Engineering Economics and Financial Accounting

Unit 4: Costing

Major Topics are:

� Job Costing

� Operating Costing

� Process Costing

� Standard Costing (Variance Analysis)

� Gross Domestic Product (GDP)

Job Costing What is job costing?

� Job costing is a product costing method adopted by an enterprise that provides

limited quantities of unique products

� This kind of enterprise produces tailor-made goods or services that conform to the

specifications designed by customer

� Costs can be determined separately for each job order

� Used in businesses which perform work on specific jobs, orders or contracts which

can be identified throughout the various stages of production. Eg:

� building

� contracting

� garages

� foundries

� engineering

Purpose of Job Costing:

� To determine the profit or loss made on each job.

� This serves as a check on the accuracy of the estimate or with the cost of similar jobs

completed in the past, and

� helps to bring to light any inefficiencies that have occurred in the course of

production.

� Thus job costing separates PROFITABLE jobs from UNPROFITABLE ones and

� provides a check on past estimates as well as a basis for estimating for similar work in

the future.

How to cost a job:

� Job costing involves a considerable amount of clerical work and in factory work it is

essential to have reliable production records

� The accounting procedure requires:

� Recording Materials Used

� Recording Wages

� Recording Overheads

Job Costing Overview:

Flow of costs in job costing:

Three different methods of costing are:

� Actual costing

� Normal costing

� Standard costing

Costing system Production cost

Actual costing Actual direct materials + Actual labour + Actual overhead

Normal costing Actual direct material + Actual direct labour + Applied overhead (I.e. Per-determined overhead rate * actual level of productivity)

Standard costing Standard direct material + standard direct labour + applied overhead

Normal product costing and standard costing are preferable.

Because,

� Under actual costing, the product cost will be delayed until the end of the accounting

period. However, the product cost should be obtained beforehand for setting selling.

price.

� Since monthly productivity may vary due to holiday periods and seasonal variation,

actual overhead is fluctuating and cannot reflect normal production conditions.

Example: Job Costing:

Job Cost Sheet:

Control Accounts:

Operating Costing

Operating (Operational) costs are the expenses which are related to the operation of a

business, or to the operation of a device, component, piece of equipment or facility. They are the cost of

resources used by an organization just to maintain its existence.

Operating Costs and the Management Cycle

Planning Stage:

� Uses of operating cost information and product costs in the planning stage.

� Develop budgets.

� Determine selling prices or fees for services and products.

� Plan human resource needs.

Executing Stage:

� Uses of operating cost information and product costs in the executing stage.

� Make decisions about dropping a service line, product line, or segment.

� Evaluate outsourcing opportunities.

� Estimate margins and income.

� Bid on special orders.

� Negotiate a selling price or fee.

Reviewing Stage:

� Uses of operating cost information and product costs in the reviewing stage.

� Calculate variances between estimated and actual costs.

� Help managers determine the causes of cost overruns and enable them to

adjust future actions to reduce potential problems.

Reporting Stage:

� Uses of operating cost information and product costs in the reporting stage.

� Report actual results of operating activities on the income statement.

� Report the value of inventory on the balance sheet.

� Report performance related to products or services.

Examples of Types and Uses of Operating Cost Information

Process Costing

Job Costing Vs Process Costing

What is Process Costing?

• Process costing is adopted when there is mass production through a sequence of

several processes

• Example include chemical, flour and glass manufacturing

• It computes the average cost per unit by dividing the costs or production for a

particular period by the number of units produced during the period

Accounting for Process Costing

• Costs are accumulated by each process

• Each process maintains its process account

• The process account is debited with the costs incurred and credited with goods

completed and transferred to other process account

• When the goods are completed, they will be transferred to finished goods account

• When the goods are sold, the amount will be transferred to the cost of goods sold

account

Accounting for Scrap:

• Damaged goods may be sold as scrap

• Revenue arising from the scrap should be treated as a reduction in cost rather than

an increase in sales revenue

Example: Joyce Ltd. operates a factory involving two production Processes. The output of process 1 is

transferred to process.

2. The information of production for January 2005 is as follows:

• Cost for Process 1

Materials: 3000 units at $5 per unit

Labour $2400

• Cost for Process 2

Materials: 2000 unit at $8 per unit

Labour $1680

• No opening and closing work in progress

• Output for January 2005

Process 1: 2300 units

Process 2 4000 units

• General overhead, for January 2005 amounted to $7140, are absorbed into the

process cost at a rate of 375% of direct labour costs in process 1 and 496.4% of direct

labour cost in process 2.

• The normal output of process 1 and process 2 is 80% and 90% of input respectively

• Waste matters from process 1 and sold for $4 per unit and those from process 2 for

$6 per unit

Required:

(a) Process 1

(b) Process 2

(c) Scrap

(d) Abnormal loss

(e) Abnormal gain

Equivalent units of production

• If there is no opening or closing work in progress (WIP) the unit cost of products can

be obtained as follows

• However, If there is opening or closing work in progress, the partly completed

production will have a lower cost than the fully completed production.

• We have to converted the work in progress into finished equivalent units of

production (EUP).

Standard Costing It is a cost accounting technique for cost control where standard costs are determined

and compared with actual costs, to initiate corrective action.

It is a control method involving the preparation of detailed cost and sales budgets.

A management tool used to facilitate management by exception.

• Set the standard cost

� A standard quantity is predetermined and standard price per unit is estimated.

� Budgeted cost is calculated by using standard cost.

• Record the actual cost

� Calculate actual quantity and cost incurred giving full details.

• Variance Analysis

� Comparison of the actual cost with the budgeted cost.

� The cost variance is used in controlling cost.

• Variance Analysis

� Take suitable corrective action.

� Fix responsibilities to ensure compliance

• Variance Analysis

� Create effective control system.

� Resetting the budget, if required.

Types of Standards:

� Ideal Standards:

These represents the level of performance attainable when prices for

material and labour are most favorable, when the highest output is achieved with the

best equipment and layout and when maximum efficiency in utilization of resources

results in maximum output with minimum cost.

� Normal Standards: These are the standards that may be achieved under normal

operating conditions. The normal activity has been defined as number of standard hours

which will produce normal efficiency sufficient goods to meet the average sales demand

over a term of years.

� Basic or Bogey standards: These standards are use only when they are likely to remain

constant or unaltered over long period. According to this standard, a base year is chosen

for comparison purposes in the same way as statistician use price indices.

� Basic or Bogey standards: When basic standards are in use, variances are not calculated

as the difference between standard and actual cost. Instead, the actual cost is expressed

as a percentage of basic cost.

� Current Standard: These standards reflect the management’s anticipation of what actual

cost will be for the current period. These are the costs which the business will incur if

the anticipated prices are paid for goods and services and the usage corresponds to that

believed to be necessary to produce the planned output.

Variance:

• The difference between standard cost and actual cost of the actual output is defined as

Variance. A variance may be favourable or unfavourable.

• If the actual cost is less than the standard cost, the variance is favourable and if the

actual cost is more than the standard cost, the variance will be unfavourable.

• It is not enough to know the figures of these variances in fact it is required to trace their

origin and causes of occurrence for taking necessary remedial steps to reduce /

eliminate them.

Variance Types:

The purpose of standard costing reports is to investigate the reasons for

significant variances so as to identify the problems and take corrective action. Variances are

broadly of two types, namely, controllable and uncontrollable.

Controllable variances are those which can be controlled by the

departmental heads whereas uncontrollable variances are those which are beyond their

control. If uncontrollable variances are of significant nature and are persistent, the standards

may need revision.

Variance analysis is the dividing of the cost variance into its components to

know their causes, so that one can approach for corrective measures.

Variance Analysis:

Variances of Efficiency:

Variance arising due to the effectiveness in use of material quantities, labour

hours. Here actual quantities are compared with predetermined standards.

Variances of Price Rates

Variances arising due to change in unit material prices, standard labour hour

rates and standard allowances for indirect costs. Here actual prices are compared with

predetermined ones.

Variances of Due to Volume:

Variance due to effect of difference between actual activity and the level of

activity estimated when the standard was set.

Reasons of Material Variance

• Change in Basic price

• Fail to purchase anticipated standard quantities at appropriate price

• Use of sub-standard material

• Ineffective use of materials

• Pilferage

•

Material Variance

• Material Cost Variance= (Standard Quantity X Standard Price) –(Actual Qty X Act Price)

• Material Price Variance= Actual Quantity (Standard Price - Actual Price)

• Material Usage Variance=Standard Price (Standard Quantity - Actual Quantity)

Reasons for Labour Variance

• Time Related Issues

• Change in design and quality standard

• Low Motivation

• Poor working conditions

• Improper scheduling/placement of labour

• Inadequate Training

• Rate Related Issues

• Increments / high labour wages

• Overtime

• Labour shortage leading to higher rates

• Union agreement

Labour Variance

• Labour Cost Variance= (Standard Hrs X Standard Rate Per Hour) –(Actual Hrs X Actual

Rate Per Hour)

• Labour Rate Variance= Actual Hrs (Standard Rate - Actual Rate)

• Labour efficiency Variance= Standard Rate (Std Hrs - Actual Hrs worked)

• Idle Time Variance= Idle Hours X Std Rate

Reasons for overhead Variance

• Under or over absorption of fixed overheads

• Fall in demand/ Improper planning

• Breakdowns /Power Failure

• Labour issues

• Inflation

• Lack of planning

• Lack of cost control

• Variable OH Cost Variance= (Standard Hrs X Standard Variable OH Rate) – Actual OH

Cost

• Variable OH Expenditure Variance= (Actual Hrs X Standard Variable OH Rate) – Actual

OH Cost

• Variable OH Efficiency Variance= (Standard Hrs - Actual Hrs) X Standard Variable OH

Rate

Fixed overhead variance:

• Fixed OH Cost Variance = Absorbed OH – Actual OH

• Absorbed OH = Actual Units * Standard OH Rate per unit

• Fixed OH Expenditure Variance= Budgeted OH – Actual OH

• Fixed OH Volume Variance= Absorbed OH – Budgeted OH

Reasons of Sales Variance

• Change in price

• Change in Market size

• Change in Market share

• Sales Value Variance = Budgeted Sales – Actual Sales

• Sales Price Variance = Actual Quantity (Actual Price - Budgeted Price)

• Sales Volume Variance = Budgeted Price (Actual Quantity - Budgeted Quantity)

Advantages

• Basis for sensible cost comparisons

• Employment of management by exception

Disadvantages

• Too comprehensive hence time-consuming

• Precise estimation of prices or rates is difficult

• Requires continuous revision with frequent changes in technology/ market trends

• Focus on cost minimization rather than quality or innovation.