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FINANCIAL MANAGEMENT
CHECK POINT 57: COST ACCOUNTING

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1. the purpose of cost accounting
2. classification of costs
3. classification of costs in a service company
4. classification of costs in a merchandising company
5. classification of manufacturing methods
6. classification of costs in a manufacturing company
7. material costs
8. labor costs
9. sub-contracting service costs
10. plant overheads and operating expenses
11. cost of goods manufactured and cost of goods sold
12. two basic cost accounting methods
13. two essential tasks of cost accounting
14. overhead recovery rates
15. the process of setting overhead rates
16. small business example
overhead rate for a custom service company
17. small business example
overhead rate for a standard service company
18. small business example
overhead rate for a wholesaler or retailer
19. overhead rates in a manufacturing company
20. the manufacturing cost recovery method
21. small business example
overhead rate for a manufacturing company
22. small business example
calculation of standard overhead rates
23. basic costing methods for a manufacturing company
24. job and work cost reports
25. small business example
job cost report
26. production timecards
27. small business example
production timecard
28. cost per product unit
29. cost-volume-profit and break-even analysis
30. small business example
break-even analysis
31. for serious business owners only
32. the latest information online
 

DO I NEED TO KNOW THIS CHECK POINT?

 

FINANCIAL MANAGEMENT
CHECK POINT 57: COST ACCOUNTING

Please Select Any Topic In Check Point 57 Below And Click.

1. the purpose of cost accounting
2. classification of costs
3. classification of costs in a service company
4. classification of costs in a merchandising company
5. classification of manufacturing methods
6. classification of costs in a manufacturing company
7. material costs
8. labor costs
9. sub-contracting service costs
10. plant overheads and operating expenses
11. cost of goods manufactured and cost of goods sold
12. two basic cost accounting methods
13. two essential tasks of cost accounting
14. overhead recovery rates
15. the process of setting overhead rates
16. small business example
overhead rate for a custom service company
17. small business example
overhead rate for a standard service company
18. small business example
overhead rate for a wholesaler or retailer
19. overhead rates in a manufacturing company
20. the manufacturing cost recovery method
21. small business example
overhead rate for a manufacturing company
22. small business example
calculation of standard overhead rates
23. basic costing methods for a manufacturing company
24. job and work cost reports
25. small business example
job cost report
26. production timecards
27. small business example
production timecard
28. cost per product unit
29. cost-volume-profit and break-even analysis
30. small business example
break-even analysis
31. for serious business owners only
32. the latest information online
 

DO I NEED TO KNOW THIS CHECK POINT?

 

WELCOME TO CHECK POINT 57

TUTORIAL 1 General Management TUTORIAL 2 Human
Resources Management
TUTORIAL 3 Financial Management TUTORIAL 4 Operations Management TUTORIAL 5 Marketing
And Sales Management
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96
2 7 12 17 22 27 32 37 42 47 52 57 62 67 72 77 82 87 92 97
3 8 13 18 23 28 33 38 43 48 53 58 63 68 73 78 83 88 93 98
4 9 14 19 24 29 34 39 44 49 54 59 64 69 74 79 84 89 94 99
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
 

HOW CAN YOU BENEFIT FROM CHECK POINT 57?

 
The main purpose of this check point is to provide you and your management team with detailed information about Cost Accounting and how to apply this information to maximize your company's performance.
 
In this check point you will learn:
 
• About the purpose of cost accounting.
• About detailed classification of direct and indirect costs.
• About detailed classification of costs in a service company.
• About detailed classification of costs in a merchandising company.
• About detailed classification of costs in a manufacturing company.
• About job order costing and process costing accounting methods.
• About setting overhead rates in a service company.
• About setting overhead rates in a merchandising company.
• About setting overhead rates in a manufacturing company.
• About basic costing methods in a manufacturing company... and much more.
 

LEAN MANAGEMENT GUIDELINES FOR CHECK POINT 57

 
You and your management team should become familiar with the basic Lean Management principles, guidelines, and tools provided in this program and apply them appropriately to the content of this check point.
 
You and your team should adhere to basic lean management guidelines on a continuous basis:
 
Treat your customers as the most important part of your business.
Provide your customers with the best possible value of products and services.
Meet your customers' requirements with a positive energy on a timely basis.
Provide your customers with consistent and reliable after-sales service.
Treat your customers, employees, suppliers, and business associates with genuine respect.
Identify your company's operational weaknesses, non-value-added activities, and waste.
Implement the process of continuous improvements on organization-wide basis.
Eliminate or minimize your company's non-value-added activities and waste.
Streamline your company's operational processes and maximize overall flow efficiency.
Reduce your company's operational costs in all areas of business activities.
Maximize the quality at the source of all operational processes and activities.
Ensure regular evaluation of your employees' performance and required level of knowledge.
Implement fair compensation of your employees based on their overall performance.
Motivate your partners and employees to adhere to high ethical standards of behavior.
Maximize safety for your customers, employees, suppliers, and business associates.
Provide opportunities for a continuous professional growth of partners and employees.
Pay attention to "how" positive results are achieved and constantly try to improve them.
Cultivate long-term relationships with your customers, suppliers, employees, and business associates.

1. THE PURPOSE OF COST ACCOUNTING

THE PURPOSE OF COST ACCOUNTING

Business owners and financial managers must be able to develop, implement, and maintain an effective cost accounting system, which represents one of the most critical financial responsibilities in every business organization.

The main purpose of the Cost Accounting System is to facilitate practical methods of identifying and measuring costs of goods and services supplied by the company. Hence, the central question of cost accounting is:

"How much does it really cost?"

Cost Accounting deals with four important tasks illustrated below.

FOUR IMPORTANT TASKS OF COST ACCOUNTING

     
Classification
Of
Costs
  Development
Of A Costing
System
  Determination
Of Cost
Recovery Rates
  Implementation
Of The Costing System
 

ADDITIONAL INFORMATION ONLINE

Understanding Cost Accounting By Ken Boyd.
Cost Accounting: Cost Per Unit By Ken Boyd.
Cost Accounting: Process Costing By Ken Boyd.
Cost Accounting: Tracking Job Costs By Ken Boyd.
Cost Accounting Introduction By Accounting Helper.

2. CLASSIFICATION OF COSTS

CLASSIFICATION OF COSTS

All costs incurred by a company during a process of supplying goods and services to customers are classified into Two Basic Categories illustrated below.

TWO BASIC CATEGORIES OF COSTS

 
Direct Costs   Indirect Costs

Both, direct and indirect costs differ, depending upon the nature of the company's activities, namely: service, merchandising, or manufacturing.

DETAILED CLASSIFICATION OF COSTS

 
Direct Costs   Indirect Costs

All operating expenses that can be physically traced to a particular product or service supplied by a company.


 

All operating expenses that cannot be physically traced to a particular product or service supplied by a company.

 
Service Company   Service Company

Direct Service Cost, i.e. salaries and wages of employees whose time is charged to customers; cost of materials supplied to customers.

 

Indirect Service Cost, or Service Overhead, i.e. all administrative, general, and selling expenses.

 
Merchandising Company   Merchandising Company

Direct Merchandising Cost, i.e. cost of merchandise purchased for resale to customers.


 

Indirect Merchandising Cost, or Merchandising Overhead, i.e. all administrative, general, and selling expenses.

 
Manufacturing Company   Manufacturing Company

Direct Manufacturing Cost:

  • Direct material cost.
  • Direct labor cost.
  • Direct sub-contracting service cost.

 

Indirect Manufacturing Cost, or Manufacturing Overhead:

  • Plant overhead.
  • All administrative, general, and selling costs.

ADDITIONAL INFORMATION ONLINE

Direct Vs. Indirect Costs By Note Pirate.
Direct And Indirect Costs By John Gunyou.
Direct Vs. Indirect Costs By Education Unlocked.
Cost Object, Direct Costs, Indirect Costs By Dee Amaradasa.
Direct Vs. Indirect Costs By Pamela D. Jones, Managerial Accounting.

3. CLASSIFICATION OF COSTS IN A SERVICE COMPANY

SERVICE COMPANY

Service Companies provide custom and standard service to customers, as illustrated below. Service companies usually do not carry inventory except for consumable items or spare parts used in the actual service process.

All Costs incurred by service companies during a specific accounting period are classified into two types illustrated below.

TWO BASIC TYPES OF SERVICES

 
Custom Service   Standard Service

Custom service is characterized by a non-repetitive operation to a specific customer's order, e.g. accounting, legal, health care, or plumbing service.


 

Standard service is characterized by rendering a repetitive service to several customers on a continuous flow basis, e.g. banking, entertainment, or communication.

CLASSIFICATION OF COSTS IN A SERVICE COMPANY

1.

Direct Service Costs.
These costs relate to all operating expenses that can be directly traced to a particular customer. These costs include salaries and wages of all employees who are directly involved in rendering a particular service, i.e. their time is charged to a customer account. These costs also include the cost of all spare parts and buy-outs used in the rendition of service to a particular customer.

2.

Indirect Service Costs Or Service Overheads.
These costs relate to all expenses that cannot be directly traced to a particular customer. These costs include all administrative, general, and selling expenses incurred by service companies.

4. CLASSIFICATION OF COSTS IN A MERCHANDISING COMPANY

MERCHANDISING COMPANY

Merchandising Companies specialize in purchasing and selling various products, or merchandise, to customers at a profit. There are two types of merchandising companies as illustrated below.

All Costs incurred by merchandising companies during a specified accounting period are also classified into two types illustrated below.

TWO TYPES OF MERCHANDISING COMPANIES

 
Wholesalers   Retailers

Wholesalers usually purchase a limited range of goods in large quantities from manufacturers and sell them to retailers.


 

Retailers usually purchase a broad range of goods in smaller quantities from wholesalers, distributors, and even manufacturers and sell such goods to the general public.

CLASSIFICATION OF COSTS IN A MERCHANDISING COMPANY

1.

Direct Merchandising Costs.
These costs can be directly traced to the merchandise and include the net cost of all merchandise purchased for resale to customers, i.e. gross cost less discounts and allowances received from suppliers. The final value of the direct merchandising cost, or Cost Of Goods Sold, must be adjusted by values of merchandise inventory at the start and at the end of a specific accounting period.

2.

Indirect Merchandising Costs Or Merchandising Overheads
These costs relate to all operating expenses that cannot be directly traced to the cost of merchandise. These costs include all administrative, general, and selling expenses incurred by merchandising companies.

5. CLASSIFICATION OF MANUFACTURING METHODS

MANUFACTURING COMPANY

Manufacturing Companies specialize in converting raw materials into a range of finished goods through the use of labor, production facilities, and sub-contracting services.

There are three basic types of production methods widely employed by manufacturing companies as illustrated below.

THREE BASIC TYPES OF PRODUCTION METHODS

   
Job Shop 
Production
  Batch
 Production
  Flow 
Production

This method is used to produce a limited number of products to a special order. The manufacturing process has distinctive starting and finishing points.


 

This method is used to produce a batch of similar products on a repetitive basis. The manufacturing process has distinctive starting and finishing points.


 

This method represents a continuous process of manufacturing a standard range of products in large quantities, e.g. brewery, textile mill, or conveyor line.


Note:

Additional information concerning Manufacturing Activities is provided in Tutorial 4.

6. CLASSIFICATION OF COSTS IN A MANUFACTURING COMPANY

CLASSIFICATION OF COSTS

All Costs incurred by manufacturing companies during a specific accounting period are classified into two types illustrated below.

CLASSIFICATION OF COSTS IN A MANUFACTURING COMPANY

1.

Direct Manufacturing Costs.
These costs relate to all manufacturing expenses that can be directly traced to a particular product. These costs include the net costs of all direct materials, direct labor, and direct sub-contracting services.

2.

Indirect Manufacturing Costs.
These costs relate to all manufacturing and operating expenses that cannot be directly traced to a particular product. These costs include total plant overhead and all administrative, general, and selling expenses.

7. MATERIAL COSTS

All Material Costs can be classified into two types outlined below.

CLASSIFICATION OF MATERIAL COSTS

1.

Direct Material Costs.
Direct material costs include the net costs of all direct materials that are used in the manufacturing process and become part of the finished goods. These materials can be directly traced and allocated to specific products, e.g. timber used in furniture or fabrics used in clothing. The final value of direct materials, or Cost Of Direct Materials Used, must be adjusted by the value of Direct Materials Inventory at the start and at the end of a specific accounting period.

2.

Indirect Material Costs.
Indirect material costs include the net costs of all indirect materials, i.e. materials which cannot be directly traced to a specific product or manufacturing process, e.g. cost of glue used in furniture or cotton thread used in clothing. The cost of these materials is allocated to indirect material costs and becomes part of plant overhead.

8. LABOR COSTS

All Labor Costs can be classified into two types outlined below.

CLASSIFICATION OF LABOR COSTS

1.

Direct Labor Costs.
Direct labor costs include the cost of all direct labor that is used in the manufacturing process and becomes part of the finished goods. These costs can be directly traced and allocated to specific products or manufacturing processes, e.g. wages of machine operators.

2.

Indirect Labor And Supervision Costs.
Indirect labor and supervision costs include the cost of all indirect labor and management cost which cannot be directly traced to a specific finished product or a manufacturing process, e.g. wages of production supervisors, planners, designers, assembly workers, maintenance, and other support personnel. These costs become part of plant overhead.

9. SUB-CONTRACTING SERVICE COSTS

All Sub-Contracting Costs can be classified into two types outlined below.

CLASSIFICATION OF SUB-CONTRACTING SERVICE COSTS

1.

Direct Sub-Contracting Service Costs.
Direct sub-contracting service costs are the costs of all direct sub-contracted services purchased from other companies. These services are used in the manufacturing process, become part of the finished goods, and can be directly traced and allocated to specific products. For example, a steel products manufacturer may sub-contract the metal plating process.

2.

Indirect Sub-Contracting Service Costs.
Indirect sub-contracting service costs are the costs of all indirect sub-contracting services purchased from other companies. These services cannot be directly traced to a specific product, e.g. equipment insurance or plant repair by an outside company. These costs become part of plant overhead.

10. PLANT OVERHEAD AND OPERATING EXPENSES

All Plant Overhead Costs and Operating Expenses are outlined below.

PLANT OVERHEAD COSTS AND OPERATING EXPENSES

1.

Plant Overhead Costs.
Plant overhead costs, also known as Factory Burden, include all manufacturing expenses that cannot be directly traced to finished products. These include the cost of indirect materials, indirect labor and supervision, and indirect sub-contracting costs. Plant overhead costs also include depreciation, property taxes, and rental expense of production equipment, rent, and utilities.

2.

Operating Expenses.
Operating expenses also cannot be directly traced to finished products. These include all administrative, general, and selling expenses incurred by the manufacturing company.

11. COST OF GOODS MANUFACTURED AND COST OF GOODS SOLD

The Cost Of Goods Manufactured and Cost Of Goods Sold are outlined below.

COST OF GOODS MANUFACTURED AND COST OF GOODS SOLD

1.

Cost Of Goods Manufactured.
Cost of goods manufactured is the sum of direct manufacturing costs and plant overhead, adjusted by the net change in work-in-process inventory at the start and at the end of a specific accounting period.

2.

Cost Of Goods Sold.
Cost of goods sold includes the cost of goods manufactured adjusted by the net change in finished goods inventory at the start and at the end of a specific accounting period.

12. TWO BASIC COST ACCOUNTING METHODS

COST ACCOUNTING SYSTEM

Once all operating costs of the company's activities are identified, a suitable Cost Accounting System needs to be developed. Development of a sound cost accounting system aims at recovering all operating costs incurred by the company. 

The costing of services and products in non-manufacturing companies is relatively simple since all costs can be easily determined. Unfortunately, this is not the case in manufacturing companies, where different production processes may be employed, i.e. job shop production, batch production, or flow production.

Cost Accountants generally use one of the two basic cost accounting methods illustrated below.

TWO BASIC COST ACCOUNTING METHODS

 
Job Order Costing   Process Costing

This method is used to determine cost of Custom Service rendered by service companies in which each customer order represents a separate task. Job order costing is also used by Wholesalers and Retailers to determine the ultimate cost of merchandise supplied to customers. Finally, job order costing is used to determine the cost of products manufactured in a Job Shop or Batch Production environments.


 

This method is used to determine cost of Standard Services rendered by service companies to customers on a continuous flow basis. Process costing is also used to determine cost of products manufactured in a Flow Production environment.

The application of two basic Cost Accounting Methods in three main types of companies is illustrated below.

APPLICATION OF BASIC COST ACCOUNTING METHODS
IN VARIOUS TYPES OF COMPANIES

 
Job Order Costing   Process Costing

Products and services are produced or supplied to special orders or in batches.


 

Products and services are produced on a continuous "flow" basis.

 
Service Company   Service Company

Custom service is rendered to a special customer order on a non-repetitive basis.


 

Standard service is rendered to several customers on a continuous "flow" basis.

 
Merchandising Company   Merchandising Company

Products are supplied on a wholesale or retail basis.


 

Not applicable.

 
Manufacturing Company   Merchandising Company

Products are manufactured in a job shop or batch production environments.


 

Products are manufactured in
a flow production environment.

ADDITIONAL INFORMATION ONLINE - JOB ORDER COSTING

Please watch these excellent videos professionally narrated and produced by Susan Crosson and SFCC:

Job Order Costing 1 - Job & Process By Susan Crosson.
Job Order Costing 2 - Cost Flows By T A/c By Susan Crosson.
Job Order Costing 3 - Job Order Costing Card By Susan Crosson.
Job Order Costing 4 - P6 Sept 1-4 By Susan Crosson.
Job Order Costing 5 - P6 Sept 8-10 By Susan Crosson.
Job Order Costing 6 - P6 Sept 15 By Susan Crosson.
Job Order Costing 7 - P6 Sept 22-27 By Susan Crosson.
Job Order Costing 8 - P6 Sept 30A By Susan Crosson.
Job Order Costing 9 - P6 Sept 30B By Susan Crosson.
Job Order Costing 10 - P6 Sept 30C By Susan Crosson.
Job Order Costing 11 - P6 Close OH By Susan Crosson.

© 2008 - 2013 Susan Crosson and CFCC. All rights reserved.

 

ADDITIONAL INFORMATION ONLINE - PROCESS COSTING

Please watch these excellent videos professionally narrated and produced by Susan Crosson and SFCC:

Process Costing 1 - Cost Flows By Susan Crosson.
Process Costing 2 - Work In Process By Susan Crosson.
Process Costing 3 - Problem 2 Facts By Susan Crosson.
Process Costing 4 - P2 FIFO 1 And 2 By Susan Crosson.
Process Costing 5 - P2 FIFO 3 And 4 By Susan Crosson.
Process Costing 6 - P2 FIFO 5 And Recap By Susan Crosson.
Process Costing 7 - P2 Average 1 And 2 By Susan Crosson.
Process Costing 8 - P2 Average 3 And 4 By Susan Crosson.
Process Costing 9 - P2 Average 5 And Recap By Susan Crosson.

© 2008 - 2013 Susan Crosson and CFCC. All rights reserved.

13. TWO ESSENTIAL TASKS OF COST ACCOUNTING

THE BASIC COST ACCOUNTING PROBLEM

Irrespective of the type of Costing Method used, its purpose is to ensure accurate recording and recovery of all operating expenses incurred by the company.

One of the basic problems of Cost Accounting is that the cost of products and services needs to be established immediately, while many operating expenses related to manufacture or supply of final products or rendering of services will occur in the future. For this reason it is important to implement two essential tasks of cost accounting outlined below.

TWO ESSENTIAL TASKS OF COST ACCOUNTING

1.

The cost accounting system must be set and reviewed on a periodic basis (annually, semi-annually, or quarterly) with an objective of recovering all budgeted annual company expenses.

2.

It is essential to monitor the company's performance on a monthly basis and adjust overhead recovery rates whenever necessary to ensure that annual budgeted expenses are fully recovered to avoid potential loss.

Cost accounting tasks can be completed manually or by using a specific accounting software program.

POPULAR ACCOUNTING SOFTWARE PROGRAMS
There are several excellent Accounting Software Programs available to small business owners at present. Some of the most popular accounting software packages are presented below:

Sage One

QuickBooks Intuit

FreshBooks

Harvest Software Systems

NetSuite

Various accounting software programs may include additional functions, depending on each specific package. This is discussed in detail in Integrated Financial Management in Tutorial 3.
Note:
Please consult with your accountant or CPA regarding the determination of correct overhead recovery rates in your company.

14. OVERHEAD RECOVERY RATES

OVERHEAD RECOVERY RATES

In order to ensure effective recovery of all budgeted operating costs, accurate Overhead Recovery Rates need to be determined in advance. An overhead recovery rate, or Overhead Rate, is applied to a specific direct cost in order to determine the ultimate total cost of product or service. 

Overhead rates can be expressed in different terms, depending upon the nature of company activities and types of products or services supplied to customers. Typical examples of overhead rates are illustrated below.

EXAMPLES OF OVERHEAD RECOVERY RATES

In A Custom Service Company Or A Standard Service Company:

  • Value Per Service Time (Dollars/Hour)
  • Value Per Service Operation (Dollars/Operation)

In A Wholesale Merchandising Company Or A Retail Merchandising Company:

  • Value Per Unit Cost Of A Product (Dollars/Product)
  • Cost Markup Percentage (%)

In A Manufacturing Company (Job Shop, Batch, And Flow Production):

  • Value Per Man-Hour (Dollars/Labor-Hour)
  • Value Per Machine-Hour (Dollars/Machine-Hour)
  • Value Per Plant-Hour (Dollars/Plant-Hour)

ADDITIONAL INFORMATION ONLINE

Overhead Recovery Analysis By John Duffield.
Under/Over Allocation Of Overhead By Ken Boyd.
Calculating Predetermined Overhead Rate By Dantehokie.
Multiple Overhead Rate Recovery Rates By Lawn Care Millionaire.
Allocating Overhead Using A Predetermined O/H Rate By Kristin Ingram.

15. THE PROCESS OF SETTING OVERHEAD RATES

SETTING OVERHEAD RATES

The general process of Setting Overhead Rates for service, merchandising, and manufacturing companies entails the following three steps outlined below.

THE PROCESS OF SETTING OVERHEAD RATES

 Step 1: Estimate The Total Company's Output.

Estimate the total output of the company, or per department, or per section, for the budgeted period. The total output must be expressed in units of the selected activity, e.g. labor-hour, machine-hour, plant-hour, number of operations, types of operations, or quantity of finished goods.

 Step 2: Estimate The Total Company's Cost.

Examine the budgeted income statement and determine the total estimated costs for the budgeted period, including interest and income taxes expenses.

 Step 3: Divide The Total Company's Cost By The Total Company's Output.

Divide the total estimated cost by the total estimated output expressed in units of the selected activity for the budgeted period.

 

Determination of overhead rates for service, merchandising and manufacturing companies is illustrated below.

ADDITIONAL INFORMATION ONLINE

Please watch these excellent videos professionally narrated and produced by Susan Crosson and SFCC:

Accounting Basics 1 - Where Did Accounting Come From By Susan Crosson.
Accounting Basics 2 - Accounting Equation By Susan Crosson.
Accounting Basics 3 - Assets By Susan Crosson.
Accounting Basics 4 - Liabilities By Susan Crosson.
Accounting Basics 5 - Stockholders Equity By Susan Crosson.
Accounting Basics 6 - Expanded Accounting Equation By Susan Crosson.
Accounting Basics 7 - Financial Statements By Susan Crosson.

© 2008 - 2013 Susan Crosson and CFCC. All rights reserved.

16. SMALL BUSINESS EXAMPLE
OVERHEAD RATE FOR A CUSTOM SERVICE COMPANY

OVERHEAD RATE FOR A CUSTOM SERVICE COMPANY

First, consider ABC Service Company, which provides a consulting service to clients, i.e. custom service. Assume that the company employs 2 senior consultants and 2 junior ones. Each consultant renders a professional service to customers on a regular basis and his or her work is charged on an hourly basis. 

Total estimated time per consultant during the budgeted period can be determined as follows:

Total Estimated Time (Hours Per Year) = H x W x C

Where:

  • H = Estimated average number of regular working hours during one week, e.g. 40 hours.
  • W = Estimated average number of working weeks during one year, e.g. 48 weeks.
  • C = Estimated average level of capacity utilization during one year, e.g. 70 %.

Hence, the total estimated time per consultant during one year:

40 hours/week  x  48 weeks/year  x  0.7 = 1,344 hours per year.

Total estimated cost of ABC Service Company, including interest and income taxes expenses, can be determined from the company's budgeted income statement. From the previous example in the Budgeted Income Statement For ABC Service Company, it follows that the total estimated cost for the budgeted period, including interest and income taxes expenses, is $252,000. Note that profit has been omitted since it does not affect cost but will be added when it comes to pricing.

If an hourly rate chargeable for a senior consultant is 1.5 times higher than the hourly rate chargeable for the junior one, then the cost to be recovered can be determined as follows:

  • Total Number Of Unit Service Hours Per Year = 
       (2 x1.5 + 2) x 1,344 = 6,720 hours per year

  • Cost Of A Unit Service Hour = $252,000 per year  = $38/hr
                                                             6,720 hours per year

  • Hourly Cost Per Junior Consultant = $38/hr

  • Hourly Cost Per Senior Consultant = 1.5 x $38/hr = $57/hr

Note:

The above hourly rates are designed to recover all company's budgeted operating costs, based on the current number of consultants, estimated average number of regular working hours during one week (H), estimated average number of working weeks during one year (W), and estimated average level of capacity utilization during one year (C).

It is essential that business owners and financial managers continuously monitor the company's actual performance to ensure that these budget assumptions are in line with corresponding budget estimates. If there is a variation between the actual and budgeted values, it is essential to adjust the hourly rates accordingly to ensure that the company's operating costs are recovered and to avoid potential losses during the budgeted fiscal period.

17. SMALL BUSINESS EXAMPLE
OVERHEAD RATE FOR A STANDARD SERVICE COMPANY

OVERHEAD RATE FOR A STANDARD SERVICE COMPANY

If ABC Service Company provides a standard service to customers on a continuous flow basis, the total service cost can be determined in a similar manner. 

Assuming that the company renders such a service for 40 hours per week during 48 weeks in a year at a 70% capacity utilization, the total cost to be recovered on a daily basis is as follows:

Total Service  = Total Estimated Budgeted Cost Per Year
Cost Per Hour    Total Estimated Service Hours Per Year


Total Estimated Service  =  $252,000     = $188/hr
Cost Per Hour                      40 x 48 x 0.7
.

18. SMALL BUSINESS EXAMPLE
OVERHEAD RATE FOR A WHOLESALER OR RETAILER

OVERHEAD RATE FOR A WHOLESALER OR RETAILER

Determination of costs in a wholesale or retail merchandising company can also be carried out in a relatively simple manner. Consider, for example, ABC Merchandising Company, which sells a particular range of merchandise to customers on a wholesale or retail basis.
 
From the previous example in the Budgeted Income Statement For ABC Merchandising Company, it follows that the total estimated Cost Of Goods Sold (COGS) during the budgeted period is $708,000 and the Total Merchandising Overhead, i.e. total operating expenses, interest, and income taxes expenses, is:

$160,800 + $12,000 + $110,400 = $283,200 per year

The cost markup percentage required to recover the merchandising overhead can be determined as follows:
                                      

Cost Markup = (Cost Of Goods Sold + Merchandising Overhead) x 100%
 Percentage                                   Cost Of Goods Sold



 Cost Markup  = ($708,000 + $283,200) x 100% = 140%
 Percentage                         $708,000


The Cost Markup Percentage signifies that the actual cost of merchandise, i.e. 100%, must be increased by 40% to recover the merchandising overhead.

Hence, the ultimate cost of merchandise should include the total cost of doing business and not just the actual cost of merchandise. For example, if an item costs $100, its real cost to the merchandising company should be increased by 40%, or $40, thereby reaching $140.

19. OVERHEAD RATES IN A MANUFACTURING COMPANY

OVERHEAD RATES IN A MANUFACTURING COMPANY

Costing of products in a Manufacturing Company represents a more complicated task in comparison with service or merchandising companies. The costing process is based on standard overhead rates, which must be determined in advance.
 
Determination of Standard Overhead Rates in a manufacturing company is based on the Manufacturing Cost Recovery Method, developed by the author of this program and it is described next. Although this method may seem to be complicated at first, you will find it quite simple to use from the example below.

Taking into consideration that a universal method for proper determination of cost recovery rates in a manufacturing environment does not exist, this method may serve as a good beginning.

Note:

You must exercise accounting prudence when using the Manufacturing Cost Recovery Method in your specific manufacturing environment and consult with your accountant or CPA to ensure correct determination of overhead recovery rates to avoid potential losses. Please keep in mind that full responsibility for determining correct cost recovery rates rests with you and your financial management team.

20. THE MANUFACTURING COST RECOVERY METHOD

THE MANUFACTURING COST RECOVERY METHOD

The Manufacturing Costing Recovery Method for determining standard overhead rates in a manufacturing company entails the following seven steps outlined below.

STEPS IN THE MANUFACTURING COST RECOVERY METHOD

 Step 1: Summarize All Estimated Manufacturing Expenses.

Examine the Production Budget (Budgeted Statement of Cost of Goods Manufactured) and summarize all estimated expenses for each work center (section or shop), excluding the cost of direct materials used and direct sub-contracting costs.

 Step 2: Classify Budgeted Expenses And Determine Costs Per Work-Center.

Classify budgeted expenses for each work center and determine total costs.

 
2.1: Direct Manufacturing Cost (DMC).   2.2: Indirect Manufacturing Cost (IMC).

This cost relates to each DMC-Type Work Center for which an hourly rate chargeable to customers can be established and easily allocated, e.g. machine shop, welding shop.


 

This cost relates to each Work Center for which an hourly rate chargeable to customers cannot be established and easily allocated, e.g. drafting office, production administration and planning, cost estimating, assembly, quality control, maintenance, inventory control, and dispatch.

 

 Step 3: Determine The Total Indirect Cost (TIC).

Examine the Budgeted Income Statement and determine the Total Indirect Cost (TIC). This cost includes cost of goods sold, total operating expenses, interest, and income taxes expense, less cost of direct materials used, direct sub-contracting service costs, and Total DMC.

 Step 4: Determine The Total Budgeted Cost (TBC), Where: TBC = DMC + TIC.

Determine the Total Budgeted Cost (TBC) to be recovered by the company. TBC is the sum of DMC and TIC.

 
4.1   4.2

Enter the individual values of DMC per each DMC-Type Work Center, as specified in Step 2 above, and compute individual percentages of such costs in relation to the total value of same.


 

Enter the value of TIC, as specified in Step 3 above, and compute individual portions of TIC to be recovered by each DMC-Type Work Center. The individual portions of TIC are determined by applying percentages specified in Step 4.1 to the value of TIC.

 

 Step 5: Select A Cost Recovery Method (1, 2 or 3).

Select a suitable Cost Recovery Method (1, 2, or 3) for each DMC-Type Work Center as follows:

   
5.1 Method 1   5.2 Method 2   5.3 Method 3

All costs are recovered solely through Machine-Hour Rates. This is applicable to batch and flow production processes and highly priced items of machinery or plant.


 

All costs are recovered solely through Labor-Hour Rates. This is applicable to job shop and batch production processes for which the labor input can be easily measured and directly allocated to a particular job.


 

All costs are recovered through Machine-Hour or Labor-Hour Rates, i.e. combination of Method 1 and Method 2.


   

 Step 6: Summarize Estimated Cost Recovery Factors.

Summarize estimated cost recovery factors for each DMC-Type Work Center based on your company's annual budget as follows:

H

Estimated average number of regular working hours per shift during 1 week (normally 40 hours).

S

Estimated average number of working shifts during 1 week (1 to 3 shifts).

W

Estimated average number of working weeks during 1 year (48 to 52 weeks).

U

Estimated required level of plant utilization during 1 year (60% -80%).

P

Estimated required level of labor productivity during 1 year (60% -80%).

N

Number of machines or machine operators (whose time is charged to various tasks - this number varies from one company to another).

 Step 7: Determine Standard Overhead Rates.

Determine standard overhead rates for each DMC-Type Work Center in accordance with the selected Cost Recovery Method (1, 2, or 3), as follows:

Standard Overhead Rate Per Machine-Hour

=

Total Budgeted Cost (TBC) Per Year 
Total Estimated Machine-Hours Per Year

Standard Overhead Rate Per Machine-Hour

=

       TBC                
 H x S x W x U x N

Standard Overhead Rate  Per Labor-Hour

=

Total Budgeted Cost (TBC) Per Year
Total Estimated Labor-Hours Per Year

Standard Overhead Rate Per Labor-Hour

=

       TBC                
 H x S x W x P x N

Note:

The above method is designed to provide an overall guideline only. You must exercise accounting prudence when using the Manufacturing Cost Recovery Method in your specific manufacturing environment and consult with your accountant or CPA to ensure correct determination of overhead recovery rates to avoid potential losses. Please keep in mind that full responsibility for determining correct cost recovery rates rests with you and your financial management team.

 

ADDITIONAL INFORMATION ONLINE

Please watch these excellent videos professionally narrated and produced by Susan Crosson and SFCC:

Cost Concepts 1 - Terms By Susan Crosson.
Cost Concepts 2 - Income Statements By Susan Crosson.
Cost Concepts 3 - Manufacturing Income Statement By Susan Crosson.
Cost Concepts 4 - Three Manufacturing Inventories By Susan Crosson.
Cost Concepts 5 - WIP & OH By Susan Crosson.
Cost Concepts 6 - OH 3 Approaches By Susan Crosson.
Cost Concepts 7 - OH 4 Steps To Success By Susan Crosson.
Cost Concepts 8 - OH Traditional & ABC By Susan Crosson.

© 2008 - 2013 Susan Crosson and CFCC. All rights reserved.

21. SMALL BUSINESS EXAMPLE
OVERHEAD RATE FOR A MANUFACTURING COMPANY

OVERHEAD RATE FOR A MANUFACTURING COMPANY

Consider ABC Manufacturing Company, which is involved in the design, manufacture, assembly, and supply of specific products. Assume that the company has 15 employees in the following departments:

1. Administration, accounting, marketing, and sales - 5 people.
2. Production:

  • Drafting office - 1 draftsman-designer.
  • Machine shop - 3 machine operators.
  • Welding shop - 2 welders.
  • Assembly shop -2 assembly workers.
  • Production administration and maintenance -2 people.

Determination of Standard Overhead Rates in a Manufacturing Company entails seven steps, as illustrated below. These steps incorporate information specified in the Production Budget and Budgeted Income Statement For ABC Manufacturing Company. As a result of these calculations, the standard overhead rates for ABC Manufacturing Company are determined as follows (Refer to the calculation of standard overhead rates which follows next):

• Machine Shop - $87 per machine-hour.
• Welding Shop - $68 per labor-hour.
 

22. SMALL BUSINESS EXAMPLE
CALCULATION OF STANDARD OVERHEAD
RATES

CALCULATION OF STANDARD OVERHEAD RATES

23. BASIC COSTING METHODS FOR A MANUFACTURING COMPANY

TWO BASIC COSTING METHODS

Once standard overhead rates are determined, the actual costing process in a manufacturing company may begin. As mentioned earlier, there are Two Basic Costing Methods frequently used as illustrated below.

BASIC COSTING METHODS FOR A MANUFACTURING COMPANY

 
The Job Order Costing   The Process Costing

This method is used in a job shop or batch production environment.


 

This method is used in a flow production environment.

Although both methods differ in their application, they are based on similar information. Three Basic Cost elements need to be established for costing of products in a manufacturing environment as outlined below.

BASIC COSTS IN A MANUFACTURING COMPANY

1.

Cost Of Direct Materials Used.
This is the total cost of all direct materials and work-in-process used during a specific manufacturing process.

2.

Cost Of Direct Labor Or Machine Time Used.
This is the total cost of all labor-hours or machine-hours used during a specific manufacturing process.

3.

Cost Of Direct Sub-Contracting Service Used.
This is the total cost of all sub-contracting services used during a specific manufacturing process.

24. JOB AND WORK COST REPORTS

All manufacturing costs must be entered into one of the two types of Reports as illustrated below.

TWO TYPES OF COST REPORTS IN A MANUFACTURING COMPANY

 
Job Cost Report   Work Cost Report

A Job Cost Report is used in a job shop or batch production environments.


 

A Work Cost Report is used in a flow production environment.

 

A typical Job Cost Report is illustrated below.

25. SMALL BUSINESS EXAMPLE
JOB COST REPORT

JOB COST REPORT

26. PRODUCTION TIMECARDS

PRODUCTION TIMECARDS

All information related to the cost of direct materials, work-in-process, and sub-contracting services used in a particular manufacturing processes is obtained from relevant Requisition Notes

The labor- or machine-time spent on a particular job is obtained from Production Timecards, which should be completed by employees on a daily basis.

These time cards are used only in DMC-Type Work Centers, where the direct labor and machine-time input are measured and allocated to specific jobs. A typical Production Timecard is illustrated below.

27. SMALL BUSINESS EXAMPLE
PRODUCTION TIMECARD

PRODUCTION TIMECARD

ABC Manufacturing Company, Inc.

Work Center: Machine Shop

1st Shift

Job No.

2nd Shift

Job No.

3rd Shift

Job No.

 8:00 – 9:00

123

16:00-17:00

 

16:00-17:00

 

9:00–10:00

123

17:00-18:00

 

17:00-18:00

 

10:00-11:00

123

18:00-19:00

 

18:00-19:00

 

11:00–12:00

123

19:00-20:00

 

19:00-20:00

 

12:00-13:00

 

20:00-21:00

 

20:00-21:00

 

13:00-14:00

123

21:00-22:00

 

21:00-22:00

 

14:00-15:00

345

22:00-23:00

 

22:00-23:00

 

15:00-16:00

345

23:00-24:00

 

23:00-24:00

 

28. COST PER PRODUCT UNIT

COST PER PRODUCT UNIT

The basic procedures related to the Process Costing Method are very similar to the Job Order Costing Method. 

One of the major differences between these costing methods is that, in process costing, all costs are collected on a time basis, e.g. once a week or once a month, using similar sources of information. Once all costs are summarized, the Total Manufacturing Cost is divided into the total number of standard units produced to determine the cost per product unit:
          
Cost Per            Total Manufacturing Cost During The Period               
Product Unit = Total Number Of Units Produced During The Period
           

Once the costs of products or services are determined, the financial manager may initiate accurate Pricing Procedures. These procedures are based on standard Pricing Methods which are discussed in detail in Tutorial 2.

Note:

All information related to cost accounting is designed to provide overall guidelines only. You must exercise accounting prudence and consult with your accountant or CPA to ensure the accurate determination of all cost accounting elements in your company to avoid potential losses. Please keep in mind that full responsibility for determining correct cost recovery rates rests with you and your financial management team.

29. COST-VOLUME-PROFIT AND BREAK-EVEN ANALYSIS

COST-VOLUME-PROFIT AND BREAK-EVEN ANALYSIS

An additional way to evaluate a company’s performance and profitability is to conduct Cost-Volume-Profit Analysis. Some of the basic questions, which should be asked at this stage are as follows:

1. What is the actual unit cost of a specific product or service provided by our company?
2. How many units of this specific product or service do we need to sell to break even?
3. How many units of this specific product or service do we need to sell to make 10-20-30-40-     50 percent profit?

These questions lead directly into Break-Even Analysis, which represents a useful management evaluation tool and it entails consideration of several financial variables, as outlined below. The break-even analysis can be also presented in a visual manner by using a Break-Even Chart illustrated below.

DEFINITIONS USED IN BREAK-EVEN ANALYSIS

• Fixed Cost.

The sum of all costs required to produce the first unit of a product. This amount does not vary as production increases or decreases, until additional capital expenditures are needed.

• Variable Unit Cost.

Costs which vary directly with the production of each additional unit.

• Expected Unit Sales.

Number of units of the product projected to be sold over a specific period of time.

• Unit Sales Price.

The amount of money charged to the customer for each unit of a product or service.

• Total Variable Cost = Expected Unit Sales x Variable Unit Cost.

The product of expected unit sales and variable unit cost.

• Total Cost = Fixed Cost + Total Variable Cost.

The sum of the fixed cost and total variable cost for any given level of production.

• Total Revenue = Expected Unit Sales x  Unit Sales Price.

The product of expected unit sales and unit price.

• Profit Or Loss = Total Revenue - Total Costs.

The monetary gain or loss resulting from revenues after subtracting all associated costs.

• Break Even = Fixed Cost / (Unit Sales Price - Variable Unit Cost).

Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs).

  BREAK-EVEN CHART


ADDITIONAL INFORMATION ONLINE

Please watch these excellent videos professionally narrated and produced by Susan Crosson and SFCC:

Cost Behavior 1 - Overview By Susan Crosson.
Cost Behavior 2 - Cost Behavior Types By Susan Crosson.
Cost Behavior 3 - Estimating Costs By Susan Crosson.
Cost Behavior 4 - High Low Example E4 By Susan Crosson.
Cost Behavior 5 - High Low Example P5 By Susan Crosson.
Cost Behavior 6 - CVP Income Statement By Susan Crosson.
Cost Behavior 7 - CVP Example E8 By Susan Crosson.
Cost Behavior 8 - Sales Mix Example E10 By Susan Crosson.

© 2008 - 2013 Susan Crosson and CFCC. All rights reserved.

30. SMALL BUSINESS EXAMPLE
BREAK-EVEN ANALYSIS

  BREAK-EVEN ANALYSIS

Management in the ABC Manufacturing Company wants to conduct a Cost-Volume-Profit Analysis to determine financial viability of a new production line for Product A.

Assume the following information from the financial statements for ABC Company. 

Description

Value

1.

Total Fixed Costs Per Year

$100,000

2.

Variable Unit Cost Per Product “A”

$1

3.

Sales Price Per Unit Product “A”

$3

4.

Contribution Margin/Unit = Product “A” Contribution To Cover Fixed Costs

$3 - $1 = $2

The Break-Even Point can be determined by using the following formulas:

Contribution Margin/Unit = Sales Price/Unit — Variable Costs/Unit

Contribution Margin Ratio = Contribution Margin/Unit 
                                                       Sales Price/Unit              


Break-Even Sales Volume =               Fixed Costs          
                                                     Contribution Margin Ratio     


In this example the break-even point is determined as follows:

Contribution Margin/Unit = $3 - $1 = $2



Number Of Product A Units Required = $100,000 = 50,000 units
To Cover Total Fixed Costs                           $2


If actual sales will exceed 50,000 units of Product A, then ABC Company will earn a profit and conversely if the company’s actual sales will be below the 50,000 units of Product A, than the company will produce a loss.

For example, if the actual sales will be 10 percent above the break-even sales volume, then  the company will sell an additional 5,000 units and make an additional profit of 5,000 units x $2 = $10,000.

If, conversely, the sales are 10 percent below the break-even volume, then the company will sell only 45,000 units and this will cause a loss of 5,000 units x $2 = $10,000.

ADDITIONAL INFORMATION ONLINE

Break-Even Analysis By Claudia Green.
Break-Even Analysis By Brian R. Lazarus.
Break-Even Analysis By PlumStreetMusic.
Break-Even Analysis And Profit Contribution By Ian Johnson.
Break-Even Analysis By Matt Alanis, Alanis Business Academy.

31. FOR SERIOUS BUSINESS OWNERS ONLY

ARE YOU SERIOUS ABOUT YOUR BUSINESS TODAY?

Reprinted with permission.

32. THE LATEST INFORMATION ONLINE

 

LESSON FOR TODAY:
The Cost Of Anything Is What You Are Prepared To Do To Obtain It!

Steven Redhead, Writer

Go To The Next Open Check Point In This Promotion Program Online.