Elements of Costing

Financial Accounting

• The information produced by financial accountants is used for external purposes and is often required by law. The reports produced contain information on the historical financial transactions over a period of time.

Two most common reports created:

• Statement of Profit or Loss - details the business' income and expenditure and compares the two. 
• Statement of Financial Position - Ddetails the business' assets and liabilities and also records any capital investment and profit made. 

Both reports need to be completed at least every 12 months. 

Managment Accounting

The information produced by managment accounting is used for internal purposes. Such as internal budgets and reports which are used by managers to facilitate both long and short term decision making. 

Helps managers to plan for the future. 

No timescale in which they need producing, although to be meaningful they need to be produced regularly. 

Cost Units and Cost Centres

A cost unit is a unit of product or service for which costs can be ascertained. 

One main area of importance in cost accounting is to determine how much a unit of output has cost - this is called a 'cost unit'. 

Cost Centres are areas of the business to which its various costs can be charged. 

Profit Centre

Profit centres analyse not only the costs of the business, but the income generated from the sales made. 

Sales income minus costs incurred equals profits. 

The information generated is used to evaluate how profitable a service or product is. 

For example: A tinned food manufacturer may have 'baked beans' as one of its profit centres. 

Investment Centres

Here, the manager will look at the level of investment that the business has made. 

For Example:

An investment made in an individual shop thats in a large chain of shops that are all part of the same company. 

Investments can range from non-current assets such as machinery, buildings and computers to inventory, which is a current asset. 

Cost Classification

Where is costs of the business are divided into logical groups. 

A car manufacturer may need to identify the costs of producing a vehicle on its production line. The most obvious classification would be to analyse the cost of the materials used, labour it takes and other relevant expenses. This would be classification by element. 

Purpose for classification  |  Classification  |  Example 

Financial Accounts - By Function - Costs of Sales, admin, distribution, sellings and finance. 

Cost Control - By Element - Materials, labour and other expenses (overheads).

Budgeting and Decision Making - By Behaviour - Fixed costs, variable costs. 

Cost Control - By Nature - Direct or Indirect costs. 

Classification by Function

Relates to the activity causing those costs. 'What function has caused those costs to occur?'

In financial accounting, costs are split into several categories such as:

Cost of Sales - The cost to produce the goods. Materials? Factory rent? Labour? Machines?

Distribution Cost - Cost to sell and distribute. Delivery costs? Delivery vehicles? Marketing?

Administration Cost - Cost to support running of business. Human resources? Head office? 

Finance Cost - Cost to finance the company. Bank interest? Bank overdraft interest? Bank charges?

Depreciation - Cost based on various assets in the business. Worn out machines and vehicles. 

Classification by Nature

There are two different categories that costs are split into. Direct costs and indirect costs. 

Direct Costs 

Direct Materials - Leather used to make a shoe. 

Direct Labour - Wages of the shoe smith. 

Direct Expenses - Expenses that can be attributed directly with the production of the unit. 

The total of the direct costs is known as 'Prime Costs' or 'Costs of Production'. 

Classification by Nature

There are two different categories that costs are split into. Direct costs and indirect costs. 

Indirect Costs 

Indirect Materials - Oil used to lubricate the factory machines. 

Indirect Labour - Wages of the supervisors. 

Indirect Expenses - Heating of the facotory, lighting, rent, rates and telephone costs. 

The total of the indirect costs is known as 'Overheads' or 'Non Production  Costs'. 

Direct Costs and Indirect costs is known as 'Total Production Costs'. 

Cost Classification by Behaviour

Costs can be identified by the way they behave when the level of activity or output changes. This is known as 'Cost Behaviour' and can be put into four sections:

• Fixed Costs - Remains the same regardless of the level of activity or output. For example; Rent, Insurance and water rates.

• Variable Costs - This increases and decreases with the level of activity or output. For example; Raw materials and hourly based wages. 

• Semi Variable Costs - A combination of both fixed and variable costs. When the activity or output changes, part of the cost will remain constant without changing (fixed) and part of the cost will increase or decrease depending on the output (variable).

• Stepped Costs - A telephone bill. The landline charge would not change and remains the same each month, whereas the call charges would differ each month. 

Combining Cost Classification

There are various combinations of costs where the costs combine different classificatons. So, for example:

• Direct materials and variable - The wood used to produce a picture frame is a direct material cost and its variable. 

• Direct labour and fixed - Production staff work is direct labour. However, they are salaried so it is a fixed cost. 

• Indirect expense and fixed - Ddepreciation on machinery is a production cost which is indirect and fixed (or stepped). 

High Low Method

Quite often we are given a semi-variable cost fpr which neither the fixed element nor the variable element are given. So we need to work it out ourselves.

Step 1 - Find the months with the highest and lowest output plus their associated costs and then deduct the lowest from the highest. 

This will give you a difference in unit output and also in the costs to produce that quantity of units. 

Step 2 - Difference in Cost / Difference in Units = Variable cost per unit. 

Step 3 - Take the higher output level of units used in step 1 and multiply it by the variable cost per unit that we just worked out in step 2. So doing this will give you your variable cost for the the production of that many units. 

Step 4 - Using your highest output level of units from step 1 and the variable cost for this...

??? Units is £££ less the variable cost of £££ = Fixed Cost. 

High Low Method

The fixed cost will remain the same regardless of the output. 

Coding of Costs - Income

Coding is to help organise and analyse data. Revenue or expenses can be classified into cost/profit centre and type of expense/income. 

Once they have been classified into cost/profit centre and type of expense/revenue it is then given a code to represent that classification. 

The codes are a system of letters and/or numbers. 

Numerical Coding

In computerised accounts, each area of the accounting system would have ts own code:

Revenue Accounts 4000-4999

Purchase Accounts 5000-5299

Expense Accounts 6000-8299

Asset Accounts 0010-1250

Liability Accounts 2100 - 2399

Capital Accounts 3000-3299

Numerical Coding. 2

Each item that is being posted to the ledgers would be given its own code depending on what the item is. 

For example, below is the expense account:

7000 - Office Cost 

7001 - Postage 

7002 - Printing 

7003 - Stationery 

Alphabetic Coding

Similar to numerical coding but uses a combinton of letters. 

Revenue Accounts AAAA - ABBB

Purchase Accounts BBBC - CDDD

Eexpense Accounts DEEE -EFFF

Asset Accounts FGGG - GHHH

Liability Accounts HIII - IJJJ 

Capital Accounts JKKK - KLLL

Alpha - Numeric 

A mix of both numerical and alphabetical coding. 

Revenue Accounts AA00 - AA99 

Purchase Accounts BB00 - BB99

Expense Accounts CC00 - CC99 

Assett Accounts DD00 - DD99

Liability Accounts EE00 - EE99

Capital Accounts FF00 - FF99

Example of a Coding System

Mr Toms Coding System:

Despatch Area:

England - 001

Wales - 002

Department:

Packing - PAC 

Distribution - DIS 

Cost Centres:

Materials - 01 ( So the structure of the coding system used is 001/PAC/01. 

Subcodes

Subcodes would be looking at exact materials used in th packaging department or wages and salaries throughout an entire business. 

So for example each item in the packing department would have its own subcode:

Boxes - AB

Postage - BC

Brown Tape - CD

Brown Paper - DE

Cardboard - EF

Enevelopes - FG

Why are codes used, using the correct code and when do we use them?

• Codes assist with data entry. 
• Data can be extracted more easily. 
• Transparency when comparing costs month to month. 

When recieving an invoice for raw materials, the invoice should be checked against the purchase order and delivery note to ensure it is all present and correct. Once this is done then a suitable code should be selected ready for computer input.  

Codes of Costing Notes 

Cost codes do not only apply to purchase invoices but also to any other form of payments or expenses. 

Inventory Types & Valuations 

Inventory/stock is held by most business'. 

• Non Prodution Businesses - Retail shops. They don't manufacture from raw materials, they would buy and sell finished goods. 
• Production Businesses' - Produce things themselves and then sell on the items. Inventories are a little more complex here as they will have different completion stages i.e. Raw materials, in progress and completed. 

Materials can be classified into direct and indirect costs. 

• Direct Materials - Flour thats used in cake mix. 
• Indirect Material - Grease proof paper used to line the cake tins. 

Methods of valuing raw materials 

FIFO - First In, First Out. 

LIFO - Last In, First Out. 

AVCO - Weighted Average. 

FIFO NOTES

Regardless of the date issued, always select the oldest item in stock and use the associated value. 

Then value the closing inventory by adding up the remaining inventory. 

How to complete an inventory card using the FIFO method

Firstly, record the reciepts and total both the quantity and value recieved into the inventory. 

Secondly, record the balance. 

Thirdly, deal with the issued amount even if it means using multiple batches. 

Finally, complete the balance section to reflect the issue. 

LIFO NOTES

Regardless of the date issued, always select the newest item in stock and use the associated value. 

Then value the closing inventory by adding up the remaining inventory. 

How to complete an inventory card using the LIFO method

Firstly, record the reciepts and total both the quantity and value recieved into the inventory. 

Secondly, record the balance. 

Thirdly, deal with the issued amount even if it means selecting from multiple batches. 

Finally, complete the balance section to reflect the issue. 

AVCO NOTES

Weighted Aaverage Cost is generally used when individual units of material are not seperatley defined. 

The formula used is:

Average Costs = Total cost of goods in stores / Number of items in stores 

How to complete an inventory card using the AVCO method

Firstly, record the reciepts. However, with AVCO everytime there is an additional reciept we need to work out the weighted average cost per unit using the formula. 

Secondly, update the balance section accordingly to each new reciept. 

FIFO, LIFO AND AVCO Features and Impact on Profit

FIFO - Inventory balance is valued at the most recent stock. 

FIFO - Results in higher profits as the inventory used to produce a current order is made up of older, less expensive inventory. 

LIFO - Inventory balance is valued at the oldest purchase price. 

LIFO - Lower profits are usually realised during this method.

AVCO - As this used weighted average, it is unlikely that it will reflect the actual purchase costs at either issue or closing inventory valuation. 

AVCO - Issues and profits are smoothed out regardless of the purchase cost. 

Overhead Absorption

The three different methods of determining how the overheads are fairly shared out between each unit of prodution. 

• Unit Basis - Overheads are split equally between the units; therefore, each unit has the same value of overheads allocated to it. 

• Labour Rate Basis - For every direct labour hour a person works on a unit then an hour's worth of overheads are allocated to it. 

• Machine Hour Basis - For every direct machine hour a unit takes to produce, then the same amount of times worth of overheads are allocated to it.

If a business is Labour intensive - Budgeted labour hours may be the basis. 

If a business is Machine intensive - Machine hours would be the basis. 

If a business demonstrates neither - Unit basis. 

Unit Basis 

Quite often we may be given a scenario where we are given various quantities of units to work out the costs per quantity. 

Firstly, work out what the variable cost per unit is, using the information that we've already been given. 

Variable Costs / Units = £ Per unit. 

Now we can apply this to various quantities. 

Add the fixed costs. You can now get the total costs at the various levels of production. 

Finally, divide the total costs by the number of units to get the cost per unit. 

Labour Rate Basis

Firstly, work out the labour hours. Units x Hours per unit = labour hours in total. 

Secondly, work out the overhead rate per labour hour. £ / hours = £ 

Then, calculate the overhead cost per unit based on ? hours. hours x £ per hour = £

Therefore, the total and unit cost for the ??? units is as follows. 

Machine Hour Basis 

Used budgeted machine hours. 

Firstly, Work out the total machine hours. Units x Hours per unit = Machine hours in total. 

Secondly, Work out the overhead rate per machine hour. £ / Hours = £

Then, calculate the overhead cost per unit based on ? machine hours. Hours x £ per hour = £

Costs of Goods Sold and The Manufacturing Account

Costs of goods are al the goods that the business has produced and sold within a period of time. These figures are recorded in a manufacturing account account. 

A retailer would not have a manuacturing account due to not actually producing goods for sale from raw materials, they would calculate their cost of goods sold using the following formula:

Opening Inventory + Purchases - Closing Inventory = Cost of goods sold. 

A manufacturing business would create a manufacturing account. 

Purchasing Materials 

The purchasing process is important as it ensures there is strict control over the items purchased. This helps to avoid over-ordering, ordering incorrect items, ordering from the least competitive supplier. 

A typical view of a materials purchasing system shpwing hpw the process is controled is s follows:

Production > Stores/Inventory > Suppliers

                                                > Purchasing 

Purchase Order 

Check the price of the goods matches the list supplied and ensure the quantity ordered is correct to avoud unnecessary waste. 

Purchase Invoice

Supplier will issue a purchase invoice detailing  what was delivered, it will also detail a payment due date, any VAT applicable and any discounts that may be available. 

Will be matched up to the purchase order to ensure no erros. 

Bin Cards and Stores Ledger Account

Records are kept detailing all movement of goods throughout a business. Records all movement such as reciepts, issues and balances. 

A copy of a bin card with values on is kept in the accounts office and is known as a stores ledger account. 

Labour Costs 

There are direct and indirect materials, there are also direct and indirect labour costs. 

Direct Labour Costs

• Basic pay of the production staff. 
• Overtime premium is worked due to a specific customer request. 

Indirect Labour Costs 

• Idle or down time of production staff. 
• Bonus, unless it is for a specific job. 
• Overtime premium that is due to the general pressure of the job. 
• Any other labour costs that are not direct to the production of the goods. 

Five types of methods used in calculating gross pay

• Time related hourly rate employees - Agreed pre -set hourly paid. Paid weekly. Sometimes monthly.

• Time related salaried employees - Will only ever earn the set amount agreed. Paid monthly. 

• Bonuses - Additional payment on top of a normal basic pay due to outstanding performance. 

• Overtime - Any hours worked over their agreed hours is overtime and can be paid at time and a quarter, time and a half or even double time. 

• Overtime premium - An additional payment above that of the basic pay. 

• Piece Rate - Can always be known as output related to pay or piecework. It is a method whereby a fixed payment is paid for each unit of output produced. This method does not consider the time it has taken to produce the unit. 

Sources of Information for Labour Cost Calculations

There are several ways a business can monitor and keep track of labour costs. 

Employee cards: details all information on the employee and is usually kept by the personel department. The main details held are:

• Full name, address and date of birth. 
• Marital status and emergency contract numbers. 
• National insurance number. 
• Previous employment history. 
• Qualifications. 

Description of Budgeting and its Purpose

They set out the costs and revenues for future periods and they aid in monitoring and controlling the business' finances. 

Why do we produce a budget?

• To lplan and set targets.
• To coordinate resources.
• To control costs and revenues.
• To manage cash flows.

Comparing a companys budget and actual money spent, going foward the business would use the actual information to revise its budget plans for the future. 

Should the variance between the budget and actual money spent be too high or too low then the managers would be prompted to investigate the reasons behind this. 

Variance and its Importance

Once the actual figures are compared against the budgeted figures, it will show either a positive or negative result, which is known as favourable or adverse. 

Favourable Variance - Is positive and means the business has made more revenue or has spent less than what was budgeted. 

Adverse Variance - Is negative,meaning the business has either not made as much revenue as expected or has spent more than was budgeted for. 

Either way,the variances indicate the performance of the business. 

Calculating the variance:

Actual - Budgeted 

Significance of Variances

Certain criteria will be set by the business to asses the significance of the variance. For example, a business may set the following criteria:

• Report if the variance is larger than £500.00
• Report if the variance is larger than 5% of the budgeted figure. 

As the business would need to investiage what had changed since the budget was set. This could be anything from Raw material prices, wastage or a difference in the perceived time it took to comlplete a job. 

Calculating a variance difference as a percentage:

Variance £   /   Budgeted Costs £    X   100   =   Difference in % 

Reporting Variances

Managers are responsible for the budgets that have been set and are in turn held responsible for the variances whether they are adverse and favourable. 

As the managers are the decision makers, they take ultimate responsibility for when an adverse variance is reported. 

Throughout a business there are several different types of managers and it is important to understand who is responsible for which budget. 

For example:

• Purchasing Manager and Production Manager are responsible for Direct Materials. 
• Sales Manager is responsible for Sales Revenue. 
• Production Manager and Human Resources are responsible for labour costs. 

You will be expected to know who is responsible for the variance reports, so it is important to understand the different types of managers as shown above.