FIA MA1 2019 - OpenTuition...FIA MA1 Management Information 1. Nature of business organisation and accounting systems 3 2. Management Information 13 3. Source Documents 19 4. Coding

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FIA MA1 Management Information

1. Nature of business organisation and accounting systems 3

2. Management Information 13

3. Source Documents 19

4. Coding Systems 25

5. Cost Classification 31

6. Cost Units, Cost Centres, Profit Centres and Investment Centres 41

7. Accounting for Materials Costs 49

8. Labour Costs and Remuneration Methods 55

9. Accounting for other expenses 61

10. Accounting for product costs 67

11. Spreadsheets 75

12. Presenting information in spreadsheets 85

Answers to Examples 91

Answers to Tests 99

FIA MA1 Management Information (2019 Exams) 1


Chapter 1NATURE OF BUSINESS ORGANISATION AND ACCOUNTING SYSTEMS

1. Introduction

This chapter gives a brief introduction to organisations, double entry bookkeeping, and manual and computer-based accounting systems.

2. The organisation, and the main functions of an office as a centre for information and administration.

An organisation can be defined as:

A social arrangement which pursues collective goals, which controls its own performance and which has a boundary separating it from its environment.

Organisations can include businesses such as companies and partnerships, clubs, charities, government departments, hospitals and schools.

Most organisations have some sort of internal structure. For example, a manufacturing business will have a factory where goods are made, a warehouse where they are stored and offices where information is stored and administration carried out. Each of these can then often be subdivided. For example, a factory might be subdivided into component production, assembly and finishing departments.

An office typically has departments for the following:

๏ Finance and accounting๏ Purchasing goods and materials๏ Sales and marketing๏ Wages and salaries๏ Information technology๏ Human resources managementThese departments allow administration tasks to be carried out (such as ensuring orders are placed for materials, that customers are billed for their purchases and that employees are paid their wages and salaries).



They also hold the information that is essential for running a business such as: which customers owe us money, how many items we have in inventory, who our best customers are, what our most profitable sales are and so on.

Typically the departments are shown on organisation charts.

2.1. Functional organisation

Finance director

Chief executive officer

Sales director IT director Production director

Financialaccountant

Management accountant

In the diagram above the departments are arranged by function.

2.2. Divisional organisation

Division A

Main board

Division B

Sales Finance etc Sales Finance etc

Divisions are often determined by geographical area (for example, a European Division and an Asian Division) or by product (for example, a Car Division and a Truck Division).

The divisional arrangement can allow each division to specialise.

As you go down an organisation chart, there is usually less power and authority at each level. Therefore, there is a hierarchy of superiors and subordinates and this allows organisations to be coordinated so that their collective goals can be achieved. It also allows responsibility and decision-making to be spread down the organisation. This is known as decentralisation and it leaves senior managers time to concentrate on the most important decisions whilst more junior staff will have responsibility for less important matters. Decentralising or delegating responsibility to junior staff members can be very motivating for them and also allows specialist decisions to be made by appropriate experts. However, there is always a danger that decentralisation results in poor coordination between departments and decisions have to be monitored carefully.



3. The function and use of a manual of policies, procedures and best practices.

It is normal for organisations to develop and document a set of policies, procedures and best practice. These perform the following important functions:

๏ Guidance for employees eg on holiday entitlements๏ Training and instruction eg on how to request replacement of a piece of equipment๏ Uniformity of approach eg that all employees are subject to the same discipline๏ Meeting legal requirements eg health and safety rules๏ Maintenance of operating standards eg on how to follow up customer complaints๏ Maintenance of efficiency eg how to process an application๏ Maintenance of security eg how to use computer passwords and back-up procedures.

4. The main types of transactions undertaken by a business and the key personnel involved in initiating, processing and completing transactions.

The main transactions undertaken by a business and the key personnel are as follows:

Purchase of raw materials: this will usually be initiated by someone in the warehouse or factory who can see that more materials will soon be needed. Often this person raises a purchase requisition which goes the buyers’ department. Buyers will then order from the most suitable supplier. Goods will be received in the warehouse and these must be checked back to the order to ensure that the correct goods are being received. Invoices from suppliers will be received and processed by the accounting department.

Sales: in a retail organisation sales will be initiated by customers either in a shop or through the internet. Payment will usually take place immediately. In businesses selling to other businesses, the sales representatives (sales men and sales women) will be responsible for encouraging customers to place orders. Once received, orders should result in goods being despatched from the warehouse and invoices being created and sent to the customers by the accounting department. The accounting department will also record what each customer owes. Once payment is made, this will be recorded by the accounting department. If payment seems slow then the credit control department might contact the customer in the hope of speeding up payment.



Paying employees: large organisations will have a wages and salaries department which is responsible for calculating amounts owing, and dealing with employees who leave and with new joiners. The amounts to be paid will usually be passed to the accounting department which will look after the cash transfers to employees.

Paying other expenses: often, these will be recurring items such as rent, electricity, telephone and insurance. Sometimes they will be once-off like paying for an advertisement in a newspaper or for the repair of a piece of equipment. The invoices will be processed by the accounting department who will make sure that the expenses look reasonable compared to previous amounts or who will ensure that the services have been properly ordered and received.

Purchase of non-current assets: The purchase of these assets will often begin with an employee raising a purchase requisition, for example for a new printer, which is then authorised by a manager or by the company accountant. When the invoice is received, someone needs to ensure that the asset has been received and that it is working properly.

5. The need for effective control over transactionsIn large organisations, which typically can have thousands of transactions, it is very easy for

๏ errors to be made๏ unauthorised transactions to take place๏ fraud to be carried outGood control of all transactions is therefore necessary. ‘Internal control’ is the name given to the system used to control transactions. All transactions should be:

๏ authorised๏ completely recorded๏ accurately recordedAn important part of internal control is known as the segregation of duties. This means that transactions are broken down into different stages with a different person being responsible for each stage. So in a purchase transaction, one person should order the goods, another receive and check them, and a third person should pay for them. Because several people are involved in the transaction it will be more difficult for unauthorised transactions to slip through; also each person, to some extent, checks up on what the previous one has done. For a fraudulent transaction to be processed would probably require collusion (co-operation) between all the parties, and this can be dangerous for the fraudster to organise.

Other types of controls include: signatures to authorise amounts, control totals to ensure all transactions have been processed and the use of sequential documents to check if any go astray.



Example 1

A company pays its employees a basic wage and often extra amounts for overtime worked. Payments are made and other information is collected on the basis of time-sheets that are completed weekly by each employee.

Describe controls that the company could use to ensure that:(a) All overtime has been properly worked(b) A time sheet is obtained from each employee(c) The total hours on each time sheet have been correctly added up.

6. The principles and practice of double-entry bookkeepingThe basic principle of double entry bookkeeping is that there are always two entries for every transaction. One entry is known as a credit entry and the other a debit entry.

The entries are often displayed in ‘T’ accounts:

Account nameAccount name

Debit (DR) side Credit (CR) side

Means: Means:

Increase in an asset Decrease in an asset

Increase in an expense Decrease in an expense

Decrease in a liability(an amount owed)

Increase in a liability(an amount owed)

Decrease in income Increase in income

Here are some simple, common transactions:

Purchase of office stationery for cash:

Debit Office stationery (increase in an expense)Credit Cash (decrease in an asset)

A cash sale:

Debit Cash (increase in an asset)Credit Sales (increase in income)

A credit sale:

Debit Receivables (increase in an asset)Credit Sales (increase in income)

Payment by a customer of an amount owing:



Debit Cash (increase in an asset)Credit Receivables (decrease in an asset)

Purchase, on credit, of goods for resale:

Debit Purchases (increase in an expense. ‘Purchases’ is the name given to purchases for resale)Credit Payables (increase in a liability)

You should understand that if the double entry as been carried out properly, then the sum of the debit entries should always equal the sum of the credit entries. This should be regularly checked by compiling a trial balance, which is simply all the accounts listed in debit and credit columns and the lists added up. The totals should always agree.

Question 1 What would be the double entry for the payment of wages to employees?

A Dr Employees Cr Wages

B Dr Wages Cr Cash

C Dr Cash Cr Wages

D Dr Cash Cr Employees

Question 2 What would be the double entry for the purchase of a car on credit?

A Dr Garage Cr Cars

B Dr Cars Cr Cash

C Dr Cars Cr Garage

D Dr Garage Cr Cash

Question 3 What would be the double entry for payment of an amount owing to a supplier?

A Dr Purchases Cr Cash

B Dr Supplier Cr Purchases

C Dr Purchases Cr Supplier

D Dr Supplier Cr Cash



7. The use of ledgers and prime entry records in both integrated and interlocking accounting systems

The word ‘ledger’ means a book. In accounting systems there are usually three ledgers:

๏ The general or nominal ledger, which records all the ‘T’ accounts, such as wages, sales, purchases, electricity, travel, advertising, rent, insurance, repairs, receivables, payables and non-current assets. The cash and bank accounts are technically part of this ledger but are usually physically kept in a separate book because cash and bank transactions are so numerous.

๏ The payables ledger (also known as the creditors’ ledger and sometime the purchase ledger). Although the total amount owed to suppliers is recorded in the general ledger, details of exactly what is owed to whom are also recorded here. There is a separate account for each supplier. The sum of the amounts owing in this ledger should agree with the payables balance in the general ledger.

๏ The receivables ledger (also known as the debtors’ ledger and sometimes the sales ledger). Although the total amount owed by customers is recorded in the general ledger, details of exactly what is owed from whom are also recorded here. There is a separate account for each credit customer. The sum of the amounts owing in this ledger should agree with the receivables balance in the general ledger.

A prime entry record (or book of prime entry) is where a transaction is first recorded.

These records consist of:

๏ The cash book: this records amounts paid into and out of the bank account๏ The petty cash book: this records small amounts of cash paid for day to day expenses, such as

buying postage stamps and teas or coffee for the office.

๏ The sales day book: sales invoices issued to credit customers๏ The purchases day book: purchase invoices received from suppliers๏ The journal: where adjustments, such as correcting errors, are first recorded.Some businesses also have sales returns and purchases returns day books.

The books of prime entry serve to ‘capture’ transactions as soon as possible so that they are not subsequently lost or forgotten about.

The cash book and the petty cash book are part of the double entry system and record cash coming in and going out.

The day books and journal are not part of the double entry system, and entries are made from there to the ledgers.



Question 4 What is the name given to the ledger which contains accounts such as rent, electricity, travel, non-current assets etc?

A General or nominal ledger

B Payables ledger

C Receivables ledger

D Purchases day book

In manufacturing businesses two types of information are needed:

Financial accounting information. For example, the amounts paid for purchases and wages. These are the amounts that appear in the financial statements published by businesses every year.

Cost accounting information. For example, how much materials and wages go into each item produced. This information is used internally by the company.

The same transactions may therefore have to be dealt with in two different ways: once for the accounting information and then again for the cost accounting information. There are two approaches to these requirements:

An integrated accounting system. Here, information is recorded once for the two separate purposes. This can save time and effort at the recording stage but might increase effort at the presentation stage.

An interlocking accounting system: Here, separate ledger systems are maintained for the financial information and the costing information. This increases the recording effort but can be more efficient later when presenting information.

8. The functions and benefits of a computerised accounting system

Most accounting information is numerical and, of course, computers excel at dealing with that type of data. Computerised accounting systems should offer the following advantages over manual systems:

๏ faster provision of information๏ provision of information that would not be easily available without a computerised accounting

system

๏ once the system is set up, cheaper information๏ more accurate information because arithmetic and certain other errors will be eliminated.Of course sometimes things go wrong and systems break down or incorrect information is produced. In particular, if incorrect data is entered, incorrect information will be produced (garbage-in, garbage-out, GIGO).



A computerised accounting system can be represented as:

Input ofdata

Processing data Output of information

Computer files

For example:

Input: Orders are input over the internet

Processing: Prices are accessed on a product file and the order value worked out.The customers’ account in the receivables ledger (now held on a computer file) is debited.Inventory records (now on a computer file) are updated.

Output: An invoice is printed for the customer.Despatch information is displayed on a screen in the warehouse to show the goods that have to be sent.

There are several important pieces of terminology that you should know:

File: A group of similar records. So, a receivables ledger file contains records for each customer.

Record: Each record refers to a single entity. So, a customer record will hold all the information about a customer; a product record will hold all the information about a product. Records are collected together into files.

Field: (Also known as an attribute.) Each field holds a separate piece of data relating to a record. Thus a customer record would have fields for: name, address, telephone number, credit limit, invoices outstanding, etc.

Key field: The field that uniquely identifies a record. For example, a part code or an employee number.

Character: Characters make up fields and are typically a – z, 0 – 9. Often a character holds no meaning on its own, but occasionally a character will be the whole field. For example M or F for male or female.

Example 2

Suggest fields (attributes) that might usefully be held in inventory records for a shop



The type of data held can be divided into:

Transaction data: this records information about each transaction and this data changes often as transaction progress and are completed.

Standing or reference data: data that is relatively permanent such as names and addresses, descriptions and prices of products.

In general, there are two types of processing that can be carried out: batch processing and real-time on-line processing.

Batch processing: transactions are accumulated into batches and then all processed together. Because transactions have to be accumulated it means that there is a delay in processing them so the information held in the accounting system is generally out-of-date. For example, if sales transactions were accumulated during the week and processed to the receivables file on the last day of the week, for most of the time the balances shown owing from each customer would be understated. The balances would be correct only just after processing. Batch processing is not so common now.

Real-time, on-line processing: ‘real-time’ means that files are updated as transaction happen; ‘on-line’ means that the files are permanently accessible to be updated. For example, when you withdraw cash from a cash machine, the machine can access your bank account record (it is on-line) to see if you have the funds. When you take the money out your bank account is immediately updated (real-time).

Question 5

Because computers are machines, the information they produce will always be correct.

Is the above statement true or false?

A True

B False

Question 6 Which of the following is true?

A Reference data is fairly static; batch processing means files are always up-to-date.

B Transaction data is fairly static; batch processing means files are usually not up-to-date.

C Reference data is fairly static; on-line, real-time processing means files are always up-to-date.

D Transaction data is fairly dynamic; real-time processing means files are usually out of date.



Chapter 2

MANAGEMENT INFORMATION

1. Introduction

This chapter looks at management information: its purpose, sources, categories, desirable qualities and potential problems. It finishes by considering the role of a trainee accountant in a cost and management accounting system

2. The purpose of management information

Management information is used by managers to

๏ Plan the future of the business. For example, future cash flows and whether borrowing will need to be arranged; whether more employees need to be recruited.

๏ Control the progress of the business. For example whether budgets set in the planning stage will be met.

๏ Decision making. For example, what to produce or which branch to close.Obviously, managers of different departments will usually require different information. However, managers at different levels within a department will also need different information. For example, senior managers will often require more summarised information so as to see ‘the whole picture’, whereas more junior managers often need more details.

3. Cost and management accounting compared with external financial reporting

The main differences are:

Cost and management accounting External financial reporting

Usually produced monthly Produced annually

Reports both historical information (results so far) and future information (budgets for the next periods)

Reports historical information only (typically: statement of financial position, income statement, cash flow statement, notes)

Can be any format management finds useful Format is strictly controlled by law and accounting reporting standards

Does not have to be audited Usually audited (independently checked)

Produced for management Produced for shareholders (or other owners)



4. Data and information

In the previous chapter the following diagram of a computerised accounting system was shown:

Input ofdata

Processing data Output of information

Computer files

Note that a distinction has been made between data and information.

Data is ‘raw fact’; information is data with meaning. For example, a record of the height of everyone living in a certain city would be data (not much use). Once that data is processed and, for example summarised into average heights of men, women etc, then the data becomes more interesting and useful.

Similarly a list of all unpaid invoices is data which only become meaningful, i.e. informative, once sorted by customer to show what each owes and also, perhaps, presented in descending order so that the customers owing most are shown at the top of any list.

Question 1 What are the three purposes, described above, for which managers use management information?

A Estimating, investigating and planning

B Planning, controlling and decision-making

C Controlling, buying and selling

D Accounting, manufacturing and auditing

Question 2 Which of the following is information rather than simply data?

1. A random list of the wages of all employees

2. A list of all stock items that haven’t sold at all in the last three months

3. A report showing where expenses are 10% or more over budget

4. A list of all invoices that have been paid by the company

A 1 and 4 only

B 2, 3 and 4 only

C 2 and 3 only

D All items are information rather than just data



Question 3 Which of the following is characteristic of cost and management accounting rather than external financial reporting?

1. Format and content strictly controlled

2. Backwards looking only

3. Often contains estimates about the future

4. Must be audited

A 1, 2 and 4 only

B 2 and 4 only

C 1, 3 and 4 only

D 3 only

5. The features of useful management information

The features of good management information are often described and remembered using the word ‘ACCURATE’.

Accurate. Certainly accurate enough for managers to use confidently. Some managers need information accurate to the last cent whilst other are happy with accuracy to the nearest $1,000.

Complete. Missing information can be very serious. For example, omitting a cash outflow that will happen next month could be fatal for a business.

Cost-beneficial There is little point having information which costs more to provide than any benefit that arises from it.

User-targeted The information should be what users need. For example, senior managers often have to be planning for the future so need forward-looking information.

Relevant Too much information causes information overload and might mean that important matters are overlooked.

Authoritative What is the information’s source and reliability? Just because you find something by ‘Googling’ the internet does not mean the information is correct.

Timely The information should be received quickly enough to be of use to the decision-maker. Real-time on-line systems can speed up the supply of information.

Easy-to-use The information should be well-set out and described.



6. Sources and categories of informationThe main sources of information are:๏ Internal information๏ External information

Example 1

List examples of internal and external information Internal External

In addition to internal/external, information can be categorised as:๏ Financial/non-financial๏ Quantitative/non-quantitative๏ Historical/future estimates๏ Routine/ad hoc (as and when needed)๏ Numerical/graphical

Example 2

List examples of information from each of the above category pairsFinancial/non-financial ___________________________________________________________

Quantitative/non-quantitative ______________________________________________________

Historical/future estimates ______________________________________________________

Routine/ad-hoc ________________________________________________________________

Numerical/graphical ___________________________________________________________



Example 3

Suggest why the provision of non-financial, non-quantitative information might be important

7. The limitations of cost and management accounting information

The limitations of cost and management accounting information are:๏ Potentially all the matters covered by ACCURATE (Accurate, Complete, Cost-beneficial, User-

targeted, Relevant, Authoritative, Timely, Easy-to-use.) ๏ Difficulty making future estimates.๏ Often quantitative and financial only, but undoubtedly matters such as quality and customer

service levels will be important.

๏ Can be difficult for manager with no financial training to understand.๏ Often too inward-looking. For example, perhaps it does not give information about competitors’

selling prices.

8. The role of a trainee accountant in a cost and management accounting system.

A trainee accountant is likely to have the following roles in a cost and management system:๏ Recording transactions. For example, making posting to the ledgers.๏ Extracting information and presenting it for management use. For example, a comparison of

budget and actual figures for a period.

๏ Investigating financial matters. For example, looking into an overrun in a cost.๏ Helping with budget preparation.๏ Helping and supervising more junior staff.Note that a trainee accountant will generally not be closely involved in decision-making and planning as these functions will normally be carried out by more senior staff.



Chapter 3SOURCE DOCUMENTS

1. Introduction

This chapter looks at how purchases, sales, labour and materials are recorded and controlled.

2. The material control cycleThe material cycle can be depicted as:

Purchase requisition

Order goods

Receive goods

Store raw materials Issue materials to production

Manufacture products

Sell products

At each stage there should be documents or other procedures that allow control to be exercised.

Purchase requisition: there will normally be a purchase requisition note showing:๏ Sequential document number๏ Date of requisition๏ Stock code๏ Quantity needed๏ Supplier๏ Supplier’s product code๏ Signatures authorising the requisitionThe purchase requisition notes are passed to the purchasing department where they will be examined and approved or queried. Sometimes, despite the supplier being entered on the purchase requisition, the purchasing department might ask several suppliers for quotations.



A purchase order is then raised (created). This will typically show:๏ Our name, address and contact details๏ Purchase order number๏ Date๏ Supplier’s name and address๏ Details of goods required: product codes, description, unit price and total price.๏ AuthorisationThe order will have at least two copies: one for the supplier one for the stores to inform them that a delivery is expected.

When goods are received, they will usually be accompanied by a delivery note. This will show the information that is on the purchase order, except for the value of the goods. Goods should not be accepted before checking to a copy of the order that they have, in fact, been ordered. One copy of the delivery note is signed and kept by the supplier. Usually the receiving company will create a standard goods received note from the delivery note. The goods will be stored in the warehouse and stock records on bin cards (see below) will be updated from the goods received note.

A purchase invoice showing the payment due will be received from the supplier, and before this is approved for crediting to the suppliers account and subsequent payment, it should be matched to the order and goods received note to ensure that the correct goods have been received.

When materials are needed for production a materials requisition note should be created requesting the release of material from the stores: part/material code, quantity, job number and so on. This should be signed by the person requesting the goods. Stock records will be updated as goods are issued.

There might be production order setting out goods and labour needed for the production of the goods ordered by customers.

As goods are produced they will be transferred from the production line to the finished goods store. Stock records there should be updated with goods description, quantities and costs.

Customer orders will initiate sales. From those, despatch (or delivery notes) will be produced. These can be used as the basis for taking goods from stores, updating the bin card (see below) packing the goods and despatching them. There will usually be three copies of the delivery note: two go with the goods and of those one stays with the customer and one is signed by the customer and returned as proof of delivery receipt. One copy will stay in the despatch department in case of later queries.

Central to the material control cycle is the recording of the amount of inventory as this will determine when goods need to be ordered and will also record the receipt and issue of goods.



In manual accounting systems bin cards are used (a bin is where a specific item of inventory is stored). The equivalent records are now usually held in computer systems. A typical bin card would look as follows:

Part number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsPart number A 1234 Bin number/location A1284Description 30cm bracketsReceiptsReceiptsReceipts IssuesIssuesIssues BalanceDate Goods

received note number

Quantity Date Requisition number

Quantity

b/f 10015/1/2013 1235 200 300

29/1/2013 1929 140 1603/2/2013 1955 120 20

10/2/2013 1384 500 520

This allows a continuous recording of stock quantities.

A particularly important figure to calculate is free inventory. This is

Free inventory = Quantity on hand plus units ordered less units allocated for use

The calculation of free inventory has the advantage of anticipating stock movements so that receipts and issues that are known about are taken into account when assessing the need to order.

To ensure that the inventory as recorded on the bin cards is accurate, companies should carry out periodic stock counts (sometimes called cycle counts) and correct the amounts on the bin cards. Some companies carry out one only stock count per year.

Question 1 What document shows the amount due to a supplier for goods bought?

A Purchase invoice

B Purchase requisition

C Goods received note

D Purchase order

Question 2 Which of the following sets out the sequence of steps in a purchases transaction

A Purchase order; purchase requisition; goods received note; purchase invoice

B Purchase order; purchase requisition; purchase invoice; goods received note

C Purchase requisition; purchase order; goods received note; purchase invoice

D Purchase requisition; purchase order; purchase invoice; goods received note



Question 3 When goods are needed for production from stores, what document is used?

A Materials requisition note


C Purchase order

D Materials order

Question 4

There are currently 120 units of an item in inventory. There are material requisitions amounting to 40 units that have not yet been acted on and there are 90 units on order.

What is the free inventory?

A 70

B 170

C 120

D 250

Question 5 When goods are received, what is the name given to the document that is raised (created) at that stage.

A Delivery note


C Goods received note

D Purchase invoice

3. The procedures and documentation to ensure the correct authorisation, analysis and recording of direct and indirect material costs

Direct materials are those which can be specifically traced to a unit of production.

Indirect materials cannot be specifically traced to a unit of production. For example, paint being used in the construction of a product will be not be identified as going to a specific product.

Direct materials will be subject to formal requisition requests. Indirect material might simply be made available. For example, it is hardly likely to be cost-beneficial to account for individual screws or the use of drops of adhesive.

The costs of materials can be traced to production: the cost of direct material can be linked to specific items but the cost of indirect materials is likely to be allocated on an average basis.



Question 6 In a factory making chairs, there are four types of material:

1. Wood

2. Glue

3. Polish

4. Fabric for covering the chair

Which would be classified as direct and indirect material?

A Direct: 1 and 2; indirect 3 and 4

B Direct: 1 and 4; indirect 2 and 3

C Direct: 2 and 3; indirect 1 and 4

D Direct: 1 and 3; indirect 2 and 4

4. The procedures and documentation needed to ensure the correct authorisation, coding, analysis and recording of direct and indirect labour and expenses.

Direct labour is labour that can be directly identified with a unit of production. A mechanic repairing a car would be an example of direct labour.

Indirect labour cannot be identified with specific units of production. For example a supervisor’s time is spread amongst all workers.

Labour time can be recorded using clock cards, time sheets, or by an assumption that everyone works a standard day. The clock card system is where the employee swipes a card through a reader when getting to work and again when leaving (“clocking-in and clocking-out”. The time working (or at least the time at work) can be calculated and wages calculated from that). The clocking-in and clocking-out processes should be supervised to ensure that employees do not clock in/out for friends.

Time sheets should be reviewed to ensure that time is recorded accurately against the jobs involved. For example, when an audit assistant spends time on a specific audit, an account code (or job code) will placed against that time on the time sheet. This code will enable the total time spent on each job by each employee to be accumulated.

Any overtime worked should be authorised by supervisors.

Employee wage rates should have been approved by the human resources department.



Question 7

In a factory there are four types of job:

1. Machine operators

2. Supervisors

3. Maintenance engineers

4. Quality control checkers

Which would be classified as direct and indirect labour?

A Direct: 1 and 2; indirect 3 and 4

B Direct: 2 and 3; indirect 1 and 4

C Direct: 1 and 3; indirect 2 and 4

D Direct: 1 and 4; indirect 2 and 3

5. The procedures and documentation to ensure the correct analysis and recording of sales.

Sales transactions will normally be initiated by receiving an order from a customer. It is important that orders are recorded as soon as possible, for example by entering them in a register (book).

The customer’s account will be checked to ensure that the customer is paying for previous orders satisfactorily and will remain within any credit limit if the new order is approved.

As outlined above, from the order a multi-set delivery note or despatch notes will be raised so that the goods can be packed and despatched to customers. It is, of course vital that all despatched goods are invoiced otherwise the company will effectively be giving goods away. One way of doing this is to enter invoice numbers against the original register of orders. This should mean that all orders received have been despatched and invoiced.

In a manual system, the invoices will be listed in the sales day book. Sometime, the sales day book can have several columns for the sales of different categories of goods. The sum of these lists will be the total of sales made in each category.

Example 1

List three examples documents that are related to each of purchases, sales and inventory (three for each category).

Purchases

Sales

Inventory



Chapter 4

CODING SYSTEMS

1. Introduction

This chapter looks at how coding systems can be devised and used in accounting systems.

2. The use of codes in categorising and processing transactions

It is universal practice in accounting systems to use coding systems to refer to customers, suppliers, accounts and employees. Codes are used because they are concise and precise, and can be subject to computer checking

Concise: instead of referring to a product as a “50cm, high resolution LED monitor”, the product is given a code such as 50HRL. This is much quicker to write or type.

Precise: there might be several makes of 50cm high resolution LED monitors and information might be confusing and ambiguous if the manufacturer (Sony, Panasonic, Samsung, LG etc) wasn’t specified. A code number can therefore be used to ensure that products and people are referred to uniquely eg 50HRLLG.

Checking: if all inventory codes are 7 digits long then forms and input screens can be designed for this. Computers can check that all 7 digits are present; sometime more sophisticated checks can be carried out on the structure off the code. This reduces the chance of errors.

Processing: Codes can also help in processing transactions. For example if all income-related accounts have the structure 1xxxx, all expense-related accounts have the structure 2xxxx, all asset-related accounts 3xxxx and all liability accounts 4xxxx, then this will help the production of the income statement (all 1xxxx amounts less all 2xxxx amounts) and the statement of financial position (3xxxx as asset amounts and 4xxxx amounts as liabilities). This is particularly needed in computerised accounting systems because the computer cannot understand that, say, rent is an expense, but doesn’t need this understanding so long as rent is coded, say 21892. Because it starts with ‘2’ it will be treated as an expense.



3. Different methods of codingThere are several methods of coding. Codes should be:๏ Simple to use๏ Understandable๏ Concise๏ Precise๏ ExpandableAs we will see, these requirements can be in conflict.

Sequential codes

In this method products or customer are simply allocated numbers in sequence:

0001! ! Abrahams0002! ! Adkins0003 ! ! Ahmad...

It is simple and concise, but as constructed might have some faults:

1. There is no relationship at all between the code and the item/person being encoded .

2. Expansion might be difficult once you have over 9999 customer if documents and computer files can hold only four digits. Additionally, if someone called Affleck becomes a customer, he will have to be tagged onto the end of the sequence ie not reflecting alphabetical order. To avoid this problem, often sequence codes proceed as 0010, 0020, 0030…etc so that gaps are built in for future use.



Hierarchical (or significant digit) codes

Here, are you progress through the code, information become increasingly specific. Many libraries use this system to code their books using the Dewey Decimal System

500 Natural sciences mathematics ..510 Mathematics520 Astronomy & allied sciences530 Physics540 Chemistry & allied sciences550 Earth sciences560 Paleontology, paleozoology570 Life sciences580 Botanical sciences590 Zoological sciences..555 Earth sciences of Asia

In a business, hierarchical codes could be used to code the accounts in the general ledger. For example a code such as 3112 could be interpreted as the Machinery Cost Account, using the following system.

3 1 1 21 = expenses2 = income3 = assets4 = liabilities

1 = non-current assets2 = current assets

1 = cost2 = accumulated depreciation

1 = property2 = machinery3 = office equipment4 = motor vehicles

The great advantage of this type of code is that its structure provides information both to human users and to computers. For example, it would be easy to program the compute to work out the total cost of all fixed assets: simply add up all accounts starting 311.

Block codes

These lie somewhere between simple sequence codes and the full, detailed hierarchical code. They start off giving some information but then lose enthusiasm. So for general ledger codes you might have

1xxx = expenses2xxx = income3xxx = assets4xxx = liabilities



Faceted codes

These are an improvement of block codes and provide more information but lack a logical hierarchical structure. The code is broken down into sections or groups of digits and each group codes for a particular attribute.

For example and employee code could be:

Facet 1 Sex of employee: 1 = male; 2 = female

Facet 2 Department: 01 = accounts; 02 = sales; 03 = IT etc

Facet 4 Full or part time 1 = full time; 2 = part time

Facet 5 Weekly or monthly paid: 01 = weekly; 02 = monthly

Mnemonic

All the codes illustrated do far have been purely numerical. Mnemonic codes contain letters to help humans to learn what the codes mean. The hierarchical code above:

3 1 1 21 = expenses2 = income3 = assets4 = liabilities




could then become

A N C ME = expensesI = incomeA = assetsL = liabilities

N = non-current assetsC = current assets

C = costA = accumulated depreciation

P = propertyM = machineryO = office equipmentM = motor vehicles

It is not common to have full mnemonic codes and often just the first character will be mnemonic and the rest will follow another system.



3. Identifying and correcting errors in coding of revenue and expenses

Identifying errors in sequence codes is almost impossible because there is no logical connection between the code and the object or person that can be used to spot an error. The only type of error that can really be identified is if the format of the code is wrong. For example, 4 or 6 digits are used when only 5 are expected.

Once the coding system has more structure then identifying errors is much easier.

Question 1

A company uses the following hierarchical system:

1st digit 2nd digit 3rd digit 4th digit1 = expenses2 = income3 = assets4 = liabilities




Which of the following correctly codes for the accumulated depreciation on cars?

A 1212

B 4124

C 3124

D 2133

Question 2

A company uses a block code with the following structure:

1xxx = expenses2xxx = income3xxx = assets4xxx = liabilities

Which on of the following accounts should not appear in the statement of financial position?

A 4321

B 3214

C 2234

D 3123



Question 3 What is the name given to a code in which the level of detail increases in a logical way as you work through the code?

A Sequence

B Hierarchical

C Faceted

D Block

Example 1

List three advantages of using coding systems

Example 2

List the desirable attributes of a coding system



Chapter 5

COST CLASSIFICATION

1. Introduction

This chapter looks at how coding systems can be devised and used in accounting systems.

2. The nature and types of cost classificationCosts can be classified in a number of different ways:๏ By their behaviour. Do they increase as an organisation gets busier or do they tend to stay the

same? This is important when it comes to budgeting as it is essential to be able to predict how costs are likely to change.

๏ By their location. Where in the organisation are they incurred? For example, costs incurred in the factory are relevant to working out the cost of production. However, costs incurred in storing and delivering finished goods are not relevant to production.

๏ By their function. For example costs related to research and development, marketing, training, manufacturing.

๏ By the person responsible for their control. All costs need to be controlled and there should be a clearly identified person who is responsible for the control of each cost. For example, the managers of a branch might be held responsible for the costs incurred there.

๏ By their type. For example, material, labour, other production expenses, such as the cost of running machinery.

๏ By their traceability. Are they direct or indirect? Direct costs are closely related and traceable to each item produced. Indirect costs are not so easy to relate and trace to each unit of production.



3. Variable, fixed, semi-variable and stepped fixed costs

These terms relate to how costs behave as the activity level of an organisation changes.

Variable costs: these are directly proportional to the level of activity.

If the number of units produced doubles, then variable production costs will double also. An example would be the cost of material used to produce units.

If the number of units sold increases by 20% then variable selling and distribution costs would increase by 20% also.

On a graph, variable costs would look like:

Total cost ($)

Activity level ($)

Fixed costs: constant over a wide range of activity

An example would be the factory rent. It does no matter how many units are made, the rent is fixed.

On a graph, fixed costs would appear as:

Total cost ($)

Activity level ($)

Note that the cost per unit will decrease as the activity level increases. For example, say that the rent was $10,000 and 1,000 units were made. Then you could argue that it takes $10 rent to make a unit ($10,000/1,000).



If, however, 10,000 units were made, the rental cost per unit would be only $1 ($10,000/10,000). Higher production volumes are making better use of the fixed resource.

Semi-variable costs have a fixed element and a variable element.

An example would be a telephone bill. Usually there is a fixed cost for the line rental then each minute of telephone calls causes an additional cost.

On a graph, fixed costs would appear as:

Total cost ($)

Activity level ($)

Fixed element

Variableelement

Stepped fixed costs: constant over a range of activity then a sudden increase, then constant again

An example would be the salary of supervisors. One supervisor for up to six workers, two for up to 12 workers, etc.

On a graph, stepped fixed costs would appear as:

Total cost ($)

Activity level ($)



Question 1 A mail order company distributes sales items by post. All other communication is by email or the internet. Are postage costs likely to be:

A Fixed

B Variable

C Semi-variable

D Stepped fixed

Question 2

A company rents a factory that will allow production of up to 10,000 units per month.

If the company is considering a new order that would push production to 15,000 units, rental costs will be:

A Fixed

B Variable

C Semi-variable

D Stepped fixed

Question 3 A company pays its staff a basis wage plus a bonus based on production. Wage costs are likely to be:

A Fixed

B Variable

C Semi-variable

D Stepped fixed

4. The classification of labour and material costsThere are three types of production expenses:๏ Material๏ Labour ๏ Expenses (often known as overheads)



Each can be direct or indirect

Direct Indirect

Material Material traceable to units of production (for example, tracing wood into furniture)

Material that is not traceable into specific units (for example, tracing sand paper in sanding machinery.

Labour Labour directly involved in making units. Not directly involved with specific units. For example maintenance engineers.

Expenses Rare, but an example would be a royalty that had to be paid for each unit of production.Direct expenses are usually also variable costs

For example, the rent and heating expenses for the factory.Indirect expenses are usually fixed or stepped-fixed

Businesses also have non-production overheads. These are costs which have nothing to do with production such as the accounting department, advertising, distribution, head office costs.

Question 4 Lubricating oil poured over a drilling machine to reduce friction and to keep it cool would be classified as a

A Direct material cost

B Indirect material cost

C Direst expense

D Indirect expense

5. The nature and purpose of, profit statements and their preparation in absorption and marginal costing formats.

Some definitions:

Marginal cost (MC): the additional cost caused when one more unit is made. Marginal cost will be the sum of all variable costs per unit.

Total absorption cost (TAC): the total cost of manufacturing a unit. This is the sum of the marginal cost and a fair share of the fixed production costs.

Fixed overhead absorption rate: budgeted fixed production costs divided by budgeted output in units.

Profit per unit: selling price per unit less total absorption cost per unit ie less marginal costs and all fixed production costs.

Contribution per unit: selling price per unit less marginal cost per unit



Here is a cost card showing selling price and costs per unit:

$ $

Selling price 100Material 20Labour 15Variable overheads 5

Marginal cost (40)

Contribution 60Fixed overhead per unit (based on budgeted costs of $25,000 divided by budgeted output of 1,000 units)

(25)

Profit 35

Note: total absorption cost per unit = $65 ($40 marginal cost + $25 fixed cost per unit)

Let us say that in a month, 1000 units were made and 900 of those were sold. This means that there must be 100 items left in inventory. The profit can be calculated in two ways.

Marginal cost (MC) approach

$ $

Sales revenue 100 x 900 90,000

Marginal cost of production 40 x 1,000 40,000Less: closing inventory 40 x 100 (4,000)

Marginal cost of sales 36,000

Contribution 54,000Less Fixed overheads (25,000)

Profit 29,000

Note:

1. Under marginal costing closing inventory is valued at its marginal cost

2. All fixed costs are deducted as a lump sum, sometimes referred to as a period cost.



Total absorption cost (TAC) approach

$ $

Sales revenue 100 x 900 90,000

Total absorption cost of production 65 x 1,000 65,000Less: closing inventory 65 x 100 (6,500)

Total absorption cost of sales 58,500

Profit 31,500

Note:

1. Under TAC closing inventory is valued at its total absorption cost

Fixed costs are accounted for in the total absorption cost of sales.

Question 5 Contribution per unit is;

A Selling price less total absorption cost per unit

B TAC – MC

C Selling price less marginal cost

D MC +overhead absorption rate per unit

Question 6 Profit can be calculated as:

A Revenue less marginal cost

B Revenue less marginal cost plus fixed production costs

C Revenue less marginal cost less fixed production costs

D Revenue less total absorption costs less fixed costs



Example 1

What is the contribution and profit if 500 units are made and sold where the selling price is $20 per unit and the marginal cost is $8 per unit? Fixed overheads are expected to be $4,000 for the period.

1.1. Commentary on the two methods of calculating profits

You will see that the two profits are different, with TAC profits of $31,500 and MC profits of 29,000, i.e. TAC profits are $1,500 greater.

This difference can be reconciled to the difference in closing inventory valuation. In TAC, the closing inventory of $6,500 contains some fixed costs ($6,500 = 100 x ($40 + $25)). These will be accounted for in the next period when those items are sold. In the MC approach all fixed costs are deducted in the period.

Both methods are correct. It’s simply if inventories are valued differently then profits will be different.

1.2. Commentary on the two methods of calculating the cost of production

Marginal cost: each unit causes $40 additional costs and when sold will generate $100 additional revenue. The contribution of $40 means that each unit makes the company $40 richer. It would even be worthwhile making for $40 MC and selling as low as $41 as that would generate a small contribution. Marginal cost is therefore good for decision making.

However, because MC does not take into account all production costs, it can be argued that the cost of production and the value of inventory is understated.

Total absorption cost: each unit costs $65 to produce, but each unit does not cause an extra $65 as fixed costs are fixed. Despite a TAC of $65 is would still be worth selling units at $50, so TAC can be bad for decision making.

However, all production costs are taken into account and arguable TAC is better for stock valuation.

Either methods can be used in internal cost accounting, but for external reporting in the financial statements TAC has to be used for stock valuation.



Question 7 Which of the following statements is true?

A Stock valuation using marginal cost is acceptable for external reporting; using TAC is not acceptable for external reporting.

B Both MC and MC are acceptable for external reporting

C TAC is better for decision-making

D Stock valuation using TAC is acceptable for external reporting; using MC is not acceptable for external reporting.

2. Calculating the cost of a product or service

This part of the syllabus has been substantially covered. All that remains is to introduce a couple of pieces of terminology.

$

Direct material XDirect labour XDirect expenses X

Prime cost XProduction overheads X

Factory cost XNon-production overheads X

Total cost X

Prime cost = direct material + direct labour + direct expenses

Factory cost = prime cost + production overheads

Total cost = factory cost + non-production overheads



Chapter 6COST UNITS, COST CENTRES, PROFIT CENTRES AND INVESTMENT CENTRES

1. Introduction

This chapter looks at how costs can be traced to production and to locations within an entity, and how the performance of those units can be appraised.

2. Cost units

A cost unit is a unit of a product or a service to which costs can be traced.

For example, for a manufacturer of laptop computers, a cost unit would be a laptop. For a bus company, a cost unit could be a bus journey.

It is important to be able to identify cost units to be able to:

๏ Work out the cost of providing that product or service๏ Work out the resources needed: material, labour and other expenses to make or supply the unit.๏ In a profit-seeking organisation, to decide on a selling price that will allow a profit to be made ๏ In a not-for-profit organisation, to plans to be made as to where to spend resources.๏ Control the use of resources by comparing actual costs to budgeted costs

3. Cost centresA cost centre is a place to which costs can be traced or segregated.

A cost centre could be:๏ A subsidiary company๏ A division๏ A department๏ A team๏ A person๏ A production line๏ A project๏ A machineThe head of a cost centre will be responsible for costs only: not revenue or profits



Examples of cost centres can include: the IT department, quality control department, the accounting department, the manufacturing facility.

4. Profit centres

A profit centre is a place where both costs and revenues are identified.

As above, a profit centre could be:๏ A subsidiary company๏ A division๏ A department๏ A team๏ A person๏ A production line๏ A project๏ A machineThe difference is that here, in addition to being responsible for costs, the head of a profit centre will also be responsible for revenues.

The revenues could be sales to outside organisations or they could be internal sales to elsewhere in the organisation. For example, an IT department could be turned from a cost centre into a profit centre if it were to be allowed to charge IT users for the services supplied.

Being head of a profit centre is usually more interesting and demanding than being just the head of a cost centre. Many people don’t get great satisfaction from ensuring that costs do not exceed budget (a cost centre manager’s responsibility), but would get much satisfaction from beating a profit budget (a profit centre manager’s responsibility).

5. Investment centres

An investment centre is a place where costs, revenues and capital investment are identified.

Because costs, revenue and capital expenditure all have to be identified separately an investment centre would normally be:

๏ A subsidiary company๏ A divisionThe head of an investment centre will be responsible for costs revenues and capital expenditure. In effect, that person has responsibility for all financial aspects of the investment centre.



Question 1 A manager is responsible for both costs and sales. Therefore, the manager is in charge of a:

A Cost centre

B Profit centre

C Investment centre

D Sports centre

Question 2 In a garage, costs are associated with each car that comes in for repair. Cars are therefore:

A Cost centres

B Cost units

C Profit centres

D Investment units

Question 3 If a manager is in charge of an investment centre, which of the following would he or she be responsible for:

1. Costs

2. Revenue

3. Investment

4. Profit

5.

A 1 and 2 only

B 2 and 3 only

C 1, 2 and 4 only

D 1, 2, 3 and 4



6. Performance measures appropriate to cost centres

It is important to monitor the performance of cost, profit and investment centres to judge how both the centres are performing economically and how their managers are performing as managers. It is important not to judge managers for elements of performance for which they have no responsibility.

Performance measures for cost centres include:๏ Cost compared to budget๏ Cost/unit๏ Efficiency, capacity utilisation, and production volume ratios6.1. Cost compared to budget:

Cost centres will usually have budgets to work to so this simple comparison is very useful. However, it says nothing about what the cost centre achieved: it could spend 10% less than budget but produce only 50% of the output expected.

6.2. Cost/unit:

Since a cost centre manager is responsible for costs, cost per unit produced or supplied is an obvious measure. A simple way to calculate this is to divide the costs incurred in a period by the units produced in the period.

6.3. Efficiency, capacity utilisation and production volume ratios

These relate to the use of time (and hence labour costs) in the cost centre.

When setting a budget for a cost centre, it is normal to specify how long it should take to produce each item (standard hours/unit) and how many hours the factory is expected to work.

For example, if each unit should take 2 hours to make, and output is planned to be 5,000 units in a period, then the planned factory hours will be 10,000. Here, 10,000 is said to be the capacity of the factory ie the hours it was expected to work.

A number of things can happen these plans:๏ Producing the units might not take the standard hours per unit. This will give an assessment of

efficiency.

๏ More or fewer hours might be worked in the factory than originally expected. This will give an assessment of capacity.

๏ More or fewer units might be produced than budgeted. This will give an assessment of production volume.



Illustration

Standard hours per unit = 2Planned production = 5,000 units

Actual production = 5,200 unitsActual hours spend = 10,800

Efficiency ratio5,200 units should take 10,400 hours (2 hours per unit)5,200 units did take 10,800 hoursProduction has been therefore been inefficient.

The efficiency ratio is: standard hours for production achieved/actual hours = 100 x 10,400/10,800 = 96%

Capacity utilisation ratioPlanned factory hours were 10,000 (2 hours x 5,000 units)Hours worked = 10,800

More work has been squeezed out of the factory than expected.

The capacity utilisation ratio is: actual hours worked/budgeted hours = 100 x 10,800/10,000 = 108%

Production volume ratioPlanned production = 5,000 units (or 10,000 hours)Actual production = 5,200 units or (10,400 hours)

Production has been higher than expected.

The production/volume ratio is: actual production/planned production = 100 x 5,200/5,000 = 104%

[Note this could be also worked out using planned and actual hours 100 x 10,400/10,000)].



Question 4 Does an efficiency percentage of 110% indicate efficient or inefficient production?

A Efficient

B Inefficient

Question 5 Does a capacity ratio of 90% indicate that better than expected or worse than expected use has been made of the factory facilities:

A Better

B Worse

Question 6 What does a production volume ratio of 120% say about the efficiency of workers?

A Better than expected

B Worse than expected

C No conclusion can be drawn about worker efficiency

7. Performance measures appropriate to profit centresPerformance measures for cost centres include:๏ Profit compared to budget: Profit centres will usually have budgets to work to so this simple

comparison is very useful.

๏ Profit per unit: because a profit centre manager is responsible for costs and revenues, profit per unit produced or supplied is an obvious measure. A simple way to calculate this is to divide the profit for a period by the units produced in the period.

๏ Gross profit percentage: this is the gross profit divided by sales and expressed as a percentage. It show how many $s of gross profit are generated by each $ of sales. Gross profit can be thought of as the mainspring of profit generation.

๏ Net profit percentage: this is the new profit divided by sales and expressed as a percentage.๏ Expenses/sales: these can be useful ratios to see if expenses (such as administration expenses)

are keeping in line with sales.



8. Performance measures appropriate to investment centresIn an investment centre it will be important to try to judge how well managers have been able to generate profits from the capital invested in the investment centre.

Performance measures for investment centres include:๏ Return on capital employed (ROCE): this measure compare the profits earned by the investment

centre to the capital invested in the investment centre. Return on capital employed is also known as return on investment (ROI). ROCE is rather like an interest rate: capital is invested in a bank account and income is then received.

๏ Residual income (RI): this measure makes a notional charge to the investment centre for its use of capital. It takes the view that head office supplies divisions with capital and that capital has to be paid for. The residual income is what’s left if the division had to pay for its use of capital.

An amount of:

Capital employed x interest rate

is deducted from the division’s profits.

Illustration$

Sales 1,800,000

Cost of sales (800,000)

Gross profit 1,000,000

Expenses (320,000)

Net profit 680,000

Gross profit % = 100 x 1,000,000/1,800,000 = 55.6%

Net profit % = 100 x 680/1,800,000 = 37.9%

Expenses compared to sales = 100 x 320,000/1,800,000 = 17.8%

Illustration

$Net profit 680,000Capital employed by the division 4,000,000Interest rate 6%

ROCE = 100 x 680,000/4,000,000 = 17%

RI = 680,000 – 4,000,000 x 6% = $440,000



Question 7 The assumption behind a residual income calculation is that:

A Divisions have to borrow from banks to finance themselves so have to be charged interest

B Head office must charge subsidiaries interest so that head office results are comparable

C Before their performance can be judged, subsidiaries should bear a notional charge for their use of capital.

D RI is just another name for ROCE

9. Application of performance measures appropriate to cost, profit and investment centres.

Example 1

Recent results of a division are:

$Sales 5,000,000Cost of sales (3,000,000)Gross profit 2,000,000Expenses (1,500,000)Net profit 500,000

It had been budgeted to produce 100,000 units and these should have taken 5 hours each. In fact, 120,000 units were produced in 580,000 hours.

The capital employed by the division is $4,000,000 and the interest rate is 7%.

Calculate:(a) Cost/unit(b) Efficiency, capacity utilisation and production volume ratios or percentages(c) Gross profit percentage(d) Net profit percentage(e) Expenses to sales ratio(f) ROCE(g) RI



Chapter 7ACCOUNTING FOR MATERIALS COSTS

1. Introduction

This chapter looks at how material costs are accounted for and how inventory can be valued.

2. Raw material, work-in-progress, finished goods

Raw materials are purchased and then undergo further processing or are incorporated into products. Raw materials can be basic materials such as chemicals, flour, or lengths of wood. Or raw materials can be items which have been manufactured by the supplier, such as components and parts for use in production.

Work in progress refers to partly made products. They have progressed from the bought in stage (raw materials) but are not yet complete.

Finished goods are complete and are ready for sale.

3. Accounting for material costsMaterials progress through a factory as follows:

Raw materials Work-in-progress Finished goodsSupplier Customer

Movement of the material between each stage has to be accounted for in a series of ‘T’ accounts.

As material moves into a department or category, the T account is debited with the cost.

As material moves out of a department or category, the T account is credited with the cost.



Raw materials Work-in-progress Finished goods

Supplier Customer

It can be useful to record units of material as well as value.

IllustrationAssume there is no opening inventory at any stage.

1,000 units of raw material are bought for $5 per unit800 are issued to production where labour worth $2 per unit and production expenses of $1 per unit are added. 700 of the units are transferred out to Finished goods at the end of the period. Although finished, 100 units are still in work in progress at the end of the period.

500 units finished units are sold.

Raw materialsRaw materialsRaw materialsRaw materialsRaw materialsRaw materialsUnits $ Units $

Payables 1,000 5,000 To WiP 800 4,000

C/f Closing inventory 200 1,0001,000 5,000 1,000 5,000

Work-in ProgressWork-in ProgressWork-in ProgressWork-in ProgressWork-in ProgressWork-in ProgressUnits $ Units $

From raw materials 800 4,000 To Finished goods 700 5,600Labour 1,600Overheads 800 C/f Closing inventory 100 800

800 6,400 800 6,400

Finished goodsFinished goodsFinished goodsFinished goodsFinished goodsFinished goodsUnits $ Units $

From WIP 700 5,600 Cost of sales 500 4,000

C/f Closing inventory 200 1,600700 5,600 700 5,600

Note: finished goods and closing inventory are values at:Material $5 + Labour $2 + Overheads $1 = 8 per unit



Question 1 Which double entry records the movement of raw material to work-in-progress?

A Cr WIP; Dr Raw material

B Dr Purchases; WIP

C Dr WIP; Cr Raw material

D Cr Raw material; Dr Finished goods

4. Material requirements making allowance for sales and product/material inventory changes

The raw materials purchased are not necessarily the same as the raw materials that will be used in production. This is because there might be changes in raw material inventory. It would, for example be possible to use raw materials in a period without having to purchase any if there were already enough raw materials in inventory.

The adjustments needed are:

Raw material purchased =

Raw material used +

Closing stock –

Opening stock

The company has to buy enough to cover usage and to provide enough for closing inventory, but it gets a ‘head start’ because there is already some in opening inventory.

Similarly:

Units produced = Units sold + Closing stock (finished goods) –Opening stock

(finished goods)

Question 2

Opening inventory = 20,000 units.

Units to be sold = 90,000

Closing inventory to be 10,000 units.

How many units must be bought or produced?

A 80,000

B 100,000

C 90,000

D 120,000



Question 3

Opening inventory of raw material = 1,000 kg

Units to be made = 5,000 (each takes 3kg of material)

Closing inventory of raw materials to be 1,500 kg

How many kilograms of raw material must be bought?

A 5,500

B 14,500

C 15,500

D 4,500

5. Different methods used to price materials issued from inventory and to value closing inventory

Consider the following:

12 March 20X4: buy 1000 units at $5 each21 March 20X4: buy 500 units at $6 each31 March 20x4: sell 800 units at $12 each.

Clearly revenue will be 800 x $12 = $9,600, but what is the cost of the units sold? Which have been sold? What is their value and the value of the inventory left?

You have to know four approaches:๏ FIFO๏ LIFO๏ Cumulative weighted average๏ Periodic weighted average

5.1. FIFO (First-in, first out)

This method assumes that the goods that arrive first are the first to be used. It is only an assumption: apart from their price all goods of a given type are identical and therefore you don’t know, or care, how they are physically used.

So, in the above case, all 800 units sold would be assumed to be those delivered on 12 March. They would have a cost of 800 x $5 = $4,000 and the value of the inventory remaining would be 200 x $5 + 500 x $6 = $4,000.

Note that receipts and sales are handled on a strict time basis.



5.2. LIFO (Last-in, first out)

This method assumes that the goods that arrive last are the first to be used. As before It is only an assumption: apart from their price all goods of a given type are identical and therefore you don’t know, or care, how they are physically used.

So, in the above case, the 800 units sold would be assumed to be all 500 of those delivered on 21 March plus 300 from the March 12 delivery. They would have a cost of 500 x $6 plus 300 x $5 = $4,500, and the value of the inventory remaining would be 700 x $5 = $3,500.

Note that receipts and sales are handled on a strict time basis.

5.3. Cumulative weighted average

Every time units are added, a new average price is calculated. Any time goods are removed they are removed at the prevailing average.

12 March 20X4: buy 1000 units at $5 each21 March 20X4: buy 500 units at $6 each31 March 20x4: sell 800 units at $12 each.

$12 March 20X4 1000 @ $5 5,00021 March 20X4 500 @ $6 3,000$5.33 = average cost 1,500 @ $5.33 8,00031 March 20X4 (800) @ $5.33 (4,267)Closing inventory 700 @ $5.33 4,733

Note:

Sales do not alter the average cost.

Receipts and sales are handled on a strict time basis.

5.4. Periodic weighted average

Here, a new inventory value is calculated at the end of a set period. The cost of goods used is given by:

Cost of opening inventory + cost of purchases in the periodUnits in opening inventory + units purchased in the period

So, all units used in the period will have the same cost.

In the above simple example this method would give the same result as the cumulative weighted average approach



Example 1

Recent results of a division are:

Date Units Unit price

1 April Opening inventory 1,000 5.005 April Purchased 500 6.009 April Sold 200 N/a14 April Purchased 600 5.5021 April Sold 1,200 N/a

Calculate the cost of inventory used each time and the cost of the inventory remaining at the end of the period using:(a) FIFO(b) LIFO(c) Average cumulative cost(d) Periodic average cost

6. Advantages and disadvantages of the methods:

Advantages Disadvantages

FIFO ๏ Permitted by accounting standards as an acceptable approach to inventory valuation

๏ Closing inventory has a value close to its replacement value

๏ Might reflect physical use of stock

๏ Requires care to get it right

LIFO ๏ Inventory is issued at close to its current cost (significant if there is high inflation of volatile stock prices)

๏ Might reflect physical use of stock

๏ Not permitted as a stock valuation method under financial reporting standards

๏ Requires care to get it right

Average stock values

๏ Averages out stock price fluctuations

๏ Rela