documents. 2. Describe the procedures used for the storage and issuing of materials. 3. Explain the reasons and importance for keeping materials in stock. 4. Name and describe the various methods that can be used to determine when to order stock as well as how much stock to order. Indicate which method will be the most appropriate. 5. Determine the value of materials issued and closing stock by making use of an example. Use the most appropriate method. 6. Determine and implement the most appropriate stocktaking method. 7. Explain the different accounting entries that are used during the purchasing of materials. 22 Unit 2

33 Material costs Keywords It is essential that you master the keywords in this unit. Write down a definition or short description in the space provided below. Keywords Definition or brief description Activity 1 Purchase requisition Purchase order Goods Received Note Warehouse Raw material stock Consumables stores stock Work-in-progress stock Finished goods Direct materials Indirect materials Bin card Stock record card FIFO method LIFO method Weighted average method Standard cost method Market value method Surcharge method Perceptual stocktaking Periodic stocktaking Lead time EOQ Minimum stock Maximum stock Re-order level JIT Unit 2 23

34 Cost and management accounting 1. Introduction The main flow of material control or logistics starts at stock ordering using various methods; then purchasing or self manufacturing to replenish materials; the receipt of materials; the storage and safekeeping of different types of materials during which time stocktaking may take place and materials may be valued; followed by the issuing of materials as and when required. The whole cycle will then start over again. All these activities or processes must be properly recorded in physical stock records as well as accounting records. 2. Purchasing procedures and documents Purchasing affects costs and profitability Elements to consider when calculating purchase price Purchasing is an important function in any organisation because it directly affects costs and profitability of the firm. When calculating the purchase price the following elements must be considered: Actual purchase price of the product or service Any discount received Freight / transportation charges for delivery of goods to the firm s premises Taxation and value-added tax that the organisation has to pay on the purchase price, or on the freight / transportation costs. The department in need of the material usually issues a purchase requisition to the purchasing department to inform them that stock is needed. Refer to Figure 1 on the following page for an example of a purchase requisition. In turn, the purchasing department determines where the order should be placed once the purchase requisition has been received. For this purpose, the purchasing department now originates a purchase order. The issuing and acceptance of the purchase order is the contract with the supplier. 24 Unit 2

35 Material costs Figure 1: Purchase requisition PURCHASE REQUISITION No. Department: Date: Code Description Quantity Example Head of department Requisitioned by: Figure 2: Goods received note GOODS RECEIVED NOTE No Date Order No. Supplier Carrier B5432 AB Manufacturing XZ Quantity Particulars Unit Price R 100 Gearboxes R R Received by: Approved by: Bin No. Z. Zuma J. Moodley E35 Stores Ledger Cost Ledger Invoice No. J.K. V.C. G 1085 The next step is to issue a goods received note (GRN) when the ordered materials are delivered. The delivered goods must be compared with the GRN as well as with the order. This comparison serves as a control measure. The purchasing department compares the amount received to the amount invoiced. The price on the purchase order is compared to the invoice price to ensure that the Control measures Unit 2 25

36 Cost and management accounting right price has been invoiced. The department ensures that the specifications and quality of the materials received correspond with that which was ordered. Subsequently the purchase price per stock unit will be calculated. Refer to Figure 2 for an example of a GRN. 3. Storage of materials Storage is of the utmost importance for materials that are only required later. The overriding concern when storing these materials is to secure their safekeeping and to ensure that materials can easily be found afterwards. When all the purchase controls have been performed on materials that were received, these materials are recorded under "stock" and then stored. It is thus necessary to have a storage system that allows workers to identify stock easily. Similar stock items should be stored in the same place and proper identification of each type of stock is necessary. The next important aspect of storing stock is the securing thereof. The stock received should be secured and controlled periodically until it is sold or used for production purposes. The following mind map shows the aspects that are important under the storage of materials. You can extend the map by adding relevant detail to the main notions, which will then result in a summary. Warehouse procedures and planning Types of stock Direct and indirect materials STORAGE OF MATERIALS Stock control systems Warehouse manager 26 Unit 2

37 Material costs 3.1 Warehouse procedures and planning The type of warehouse determines the warehouse procedures and planning. For instance, a warehouse could be centralised which means that all stocks are stored at one point. With decentralised storage, stock is stored in different locations. Moreover, the warehouse layout is also a very important part of planning. If similar stock types are grouped together, it provides easy access and control. Centralised vs. decentralised storage 3.2 Warehouse manager The warehouse manager is responsible for controlling the warehouse. It is his task to ensure that the physical stock agrees with the stock according to the accounting records. The responsibilities of the warehouse manager may be summarised as follows: the effective and secure storage and issue of materials. Physical stock must be = the stock in accounting records 3.3 Stock control systems The necessity of ensuring effective control over stock cannot be overemphasised. Physical stock counts are not sufficient by itself to counter fraudulent practices. In addition, accurate stock records must be maintained which show all receipts and issues and therefore the correct balance of stock on hand. In practice these stock records are referred to as "stock according to the books". To ensure effective control over stock, it is necessary to reconcile the physical stock with the stock according to the books. This is done by means of a stocktake (discussed under paragraph 6, on page 42). Reconcile physical stock with the stock according to the books Unit 2 27

38 Cost and management accounting 3.4 Types of stock Different types of stock have to be stored for the different purposes they are required. Examples of the various types are: Raw material stock, i.e. materials in unprocessed form. For example, iron ore, flour and baking powder. Consumables stores stock, i.e. materials used in the manufacturing process and allocated as part of overheads. For example, fuel. Work-in-progress, i.e. the product has not yet passed through the entire production process and is in an incomplete form. For example, bread while it is being mixed. Finished goods, i.e. completed products made of the primary materials in the production process. For example, bread. Different types of stock can also be distinguished based on their availability for ensuring the continuity of operations: Normal stocks are in stock either because they are being used in the process of manufacture, or are on the point of being manufactured or not yet sold. Buffer stocks are additional stocks held to accommodate uncertainty in usage. Safety stock entails more than just buffer stock and aids the organisation to continue production even if a certain type of material is delivered late or is not available. Stock-in-transit is stock that has already been bought, but not yet received from suppliers. Strategic stocks are held to reduce the risk of future nonavailability of certain types of material. These risks are occurrences such as war, bad crops, international boycotts and strikes. 28 Unit 2

39 Material costs 3.5 Direct and indirect materials Materials are converted in the production process into a finished product by making use of labour and machines. Materials can be classified into direct and indirect materials. Direct materials become part of the finished product. Indirect materials, on the other hand, are materials that cannot be allocated directly to the finished product, for the following reasons: Direct materials Indirect materials It is not worth the effort because of the cost implication. The material used per product is difficult to calculate and usually represents only a small percentage of the material cost needed to produce the completed product. To illustrate this, we look at a printer who prints books. If he has to determine the price for printing and binding three books, he will separate the material for the calculation as follows. The direct materials, i.e. paper and even the ink when it is a big order, will be calculated per book or per order in total. It can be determined rather accurately and is an important cost component when printing books. However, to calculate how much glue and string are necessary, the printer will either take a percentage of the paper or an amount per book to reach a rough estimate. The exact amount per book is not easy to estimate as it is a relatively small part of the total material cost. It is therefore usually not important to calculate this cost precisely to determine whether the printer has made a profit or a loss on the production of an order of books. The paper and ink are direct material costs, whereas glue and string are indirect material costs. Example Direct material costs can be calculated accurately Indirect material costs 4. Issuing of material If an effective and efficient warehouse system exists in an organisation it simplifies the issue and control of materials. Unit 2 29

40 Cost and management accounting 4.1 Issuing procedures These procedures vary between organisations. The following merely serve as guidelines when issuing materials. The production department issues a material requisition to the warehouse. The following information is necessary with regard to the materials required and appears on the above requisition: Type of material Quality Amount The warehouse issues the materials according to the requisition and hands a "materials transfer" note to the production department. The materials transfer note contains the same information as the requisition, except the issue price is also shown. The warehouse records the issues according to the type of stock control system in use. 4.2 Documenting stock issues In many organisations issues are recorded on bin card in the warehouse. These bin cards are not part of the accounting records, but reflect the stock on hand at all times. An example of a bin card is given below. Figure 3: Bin card Example BIN CARD Part No.... Location... Date Reference / Doc Receipts Issues Balance 30 Unit 2

41 Material costs In addition to the bin card, a second record is usually maintained in the warehouse for recording the issues and receipts of materials. This is a stock record card when a manual system is used. The stock record card is a basic record of all the material in a cost accounting system. These stock record cards are part of the auxiliary books that are cross checked to the general ledger. In a computerised system the stock record cards are held in a computer file. The stock record card shows the record of the materials in the cost accounting system Figure 4: Stock record card STOCK RECORD CARD Material/Item Description: Maximum Level. Material/Item Code: Minimum Level:.. Stores Location:. Re-Order Level: Special Requirements:.. EOQ: Date Ref Receipts Issues Balance Units Unit Units Unit Units Unit Price Price Price Example 5. Stock valuation A major costing problem relating to materials is to decide what is the accurate cost of materials used or issued. It is important that materials are charged to the manufacturing department on a consistent and realistic basis. NB Due to inflation, the prices for materials and components bought-in change rapidly. This results in the stock of any given material being made up of several deliveries that have been made at different purchase prices. Inflation affects purchase price Unit 2 31

42 Cost and management accounting The firm must now decide at what price to issue the items. What it needs is a method or a procedure to consistently and fairly value the items in stock so that the cost price does not fluctuate every week or month. Methods for the calculation of issue prices Different methods can be used for the calculation of issue prices and valuation of closing stocks. The most popular methods are as follows: First-in-first-out method (FIFO) Last-in-last-out method (LIFO) Weighted average method Standard cost method Market value method Replacement cost method Surcharge method These methods are explained below. 5.1 First-in-first-out method (FIFO) Definition If the purchase price of the material is fairly stable, this is the most effective method of valuation. FIFO is based on the principle that stock bought first is used first. Issues are priced according to the price of the oldest batch in stock until all units of that batch have been issued and then the price of the next oldest batch is used, and so on. Bought first, used first " Advantages Organisations are forced to store stock in an identifiable way; It is a logical system and stock control is easy; This method is acceptable to the South African Revenue Services. 32 Unit 2

43 Material costs " Disadvantages FIFO entails more administrative work because batches may have to be stored separately; Profits or losses on stock are not taken into account which may cause the income statement to be misleading; Stock is not valued at current market prices. " Example The following information will be used for the FIFO, LIFO and weighted average examples. In Knockout Ltd s books the stock calculation for a material Y shows the following changes for November 1999: Example Purchases 1 November R1,00 each 12 November R1,22 each 20 November R1,26 each Issues 8 November 900 units 15 November units 26 November 800 units Required: 1. Calculate the closing stock value according to the FIFO method. 2. Determine which method of stock valuation is used in your organisation and why. Activity 2 Unit 2 33

44 Cost and management accounting DATE TOTAL Units SUGGESTED SOLUTION ACCORDING TO FIFO RECEIPTS ISSUES BALANCE Unit Price (R) Value (R) Units Unit Price (R) Value (R) Units Unit Price (R) R1,00 R1 000, R1, R1,00 R 900, R1,00 R1,22 R1 220, R1, R1,00 R 100, R1,22 R1 098, R1,22 R1,26 R1 260, R1, R1,22 R 122, R1,26 R 882, R1,26 R3 480,00 R3 102,00 Value (R) R1 000,00 R 100,00 R1 220,00 R 122,00 R1 260,00 R 378,00 R 378,00 34 Unit 2

45 Material costs 5.2 Last-in-first-out method (LIFO) Using this method the most recently acquired items of stock on hand are used first and charged out at the price of the most recently acquired batch. The items remaining in stock will be those that were purchased first. Definition " Characteristics LIFO will frequently result in many batches being only partly charged to production when a subsequent batch is received; Stocks are valued at the oldest prices; The LIFO system is not acceptable to the South African Revenue Services. NB " Example 1. Using the information provided under FIFO, calculate the value of the closing stock using the LIFO method. 2. Compare the results obtained under FIFI with that obtained under LIFO. Explain in your own words the reason/s for the difference. Activity 3 Unit 2 35