Question solutions. Learning Unit 5. Controlling inventory and overhead costs. Financial Management 1 A Degree. Question 5.1

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1 Financial Management 1 A Degree Question solutions Learning Unit 5 Controlling inventory and overhead costs Question 5.1 (i) Opportunity costs could be defined as being the value of the next best alternative forfeited by choosing to engage in a particular activity or venture. It is therefore the potential benefit that is given up when one alternative is selected over another. Almost every decision in life has an inherent opportunity cost. Choosing to study full time has the opportunity cost of losing out on a salary that you could have earned had you started working immediately upon leaving school. For a business owner there is an opportunity cost in starting the business. Had the owner invested the money in a government bond or in a fixed deposit (at virtually no risk), interest would have been earned. However, there would also be other benefits had he/she taken this route instead. Such benefits would include time with family and friends, a less stressful life, etc. When a managerial accountant has to make a judgement call about the viability of a project, the opportunity cost of this project should be central in his/her thought process. Although opportunity cost is not usually entered in the accounting records of an organisation, it is a cost that must be explicitly considered in every decision a manager makes. The benefits of engaging in a project must always outweigh the opportunity cost thereof, or else the project is fundamentally flawed. From our example on the baker, it is clear that trying to save costs by postponing the purchases of flour at regular re-order levels has major repercussions loss in sales, late delivery, poor rapport with customers and suppliers - all being opportunity costs. EDGE Learning Media CC 1

2 (ii) If a business uses a perpetual inventory system, the cost of inventory or raw materials purchased is debited to an inventory account. This system allows the firm to charge inventory costs to production or to cost of goods sold as inventory is used. Each acquisition of raw materials and each transfer of inventory to work in process is recorded in the inventory account as it takes place. With the periodic inventory system, acquisitions and reductions of inventory are not recorded in the inventory account. Instead, all inventory acquisitions are recorded in a purchases account. When inventory is sold, the cost thereof is usually unknown, and will only be calculated at the end of the trading period when a physical count of inventory is made. Question 5.2 FIFO method Day Purchases Issues Balance 1 2 R R R Thus: Value as at 31 July 20.8 according to FIFO: (70 x R 26.05) + (120 x R 26.47) = R R R R R R R R R R R R R R R R R R R R R R EDGE Learning Media CC 2

3 Weighted average cost method Day Purchases Issues Balance 1 R R R R R R R R R R R Alternative layout: Day Type Units Unit cost Value 1 Open Open Purchase Sale (350) Purchase Purchase Sale Closing value Thus: value as at 31 July 20.8 according to weighted average method: 190 x R = R Note the rounding differences in the calculation of weighted average cost. EDGE Learning Media CC 3

4 Question 5.3 (i) (a) Opening stock = 500 diaries x R 60 = R Bought on 30 April 20.8 = (100 diaries x R 64 = R 6 400) + R 280 = R 6 680, thus landed cost = R each Bought on 31 August 20.8 = (180 diaries x R 72 = R ) + R 680 = R , thus landed cost = R each Bought on 31 January 20.9 = (200 diaries x R 82 = R ) + R = R , thus landed cost = R 87 each. Thus, value of inventory on 28 February 20.9: R each = R R each = R each = R (b) Calculate the cost of sales R each = R R each = R (c) Calculate the gross profit Sales = R 100 each = R Cost of sales = R Gross profit = R = R (d) Calculate the mark-up % for the year: / x 100 = 65.9 % EDGE Learning Media CC 4

5 (e) Perpetual inventory system Trading account F1 Date Details Fol. Amount Date Details Fol. Amount Feb. 28 Cost of sales GJ# Feb. 28 Sales GJ# Profit and loss GJ# (f) Periodic inventory system Trading account F1 Date Details Fol. Amount Date Details Fol. Amount Feb. 28 Trading inventory (opening stock) GJ# Purchases Carriage on purchases GJ# GJ# Profit and loss GJ# Feb. 28 Sales GJ# Trading inventory (Closing stock) GJ# (ii) (a) Opening stock = 500 diaries x R 60 = R (This is the weighted average cost) Bought on 30 April 20.8 = (100 diaries x R 64 = R 6 400) + R 280 = R 6 680, thus landed cost = R each Bought on 31 August 20.8 = (180 diaries x R 72 = R ) + R 680 = R , thus landed cost = R each Bought on 31 January 20.9 = (200 diaries x R 82 = R ) + R = R , thus landed cost = R each EDGE Learning Media CC 5

6 Thus, value of inventory available for sale Date No of units Value Open /04/ /08/ /01/ diaries at a total landed cost of R = R each Stock value for the 460 diaries on hand at the year-end: 460 at R = R (b) Calculate the cost of sales 520 at R = R Note: the assumption is that 520 stock items were disposed of on 28 February (c) Calculate the gross profit Sales = R 100 = R Cost of sales = R Gross profit = R (d) Calculate the mark-up % for the year / x 100 = % (e) Perpetual inventory system Trading account F1 Date Details Fol. Amount Date Details Fol. Amount Feb. 28 Cost of sales GJ# Feb. 28 Sales GJ# Profit and loss GJ# EDGE Learning Media CC 6

7 (f) Periodic inventory system Trading account F1 Date Details Fol. Amount Date Details Fol. Amount Feb. 28 Trading inventory (opening stock) GJ# Purchases Carriage on purchases GJ# GJ# Profit and loss GJ# Feb. 28 Sales GJ# Trading inventory (Closing stock) GJ# (Note: The gross profit is R 2 out due to rounding) (iii) (a) (b) (c) No, manipulating valuation methods could lead to serious misrepresentation of company results. A business should stick to one acceptable and legal method of valuation. The Companies Act requires that the method that has been chosen by the business be disclosed in their financial statements. The advantage of the perpetual system is that the trading inventory account reflects the balance of what should be on hand in the event of a stock take being done. In this way, obsolete stock and theft can easily be detected. This is difficult to do under a periodic system, where there is no benchmark figure or balance to compare actual stock take values against. Stock losses automatically defaults to cost of sales, and the business owner might be under the wrong impression, i.e. that these goods were in fact sold to customers. EDGE Learning Media CC 7

8 Question 5.4 (i) EOQ = 2 x x EOQ = 500 units (ii) (a) EOQ No of orders = = 12.5 Cost of orders = 12.5 x 200 = Stock held = = 250 Cost of holding stock = 250 x Total cost R (b) Order 1 250: No of orders = 6 250/1 250 = 5 Cost of orders = 5 x 200 = Stock held = 1 250/2 = 625 Cost of holding stock = 625 x 10 = Total cost R Saving = R R = R (iii) R 2 per units per annum = R Assume order size of 625 units 6250/625 = 10 orders x R 200 = R Stock holding = 625/2 = units x R 10 = R R EOQ as in (ii) = R Additional cost (Order size 625) R 125 Saving by taking discount of R 2 = R R 125 = R It is recommended that Dubega Ltd takes up the offer. EDGE Learning Media CC 8

9 Question 5.5 (i) EOQ = 2 x 10 x (52 x 20) 2.50 EOQ = 91 units (ii) EOQ = 2 x 10 X (52 X 20) (R 10 x 25 %) EOQ = 64 units The high cost of capital means that the organisation has to pay for borrowed funds which increase the cost of holding the inventory. Smaller quantities purchased more often will decrease this cost as the units are likely to be sold (turned into cash) and the borrowed funds paid off more quickly, thereby reducing the interest expense. EDGE Learning Media CC 9

10 (i) Question 5.6 EOQ = 2 x x 15 R 0.40 EOQ = 450 units (ii) Maximum expected usage per week Average usage per week Excess: Lead time Safety stock 75 parts 54 parts 21 parts X 4 weeks 84 parts (iii) Average weekly usage Lead time Normal usage Safety stock Reorder point 54 parts X 4 weeks 216 parts 84 parts 300 parts (iv) An order for 450 parts will be placed when the stock on hand drops to 300 parts. EDGE Learning Media CC 10

11 (i) Question 5.7 EOQ = 2 x x * EOQ = units * (0.5 x 10 %) = 0.15 (ii) Number of orders per year = Annual demand Quantity per order = / 8000 = 40 (iii) Total annual ordered costs = Number of orders x Cost per order = 40 x R 15 = R 600 (iv) Total annual carrying costs = Holding cost x Average ordered inventory = R 0.15 x ( ) = R 600 (v) Annual Purchase cost + freight Total EOQ Annual discounted Purchase cost + freight Total units a Ordering cost Ordering cost b Carrying cost Carrying cost c a x 0.50 x (1-0.04) = R b x 15 = R c = R units to R 0.15 per unit = R I.e., since the cost of ordering at the discount is cheaper than the standard set by the EOQ, the business should accept the discount offer (the net benefit of taking the discount is R ). EDGE Learning Media CC 11

12 (vi) Reorder point = x 9 days = (vii) 1 R 15 plus holding cost ( x 15 cents) = R 15 + R = R Question 5.8 (i) Direct method: Admin: Women s clothing: 15/24 x = Men s clothing: 9/24 x = Facilities: Women s clothing: 150/225 x = Men s clothing: 75/225 x = Total: Direct cost Admin Facilities Total Women s clothing: Men s clothing: (ii) Step method: Facilities: Women s clothing 150/250 x = Men s clothing 75 /250 x = Admin 25/250 x = Admin: Admin + Facilities = = Women s clothing 15/24 x = Men s clothing 9/24 x = Total: Direct cost Admin Facilities Total Women s clothing: Men s clothing: EDGE Learning Media CC 12

13 (iii) The following algebraic equations will be used: (Where: A = Admin; W = Women s clothing; F = Facilities; M = Men s clothing ) A = F F = A W = A + 0.6F M = A + 0.3F Step 1: Substitute A into F F = ( F) F = F 0.98F = F = R Step 2: Substitute the solution of F into A A = ( ) A = R Step 3: Substitute the solution of A and F into W W = ( ) + 0.6( ) W = W = Step 4: Substitute the solution of A and F into M M = ( ) + 0.3( ) M = M = R Question 5.9 (i) Algebraic equation X = A B Y = A B A = B B = A EDGE Learning Media CC 13

14 (ii) A = R , B = R , X = R , Y = R (iii) R [( ) + ( )] (iv) R ( ) (i) Question 5.10 Distribution factor Admin Cutting 35 β Assembly 35 Ω β (35 70) x Ω (35 70) x Distribution factor Maintenance Cutting 60 β Assembly 35 Ω β (60 95) x Ω (35 95) x Therefore: Direct costs Allocated costs Admin Maintenance EDGE Learning Media CC 14

15 (ii) M = ( m) = m 0.985m = m = ad = (0.05 * ) = = c = (0.35 * ) + (0.6 * ) = as = (0.35 * ) + (0.35 * ) = (iii) In the direct method there is no recognition of interdepartmental servicing while this type of servicing is recognised in the linear algebraic method. Question 5.11 (i) R [(R /10) x 3/10] (ii) R [(R /10) x 2/10] (iii) hrs [(R ) R 8.20] (iv) R 14 per hr [(R R ) R 6 720] hrs (v) hrs [( hrs) + (R R 14)] (vi) R per hr [(R R ) hrs] (vii) hrs [ hrs (R R 12.20)] (viii) R (over-applied) [(R x R 8.20) ( )] Question 5.12 Company X: Allocation rate: Labour costs = Budgeted overheads / budgeted labour costs x 100/1 = / x 100/1 = 400 % EDGE Learning Media CC 15

16 Total manufacturing costs as determined during the year: Direct material cost R Direct labour cost R Applied manufacturing overhead cost (R x 400 %) R Total manufacturing cost R Under- or over-allocation: Applied manufacturing overheads Actual manufacturing overheads = R R = (R ) Under-allocated. Company Y: Allocation rate: Labour hours = Budgeted overheads / budgeted labour hours = / = R 10 per labour hour Total manufacturing costs as determined during the year: Direct material cost R Direct labour cost R Applied manufacturing overhead cost ( x R10) R Total manufacturing cost R Under- or over-allocation: Applied manufacturing overheads Actual manufacturing overheads = R R = R Over-allocated. Company Z: Allocation rate: Labour hours = Budgeted overheads / budgeted units of production = R / = R 2 per unit produced EDGE Learning Media CC 16

17 Total manufacturing costs as determined during the year: Direct material cost R Direct labour cost R Applied manufacturing overhead cost ( x R 2) R Total manufacturing cost R Under- or over-allocation: Actual manufacturing overheads Allocated manufacturing overheads = R R = R Under-allocated. Question 5.13 Calculation of activity relates: Overhead Overhead cost R Cost driver Cost driver value (total) Cost driver rate Machine Machine hours hours R 2.5 per hour Set-ups No. of set-ups 20 set-ups R 265 per set up Materials ordering No. of material orders 12 material orders R per order Materials handling No. of times handled 32 times R per time Spare parts No. of spare parts 14 spare parts R per part J R Machine (180, 1 800, 864, ) Set-ups (1, 7, 2, 10) Materials ordering (1.5, 1.5) Materials handling (2.12, 4.14) Spare parts (2.6, 1.5) Overhead costs per product Units Overhead costs per unit R 4.91/u R 2.52/u R 6.61/u R 5.84/u K R L R M R 1 Machine hours: J: 600 units x 0.3 = 180 hours K: units x 0.3 = hours L: 720 units x 1.2 = 864 hours M: units x 1.8 = hours hours EDGE Learning Media CC 17

18 There are alternative ways in which you can answer this question. What follows below is one such alternative. (Alternative solution): Machine-related costs Product Units Hrs/unit Total J K L M Machine department overhead cost Cost driver rate ( ) 2.50 Set-up costs Cost per set-up = R [5 300/20] Product # set-ups Units Cost driver rate Workings J x 265 / 600 K x 265 / L x 265 / 720 M x 265 / Material ordering costs Cost per material order = R [2 300/12] Product # orders Units Cost driver rate Workings J x / 600 K x / L x / 720 M x / EDGE Learning Media CC 18

19 Material handling costs Cost per material handling = R [9 100/32] Product # handling Units Cost driver rate Workings J x / 600 K x / L x / 720 M x / Spare parts Cost per spare part = R [10 300/14] Product # spare parts Units Cost driver rate Workings J x / 600 K x / L x / 720 M x / Cost per unit of output using ABC is as follows: Product J K L M Machine overheads Set-ups Material ordering Material handling Spare parts Overhead cost per unit EDGE Learning Media CC 19

20 Question 5.14 Calculation of product costs using traditional costing system Under the traditional costing system, overhead costs will be absorbed on a machine hour basis, as follows: R Total overheads Total machine hours [(132 x 5) + (110 x 3) + (88 x 2) + (132 x 3)] Machine overhead rate Product cost: Product A B C D Direct materials Direct labour R 18.31/hour Cost per unit Units of output Total cost Calculation of product costs using ABC Cost R Cost driver Cost driver transactions Activity rate Machine department # machine hours Set-up costs # production runs Stores receiving # requisitions raised Quality control # production runs Materials handling and dispatch # orders executed EDGE Learning Media CC 20

21 Product A B C D Direct materials Direct labour Machine department Set-up costs Stores receiving Quality control Materials handling and dispatch Total cost Comparison of costs: Traditional v ABC Product A B C D Traditional ABC Over-cost / (under-cost) (499) (1 535) (400) Per unit (4.54) (17.44) (3.03) Product A is over-costed using the traditional costing method, whereas B, C and D are under-costed. Question 5.15 Traditional costing Product X Y Z Prime cost/unit Machine dept Assembly dept Cost per unit # units produced Total cost EDGE Learning Media CC 21

22 ABC Machining services Assembly services Set-up costs Order processing Purchasing Overhead cost Cost driver units machine hours direct labour hrs 624 set-ups customer orders supplier orders Cost driver rate Product X Y Z Prime cost Overheads: Machine dept Assembly dept Set-ups Order processing Purchasing Total cost Comparison of costs: Traditional v ABC Product X Y Z Traditional ABC Over-cost / (under-cost) (9 120) Per unit (0.25) Product X and Y are over-costed using the traditional costing method, whereas Z is slightly undercosted. EDGE Learning Media CC 22

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