What is cost?
Cost is the amount of expenditure
incurred on or attributable to a specified activity. Costs are usually
ascertained in respect of cost units or cost objectives
Cost unit
A cost unit is a quantitative unit of a
product or service in relation to which costs are ascertained e.g. kilowatt
hours.
Cost object
A cost object is any activity for which a
separate measurement of cost is desired. A cost unit is a cost objective.
However, there are some cost objects which are not cost units. Examples of cost
objects include a product, a service, a department or segment of the business,
a function, a process or activity or indeed anything for which one wants to
measure the cost of resources used. Sometimes it is impossible to trace some
costs direct to cost units. Under such situations costs are first traced to
cost centers for further spreading unto cost units.
Cost center
A cost center is a location, a person, an
item of equipment (or a group of these in relation to which cost are
ascertained and further related to cost units e.g. maintenance section,
managing director and the plant. Cost centers are broadly classified into:
1. Production cost centers
2. Service cost
centers
Cost can be classified variously for
different objectives.
COST
CLASSIFICATION
I. Classification According To Element
of Cost
Costs can be classified by element. There
are three basic elements of cost. These are materials, labor and other
facilities or resources other than materials and labor. Thus when classified according
to elements, there are the following classes of cost:
Materials cost: These are the costs of materials or commodity other than fixed
assets, introduced into product or consumed in the operations of an
organization. In other words, they are the cost of materials input into the
production of goods and services. For example, the cost of: Raw materials,
Component parts, Work in progress, Primary] packing materials and Stationary
Labor Cost: These are the cost of employee remuneration i.e. payments made to
and on behalf of employees for offering labor services in the production
function.
Expenses These
are all other costs other than material cost and labor costs. For example
the cost of: hiring special equipment and
maintaining such equipment, royalty payments, copyrights and patent payments,
utilities such as electricity and water, rent etc.
II. Classification As Direct Or
Indirect
Cost can also be classified either as
direct cost or as indirect costs.
Direct Cost: These are cost that can be directly identified and charged to a cost
unit without apportioning. Direct costs comprises of:
Direct material cost: These are the costs of material that can be physically identified with
a specific cost unit. They are the cost of materials entering into and becoming
constituent elements of a product or saleable service. Direct materials costs
are allocated to cost units. Note Some materials which could qualify as direct
materials may be treated as indirect materials for purposes of materiality and
convenience. Examples: Materials specifically purchased for a particular job
order or process, Materials requisitioned from from store for a particular
production order, Work in progress and component parts and Primary packing
materials.
Direct labour or wages cost: These are the cost of remuneration for employees‟ efforts and skill applied directly to a product or saleable service.
Such wages are allocated directly to cost units. Examples of direct labour cost
are: Wages of production operatives who are involved in transforming the raw
materials into finished goods, Wages of waiters who serve meals at a hotel and
Wages of sales assistants involved in selling goods in a retailing shop.
Direct Expenses: These are costs other than material cost, labour cost which can be identified
with and charged or allocated to a cost unit. In other wards they are costs
other than material cost and labour cost which are incurred for a specific
product or saleable service. Examples of direct expenses are: the cost of
hiring a special equipment for a particular production order, the maintenance
cost of special equipment’s hired for particular production orders, royalty
payments and traveling expenses
Indirect Cost
All costs that cannot be identified with
and allocated to a cost unit but that has to be apportioned to a number of cost
centres and further absorbed by cost units are described as indirect cost. Another
term for all indirect costs is overhead costs. Indirect costs comprise of:
Indirect Material Cost: These are the cost of material items that cannot be identified with
any one product because they are used for the benefit of all products rather
than for any one specific product. In other words, these are materials cost
which cannot be allocated to cost units but are apportioned and absorbed by
cost units. For example; The cost of materials required for operating and
maintaining plant & equipment such as , cost of stationary and cost of
cleaning materials
Indirect labour cost: These are wages of employees who do not work on the product itself
but who assist in the manufacturing process. Such costs cannot be allocated to
cost units; rather they are apportioned to cost centres and further related to
cost units through absorption. For example: salaries of factory supervisors,
wages of the stores dept employees’
Indirect Expenses These are expenses incurred in general and not for the production of
a specific cost unit. For example” Selling and distribution expenses,
advertising, sales promotion and administrative expenses
COST CARD
Direct material cost xx
Direct labour cost xx
Direct Expenses xx
Prime cost xxx
Indirect material cost xx
Indirect labour cost xx
Indirect expenses xx
Overhead cost xxx
Total cost xxx
III. Classification According To
Function
All the indirect costs, that is, overhead
cost, can also be classified according to function. Thus, overhead can be
classified as:
Production Overheads: These are the indirect cost of manufacturing a cost unit. It comprises
of indirect materials consumed in the factory, indirect factory wages and other
indirect expenses incurred in connection with production.
Selling Overheads: These are marketing costs incurred in securing orders, e.g. sales promotion
cost.
Marketing Overheads: These are the costs incurred in publicizing and presenting to customers
the products of the undertaking in suitably attractive forms at acceptable
prices together with the cost of all relevant research work, the securing of
orders and delivery of the goods to customers. It also includes the costs of
after sales services or processes. Thus, marketing costs comprise of: selling
costs, distribution costs and other connected costs.
Distribution Overheads: These are the costs incurred in making the finished goods ready for
dispatch and the delivery of the product to customers, e.g. cost of carriage outwards.
e. Administrative Overheads: These are the costs of formulating policy, directing
and controlling operations not related directly to production, selling,
distribution or research and development. Research and Development
Overheads: These are the costs of seeking new ideas, materials, methods of
production and improved products and the development and design of such ideas
so that they can be applied to formal production.
Cost Card
Direct material cost xxx
Direct labour cost xxx
Direct expenses xxx
Prime cost xxx
Indirect production material cost xxx
Indirect production labour cost xxx
Indirect production expenses xxx
Production overheads xxx
Production cost xxx
Selling overheads xxx
Distribution overheads xxx
Administrative overheads xxx
Total cost xxx
Profit margin xxx
Selling price xxx
IV. Classification According To
Behavior
Costs may be classified according to the
way the cost behaves in relation to activity level. In this regard, cost may be
classified as:
Fixed Cost These are costs that do not vary with changes in activity levels.
They usually change with the passage of time. For example, rent and rates, the
managing director’s salary etc
Variable Cost These are costs which vary in direct proportion with changes in
activity levels. For example, the cost of raw materials, direct wages and
direct expenses such as royalties.
Semi-fixed\semi-variable or mixed
cost: These are costs which contain fixed and variable
elements. That is, for a given range of activity level. The cost may remain constant
and beyond the relevant ranges, costs may then vary in direct proportion with changes
in activity level. For example, the cost of utilities such as electricity,
water and telephone.
Stepped fixed cost: These are costs which are fixed for a given range of activity level but
which change discretely for ranges of activity levels beyond the given ranges.
V. Classification as Product Costs or
Period Costs
Product Costs These are the costs that are identified with goods produced or
purchased for resale. These usually are the production or manufacturing costs.
They are the costs used for the valuation of stocks and work in progress.
Examples of product costs are: cost of raw materials, production wages and
production overheads such as electricity, depreciation of plant, rent of
factory premises etc. Product costs can be analyzed as expired costs or
unexpired costs.
Period Costs These are the costs incurred and charged against profit for a
period, and not included in cost for stock valuation purposes. These usually
are non-manufacturing costs. Examples are selling and distribution overheads
and administrative overheads. Period costs are charged in full to the profit
and loss account for the period. They are not included for stock valuation
purposes.
Relevant Costs/Revenue These are those future costs and revenues that can be altered by a
given decision. Examples: Future costs Opportunity costs Avoidable costs
Incremental costs etc.
Irrelevant Costs/Revenues These are those costs/revenues that will not be affected by a given
decision. Irrespective of what decision is taken, the cost will not alter.
Examples Past costs Sunk costs Unavoidable costs
VII. Other Classifications of Cost
Avoidable Costs These are costs that may be saved by the adoption of a given
alternative option.
Non-Avoidable Costs These are costs that cannot be saved or eliminated by the adoption of
a given alternative line of action.
Normal Costs These are costs planned for and expected at given levels of activity
under specified conditions. For example, normal scrap and loss of materials
cost of expected idle time etc.
Abnormal Costs These are costs not planned for and therefore not expected to be incurred
at a given level of activity under conditions in which that level of activity
is normally achieved, e.g. cost of excessive scrap and abnormal idle time pay
etc.
Sunk Costs These are the costs of resources already acquired. They are costs
created by decisions made in the past and cannot be altered by decisions to be
made in the future.
For example the written down value of
plant previously acquired.
Opportunity Costs These are the values of benefits forgone or sacrificed in favour of alternative
courses of action.
Incremental Costs/Revenue They are the additional costs or revenues that arise from the production
or sale of a group of additional units. These are sometimes termed differential
costs.
Marginal Costs/Revenues These are the additional cost or revenue that arises from the production
of one additional unit of output or service.
Future cost these are costs estimated and are reasonably expected to be incurred
in the future.
Replacement Costs These are the estimated costs at which an identical item can be acquired
or produced.
Conversion costs these are the cost of transforming raw materials into finished goods
or the cost of converting raw materials from one stage of production cycle to
the next. It is total cost of production less cost of bought in materials.
Policy Costs These are costs additional to normal requirement incurred in
accordance with the policy of an undertaking. They are also termed discretional
costs.
Development Costs These are costs of research into improving the production of goods and
services.
Value Added This is the increase in market value of a product as a result of
changing the form, location etc, of that product. It is the total market value
of the product less cost of bought in materials and services.
Standard Costs These are cost estimated and expected to be incurred per unit of
activity under efficient production conditions.
Budgeted costs these are costs estimated and planned for a given activity level,
function or segment of the organization within a specified time horizon.
Actual costs These are the cost actually incurred in the production process.
Actual costs are not estimates but are historical or past costs.
BUDGETING
What is budget?
A budget is " A financial and/or
quantitative statement, prepared and approved prior to define period of time,
of the policy to be pursued during that period for the purpose of attaining a
given
Objective." According to Brown and
Howard of Management Accountant "a budget is a predetermined statement of
managerial policy during the given period which provides a standard for comparison
with the results actually achieved." achieved."
Essentials of a Budget:
(1) It is prepared for a definite future
period.
(2) It is a statement prepared prior to a
defined period of time.
(3) The Budget is monetary and I or
quantitative statement of policy.
(4) The Budget is a predetermined
statement and its purpose is to attain a given objective.
A budget, therefore, be taken as a
document which is closely related to both the managerial as well as accounting
functions of an organization.
Requisites for Effective Budgetary
Control
The following are the requisites for
effective budgetary control:
(1) Clear cut objectives and goals should
be well defined.
(2) The ultimate objective of realizing
maximum benefits should always be kept uppermost.
(3) There should be a budget manual which
contains all details regarding plan and procedures for its execution. It should
also specify the time table for budget preparation for approval, details about
responsibility, cost centers etc.
(4) Budget committee should be set up for
budget preparation and efficient execution of the plan.
(5) A budget should always be related to
a specified time period.
(6) Support of top management is
necessary in order to get the full support and co-operation of the system of
budgetary control.
(7) To make budgetary control successful,
there should be a proper delegation of authority and responsibility.
(8) Adequate accounting system is
essential to make the budgeting successful.
(9) The employees should be properly
educated about the benefits of budgeting system.
(10) The budgeting system should not cost
more to operate than it is worth.
(11) Key factor or limiting factor, if
any, should consider before preparation of budget.
(12) For
budgetary control to be effective, proper periodic reporting system should be
introduced
As budgets serve different purposes,
different types of budgets have been developed. The following are the different
classification of budgets developed on the basis of time, functions, and
flexibility or capacity.
(A) Classification on the Basis of
Time
1. Long-Term Budgets: Long-term budgets are prepared for a longer period varies between
five to ten years. It is usually developed by the top level management. These
budgets summaries the general plan of operations and its expected consequences.
Long-Term Budgets are prepared for important activities like composition of its
capital expenditure, new product development and research, long-term finance
etc.
2. Short-Term Budgets: These budgets are usually prepared for a period of one year.
Sometimes they may be prepared for shorter
period as for quarterly or half yearly. The scope of budgeting activity may
vary considerably among different organization.
3. Current Budgets: Current budgets are prepared for the current operations of the
business.
The planning period of a budget generally
in months or weeks. As per ICMA London, "Current budget is a budget which
is established for use over a short period of time and related to current conditions."
(B) Classification on the Basis of
Function
1. Functional Budget: The functional budget is one which relates to any of the functions
of an organization. The number of functional budgets depends upon the size and
nature of business.
The following are the commonly used:
(1) Sales Budget
(2) Purchase Budget
(3) Production Budget
(4) Selling and Distribution Cost Budget
(5) Labour Cost Budget
(6) Cash Budget
Budget
(7) Capital Expenditure Budget
2. Master Budget: The Master Budget is a summary budget. This budget encompasses all
the functional activities into one harmonious unit. Master Budget is the
summary budget incorporating its functional budgets, which is finally approved,
adopted and employed.
(C) Classification on the Basis of
Capacity
1. Fixed Budget: A fixed budget is designed to remain unchanged irrespective of the
level of activity actually attained.
2. Flexible Budget: A flexible budget is a budget which is designed to change in
accordance with the various level of activity actually attained. The flexible
budget also called as Variable
Budget or Sliding Scale Budget, takes
both fixed, variable and semi fixed manufacturing costs
into account.
COST STATEMENT/SHEET
Cost statement is an analytical statement
of expenses relating to production of an article which informs regarding total
cost, per unit cost and quantity of production. According to Weldon,
“Cost statements are prepared for the use
of management and consequently, they must include all the essential details
which will assist the manager in checking the efficiency of production “Cost sheet
is a cost schedule or document which provides for the assembly of the estimated
detailed cost in respect of a cost centre or cost unit” When cost per unit of
production is not necessary to calculate then a statement of cost is prepared
to ascertain total cost and profit or loss on production otherwise prepare cost
sheet.
Example
The following figures have been extracted
from the records of a manufacturing company for the
year ending 31st December, 2014. You are
required to prepare a statement of cost showing: (a)
Cost of raw materials consumed (b) Prime
Cost (c) Factory Cost (d) Cost of production (e) Cost
of goods sold (f) Total cost of goods
sold and profit on sales.
Stock of Raw Materials (1-1-14) 3,000.00
Stock of Raw Materials (31-12-14) 2,400.00
Purchases of Raw materials 14,000.00
Stock of work-in-progress (1-1-14) 1,000.00
Stock of work-in-progress (31-12-14) 800.00
Carriage inward 500.00
Manufacturing wages 4,000.00
Other direct expenses 200.00
Indirect wages 1,000.00
Experiment expenses
400.00
Wastage of materials 50.00
Factory overhead 7,000.00
Establishment on costs
2,000.00
Selling overhead 4,000.00
Distribution overhead 1,000.00
Stock of finished goods (1-1-14) 1,200.00
Stock of finished goods (31-12-14) 3,000.00
Sales 40,000.00
Mr sifuna had
the following trial balance on 31 march 2018
Drsh’000 Cr sh’000
Capital
1224000
Freehold Land
and Buildings
900000
Freehold
Machinery (cost)
870000
Plant and
machinery provision for depreciation
420000
Loose tools at
valuation 1.4.2017
72000
Salesmen motor
vehicles at cost
24000
Salesmen motor
vehicle provision for depreciation
168000
Stock :Raw
Materials
198000
Finished goods
36000
Purchases:Raw
materials
1110000
Loose tools
48000
Sales
3960000
Wages and
Salaries :Factory
818000
Administration
324000
Sales
department
180000
Rates and
Insurance
96000
Repairs and
Maintainance to Buildings 60000
Sales Expenses
,including motor running expenses 86000
Electricity and
Power
360000
Industrial
Training Levy
18000
Administration
Expenses
168000
Provision for
doubtful debts
60000
Debtors and
Creditors
496000 482000
Drawings
120000
Cash in Hand and
Bank Overdraft
6000 216000
6530000 6530000
The following additional information is available
i.
Closing stock 31 march
2018
Raw
materials 168000000 Finished Goods 334000000 Loose Tools 96000000
ii.
Provision is to be made
for the following amounts owing on 31
March 2018
Electricity
and Power 48000000 New Machinery 150000000
iii
Payments in advance on 31 March 2018
were as follow Vehicle licences
630000 rates 3450000
iv Depreciation
on Plant and Machinery and salesmen vehicles is to be provided at the rate of
20% and 25% respectively on cost at the end of the year
v Bad debts
amounting to 6500000 are to be written off and provision for doubtful debts to
be 10% of Trade Debtors
vi The following
expenses to be apportioned two thirds to factory and one third to
administration
Electricity and
Power
Repairs and
Maintenance
Rates and
Insurance
Required: Manufacturing, Income Statement and
Statement of Financial Position as at 31 March 2018
FINANCIAL
PLANNING PROCESS
The process of
generating short-term financial forecasts is depicted in Figure 11.1 below. A
systems approach is necessary for development of the budgets. They input is the
sales forecast, from productions are prepared then the cash budget and the
pro-forma income statement and finally the pro-forma balance sheet. The steps
are summarized as:
1.
Establish a sales projection.
The key input to preparation of cash budgets is the firms revenue
(sales) forecast. It is on the basis of
this forecast that the manager predicts cash receipts, cash outlays, fixed
asset requirements and the amount of outside financing that will be
necessary. The sales forecast could be
eternally based (i.e. on the national GDP) internally based or a combination of
the two.
2.
Determine a production schedule and the associated
use of raw materials, labour, overheads and operating expenses. The number of
units produced will depend on the beginning inventory, the sales projections,
and the desired level of ending inventory
3.
Prepare the pro-forma income statement and the cash budget.
4.
Finally, develop the pro-forma balance sheet.
Figure 11.1
Short term financial planning process
|
9.3 PREPARING FINANCIAL FORECASTS
Two key outputs
of short-term financial planning are:-
(i)
cash budgeting
(ii)
Pro-forma financial statements
We will from now
hence in this lecture concentrate on the preparation of these statements.
11.3.1 Cash
Budgets
The cash
budget is a statement of the firm’s planned cash inflows and outflows over
a period of time. Typically a cash
budget may be for a year, divided into smaller time intervals. Its main uses
are enable the firm foresee any future deficits in cash and hence make prior
arrangement to obtain necessary bridging short term financing (overdraft and
short term loans): in the case of a surplus cash, a plan can plan for
beneficial short term investments (marketable securities).The general format of
a cash budget is as follows:-
|
|
JANUARY |
FEBRUARY |
|
Cash receipts |
XXX |
XXG |
|
Less cash disbursements |
XXA |
XXH |
|
Net cash flow |
XXB |
XXI |
|
Add beginning cash balance |
XXC |
XXD |
|
Ending cash balance |
XXD |
XXJ |
|
Less minimum balance |
XXE |
XXK |
|
Required total financing |
|
XXL |
|
Excess cash balance |
XXF |
|
Let’s now
examine the two main components of the cash budget.
Cash Receipts
Cash receipts
include all of a firm’s cash inflows during the period. The most common sources
of cash are cash sales, collections from debtors, other operating receipts and
capital receipts from sales of fixed assets, borrowings and issue of shares.
Depending on the credit terms offered to customers, and their payment habits, a
schedule for collections from debtors could be necessary working for the
preparation of the budget..
Cash Disbursement
The most common cash disbursements are cash purchases of stock, payment
to creditors, payment of expenses like rent, wages, and utilities, purchase of
fixed assets, interest payments, dividend distributions, repayment of loans and
payment of taxes. Depreciation and other
non cash charges are not included in the cash budget.
Example
The actual sales
and purchases for Sirikwa Importers Ltd. for September and October 2005, along
with its forecast sales and purchases for the period November, 2005 through
April, 2006, follows:-
|
MONTH |
SALES Sh.‘000’ |
PURCHASES Sh.‘000’ |
|
September (actual) |
210,000 |
120.000 |
|
October (actual) |
250,000 |
150.000 |
|
November |
170.000 |
140.000 |
|
December |
160.000 |
100.000 |
|
January |
140.000 |
80.000 |
|
February |
180.000 |
110.000 |
|
March |
200.000 |
100.000 |
April
|
250.000 |
90.0000 |
The firm makes 20% of all sales for cash and collects on 40% of its
sales in each of the 2 months following the sale. Other cash inflows are expected to be Sh. 12
million in September and April, Sh. 15 million, in January and March and Sh. 27
million in February. The firm pays cash
for 10% of its purchases. It pays for 50% of its purchases in the following
month and for 40% of its purchases 2 months later.
Wages and salaries amount to 20% of the preceding months sales. Rent of Sh.20 million per month must be
paid. Interest payments of Sh.10 million
are due in January and April. A principal payment of Sh.30 million is also
one in April. The firm expects to pay
cash dividends of Sh.20 million in January and April. Taxes of Sh.80 million
are due in April. The firm also expects
to make a Sh.25 million cash purchase of fixed assets in December.
The firm had a cash balance of Sh.22 million at the beginning of
November and wishes to maintain a minimum balance of Sh.15 million
Required:
(a) A cash budget for the six months November
through April
(b) If the firm were requesting a line of
credit to cover needed financing for the period November to April, how large
would this line of credit have to be?
Explain.
