OVERVIEW

Objective

• To understand the different ways costs can be classified, and the different types of costs

1 COST OBJECTIVES

1.1 Why does an enterprise need cost information

• Costs for stock valuation purposes – eg cost of manufacturing an article
• Costs for decision-making purposes – eg whether to make or buy a component for a production process
• Costs for control– eg costs of operating a department compared with budget.

1.2 Terminology

• Cost unit – a unit of product or service in relation to which costs are ascertained. Examples:
• Brewery – barrels of beer
• Coal mining – tonnes
• Electricity – kilowatt hours.
• Cost centre – a location, function or item of equipment in respect of which costs may be ascertained and related to cost units for control purposes. Examples:
• a production department
• quality control
• a specific machine, such as a lathe.
• Profit centre – a business segment in respect of which revenues are received and expenditures caused.

2 COSTS FOR STOCK VALUATION

2.1 Asset/expense

For stock valuation and profit measures must distinguish between

• asset (unexpired cost) balance sheet

• expense (expired cost) P&L a/c.

2.2 Period/product

• Period costs – expensed in the period in which they are incurred therefore not assigned to products for stock valuation purposes.

• Product costs – identified with goods purchased or manufactured for resale.

2.3 Functional classification

2.4 Direct/indirect costs

All costs fall into one of these two categories:

Direct costs which can be separately identified in units of product or service.

• Arise solely from the existence of WHAT is being costed.

Indirect costs which are not directly attributable to units of product or service

• Do not depend solely on what is being costed therefore implies some element of sharing joint or common costs.

• Units are valued to include both direct and indirect production costs only.
• Non-production costs are not included in the stock value, since they are not costs of making the product but are involved in converting the finished units into revenue.

2.5 Costing methods

• Product costing

• Specific-order cost – the costs of each unit of output are separately identified and costed individually (also called job costing)

• Process costing – the cost of a single unit is the average cost of all units produced in a period

• Service costing – where the cost unit is a unit of service, such as insurance, transport, catering

3 COSTS FOR DECISION-MAKING

3.1 Cost behaviour

Costs can also be classified according to how they behave (are affected) as the level of production increases as

3.2 Fixed costs

Do not change regardless of the level of output (eg factory rent).

3.3 Variable costs

Increase (usually in direct proportion) with the level of output. Direct costs are variable costs (eg direct material, direct labour).

Semi variable/mixed costs

Contain both a fixed and variable element (eg electricity bill). For costing purposes these can be divided into their separate (ie fixed and variable) parts.

3.4 Stepped costs

Are fixed for a certain range of output, then increase in a "step" (eg additional supervisor’s salary).

If steps are very small the cost will approximate to a variable cost

If steps are large the cost can be treated as fixed within appropriate ranges.

3.5 Costs per unit

3.5.1 Fixed cost

3.5.2 Variable cost

3.6 Avoidable/unavoidable

• Avoidable– costs that may be saved by not following an alternative course of action therefore relevant for decision-making purposes.

• Unavoidable – cannot be saved therefore irrelevant.

3.7 High-low analysis

• Selects the costs for the highest and lowest levels of activity (output) and assumes a straight line relationship between the two.

• Expresses cost as a linear function of output, ie of the form:
  y = ax + b where

• "a" is the slope (ie variable cost per unit)
• "b" is the intercept on the y axis (ie total fixed cost).

Example 2

Total costs have been recorded for a process for each of the last six months as follows.

Required

(a) Calculate variable cost per unit and total fixed cost using high-low analysis.
(b) Express cost as a function of output (ie in the form of a straight line)
(c) Predict total cost at the budgeted activity level for month 7 of 6,000 units.

3.7.1 Advantage

• Simple to calculate and use.

3.7.2 Disadvantages

• Only two sets of data are considered and all others are ignored.
• Observation at extreme levels of activity are least likely to be typical of normal operating condition.
• A linear relationship is assumed between the variables.

Costing the common inputs-materials, labour and overheads

All products require materials and some other inputs such as labour. The next three sections deals with materials, labour and other production costs. The principles learned from these should enable you to cost a product or unit of service

We start with materials

1 ORDERING AND RECEIVING

1.1 Procedures

1.1 Procedures	1.2 Documents
1.1.1 Requisitioning
Storekeeper requests purchasing department to obtain re-order quantity from appropriate supplier.	Purchase requisition – is authorised to raise a purchase order
1.1.2 Ordering
Purchasing officer (or buyer) requests supply of materials listed.	Purchase order (PO) – specifies quantity, price, delivery date & terms
1.1.3 Receiving
Goods are inspected and checked to the supplier’s delivery note and copy PO before being recorded.	Goods received note (GRN) – creates a common format
1.1.4 Purchase invoicing
When a supplier’s invoice is received it is checked to a GRN before being authorised for payment.	Purchase (supplier’s) invoice

3 ACCOUNTING FOR STOCK MOVEMENT

3.1 Stores record cards/stock cards

Prepared for each item of material. Show

• identification information and location in stores
• quantities on order/ received/issued and a running balance of quantity in stock
• prices and values of all receipts and issues
• all materials control quantities (eg maximum, minimum re-order levels and re-order quantity).

3.2 Bin cards

Prepared for each bin or storage location. Data usually limited to

• location code of bin
• identification of material
• receipts, issues and remaining balance of material held in that location.

4 STOCK CONTROL

4.1 Reasons for holding stock

• To satisfy customer demand (finished goods) or avoid production stoppages (raw materials)

• To provide a "buffer" if demand high or lead time long

• To take advantage of quantity discounts

• To buy in ahead of a shortage or price rise

• For technical reasons (eg maturing whiskey or keeping oil in pipelines).

4.2 Costs associated with stock

Purchase price +/- conversion costs	after quantity discounts labour, overheads, etc
· Holding costs	cost of capital tied up insurance obsolescence, pilferage warehousing (and other "space" costs) stores admin
· Procurement/ ordering costs	transport (goods inwards) clerical and admin batch set-up costs
· Shortage costs	production stoppages "stock-out" costs for finished goods emergency costs
· Systems costs	people/computers maintaining records

4.3 Inventory problems

• How much to order at a time economic order quantity (EOQ)

When to place an order re-order level (ROL)

5 RE-ORDER QUANTITY

5.1 Cost considerations

5.1.1 Holding costs varying with stock levels	5.1.2 Incremental costs of placing an order
Eg opportunity cost of capital invested in stock Normally expressed as a % per £ of average investment	· Fixed costs of placing an order eg sending a fax
· As order quantity , stockholding total annual holding cost (TCH) .	· As order quantity , the number of orders total annual ordering costs (TCO) .

• The problem is trading off costs of carrying large stocks against the costs of placing more orders.

5.1.3 Annual holding cost

• If x is the re-order quantity and it is consumed at a constant rate, then

• If holding a unit in stock for one year costs £C_H then the annual stock holding cost is

5.1.4 Annual order cost

• If C_O is the fixed cost of an order and D the demand per annum in units, then the annual order cost is

.

5.1.5 Graphical representation

Example 1

If D = 40,000, C₀ = £2, C_H = £1

Find the annual ordering cost, annual holding cost and annual total cost when orders of the following sizes are placed:

(a) 200
(b) 400
(c) 600

5.2 Economic order quantity model

5.2.1 Symbols used

Illustration Annual demand for a particular stock item (D) is steady at 120 units. The incremental cost of ordering the stock (CO) is £20 and the cost of holding a unit of stock for a year (CH) is £3.
Order quantity Q	Average stock Q/2	Annual holding cost QCH/2	Numbers of orders pa D/Q	Annual reorder cost COD/Q	Total annual cost QCH/2 + COD/Q
120 60 40 30 20 10	60 30 20 15 10 5	180 90 60 45 30 15	1 2 3 4 6 12	20 40 60 80 120 240	200 130 120* 125 150 255

5.2.2 EOQ formula

Total annual cost =

EOQ = ACCA Exam Formula

In the above illustration, EOQ = = 40

5.2.3 Assumptions

• Constant unit purchase price

• Constant demand (or instantaneous resupply)

• Constant lead time

• No shortage costs because "stock-outs" will not arise

• Reorder cost is independent of order size

• Holding cost per unit (C_H) is constant

• Average stock holding is ^X/_2.

Example 2

If D = 40,000, C_O = £2 and C_H = £1, find

(a) the economic order quantity
(b) the number of orders to be placed each year
(c) the frequency of orders (assume 300 working days).

Solution

(a) EOQ = =

(b) Number of orders =

(c) Frequency of orders =

5.3 Maximum stock levels

• The EOQ formula applies the cost of holding a unit of stock for one year to the average stock level.
• Some elements of cost vary with maximum stock level.
• The EOQ formula can still be used with care.

Example 3

Annual demand = 500,000 units

Fixed cost of placing an order = £20

Sundry holding costs (including the cost of capital tied up) = £3 per unit per annum.

Stock is kept in a warehouse which is on a long lease at a rental cost of £5,000 per annum. Any unused space can be sub-let on annual contracts at a rental of £4.25 per square metre per annum. Each unit takes up 2 square metres of space.

Required

Determine the optimal order quantity.

6 RE-ORDER LEVEL

6.1 Lead time

• The time between placing an order and the actual delivery of goods.

6.2 Optimal re-order level

6.2.1 Demand is constant and lead time is zero

ROL = Zero

6.2.2 Demand is constant and lead time finite, but constant

ROL = Demand in lead time

Example 4

Given daily demand for projector pens at 30, the supplier always delivers exactly four days after the order is placed. What is the ROL?

Solution

ROL =

6.2.3 Finite lead time for deliveries, but demand in lead time is not constant

ROL

=

Average demand in lead time

+

Buffer stock

There are various ways of determining the optimal reorder level in these circumstances (eg tabulation).