Elements of costing

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Elements of costing 2016 Specification
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Page 1

Chapter 1: The costing system

Purpose of costingCosting enables the managers of a business to know the cost of the firm's output. Once costing information is available, managers can use it to assist with decision making, planning the future and the control of expenditure. Cost accounting is widely used by: A manufacturing business A business that provides a service By being able to work out the cost of a product or service, the managers of an organisation can then use this cost to: Determine a selling price Value inventory Provide information for financial statements Make management decisions What is a costing systemA costing system is used by an organisation to collect information about costs and use that information for decision making, planing and control. Financial accounting and management accountingWhat is financial accounting: Financial accounting is concerned with recording financial transactions that have happened already, and with providing information form the accounting records. The main features of financial accounting are: Records transactions hat have happened already Accurate to the nearest penny A legal requirement Maintains confidentiality of information What is management accounting: Management accounting is concerned with looking at actual transactions in different ways from financial accounting. In particular, the costs of each product or service are considered both in the past and as the likely costs in the future. In this way, management accounting is able to provide information to help the business or organisation plan for the future. The main features of management accounting are: Makes estimates for the future Looks in detail at the costs and sales income Looks forward to show what is likely to happen in the future Provides management with reports Used internally within the business Maintains confidentiality of information Sources of data for costingCosts can be seen as: Historic costs Current costs Future costs Introduction to classifying costs and incomeThe elements of cost: Materials Labour Expenses Materials costs include: Raw materials Products bought for resale Service items/consumables Labour costs include: Wages Salaries Public sector wages Expenses is a term that refers to all other running costs of the business or organisation that cannot be included under the headings of materials and labour. eg. rent, rates, heating lighting. Expenses may also be classed as 'overheads'.Classification of costs by function and natureAs well as dividing costs into materials, labour and expenses, it is also useful to show why the costs have been incurred. This breakdown of costs is sometimes called 'functional' as it links to the different sections of an organisation. The two main functions are generally carried out in: The factory The warehouse Costs in the factory - production costsThe costs incurred in the factory are production costs. 'Production' is the function into which these costs are classified. We can divide these production costs further into: Direct costs Indirect costs This analysis is sometimes called classification by nature.Direct costs - Costs that can be directly identified with each unit of output.Indirect costs - Costs that cannot be directly identified with each unit of output. Direct costs: Direct materials - The cost of the materials used to make the items produced. Direct labour - The cost of paying the employees that make the product. Direct expenses The total of direct costs is also called the prime cost. Indirect production costs: Indirect materials - The cost of materials that cannot be directly linked to specific items produced. Indirect labour - The cost of employing people in the factory who do not actually make the products. Indirect expenses - The other costs of running the factory. The total of direct costs and indirect production costs is simply known as total production costs.Non production costs (indirect): Administration Selling and distribution Finance Key terms:Costing system - The system that an organisation has developed to collect information about costs and income so that it can be used to help with decision making, planning and control. Management accounting - The area of accounting that includes costing; it concentrates on providing internal information about the future in a form that is useful; it has no externally set rules that must be followed.Financial accounting - The area of accounting that includes bookkeeping; it concentrates on providing historic information that can be used internally and also provided to external parties. Budget - A future plan for an organisation, showing all the detail in financial terms; it is usually made up of various individual budgets.Cost classification by element - Grouping costs together according to the type of cost based on three categories; materials, labour and expenses. Cost classification by nature - Grouping costs together according to whether they are direct costs or indirect costs.Direct costs - Costs that are directly identified with the units of output.Prime cost - A term relating to the total of direct costs; it is often used to describe the total direct cost for a unit of output. Indirect costs - Costs that are not directly identified with the units of output; these costs are divided into production and non-production costs in a manufacturing organisation.Cost of production - A term relating to the total of direct costs and indirect production costs.

Page 2

Chapter 2: Cost centres and overhead absorption

Cost centresCost centres are sections of an organisation to which costs can be charged. Profit centres:Profit centres are sections of a business to which costs can be charged, income can be identified and profit can be calculated. Investment centres:A section of an organisation to which costs can be charged, income can be identified and investment can be measured.The term 'responsibility centre' is sometimes used to describe cost centres, profit centres and investment centres. Coding systemsNumeric coding - A code made entirely of numbersAlphabetic coding - A code made entirely of lettersAlpha-numeric coding - A code made of both numbers and lettersUnits of output method:Budgeted overheads / Budgeted units of outputDirect labour hours method:Budgeted overheads / Budgeted direct labour hoursMachine hours method:Budgeted overheads / Budgeted machine hoursKey terms:Cost centre - A section of an organisation to which costs can be charged. The number and type of cost centre would depend on the requirements of the organisation.Profit centre - A section of an organisation to which costs can be charged, income can be identified and profits can be calculated. Investment centre - A section of an organisation to which costs can be charged, income can be identified and investment can be measured.Coding system - A way of using unique headings to analyse data. They can also be used to place the data in logical order.Numeric code - A code made entirely of numbersAlphabetic code - A code made entirely of lettersAlpha-numeric code - A code made up of a combination of numbers and letters.Absorption - Means of incorporating indirect costs into costs of units of output.Absorption base - Chosen method of absorption used by an organisation.Overhead absorption rate - The rate used to absorb overheads into products or services.Units of output method - A method of absorption based on dividing budgeted overheads by budgeted number of units to provide an overhead absorption rate per unit.Direct labour hours method - A method of absorption based on dividing budgeted overheads by budgeted direct labour hours to provide an overhead absorption rate per direct labour hour.Machine hours method - A method of absorption based on dividing budgeted overheads by budgeted machine hours to provide an overhead absorption rate per machine hour.

Page 3

Chapter 3: Cost behaviour

Cost behaviourCost behaviour is the way in which costs alter with changes in the level of output or activity. There are three main ways that costs may behave: Fixed costs Variable costs Semi-variable costs Fixed costs:Fixed costs do not alter when the level of output or activity changes.Variable costs:Variable costs change in proportion to the level of output or activity.Semi-variable costs:Semi-variable costs contain both a fixed element and a variable element.Cost behaviour calculations:Total costs - Variable costs per unit X Output + Fixed costsUnit costs - Fixed costs / Output + Variable costs per unit.Key terms:Cost behaviour - The way that costs alter with changes in the level of output or activity.Fixed cost - A cost that does not alter in total when the level of output or activity changes. Variable cost - A cost that changes in proportion to the level of output or activity.Semi-variable cost - A cost that contains both a fixed element and a variable element.High-low method - A technique for calculating the variable and fixed costs that comprise a semi-variable cost by analysing the total costs at two activity levels.

Page 4

Chapter 4: Inventory valuation and the manufacturing account

Types of inventoryManufactures - businesses that manufacture products will hold inventory in various forms: Raw materials - These are the materials that have been bought by a manufacturing business and are ready to be transferred to the production area where they will be used to make the finished goods. Work-in-progress - This comprises part finished products that are awaiting completion. Finished goods - Manufactured items that have been completed and are ready for sale. Valuation methodsThere are three main methods of valuing inventory: FIFO (First in first out) LIFO (Last in first out) AVCO (Average cost) FIFO (First in first out)Using this method, the purchase price of the inventory that has been in the stores the longest is used to value the inventory that is issued from the stores. This means that the inventory left in the stores is valued at the most recent cost prices.LIFO (Last in first out)The valuation of the inventory issued is based on the cost of the inventory most recently purchased. This means that the inventory left in the stores is valued at the older cost prices. AVCO (Average cost)In this method, an overall average cost is calculated for the inventory held in the stores. This average cost is then used to value the inventory issued from the stores. This also means that a new average cost must be calculated each time that a new purchase of inventory is made. Average cost = Total cost of goods in stores / Number of items in storesManufacturing accountsManufacturing account format: Opening inventory of raw materials Purchases of raw materials Closing inventory of raw materials Direct materials used Direct labour Direct cost Manufacturing overheads Manufacturing cost Opening inventory of work in progress Closing inventory of work-in-progress Cost of goods manufactured Opening inventory of finished goods Closing inventory of finished goods Cost of goods sold Summary figures:Direct materials used = Opening inventory of raw materials + Purchases of raw materials - Closing inventory of raw materialsDirect cost = Direct materials used + Direct labourManufacturing cost = Direct cost + Manufacturing overheadsCost of goods manufactured = Manufacturing cost + Opening inventory of work in progress - Closing inventory of work in progressCost of goods sold = Cost of goods manufactured + Opening inventory of finished goods - Closing inventory of finished goodsKey terms;Raw materials - The materials bought by manufacturing organisations and used to manufacture the finished products.Work in progress - The name given to partly-completed items in a manufacturing organisation.Finished goods - The items that have been manufactured and are ready for sale.First in first out (FIFO) - A method of inventory valuation that assumes that goods will be used up in the order that they are acquired. This means that the remaining balance will be valued based on the prices of more recent purchases.Last in first out (LIFO) - This method of inventory valuation assumes that the most recently acquired inventory will be used first, leaving the earlier acquisitions to make up the value of he remaining balance. This does not have to correspond with the actual order of usage. Average cost (AVCO) - This inventory valuation method involves calculating a new weighted average cost of goods each time that a new purchase is made, and using this valuation for subsequent issues and balances until further purchases are made. Manufacturing account - This cost statement is produced at the end of a period to summarise costs under various categories.Direct materials - This is calculated as the total of opening inventory of raw materials, plus materials purchased, minus closing inventory of raw materials. Direct cost - The total of direct costs in a manufacturing account it is calculated by adding direct materials used in manufacture to direct labour.Manufacturing cost - A subtotal made up of the total of direct cost and manufacturing overheads.Cost of goods manufactured - This subtotal is the production costs of goods that have been completed and is made up of manufacturing cost adjusted for inventories of work-in-progress.Cost of goods sold - A total based on the factory cost of goods manufactured which has been adjusted for inventories of finished goods.

Page 5

Chapter 5: Labour Costs

Methods of calculating payments for labourThere are four main methods of calculating pay: Time rate Overtime Bonus Piecework Time rate:Time rate is based on payment for the amount of time spent working. Overtime rate:An overtime rate is a time rate that is paid for time worked in excess of the normal contracted time. Bonus payments:A bonus payment is an extra payment paid to employees as a reward for productivity. Piecework:Piecework is payment based on the number of items produced by the employee.

Page 6

Chapter 6: Budgets and variances

What is a budget?A budget is a financial plan for an organisation that is prepared in advance.What are the purposes of a budget? The budget creates plans The budget communicates and coordinates the plans The budget can be used to monitor and control Standard costs - Expected costs that have been calculated in the past. Calculating variancesVariance - The difference between the budgeted figure and the actual figure.Variances can be either; Adverse Favourable Adverse - Where the actual cost is greater than the budgeted cost.Favourable - Where the actual cost is less than the budgeted cost. Variances are calculated: Budgeted cost - actual costReporting to managers:Income - Sales managerMaterials - Production manager - Purchasing managerLabour - Production manger - Human resources managerExpenses - Administration managerProduction overheads - Production managerAdministration overheads - Administration managerSelling and distribution manager - Sales manager - Distribution/transport managerFinancial overheads - Finance manager - Company accountant

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