Module 9. Cost Accumulation 1

 Direct /Indirect Cost  Cost Allocation  Cost Apportionment  Cost Driver  Cost Absorbtion  Treatment of Over/Under absorbed overheads 2

3 Material Elements of Cost LabourExpenses Direct Material Direct Labour Direct Expenses Indirect Material Indirect Labour Indirect Expenses Direct Cost Indirect Cost

4 Direct Costs A cost that can be directly traced to a particular department or other subunit of an organization is called a direct cost. e.g.: The cost of materials required for a particular product is a direct cost because it can be directly traced to the product.

Direct Material Cost Includes the cost of materials and reasonable allowances for scrap and defective units. The cost considered for material include freight and related charges but exclude purchase discounts. Direct Labour Cost Consists the cost of the labour that is used in the actual manufacture of the product or that is used to provide the service. It also includes the cost associated with the nonproductive time that is considered unavoidable and normal. 5

Direct Expenses It includes all expenses other than direct material or direct labour which are specially incurred for a particular cost object and can be identified in an economically feasible way. 6

7 Indirect Costs An indirect cost has no convenient or economical trace from the cost to the cost pool (the meaningful groups into which the jobs are often collected) or from the cost pool to the cost object (any product, service, customer, activity or organizational unit to which costs are assigned for some management purpose).

Indirect Material Cost Refers to the cost of materials used in manufacturing that are not physically a part of finished good. E.g.: supplies used by manufacturing employees, materials required by machines such as lubricants. 8

Indirect Labour cost Includes the costs associated with quality control, supervision, support cost associated with manufacturing, inspection, purchase and receiving costs. 9

10 Indirect Expenses Other Indirect Expenses include depreciation on machines and plant, property taxes, utilities, carriage outward, etc.

Enable a business to identify where costs are arising To manage those costs more effectively. 11 Cost Centres

Cost centre means a location, person or an equipment for which cost may be ascertained, accumulated and accounted for. The main objective is to account and control the cost. 12

Cost Centres Example, In rent a cab system cost centre can be a particular cab, for a carpentry workshop activities like crafting, assembling, polishing & finishing etc. can be cost centres. 13

14 All indirect factory costs are commonly combined into a single cost pool called manufacturing overhead. In a manufacturing firm, it is also called factory overhead. All indirect factory costs are commonly combined into a single cost pool called manufacturing overhead. In a manufacturing firm, it is also called factory overhead. Manufacturing Overheads

15 Manufactu ring Overheads Indirect Material Indirect Labour Indirect Expenses

16 Manufactu ring Overhead Direct Material Direct Labour Finished Goods Inventory Cost of Goods Sold Work in Process Inventory Direct Expenses Prime Cost MANUFACTURING COST FLOW

17  Cost allocation is the process of assigning direct costs to a cost centre.  All direct costs are traced to cost centres through allocation.  Indirect costs (overheads) have to be assigned to cost centers through cost apportionment.  The basis on which costs are apportioned to cost centers is called cost driver. Cost Allocation

Cost Apportionment At this stage, those items of estimated overheads which cannot be directly allocated to various cost centers or departments are apportioned. Apportionment implies the allotment of proportions of items of cost to cost centers or departments. It implies that 18

unallocable expenses are to be spread over the cost centers or departments on an equitable basis. After this stage, all the overhead costs would have been either allocated to or apportioned over various departments. 19

20 COST DRIVER A cost driver is a factor such as the level of activity or volume, that casually affects costs. That is, a cause and effect relationship exists between a change in level of activity or volume and a change in the level of total costs of that cost object.

21 ActivitiesCost Driver Machining operations Machine Hours SetupSetup Hours InspectionPieces Inspected Order CostPurchase Orders Example

Methods of Absorbing Overheads Percentage of direct material Percentage of prime cost Percentage of direct labour cost Labour hour rate Machine hour rate 22

23 Pre-determined overhead rate Pre-determined Overhead rate is a rate, based on budgeted factory overhead cost and budgeted activity, which is calculated before a period begins. A pre-determined overhead rate normally applies for a a single, plant-wide base to calculate and

24 apply overhead. Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units. Predetermined Overhead Rate Budgeted yearly Factory Overheads Budgeted Yearly Activity (direct labor-hours, etc.)

25 Steps for calculating Pre- determined overhead rate Step 1: Estimate the amount of the activity base will be required to support operations in the coming period. Step 2: Estimate the total manufacturing cost at that level of activity.

26 Step 3: Compute the predetermined overhead rate by dividing the estimated total manufacturing overhead costs by the estimated total amount of cost driver or activity base. (Note: Common activity bases used in the calculation include direct labour costs, direct labour hours, or machine hours)

27 Over and Under Application of Overheads Through the use of pre- determined overhead rate, overheads are applied into actual production throughout accounting period. Since the pre-determined rates are based on expected overheads to be incurred and estimated

28 production, usually the overheads absorbed into the production cost may not fully agree with actual overheads. If the overheads absorbed are higher than actual incurred then it is called Over Application. If the overheads absorbed are lesser than actual incurred for the accounting period, it is called Under Application.

29 Reasons The actual hours worked can be more or less than the estimated hours The actual overhead costs are different from budgeted overhead. The application method used may not be correct.

30 Both actual overhead costs and actual activity levels are different from the budgeted costs and level Extra-ordinary expenses might have been incurred during the accounting period. Seasonal variations in the overhead expenses from period to period.

31 Major changes might have taken place for example replacement of manual labour with machines, replacement of general purpose machine with automatic high speed machine etc.

32 Treatment of over/under absorbed overheads in cost accounting Application of supplementary rate: The supplementary rate is calculated by dividing the under or over application amount by the actual base. In case of under application, by applying the supplementary rate

33 the uncovered amount will be adjusted and vice versa. Write off to costing profit and loss account: If the under or over absorbed overheads is small, the it will be written off by transferring it to the costing P&L Account.

34 Carry forward to subsequent year: By treating the under or over absorbed as seasonal fluctuations, we can carry forward it to subsequent accounting year. This may be transferred to Overhead Suspense A/c or Overhead Reserve A/c.