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Cost may be classified using a number of different criteria. Classification us the logical grouping of similar items and the purpose of classifying costs is so that meaningful cost accounting reports may by prepared based upon such costs.
The classification criterion chosen will depend on both the purpose of the classification and the type of organisation. Some classifications greatly assist the collection of costs. Different classifications are dealt with below.
Elements of cost- The initial classification of costs is according to the elements upon which expenditure is incurred:
Figure-1 Elements of cost
Within the cost elements, costs can be further classified according to the nature of expenditure. This is the usual analysis in a financial accounting system, e.g. raw materials, consumable stores, wages, salaries, rent, rates and depreciation.
Direct and indirect costs
Direct costs: Direct costs are costs which are incurred for, and can be conveniently identified with, a particular cost unit. The aggregate of direct materials, direct wages and direct expenses is known as prime cost.
Indirect costs: Indirect costs are costs which cannot be associated with a particular unit of output. The total of indirect materials, indirect wages and indirect expenses represents overheads.
To ascertain the total cost of a cost unit, indirect costs are allotted to cost centres and cost centre costs are shared over (absorbed by) cost units. The subject of allotment and absorption of overhead costs is revised later.
Total cost = Prime cost + Overhead
(Sources- Drury, 2004)
Functional analysis of cost
Overhead classification: Overhead are usually categorized into the principle activity groups:
Prime cost classification: Prime costs are usually regarded as being solely related to production, and so are not classified.
Normal and abnormal costs: An important feature of management reporting is that it should emphasise the areas of the business which require management attention and possible action.
Controllable and non-controllable costs: The need to emphasise abnormal costs to management has been explained above. The purpose of this is to encourage management action. The distinction between controllable and non-controllable costs is dependent on the person to whom any report is directed. The classification emphasises the costs which can be affected by the actions of a particular manager.
Relevant and irrelevant costs: In the context of decision making management needs information to assist in making the correct choice between alternatives. For these purposes and to ensure that valuable management time is not wasted, only those costs affected by the management's decision are important. These are classified as relevant costs, and include opportunity costs.
(Sources- Drury, 2004)
The behaviour of costs
Costs represent the resources that have to be sacrificed to achieve a business objective. The objective may be, for example, to a particular product, to provide a particular service, or to operate a particular hospital for a month. The costs incurred by a business may be classified in various ways and one important way is according to how they behave in relation to changes occur to the volume of activity , and costs that vary according to the volume of activity.
Variable cost: Variable cost is cost those changes with changes in the volume of activity. Combined with fixed costs, variable costs make up the total cost of production.
Fixed cost: Fixed cost remains constant and does not change with a change of activity. A fixed cost is one which does not vary in total when the level of output by the business does vary.
As fixed costs are not dependent upon the level of output (sales), they are often expressed as being per period of time, for example annually, weekly or monthly.
It can be helpful to picture costs in the form of a chart.
Semi-Variable cost: Semi-variable cost is a type of cost that starts begin as a fixed cost and as the volume of activity increases the cost will start increasing. In some cases, costs have an element both a fixed and variable cost.
Stepped cost: Stepped cost is a type of fixed cost that will be fixed for a relevant range (RR) but as this range is exceeded the cost will be increased till the next relevant range. Stepped cost is a cost that increases by a reasonably constant sum each time volume or activity increases by a predictable, constant and multiple.
Different costing methods
Task 1.3- use of appropriate costing technique-
Estimate the production cost:
Cost per can
Task 1.4- costing analyzing and presenting data-
Budgeted contribution per unit of A and B, and the company's budgeted profit and loss for two different years shown-
Selling price per unit
Less: variable costs per unit
Contribution per unit
Sales volume (units)
Less: fixed costs
Budgeted profit or loss
Pricing decision: Costing systems can influence pricing decisions. Where the aim of an organisation is to make a profit, it is reasonable to assume that products or services should be sold at a price in excess of their cost. Consequently, pricing decisions could be based on a cost-plus approach, by adding a profit mark-up to cost. However, pricing should be based on what the market will bear, and cost-plus pricing, for both selling externally and for internal transfers between profit centres of the business, has service limitations and should be regarded as inferior in most circumstances to a market-based approach to pricing.
(Sources- Gazely and Lambert, 2006)
Total Quality management: Total quality management is technique designed to involve all parts of the business in the pursuit of, and commitment to, the highest quality result. TQM helps to move based on information and it is a continuous process. Total quality management carries six concepts. They are
Philosophy of total quality management:
Dr. Deming is recognized with provide the foundation of the Japanese quality miracle. He developed the following 14 points for managing the improvement of quality, productivity, and competitive position and they are:
Create a vision and demonstrate commitment- The management of every organisation should main goals, objectives and values. This should be done by the participation of all employees. A constancy of purpose must also be maintained.
Learn the New Philosophy - It helps to work more towards quality rather than quantity but does not accept errors and out of order workmanship.
Understand Inspection- Employees of a company depend too much on inspection but inspection is never fully correct and is costly. Inspection can only be used as informative too.
4. End the practice of awarding business on price alone; instead, minimize total cost by working with a single supplier.
5. Improve constantly and forever every process for planning, production, and service.
6. Institute training on the job.
7. Adopt and institute leadership.
8. Drive out fear.
9. Break down barriers between staff areas.
10. Eliminate slogans, exhortations, and targets for the workforce.
11. Eliminate numerical quotas for the workforce and numerical goals for management.
12. Remove barriers that rob people of pride in their work, and eliminate the annual rating or merit system.
13. Institute a vigorous program of education and self-improvement for everyone.
14. Put everybody in the company to work to accomplish the transformation.
Deming's basic quality philosophy is that productivity improves as variability decreases, and that statistical methods are needed to control quality.
He advocated the use of statistics to measure performance in all areas, not just conformance to product specifications.
Aim of total quality management: The aims of total quality management have been defined; every organization will set itself a series of objectives that they intend to achieve through TQM. These business objectives are effectively the benefits to be gained and l, although they will vary from organisation to organisation, often realized benefits include:
The improvement of profitability by increased operational efficiency
Cultural and behavioural change
The prevention of waste
The improvement of customer satisfaction
Maintaining or increasing market share
The achievement of product and business excellence
Releasing organisation's people potential
The improving of product or service quality, product safety and reliability
The minimization of loss to the individual, the company and the community
Associated improvements in operational safety, occupational health and the environment
Encouragement of each individual's personal improvement, innovation and creativity
Cost of quality: Total quality management has evolved; a more radical approach to the cost of quality has developed. This model is used to determine the profile of quality costs within an organisation against three main categories; prevention, appraisal, internal failure costs and external failure costs.
Categories of Cost of Quality
Cost of Quality Classification:
1. Prevention: There are the costs of activities that prevent failure from occurring.
2. Appraisal: These are the costs incurred to determine conformance with quality standards.
3. Failure: This can be subdivided into failure up to delivery or after delivery to the customer.
Internal failure: These are the costs of correcting products or services which do not meet quality standards prior to delivery to customers.
External failure: These are the costs of correcting products and services after delivery to the customer.
Task-2.2 .Calculate and evaluate indicators of productivity, efficiency and effectiveness
Gross Profit Margin-
Actual = (Gross Profit ÷ Turnover) 100
= (460,400 ÷ 2,750,000) 100
= (0.16 - 100)
Budgeted = (600,000 ÷ 3,000,000) 100
= (0.2 - 100)
Operating Profit Margin-
Actual = (Operating Profit ÷ Sales) - 100
= (115,400 ÷ 2,750,000) - 100
= 0.04 - 100
Budgeted = (240,000 ÷ 3,000,000) - 100
= 0.08 - 100
Return On Capital Employed-
Actual = (Net Profit After Tax ÷ Net Asset) -100
= (115,400 ÷ 1,075,400) -100
= 0.10 - 100
Budgeted = (240,000 ÷ 1,200,000) - 100
= 0.2 - 100
Stock Turnover in Months-
Actual = (12 - Average Stock) ÷ Cost of Sale
= (12 - 220,000) ÷ 2,289,600
= 2,640,000 ÷ 2,289,600
= 1.15 months
Budgeted = (12 - 200,000) ÷ 2,400,000
= 2,400,000 ÷ 2,400,000
= 1 month
Labour Capacity Ratio-
= (Actual hours ÷ Budgeted Hours) -100
= (58,200 ÷ 60,000) - 100
= 0.97 - 100
Labour Efficiency Ratio-
= (Budgeted Hours ÷ Actual Hours) -100
= (60,000 ÷ 58,200) -100
= 1.03 - 100
Efficiency indicators: It will be in terms of total cost per productivity objectives steady by yearly operating budget. The direct cost that is rewarded from proper funds will not be incorporated in total cost of productivity estimates.
Effectiveness indicators: This will imitate features of the closing product produced by the movement and acknowledged by the customer. Effectiveness indicators should be steady with, but not essentially industrial to movement measures for performance budgeting and this consist of-
Impact on customers outcomes
Profitability indicators: It simply means the company's earnings performance. To assist investors assess the business ability to generate earning compared with its expenses and other relevant costs incurred during a specific period.
The purpose and nature of the budgeting process:
Budget: A budget is a plan quantified in monetary terms, prepared and approved prior to a defined period of time, showing planned incomes to be generated and expenditure to be incurred and the capital to be employed in order to attain a given objective.
Purposes of Budget: A budget serves four main purposes-communicating, coordinating, planning and control.
Communicating: the budgeting process establishes a formal system which ensures that each person affected by the plans is aware of their responsibilities and what is expected of them.
Coordinating: The Budget help to ensure that the activities of different departments are coordinated to ensure that there is a maximum integration of effort towards common goal.
Planning: This happens when every department is signified by the senior members throughout the budget preparation. E.g. sales dept represented by the sales director.
Controlling: It involves the evaluation of the budget and actual consequence to perceive any variations.
The modeling: To construct budgeted financial statement, it needs good models of the profit, cash flow, and financial condition of a business. Models are blueprints, or schematics of how things work. A business budget is, at its core, a financial blueprint of the business.
Motivation: Budgets also allow a company to motivate its employees by involving them in the budget. While top-down budgeting does not complete this goal very effectively, participative budgeting can be motivating. When an employee is involved in creating his or her department's budget, that person will be more likely to strive to achieve that budget. It increases productivity of employees.
Evaluating performance: One of the functions of accounting information is that it provides a basis for the measurement of managerial performance. By setting targets for each manager to achieve, the budget provides a bench-mark against which his actual performance can be assessed objectively.
(Sources-Tracy and Barrow, 2008)
Nature of Budgets:
profit and loss budget
balance sheet budget
Budget committee means a group of people who are involved to create and maintain a budget of a company, this committee usually consists of the top management and the CFO. Budget committees naturally review and agree departmental budgets that are submitted by the different department heads.
A typical budget committee comprises the chief executive, the management accounting and functional heads. The functions of the committee are to:
- Agree policy with regard to budgets
- Co-ordinate budgets
- Suggest amendments to budgets
- Approve budgets after amendment, as necessary
-Examine comparisons of budgeted and actual results and recommend corrective action if this has not already been taken.
Role of budget committee
Ensure that the company budget supports the company's mission and goals and links the company budget with company planning.
Provide oversight in the development and creation of the unrestricted budgets.
Recommend funding priorities in the creation and implementation of the unrestricted budgets.
Review and recommend for approval or disapproval budget requests beyond the Final Unrestricted Budget based on the impact of such funding requests upon the unrestricted budgets in both short and long terms.
Actively monitor revenue and expenditures of the Unrestricted, Restricted, and Enterprise funds of the company by reviewing operating financial statements for these various programs.
The Budget Committee recognizes that the Company needs to take advantage of any grant funding opportunities and as such will not interfere with any grant application process.
Provide training in budget related matters to the membership of the committee and other segments of the college as needed.
(Sources- ACCA 2.4, 2005)
Types of budgets
Incremental Budget: Incremental budgeting takes historic, actual data from the previous period and makes a markup (or down) depending on how management anticipate the company should perform in the next period.
Zero Based Budget: ZBB is a method of budgeting whereby all activities are re-evaluated each time a budget is prepared. Discrete levels of activity are valued and a combination chosen to match funds available.
ZBB makes no initial assumptions-each year's budgets are compiled by assessing each potential activity from scratch (zero base).
ZBB carries some benefits to prepare a budget. They are following
It helps to create an organizational environment where change is accepted.
It helps management to focus on company objectives and goals.
It concentrates the attention of management on the future rather than on the past.
It helps to identify inefficient and obsolete operations within the organization.
It can assist motivation of management at all levels.
It establishes minimum requirements from departments.
Activity Based Budget: Activity base budgeting extends the use of activity-based costing (ABB) from individual product costing, for pricing and output decisions, to the overall planning and control system of the business. It is a method of budgeting based on an activity framework and utilizing cost driver data in the budget-setting and variance feedback processes.
The basic approach of ABB is as follows:
The work of each department for which a budget is to be prepared is analysed by its major activities, for which cost drivers may be identified.
The budgeted cost of resources used by each activity is determined and, where appropriate, cost per unit of activity is calculated.
Future costs can then be budgeted by deciding on future activity levels and working back to the required resource input.
ABB carries some benefits to prepare a budget. They are following
It takes into account the impact of activity levels on resource costs, of assistance in cost reduction programmers and in setting realistic cost target.
Activity unit costs allow easier analysis of cost trends over time and intra-departmental comparisons.
Resource allocation decisions are assisted by the activity related cost information arising from an ABB system.
Rolling based Budgeting: A rolling budget is `a budget continuously updated by adding a further period, say a month or quarter, and deducting the earliest period. Beneficial where future costs and/or activities cannot be forecast reliably'.
A typical rolling budget might be prepared as follow:
A budget is prepared for the coming year (say January-December) broken down into suitable, say quarterly, control period.
At the end of the first control period (31 March) a comparison is made of that period's results against the budget. The conclusions drawn from this analysis are used to update the budgets for the remaining control periods and to add a budget for a further three months, so that the company once again has budgets available for the coming year (this April-March).
The planning process is repeated at the end of each three-month control period.
(Sources-Tracy and Barrow, 2008)
Before preparing budgets has to remember some roles. They are follows
Forecast time-lag on converting debtors to cash, and hence forecast cash receipts from credit sales.
Determine stock levels, and hence purchase requirements.
Forecast time-lag on paying suppliers, and thus cash payments for purchases.
Incorporate other cash payments and receipts, including such items as capital expenditure and tax payments.
Collate all this cash flow information, so as determine the net cash flows.
Prepare a cash budget below
The preparation of cash budgets or budgeted cash flow statements has two main objectives. They are following
To provide periodic budgeted cash balances for the budgeted balance sheet.
To anticipate cash shortage/surpluses and thus provide information to assist management in short and medium-term cash planning and longer-term financing for the organization.
Cash budget for new market Ltd for June, July and August-
(+) cash inflows:
(-) cash outflows:
Variance analysis is a means of assessing the difference between budgeted and actual amount. These can be monetary amounts or physical quantities. Variances will be disclosed where the actual cost of some, or all, elements differ from the standard cost for the quality actually produced. These variances could be expressed as a (+) or a (-) representing an adverse or favorable result, or the symbol letters (A) or (F) used instead. The disadvantage of using (+) and (-) signs is that one has to get the formula the right way round. The advantage of using (F) and (A) signs is that one can use common sense regardless of which way round the formula is put. Basically there are two main types of variance:
Price variances: Price variances relating to purchase of resources.
Volume variances: Volume variances relating to the volume of resources consumed or activity level.
Classifications of Variances
Material cost variance Labour cost variance Variable overhead variance Fixed overhead variance sales variance
M price M usage L rate L efficiency V overhead expen V overhead efficiency Sales price Sales volume
variance variance variance variance variance variance variance variance
Fixed overhead expenditure Fixed overhead volume
(Note: M means material, L means labour and V means variable )
Material cost variances
(i)Material price variance: Material price variance represents the difference in purchase cost caused by a variance in the unit price of the material. It is calculated from the difference between the actual and standard price per unit of material multiplied by the actual purchased.
Material price variance: actual quality of raw material (STD price -Actual price)
Standard price per meter £4
Standard usage per unit 5 meters
Actual price per meter £3
Actual usage per unit 5 meters
Usage is the same as standard; therefore the only variance is that of price calculated:
Actual cost per unit £3-5 15
Standard cost per unit £ 4-5 20
Variance (favorable) 5
Price (£ )
Standard price per meter £9
Standard usage per unit 8 meters
Actual price per meter £11
Actual usage per unit 8 meters
Actual cost per unit £3-5 88
Standard cost per unit £ 4-5 72
Variance (favorable) 16
(ii)Material usage variance: Material usage variance represents the difference in the cost of material used caused by more or less efficient use of that material. It is calculated from the difference between the actual and standard quantity used evaluated at the standard price.
Material usage variance: STD price (STD quantity - Actual quantity)
Standard price per ton £5
Standard usage per unit 100 tones
Actual price per ton £5
Actual usage per unit 95 tones
Cost is the same as standard; therefore the only variance is that of usage calculated:
Actual cost per unit £11-8 units 475
Standard cost per unit £ 9-8 units 500
Variance (favorable) 25
0 95 100
Standard price per centimeter £8
Standard usage per unit 11 cm
Actual price per meter £8
Actual usage per unit 13cm
0 11 13
Variance computed: £
Actual cost per unit £8-13 104
Standard cost per unit £ 8-11 88
Variance (favorable) 16
Combinations of materials price and usage variance
Favourable and adverse variances combined:
Standard price per meter £6
Standard usage per unit 25 meters
Actual price per meter £7
Actual usage per meter 24 meters
The net variance is calculated as:
Actual cost per unit £7-24 168
Standard cost per unit £ 4-5 150
Variance (adverse) 18
0 24 25
Both adverse variances combined:
Standard price per kg £9
Standard usage per unit 13kg
Actual price per kg £11
Actual usage per unit 15 kg
The net variance is computed:
Actual cost per unit £11-15 165
Standard cost per unit £ 9-13 117
Variance (Adverse) 48
Price (£) B
0 13 15
Both favourable variances combined:
Standard price per ton £20
Standard usage per unit 15 tones
Actual price per ton £19
Actual usage per unit 13 tones
The net variance is computed:
Actual cost per unit £19-13 247
Standard cost per unit £ 20-15 300
Variance (favourable) 53
20 A C
Price (£) B
0 13 15
Labour cost variances
(i) Labour rate variance: Labour rate variance represents the difference in labour cost caused by any variation from normal rates of pay. It is calculated from the difference between the actual and standard rate per hour multiplied by the actual number of hours paid.
Labour rate variance: actual labor hour (STD labor hour - actual labor rate)
Standard hours to produce 100
Actual hours to produce 100
Standard wage rate per hour £0.9
Actual wage rate per hour £1.0
Rate per hour
As the actual and standard hours are the same, then the only variance will be a wage rate variance, computed as follows:
Actual cost per unit £1.0-100 100
Standard cost per unit £0.9-100 90
Variance (Adverse) 10
(ii) Labour efficiency variance: Labour efficiency variance represents the difference in labour cost caused by the degree of dfficiency in the use of labour compared with the specified standard. It is calculated from the difference between the actual hours taken and the standard hours allowed, evaluated at the standard rate per hour.
STD labor rate (STD labor hour - actual labor hour)
Standard hours to produce 400
Actual hours to produce 370
Standard wage rate per hour £1.0
Actual wage rate per hour £1.0
Rate per hour
0 370 400
As the actual and standard wage rates are the same, and then the only variance will be a labour efficiency variance, computed as follows:
Actual cost per unit £1.0-370 370
Standard cost per unit £1.0-400 400
Variance (Favourable) 30
Combined wage rate and efficiency variance
Standard hours to produce 500
Actual hours to produce 460
Standard wage rate per hour £0.9
Actual wage rate per hour £1.1
Rate per hour
0 450 506
The net variance can be computed as:
Actual cost per unit £1.1-460 506
Standard cost per unit £0.9-500 450
Variance (Adverse) 56
Note: Labour rate variance is the same as the material usage variance.
Variable overhead variances
(i) Variable overhead expenditure variance: Variable overhead expenditure variance represents the difference between that actual cost and the total amount recovered at the standard rate per unit of output. It is calculated from the difference between actual variable overheads and the quantity of output multiplied by the standard recovery rate per unit.
Formula: (actual rate - standard rate) - actual hours worked
(ii) Variable overhead efficiency variance: The difference between the variable overhead cost budget flexed on actual labour hours, and the variable oberhead cost absorbed by output produced.
Formula: (actual hour worked - standard hours) - standard rate
Fixed overhead variance
(i) Fixed overhead expenditure variance: It represents the difference between the actual cot and the estimated or budgeted cost of those overheads.
Formula: Budgeted fixed production overhead- actual fixed production overhead
= (20-1000 -23000)
(ii) Fixed overhead volume variance: It refers the over or under-absorption of overhead cost caused by actual production volume differing from that budgeted.
Formula: (actual output- budgeted production) - standard cost per unit
= (1000-900) - 20
= 2000 (A)
(iii)Fixed overhead capacity volume-
= BOAR (Actual labor hour - Budgeted labor hour)
= 4(4200 -5000)
(iv)Fixed overhead efficiency variance -
=BOAR (STD hour - Actual hour)
=4 (4500 - 4200)
(i) Sales price variance: Sales price variance refers the profit lost or gained by selling at a non-standard price. It is calculated from the difference between standard and actual selling price multiplied by the actual quantity sold.
Formula: (standard price -Actual price) - actual quantity sold
= (£59-£57) 82400 units
= £164800 (A)
(ii) Sales volume variance: It shows the profit margins on the difference between actual sales and budgeted sales. It is calculated from the standard profit margin multiplied by the difference between budgeted sales volume and actual sales volume.
Formula: (Budgeted quantity - actual quantity sold) standard margin
= (81600-82400) - £31
= £ 24800 (F)
(Sources- Wood and et l 2008)