BAC 202

COST ACCOUNTI NG I

SEPTEMBER DECEMBER 2017

COURSE CONTENT

1. NATURE OF COST ACCOUNTI NG

2. COST CLASSI FI CATI ON

3. BASI C COST ESTI MATI ON AND FORECASTI NG METHODS

4. ACCOUNTI NG FOR MATERI ALS

5. ACCOUNTI NG FOR LABOUR

6. ACCOUNTI NG FOR OVERHEAD

7. COSTI NG TECHNI QUES

1
 TOPI C ONE

I NTRODUCTI ON TO COST ACCOUNTI NG

Def init ion of Cost Account ing

Cost account ing is t he pr ocess of det er mining t he cost of pr oducing some

pr oduct , pr oviding some ser vice or under t aking some act ivit y. I n abr oad sense, it
t hat par t of management account ing which est ablishes budget s and st andar d
cost s and act ual cost s of oper at ions, pr ocesses, depar t ment s or pr oduct s and
t he analysis of var iances, pr of it abilit y or social use of f unds.

Pur pose of Cost Account ing in Planning and Cont r ol

1. I t indicat es wher e losses and wast es ar e accr uing bef or e t he wor k is

f inished. I mmediat e act ion can be t aken t o minimize t he losses.
2. I t enables management t o consider alt er nat ive met hods and pr ocedur es in
management in or der t o decide whet her t o manuf act ur e a pr oduct or buy
it f r omout side or t o cont inue pr oduct ion at a loss or adj ust t he pr ices.
3. Enables management t o ar r ive at t he cost of pr oduct ion of ever y unit , j ob,
oper at ion, pr ocess, depar t ment or ser vice, t hus, develop a cost st andar d.
4. Pr ovides f or per iodic pr of it s or loss account and balance sheet s at such
int er vals e.g. weekly, mont hly, or quar t er ly as management may
r ecognize dur ing he f inancial year eit her f or t he business as a whole,
depar t ment s or pr oduct s.
5. Reveals sour ces of economies in pr oduct ion having r egar d t o met hods,
t ypes of equipment s, design, out put or layout .
6. Pr esent s compar at ive cost dat a f or dif f er ent per iods and var ious volumes
of pr oduct ion. Management can t her ef or e monit or t he development of t he
business and use t he inf or mat ion f or budget ar y cont r ol.
Cost Account ing Ver sus Financial Account ing

Financial account ing is t hat par t of account ing t hat cover s t he classif icat ion
and r ecor ding of act ual t r ansact ions of an ent it y in monet ar y t er ms in
accor dance wit h est ablished concept s, pr inciples, account ing st andar ds and legal
r equir ement s. I t also pr esent s as

1
accur at e as possible t he ef f ect s of t hose t r ansact ions over a per iod of t ime and
at t he end of f inancial year . The emphasis of f inancial account ing is upon
classif icat ion by t ype of t r ansact ion and t ype of expendit ur e r at her t han
f unct ional analysis of cost account ing.
Cost Account ing Ver sus Management Account ing

Management account ing is t he pr ovision of inf or mat ion r equir ed by management f or :

1. policy f or mulat ion
2. planning and cont r olling t he act ivit ies of t he ent er pr ise
3. decision making
4. disclosur e t o employees
5. disclosur e t o shar e holder s and ot her int er est ed par t ies
6. saf eguar ding asset s

I n gener al, management account ing is wider in scope and uses. Mor e advanced
t echniques t han t hose used in cost account ing ar e applied in management
account ing. However , a f undament al r equir ement of management account ing is
t he exist ence of a sound cost ing syst emt o pr ovide basic dat a.

Bot h management account ing and cost account ing ar e concer ned wit h t he
pr ovision of inf or mat ion f or int er nal planning, cont r ol, and decision making
pur poses wit h consider able emphasis on t he cost s, f unct ions, act ivit ies,
pr ocesses and pr oduct s.
I nst allat ion and Oper at ion of Cost Account ing

Bef or e inst alling a cost account ing syst em, t he or ganizat ion needs should be
st udied and invest igat ed in or der t o est ablish t he f ollowing:
1. The nat ur e of t he or ganizat ion
2. t he size of t he or ganizat ion
3. t he pur pose f or which cost inf or mat ion is r equir ed
4. t he benef it s of cost inf or mat ion t hat will accr ue
5. t he availabilit y of wor kf or ce who have t he necessar y skills of cost account ing

Char act er ist ics of an Ef f ect ive Cost Account ing Syst em

Any account ing syst emshould meet t he f ollowing minimumr equir ement s:
a. Ther e should be a separ at e cost account ing depar t ment . The dut ies of
cost account ing should be clear ly laid out . This is f or t he pur pose of
avoiding conf lict and duplicat ion of dut ies wit h t hose of f inancial
account ing.
b. Ther e should be st andar d pr e- pr int ed f or ms. These will be used f or
r ecor ding labor hour s, issue of mat er ials, and t he cost involved.
c. Ther e should be coor dinat ion and cooper at ion among st af f member s of t he
ent ir e or ganizat ion par t icular ly t hose involved in r ecor ding and analyzing
cost s.
d. Ther e should be a syst emof r ecor ding over heads accur at ely and char ging
t he same t o j obs.
 e. The cost account s and f inancial account s should be maint ained in such a
way t hat t hey can be r econciled easily.
f . The cost account ing syst emshould be simple and meet t he r equir ement of
cost ver sus benef it .
1.1 Cost Concept s

Cost

Cost is def ined as t he amount of expendit ur e incur r ed on or at t r ibut able t o a

specif ied act ivit y or pr oduct . I t r elat es t o past cost s which ar e t he basis of cost
ascer t ainment . At t he simplest level, cost s include component s, quant it y used
and pr ice.
Cost Unit s

A cost unit is a unit of quant it y of pr oduct or ser vice or t ime in r elat ion t o which
cost s ar e ascer t ained or expr essed. The cost unit will be dif f er ent in dif f er ent
or ganizat ions. For example it may be unit of pr oduct ion like a passenger seat , a
hair cut , a pat ient bed, et c. it may also be a unit of t ime like one labor hour or
one consult ing hour .
Cost Cent r e

A cost cent r e is a pr oduct ion or ser vice locat ion, f unct ion, act ivit y or it em of
equipment whose cost s may be at t r ibut ed t o cost unit s. Examples of cost cent er s
ar e: t he wor ks of f ice, sales r epr esent at ions, invoicing sect ion, and inspect ion.
Any par t icular par t of t he ent er pr ise in gener al (such as t he account s
depar t ment , t he st or e depar t ment , and administ r at ion depar t ment ) is r egar ded
as cost cent er s.

TOPI C 2

COST CLASSI FI CATI ON

Cost classif icat ion is t he ar r angement of it ems of cost in a logical sequence

having r egar d t o t he nat ur e and pur pose of t hose cost s. These classes of cost s
can be cat egor ized as:
Funct ional classif icat ion

Cost s ar e ar r anged accor ding t o f unct ions of t he or ganizat ion. The f ollowing ar e
common f unct ional cost s in most or ganizat ions:

a. Pr oduct ion cost s

These ar e cost s incur r ed in t he pr oduct ion act ivit ies of t he or ganizat ion.
Pr oduct ion cost s include t he r aw mat er ials and labor cost s and dir ect
over heads. These cost s ar e collect ively known as element s of manuf act ur ing
cost s.
Mat er ial cost s- mat er ial cost s can be dir ect or indir ect . Dir ect
mat er ial cost s ar e t hose t hat can be physically ident if ied wit h a
specif ic pr oduct e.g. t he cost of wood in t he manuf act ur e of a t able.
I ndir ect mat er ial cost s ar e

3
 t hose t hat can not be dir ect ly ident if ied wit h t he pr oduct e.g. t he
cost of nails or glue in t he manuf act ur e of a t able.

Labor cost s- labor cost s can also be dir ect or indir ect . Dir ect labor
cost s ar e t hose t hat can be specif ically t r aced t o a par t icular
pr oduct e.g. wages of machine oper at or s engaged in t he pr oduct ion
pr ocess. I ndir ect labor cost s consist of all wages of employees who
ar e not dir ect ly involved in t he pr oduct ion of t he pr oduct but assist
in pr oduct ion of t he pr oduct e.g. t he salar ies of f act or y
super visor s.

Dir ect over heads/ expenses- t hese consist s of all manuf act ur ing
cost s ot her t han dir ect labor and dir ect mat er ial cost s. These
over heads include: indir ect wages, indir ect mat er ials, r ent and
r at es, and depr eciat ion

b. Administ r at ion cost s- t hese ar e cost s associat ed wit h t he over all

management of t he business. They can not be ident if ied wit h a specif ic
f unct ion e.g. salar ies of of f ice st af f , of f ice r ent , post age and t elephone,
et c.

c. Selling cost s- t hese ar e cost s consumed in t he gener at ion of r evenues or

secur ing or der s f r omcust omer s e.g. sales commission and adver t isement
expenses

d. Dist r ibut ion cost s- t hese ar e cost s incur r ed in handling t he pr oduct f r om

t he t ime t he pr oduct is complet ed unt il it r eaches t he f inal dest inat ion.
Such cost s include: war ehouse expenses and packaging cost s.
The composit ion of pr oduct cost s can be illust r at ed by use of a diagr amshown below.

Dir ect mat er ial

cost

Dir ect labor Pr ime or Dir ect

cost cost

Dir ect
expenses

I ndir ect
Tot al cost
Mat er ial Cost

I ndir ect labor

cost

Administ r at ion I ndir ect cost s

cost s or over heads

Selling cost s

Dist r ibut ion

cost s.

1.3 Cost Behavior

Cost behavior is how cost s change wit h an incr ease in t he level of act ivit y or
pr oduct ion level of t he f ir m. Cost s in gener al can be classif ied int o:
• Fixed cost s.
• Var iable cost s.
• Mixed cost s.

5
Fixed Cost s

A f ixed cost is said t o be f ixed if t hat cost t ends t o r emain unchanged in t ot al

despit e even r elat ively wide f luct uat ions in levels of out put or act ivit y. Rent al
cost s, pr oper t y t axes, super vising salar ies, and depr eciat ion ar e of t en given as
a good example of a cost t hat is f ixed in t hat t he amount paid or incur r ed does
not var y no mat t er how many unit s ar e pr oduced or pr ovided.

However , it does not mean t hat f ixed cost s never change. The assumpt ion is t he
oper at ions of t he f ir m ar e maint ained at t he same capacit y over a longer per iod
of t ime. Should t he f ir m decide t o expand and invest in new asset s, t he f ixed
cost s will def init ely change.

Gr aphically, f ixed cost s ar e r epr esent ed by a hor izont al line as shown below.
Cost s

Fixed Cost

Volume of pr oduct ion

Classif icat ion of Fixed Cost s

Fixed cost s can be classif ied f ur t her int o t he f ollowing classes:

i. Commit t ed cost s- t hese ar e cost s incur r ed t o maint ain company’s
f acilit ies and physical exist ence, and over which management has lit t le
or no discr et ion. Plant and equipment depr eciat ion, t axes, insur ance
pr emiumr at e and r ent char ges ar e examples of commit t ed cost s.
ii. Managed cost s- t hese ar e r elat ed t o cur r ent oper at ions which must
cont inue t o be paid t o ensur e t he cont inued oper at ion of t he company.
For example, management and st af f salar ies.
iii. Discr et ionar y cost s- t hey ar e also known as pr ogr ammed cost s. They
r esult
f r omspecial policy decisions, management pr ogr ams, new r esear ches, et c.
f or

6
 example r esear ch and development cost s, mar ket ing pr ogr ams, and
new syst emdevelopment cost s.
iv. St ep cost s- a st ep cost is const ant f or some level of out put beyond
which it st ar t s t o change. I f pr oduct ion is incr eased again, t he cost s
will shif t upwar ds in st air - case behaviour . An example of such cost s is
t he cost of super vision. These cost s can be shown diagr ammat ically as
below:

Super vision cost s

Number of wor ker s

Var iable Cost s

A var iable cost is said t o be var iable if t he t ot al cost changes in pr opor t ion t o
changes in t he levels of out put or act ivit y. The r at e of change in a var iable cost
need not be 1: 1. That is, a cost may var y in dir ect pr opor t ion wher e f or ever y
unit change in out put t her e is a unit change in t ot al cost . Alt er nat ively, t he
t ot al cost may var y in t he r at io of 5: 1, or
10: 3. The impor t ant point is t hat t her e is a signif icant r elat ionship bet ween
changes in out put and changes in t ot al cost . Dir ect mat er ials cost and dir ect
labour cost is gener ally var iable cost s.

Var iable over heads like f act or y supplies, indir ect mat er ials, sales commission,
and of f ice supplies ar e some ot her examples of var iable cost s. I f t he f act or y is
shut down, var iable cost s ar e eliminat ed. Var iable cost is always expr essed in
t er ms of unit s or per cent age of volume; it can not be st at ed in t er ms of t ime.
The behaviour of var iable cost could be linear or non- linear depending on t he
act ivit y involved.
I llust r at ion of var iable cost behaviour .

(a) (b) (c)

Var iable cost s

Var iable cost s

Var iable cost s

Unit s
Unit s pr oduced Unit s pr oduced pr oduced

(a) Var iable cost exhibit ing a linear r elat ionship bet ween cost and unit s
pr oduced.
(b) Var iable cost exhibit ing a non- linear r elat ionship bet ween cost and
unit s pr oduced (var iable cost s incr easing at an incr easing r at e).
(c) Var iable cost exhibit ing
a non- linear
r elat ionship bet ween
cost and unit s pr oduced
(var iable cost s
incr easing at a
decr easing r at e).

Mixed Cost s

Mixed cost s ar e made of f ixed and var iable element s. They ar e a combinat ion of
semi- var iable cost s and semi f ixed cost s. Because of t he var iable component ,
t hey f luct uat e wit h volume; because of t he f ixed component t hey do not change
in dir ect pr opor t ion t o out put .

8
1.4 Cost s f or Decision Making and Planning

Pr oduct and Per iod Cost

Account ant s classif y cost s as pr oduct cost s and per iod cost s. Pr oduct cost s ar e
t hose t hat ar e ident if ied wit h goods pur chased or pr oduced f or r esale. I n a
manuf act ur ing or ganizat ion t hey ar e cost s t hat t he account ant at t aches t o t he
pr oduct and t hat ar e included in t he invent or y valuat ion f or f inished goods.

Per iod cost s ar e t hose cost s t hat ar e not included in t he invent or y valuat ion and
as a r esult ar e t r eat ed as an expense in t he per iod in which t hey ar e incur r ed.
Hence no at t empt is made t o at t ach per iod cost s t o pr oduct s f or invent or y
valuat ion pur poses. I n manuf act ur ing or ganizat ions, all manuf act ur ing cost s
ar e r egar ded as pr oduct cost s and non- manuf act ur ing cost s ar e r egar ded as
per iod cost s. Companies oper at ing in t he mer chandising sect or will r ecor d t he
pur chase pr ice of goods t r aded as pr oduct cost s; while ot her cost s like
administ r at ion and selling expenses will be consider ed as per iod cost s.

Oppor t unit y Cost

This is t he cost of t he best f or egone alt er nat ive. I t is t he benef it lost by

r ej ect ing t he best compet ing alt er nat ive t o t he one chosen. The benef it lost is
usually t he net ear nings or pr of it s t hat might have been ear ned f r om r ej ect ed
alt er nat ive. For example, assume t hat a manuf act ur er can sell a semi f inished
pr oduct f or Sh 100, 000. However , t he manuf act ur er decides t o f inish t he pr oduct
bef or e selling it . The oppor t unit y cost of t hat pr oduct is t her ef or e Sh 100, 000.
(Revenue f or egone in or der t o f inish t he pr oduct bef or e selling). Oppor t unit y
cost s ar e impor t ant in decision- making and evaluat ing alt er nat ives. However ,
t hese cost s ar e not r ecor ded I t he account ing syst em.
Sunk Cost

A sunk is t he cost t hat has alr eady been incur r ed and it s amount will be af f ect ed
by t he choice bet ween var ious alt er nat ive. They ar e gener ally known as
unavoidable cost , it r ef er s t o all past cost s since t hese amount s can not be
change once t he cost is incur r ed. They ar e cost s which have been cr eat ed by a
decision in t he past and can not be changed or avoided by any decision t hat is
made in t he f ut ur e. Examples of sunk cost s ar e t he book values of exist ing
asset s (plant and equipment , invent or y, invest ment in ir r edeemable secur it ies).
Except f or t he possible gain or loss on disposal of such asset s, t he book value is
not r elevant f or decisions t o be made.

Relevant and I r r elevant Cost

For decision- making, cost s and r evenues can be classif ied accor ding t o whet her
t hey ar e r elevant t o a par t icular decision. Relevant cost s ar e t hose cost s t hat
will be change by a decision, wher eas ir r elevant cost s can not be changed by a
decision. For example, if you ar e f aced wit h a choice of making a j our ney using
your own car or by public t r anspor t ,
t he car t ax and insur ance cost s ar e ir r elevant , since t hey will r emain t he same
what ever alt er nat ive chosen. However , pet r ol cost s f or t he car will dif f er
depending on which alt er nat ive is chosen, and t his cost will be r elevant f or
decision making. All sunk cost s ar e ir r elevant cost s but not all ir r elevant cost s
ar e sunk cost s because some ir r elevant cost s can be ir r elevant now but could be
incur r ed in f ut ur e.

I ncr ement al and Mar ginal Cost s

I ncr ement al (dif f er ent ial) cost s ar e t he dif f er ence bet ween cost s f or t he
cor r esponding it ems under each alt er nat ive being consider ed. For example, t he
incr ement al cost s of incr easing out put f r om 500 t o 600 unit s per day ar e t he
addit ional cost s of pr oducing ext r a 100 unit s per day. I ncr ement al cost s may or
may not include f ixed cost s. I f f ixed cost s change because of a decision, t he
incr ease in cost s r epr esent s an incr ement al cost .

I ncr ement al cost s ar e similar in pr inciple t o t he economist ’s concept of mar ginal

cost . The main dif f er ence is t hat mar ginal cost r epr esent s t he addit ional cost
r esult ing f r om an addit ional unit of out put . Economist s nor mally r epr esent t he
t heor et ical r elat ionship bet ween cost and out put in t er ms of an addit ional unit
of pr oduct ion.
I mput ed Cost s

These ar e cost s not incur r ed in some t r ansact ion but which ar e r elevant t o t he
decision making as t hey per t ain t o a par t icular sit uat ion. These cost s do not
ent er t he t r adit ional account ing syst em. I nt er est s on int er nally gener at ed
f unds, r ent al value of company owned pr oper t y, and salar ies of owner s of a
single pr opr iet or ship ar e some examples of imput ed cost s.

Shut Down Cost s

These ar e cost s which have t o be incur r ed under all sit uat ions in t he case of
st opping manuf act ur e of a pr oduct or closing down a depar t ment or division.
Shut down cost s ar e always f ixed cost s. I f t he manuf act ur e of a pr oduct is
st opped, var iable cost s will not be incur r ed. However , a par t of f ixed cost s will be
incur r ed (such as r ent , secur it y, pr oper t y t axes, et c.)

1.5 Cost Cont r ol and Cost Reduct ion

Cost cont r ol is t he compar at ive analysis of act ual cost s wit h st andar d cost s or
budget ed cost s t o f acilit at e per f or mance evaluat ion and f or mulat ion of
cor r ect ive measur es. I t aims at accomplishing conf or mit y bet ween act ual r esult
and st andar ds or budget s.

Cost r educt ion on t he ot her hand is an at t empt t o br ing down cost s. Cost s
r educt ion implies r eal and per manent r educt ion in unit cost of goods
manuf act ur ed wit hout impair ing t heir suit abilit y f or t he int ended use. The cost s
can be r educed by incr easing pr oduct ivit y, sear ch f or cheaper mat er ials, use of
cheaper labor , et c. cost cont r ol measur es should r esult in cost r educt ion
The dif f er ence bet ween cost cont r ol and cost r educt ion is t hat cost cont r ol is
conser vat ive, pr event ive and pr ocedur al while cost r educt ion cont inuous,
dynamic and innovat ive in nat ur e. Reduct ion of cost s is a cor r ect ive measur e and
is applicable t o all kinds of businesses.

Tools used f or cost r educt ion

i. value analysis or value engineer ing
ii. wor k st udy
iii. Job evaluat ion and mer it r at ing.
iv. Pr oduct ion planning and cont r ol
v. Rat ionalizat ion
vi. Qualit y cont r ol
vii. Economic or der quant it y
viii. Use of bet t er t echnology
ix. Simplif icat ion of pr ocesses
x. Var iet y r educt ion
xi. Mar ket r esear ch
xii. I nvent or y management and cont r ol
xiii. Wast age management

11
TOPI C 3

COST ESTI MATI ON

Det er mining how cost will change wit h out put or ot her measur able f act or s of
act ivit y is of vit al impor t ance f or decision making, planning and cont r ol. The
pr epar at ion of budget s, t he pr oduct ion of pr oduct ion r epor t s, t he calculat ion of
st andar d cost s and t he pr ovision of r elevant cost s f or pr icing and ot her decisions
all depend on r eliable est imat es of cost s and dist inguishing bet ween f ixed cost s
and var iable cost s at dif f er ent act ivit y levels.

The basic idea in cost est imat ion is t o est imat e t he r elat ion bet ween cost s and
t he var iables af f ect ing cost s. The basic f or mula of est imat ing cost s is:

TC = F + VX

Wher e TC is t he t ot al cost
F is t he f ixed cost
V is t he var iable cost per unit of out put
X is one unit of out put .
The dif f icult t ask in cost est imat ion is separ at ing cost s int o f ixed and var iable
cost s. This is because some cat egor ies of cost s have no clear cut behaviour and
neit her f all on Fixed nor var iable cost . Consequent ly, not all var iable cost s have
a linear r elat ionship wit h pr oduct ion levels. For example, labor cost s can be
classif ied as var iable when t he company uses casual labor hir ed on a daily basis so
t hat t he employment of labor can be exact ly mat ched t o meet t he pr oduct ion
r equir ement s. I n cont r ast , dir ect labor may be classif ied as st ep f ixed cost s f or
act ivit ies wher e a f ixed number of people ar e employed and t his number is
maint ained even when t her e is a t empor ar y r educt ion in t he quant it y of act ivit y.
This br ings complicat ions in modeling cost s int o an equat ion. However , t his

12
does not mean t hat t he exer cise of cost est imat ion should be shelved on t hese
gr ounds. I n pr act ice, sever al met hods out lined below of cost est imat ion have
been developed:
i. account analysis
ii. Engineer ing est imat es.
iii. Scat t er gr aph and high- low est imat es.
iv. St at ist ical met hods (usually employing r egr ession analysis)

Result s will obviously dif f er f r om met hod t o met hod and usually mor e t han one
met hod is applied in or der t o compar e r esult s. Because line manager s bar e
ult imat e r esponsibilit y f or all cost est imat es, t hey f r equent ly apply t heir own
j udgment as a f inal st ep in t he est imat ion pr ocess. These met hods t her ef or e
should be seen as ways of helping management t o ar r ive at t he best est imat e
possible.

2.1 Account Analysis

The account analysis appr oach calls f or a r eview of each cost account used t o
r ecor d cost s t hat ar e of int er est . Each cost is t hen ident if ied as eit her f ixed or
var iable, depending on t he r elat ionship bet ween t he cost and some act ivit y.

The t able below illust r at es how cost s can be classif ied int o f ixed and var iable cost .

Cost at 4, 600 unit s of out put

(115 dir ect labor - hour s)

Var iable Fixed

Account Tot al Cost Cost
I ndir ect labor Sh 321 Sh 103 Sh 218
I ndir ect mat er ials 422 307 115
Building occupancy 615 - 615
Pr oper t y t axes 51 40 11
Power 589 535 54

Repair s 218 119 99

Dat a pr ocessing 113 88 25
Qualit y inspect ions 187 187 -
Per sonnel ser vices 115 47 68
Tot als 2, 631 1, 426 1, 205

The t ot al cost s f or t he coming per iod ar e t he sum of t he est imat ed t ot al var iable
and t ot al f ixed cost s. Since t he t ot al var iable cost s ar e dir ect ly r elat ed t o
quant it y of expect ed pr oduct ion, t he var iable pr oduct ion over head per unit may
be st at ed as Sh. 0.31 (Sh. 1426/4600 unit s). The gener al cost equat ion may be
expr essed as:

TC = F + VX
= 1, 205 + 0.31*4600 (f or 4600 unit s)
= 1205 + 1426
 = Sh 2631.

I f management want ed t o est imat e t he cost s at a pr oduct ion level of 4, 800 unit s,
it would subst it ut e t he f igur e of 4, 600 wit h 4, 800.
Ther ef or e,
TC = 1205 + 0.31*4800
= 1205 + 1488
= Sh 2693.

Account analysis is a usef ul way of est imat ing cost s. I t makes use of t he
exper ience and j udgment of manager s and account ant s who ar e f amiliar wit h
company oper at ions and t he way cost s r eact t o changes in act ivit y levels.
Account analysis r elies heavily on per sonal j udgment . This may be an advant age
or a disadvant age depending on t he bias of t he per son making t he est imat e.
Decisions based on cost est imat es have maj or economic consequences f or t he
people making t he est imat es. Thus, t he individual may not be ent ir ely obj ect ive.
Mor e obj ect ive met hods ar e of t en used in conj unct ion wit h account analysis so
t hat t he advant age of mult iple met hods is obt ained.

2.2 Engineer ing Est imat es

Engineer ing est imat es of cost s ar e usually made by measur ing wor k involved in a
t ask. A det ailed st ep- by- st ep analysis of each phase of each manuf act ur ing
pr ocess, t oget her wit h t he kind of wor k per f or med and cost s involved, is
pr epar ed. (This is somet imes par t of a t ime- and- mot ion st udy). The t ime it
should t ake t o per f or m each st ep is t hen est imat ed. These t imes ar e of t en
available f r omwidely published manuals and t r ade associat ion document s.

The t imes r equir ed f or each st ep in t he pr ocess ar e summed t o obt ain an

est imat e of t he t ot al t ime involved, including allowance f or unpr oduct ive t ime.
This ser ves as a basis f or est imat ing dir ect labor cost s. Engineer ing est imat es of
mat er ials r equir ed f or each unit of pr oduct ion ar e usually obt ainable f r om
dr awing and specif icat ion sheet s.

Ot her cost s ar e est imat ed in a similar manner . For example, t he size and cost of
a building needed t o house t he manuf act ur ing oper at ion can be est imat ed based
on ar ea const r uct ion cost s and space r equir ement s. An est imat e of t he needed
number of super visor s and suppor t per sonnel can be based on an est imat e of
dir ect labor t ime.

One advant age of t he engineer ing appr oach is t hat it can det ail each st ep
r equir ed t o per f or m an oper at ion. This per mit s compar ison wit h ot her set t ings
wher e similar oper at ions ar e per f or med. I t enables a company t o r eview it s
manuf act ur ing pr oduct ivit y and ident if y specif ic st r engt hs and weaknesses. Also,
it does not r equir e dat a f r om pr ior act ivit ies in t he or ganizat ion and it can be
used t o est imat e cost s f or t ot ally new act ivit ies.

A company t hat uses Engineer ing est imat es can of t en ident if y wher e “ slack”
exist s in it s oper at ions. For example, if an engineer ing est imat e indicat es t hat
80, 000 squar e f eet of f loor ar ea ar e r equir ed f or assembly pr ocess but t he
company has been using 125, 000
squar e f eet , t he company may f ind it benef icial t o r ear r ange t he plant t o make
f loor space available f or ot her uses.

A dif f icult y wit h engineer ing pr ocess is t hat it can be quit e expensive t o use.
Anot her consider at ion is t hat engineer ing est imat es ar e of t en based on opt imal
condit ions. Ther ef or e, when evaluat ing per f or mance, bidding on a cont r act ,
planning f or expect ed cost s, or est imat ing cost s f or any pur pose, it is wise t o
consider t hat t he act ual wor k condit ions will be less opt imal.

2.3 The Scat t er gr aph Met hod

The Scat t er gr aph met hod involves plot t ing past cost s against past act ivit y levels.
I t is of t en a usef ul way of visually depict ing cost - act ivit y r elat ionships. The plot
(scat t er gr aph) will also indicat e any signif icant change in t he r elat ionship
bet ween cost s and act ivit y at dif f er ent levels of pr oduct ion.

To pr epar e a scat t er gr aph, f ir st obt ain t he r elevant dat a of cost incur r ed and
t he level of act ivit y involved. The number of obser vat ions t o include depends on
t he availabilit y of dat a and t he cost - benef it of obt aining r eliable dat a. A r ule of
t humb is t o use t hr ee year s of dat a ext r act ed mont hly. I f cost s and act ivit y ar e
r elat ively st able, t hen a r elat ively shor t per iod (12 mont hs or so) may be
adequat e.

The slope of t he line r epr esent s t he est imat ed var iable cost s, and t he int er cept
wit h t he ver t ical axis r epr esent s an est imat e of f ixed cost s. Det er minat ion of
t he best f it is of t en a mat t er of “ eyeball j udgment ”. Consequent ly,
scat t er gr aphs ar e usually not used as t he sole basis f or cost est imat es. Rat her
t hey er e used t o illust r at e t he r elat ionships bet ween cost s and act ivit y levels
and t o point out any past dat a t hat might be signif icant ly out of line.

I llust r at ion:
Dat a f or t he past 15 mont hs wer e collect ed f or Gr eenhor n Co. t o est imat e
var iable and f ixed manuf act ur ing over heads. These dat a ar e pr esent ed and
plot t ed on t he scat t er gr aph. Once t he dat a point s wer e plot t ed, a line was dr awn
t o f it t he point s as closely as possible. The line was ext ended t o t he ver t ical axis
on t he scat t er gr aph in or der t o ident if y t he int er cept .

Over hea
Time Dir ect d
Labor - Cost s
Per iod hour s (Sh)
1 62 2107
2 62 2040
3 120 2916
4 71 2322
5 50 1896
 6 95 2471
7 142 3105
8 86 2316
9 112 2555
10 136 2780
11 85 2061
12 103 2910
13 96 2835
14 101 2715
15 53 1986

3500

3000

2500

2000

1500

1000 Over head Cost s (Sh)

Labor hour s

500

0
0 20 40 60 80 100 120 140 160

Y axis- Repr esent Cost s.

X axis- Repr esent Labor hour s.

2.4 High- Low Met hod

Fr om t he act ual obser vat ions, t he per iod wit h t he highest level of act ivit y and
t hat wit h t he lowest level of act ivit y ar e ident if ied. The obser vat ions of t he t wo
point s ar e t hen used t o f or mulat e a st r aight line equat ion. This might be applied
wher e t her e is insuf f icient dat a and wher e a st r aight line r elat ionship can be
assumed. This met hod has t he weakness of using only t wo values while ignor ing
t he r est of t he dat a. The t wo values used ar e ext r eme and might dist or t t he
r esult s obt ained.

I llust r at ion:
The f ollowing obser vat ions wer e r ecor ded over t he past f ive mont hs.

16
 Over head
Mont h Unit s s
(Labor Hr s) (Sh)
Januar y 150 400
December 250 600
November 100 300
Oct ober 160 425
Sept ember 50 200

Requir ed:
Use High- Low met hod t o f ind a cost equat ion and est imat e over head cost s
f or t he mont h of Febr uar y if t ot al unit s expect ed f or t he per iod ar e 300
unit s.

Solut ion:
High act ivit y 250
Relat ed Cost s Sh 600

Low act ivit y 50

Relat ed Cost s Sh 200

Unit var iable cost = (600- 200)/ (250- 50)

Sh 2.0 per unit of labor
hour .

TC = F + VX
600 = F + 2(250)
600 = F + 500
F = 600 – 500
F = 100

For Febr uar y, est imat ed cost s = 100 + 2(500)

= 100 + 1000
= Sh 1100.00

2.5 St at ist ical Cost Est imat ion (Regr ession Analysis)

Regr ession t echnique (also called t he least squar es met hod) is designed t o
gener at e s line t hat best f it s a set of dat a point s. Because r egr ession
pr ocedur es use all dat a point s, t he r esult ing est imat es have a br oader base t han
est imat es based only on high- low point s. I n addit ion, r egr ession t echniques
gener at e a number of st at ist ics t hat under cer t ain assumpt ions enable a
manager t o det er mine how well t he est imat ed r egr ession pr ocess also per mit s
inclusion of mor e t han one pr edict or . This may be usef ul when mor e t han one
act ivit y af f ect s cost s. For example, var iable manuf act ur ing over heads may be a
f unct ion of bot h dir ect labor - hour s and t he quant it ies of dir ect mat er ials
pr ocessed.
Regr ession equat ions can be illust r at ed below:

Y = a + bX… … … … … … … … … Simple r egr ession equat ion

Y = a0 + b1X1 + b2X2… … … … . Mult iple r egr ession equat ion

2
Y = a0 + b1X + b2X … … … … … ... Non- Linear r egr ession equat ion.

Wher e Y is t he t ot al cost est imat ed.

a is t he f ixed cost .
b is t he coef f icient
X is t he unit s of act ivit y

Regr essing t he equat ion enables one t o get t he line of best f it by employing
st at ist ical t echniques. This t echnique is based on t he pr inciple t hat t he sum of
squar ed r esiduals (SSR) f r om t he r egr ession line can be minimized using t he
f ollowing f or mula:

Coef f icient b = n ∑xy – ( ∑x )( ∑y )

2 2
n ∑x – ( ∑x )

I nt er cept a = ∑y – b∑x
n

wher e n is t he number of obser vat ions

I llust r at ion:
The dat a below r elat es t o act ivit y (x) and t he r espect ive cost s incur r ed in
past mont hs. You ar e r equir ed t o f ind t he simple r egr ession equat ion of (y)

Cost
Mont h Unit s (x) (y)
Januar y 2 60
Febr uar y 5 100
Mar ch 4 70
Apr il 6 90
May 3 80

Solut ion: 2
Unit s (x) Cost (y) xy x
2 60 120 4
5 100 500 25
4 70 280 16
 6 90 540 36
3 80 240 9
2
∑x = 20 ∑y = 400 ∑xy = 1680 ∑x = 90

Coef f icient b = n ∑xy – ( ∑x )( ∑y )

2 2
n ∑x – ( ∑x )

= 5 ( 1680 ) – 20 ( 400 )
2
5 ( 90 ) – ( 20 )

= 400/50 = 8

I nt er cept a = ∑y – b∑x
n

= [ 400 – 8 ( 20 )] /5

= 48.

Ther ef or e, t he r egr ession equat ion will be:

y = 48 + 8x

Cor r elat ion Coef f icient s

The disadvant age wit h r egr ession equat ion is t hat t he calculat ions involved ar e
complex. However , comput er sof t war e pr ogr ams ar e now available and can be
applied wit h ease. The maj or advant age of t he r egr ession pr ogr ams is t hat in
addit ion t o est imat ing t he cost equat ion, it also pr ovides ot her st at ist ics. Such
st at ist ics include t he cor r elat ion coef f icient (R), which is a measur e of t he
pr oximit y of t he dat a point s t o t he r egr ession line. The closer R is t o 1.0, t he
closer t he dat a point s ar e t o t he r egr ession line. Conver sely, t he closer R is t o
Zer o, t he poor er t he f it of t he r egr ession line.

The adj ust ed R- squar e is t he cor r elat ion coef f icient squar ed and adj ust ed f or
t he number of independent var iables used t o est imat e. This adj ust ment t o R-
squar e r ecognizes t hat as t he number of independent var iables incr eases, R-
squar e (unadj ust ed) incr eases. For example, if t her e ar e as many independent
var iables as t her e ar e obser vat ions; R- squar e (unadj ust ed) would be 1.0. The
adj ust ed R- squar e is int er pr et ed as t he pr opor t ion of t he var iat ion in Y
explained by t he r ight - hand side of t he equat ion; t hat is, by X pr edict or s.
St eps Followed in Est imat ing Cost Funct ions

i. Select t he dependent var iable (y) t o be pr edict ed.

19
 The choice of t he cost (s) t o be pr edict ed will depend upon t he pur pose of
t he cost f unct ion. I f t he pur pose is t o est imat e t he indir ect cost s of a cost
cent r e t hen all t he indir ect cost s associat ed wit h t he pr oduct ion cent r e t hat
ar e consider ed t o have t he same cause and ef f ect r elat ionship wit h t he
pot ent ial cost dr iver s should be gr ouped t oget her . A separ at e cost f unct ion
would be est ablished f or each cost pool. ii. Select t he pot ent ial cost dr iver s.
Examples of pot ent ial cost dr iver s include dir ect labor hour s, machine hour s,
dir ect labor cost , number of unit s of out put , number of pr oduct ion r un set -
ups, number of or der s pr ocessed and weight of mat er ials.

iii. Collect dat a on t he dependent var iable and cost dr iver s.

A suf f icient number of past obser vat ions must be obt ained t o der ive r ealist ic
cost f unct ions. The dat a should be adj ust ed t o r ef lect any changes of
cir cumst ances, such as pr ice changes, inf lat ion, changes in t he pr oduct ion
pr ocess et c. t he t ime per iod used t o measur e t he dependent var iable should
cor r espond t o t he t ime used t o measur e t he independent var iable.

iv. Plot t he obser vat ions on a gr aph.

A gener al indicat ion of t he r elat ionship bet ween t he dependent var iable and
t he cost dr iver can be obser ved f r om t he gr aph. The gr aph will pr ovide visual
indicat ion on t he cost behaviour .

v. Est imat e t he cost f unct ion

St at ist ical t echniques ar e nor mally applied in est imat ing t he cost f unct ion.

vi. Test t he r eliabilit y of t he cost f unct ion.

The r eliabilit y of t he cost f unct ion det er mines t he conf idence t hat can be
placed on t he cost f unct ions. Wit h t he aid of sof t war e pr ogr ams, t his t ask
can be per f or med wit h much ease.

TOPI C 4

MATERI AL COSTI NG

The Essent ials of Mat er ial Cont r ol

Fr omt he cost ing per spect ive, t he essent ials of mat er ial cont r ol pr ior t o act ual
use in pr oduct ion can be summar ized as f ollows:
i. Mat er ials of appr opr iat e qualit y and specif icat ion should be pur chased
only when r equir ed and appr opr iat ely aut hor ized.
ii. The supplier s chosen should r epr esent an appr opr iat e balance bet ween
qualit y, pr ice and deliver y.
iii. Mat er ials should be pr oper ly r eceived and inspect ed.
iv. Appr opr iat e st or age f acilit ies should be pr ovided and st ock levels
physically checked on a r egular basis.
v. Dir ect mat er ial used in pr oduct ion should be char ged t o pr oduct ion on
an appr opr iat e and consist ent pr icing basis.
vi. I ndir ect mat er ial used in pr oduct ion and non pr oduct ion depar t ment s
should be appr opr iat ely char ged t o cor r ect cost cent r e and included in
 t he over heads of t he cost cent r e.
vii. The document at ion, account ing syst emand cont r ols at each st age
should be well designed and ef f ect ive
viii. St ock t aking must be well or ganized t o ensur e t hat st ock quant it ies on
hand ar e available when r equir ed.

23
3.1 The Mat er ial Cont r ol Pr ocess

The impor t ant f eat ur es mat er ial cont r ol pr ocesses ar e: pur chasing, r eceipt ,
st or age, and issue.
Pur chasing

Because such a lar ge pr opor t ion of a f ir m’s cost s ar e r epr esent ed by bought in
mat er ials and ser vices, t he pur chasing f unct ion is of gr eat impor t ance and has
become highly specialized. The r esponsibilit y of pur chasing f unct ion includes
pr ice, qualit y, and deliver y all of which ar e cr ucial f act or s. Lat e deliver y, poor
mat er ials, incor r ect specif icat ion and ot her mist akes associat ed wit h poor
pur chasing pr ocedur es ar e likely t o have adver se ef f ect on t he pr of it abilit y of
t he f ir m. The avoidance of pr oduct ion delays, excessive scr ap caused by incor r ect
mat er ials and avoidance of excessive st ocks ar e among t he aims of an ef f icient
pur chasing f unct ion.

Pur chasing Pr ocedur es

Alt hough t he exact syst emvar ies f r omf ir mt o f ir m, t he f ollowing pr ocedur es ar e
common as illust r at ed by f igur e 3.1
Or iginal demand: Pr oduct ion cont r ol, I nvent or y cont r ol, St or e keeper s, Depar t ment al manager s

Pur chase r equisit ion (quant it y, Qualit y, Deliver y t ime,

Compat ibilit y r equir ement s

Supplier sear ch

Request f or t ender s

Receipt of
quot at ions

Supplier select ion

Pur chase or der

Monit or ing of
deliver ies

Receipt of goods

24
Not es t o f igur e 3.1
• Alt hough t he diagr am shows var ious or iginat ing sour ces pr oducing a
pur chase r equisit ion, f r equent ly pr oduct ion and invent or y cont r ol may
pr oduce a schedule of r equir ement s specif ying deliver y dat es and call of f
r at es.
• The pur chase or der is t he basis of legal cont r act bet ween t he f ir mand t he
supplier and should clear ly def ine t he r equir ed goods or ser vices. Vir t ually
all or ganizat ions r ef use t o r ecognize an invoice f r om a supplier which is
not cover ed by a pur chase or der . The issue of pur chase or der s must be
closely cont r olled and signing r est r ict ed t o f ew senior people.
• The monit or ing of deliver ies (pr ogr ess chasing) is a pur chasing pr ocedur e.
However , it is somet imes t he r esponsibilit y of pr oduct ion cont r ol and
wor ks administ r at ion.
Recept ion and I nspect ion Pr ocedur es

Recept ion pr ocedur es can be shown diagr ammat ically (f igur e 3.2)

Receipt of goods in mat er ials

r ecept ion

Quant it ies r eceived checked and

GRN r aised.

I nspect ion of goods f or qualit y,

specif icat ion, et c.

Goods t aken int o st or es and GRN

signed.

Not es t o f igur e 3.2

• The goods r eceived not e (GRN) is a document necessar y so t hat t he
supplier ’s invoice can be ver if ied and passed f or payment usually by t he
pur chase depar t ment .
• The usual pr ocedur e of passing t he supplier ’s invoice includes: checks t hat
it ems invoiced wer e as or der ed (f r om t he pur chase or der ) and as r eceived
(f r om GRN), ver if icat ion of pr ice, discount s and cr edit t er ms (f r om
pur chase or der ), coding of invoice bot h f or t ype of expendit ur e and place
t o be char ged
St or ekeeping

I t is nor mal t o compar e t he cont r ols and checks on pet t y cash f loat of a f ew
hundr ed shillings wit h t he f r equent ly haphazar d pr ocedur es used in many st or es
cont aining hundr eds of t housands of shillings wor t h of st ock. St or ekeeping is an
impor t ant f unct ion and can make a subst ant ial cont r ibut ion t o ef f icient
oper at ions. St or ekeeping includes t he f ollowing act ivit ies:
i. Ef f icient and speedy issue of r equir ed mat er ials, t ools et c.
ii. r eceipt of par t of mat er ials f r omgoods r ecept ion (i.e. ext er nal it ems )
and f r ompr oduct ion (i.e. int er nal it ems)
iii. Or ganizing st or age in logical sequence, t hus ensur ing it ems t o be
f ound speedily when r equir ed, and t hat all it ems can be pr ecisely
ident if ied and st or age space is used ef f ect ively.
iv. Or ganizing st ock checks eit her on a cont inuous basis or a per iodic basis
as t o be able t o pr ovide accur at e st ock f igur es when r equir ed.
v. Pr ot ect ing it ems in st or e f r omdamage and det er ior at ion.
vi. Secur ing t he st or es f r ompilf er ing, t hef t and f ir e.

St or age I ssues and Ret ur ns

The issue of mat er ials must be appr opr iat ely aut hor ized and amount issued
r ecor ded so t hat t he appr opr iat e char ges can be made t o pr oduct ion or t o
r eceiving cost cent r e. The usual way t his is done is by mat er ial r equisit ion (MR)

An MR would cont ain:

Qualit y, par t No., Descr ipt ion, Job or Cost Cent r e, Aut hor izat ion.

On pr esent ing an MR t o t he st or e man, it would be checked f or cor r ect ness and

aut hor izat ion and if sat isf act or y, t he issue would be made. The MR would be
r et ained by st or es who would inser t dat e of issue and f or war d t he MR t o st or es
r ecor ds (f or updat ing t he st ock r ecor ds) and t o t he cost depar t ment f or pr icing
and char ging. The st or e man must ensur e t hat t he MR is amended when t he issue
can not be made exact ly as t he or iginal r equest , e.g. wher e only a par t of t he
issue is made or an alt er nat ive mat er ial is accept able when an or iginal r equest is
unavailable.

The pr ocedur e f or goods r et ur ned t o st or e is similar t o t hose out lined above

except t hat t he document involved is t er med as mat er ial r et ur n not e and, of
cour se, t he goods ar e t aken int o st or es r at her t han issued.

26
3.2 St ockt aking

Ther e ar e t wo appr oaches t o t he t ask of st ockt aking: Per iodic (usually annual)
and per pet ual (cont inuous).
Per iodic St ockt aking

The obj ect ive of per iodic st ockt aking is t o f ind out t he physical quant it ies of
mat er ials of all t ypes (r aw mat er ials, f inished goods, W- I - P et c) at a given dat e.
This is a subst ant ial t ask even in a modest or ganizat ion and becomes a dif f icult
t ask in a lar ge f ir m. The f ollowing f act or s need t o be consider ed:
• Adequat e number of st af f should be available who should r eceive clear and
pr ecise inst r uct ions on t he pr ocedur es.
• The st ock t ake should be done on a weekend or over night so as not t o
int er f er e wit h pr oduct ion.
• The st ock t ake should be or ganized int o clear ly def ined physical ar eas and
t he checker s should count or est imat e all mat er ials in t he ar ea.
• Adequat e t echnical assist ance should be available t o ident if y mat er ials,
par t no’s et c.
• Gr eat car e should be t aken t o ensur e t hat only valid st ock it ems ar e
included and t hat all valid it ems ar e checked.
• The complet ed st ock sheet s should have r andom, independent checks t o
ver if y t heir cor r ect ness.
• The quant it ies of each t ype of mat er ial should be checked against t he
st ock r ecor d t o expose any gr oss er r or s which may be due t o st ockt aking
er r or s or er r or s in t he r ecor ding syst em.
• The pr icing and ext ension of t he st ock sheet s, which ar e done manually,
should be closely cont r olled. I f t he pr icing and value calculat ions ar e done
by comput er , t he input quant it ies and st ock par t number s should be
cor r ect ly ent er ed.
Cont inuous St ockt aking

To avoid some of t he disr upt ions caused by t he per iodic st ockt aking, many
or ganizat ions oper at e syst ems wher eby a pr opor t ion of st ock is checked daily so
t hat over t he year all st ocks ar e checked at least once and many it ems
par t icular ly t he high valued or f ast moving it ems would be checked sever al t imes.
Wher e cont inuous st ockt aking is adopt ed, it is invar iably car r ied out by st af f
independent f r omt he st or ekeeper s.

27
Cent r alized vs. Decent r alized St or age Syst em

The t ype of st or age syst em will depend on t he nat ur e of t he or ganizat ion. The
t ype of st or age syst em t o be adopt ed will depend on t he management decision of
t hat or ganizat ion. I n making t he decision on what t ype of st or age syst em is
appr opr iat e, t he management will weigh t he advant ages and disadvant ages of
each syst emin line wit h t he company’s oper at ions.

Advant ages of Cent r alizat ion.

i. lower st ock is maint ained

ii. t her e is less r isk of duplicat ion
iii. t her e is opt imumut ilizat ion of st or e st af f
iv. Closer cont r ol of invent or y.
v. Ther e is mor e secur it y f r ompilf er age.
vi. Paper wor k is r educed
vii. St ockt aking is easier t han when t he syst emis a decent r alized one
viii. Mor e advanced equipment f or handling and monit or ing st ocks will be
viable. E.g. t he use of comput er s and mechanized equipment s.
Disadvant ages of Cent r alizat ion

i. I t is less convenient when t he company has numer ous br anches or

depar t ment s t hat ar e f ar apar t .
ii. I t may not be possible t o know what is going on in a local ar ea.
iii. Ther e ar e longer delays in obt aining mat er ials.
iv. Gr eat er int er nal or ext er nal t r anspor t cost s in car r ying mat er ials.
v. Bur eaucr acy and slow decision making.
The disadvant ages of decent r alizat ion ar e t he advant ages of
decent r alizat ion and vice ver sa.
3.3 Changes in Pr oduct ion and Pur chasing Syst ems

Ther e ar e a number of changes t aking place in indust r y which ar e alt er ing

dr amat ically t he way t hat pr oduct s ar e made and pr oduct ion is or ganized.
These changes nat ur ally inf luence suppor t ing act ivit ies such as pur chasing
and st or age. Sever al of t he mor e impor t ant development s ar e out lined below.
These ar e Just - I n- Time pur chasing, Just - I n- Time pr oduct ion and Mat er ials
r equir ement s planning.

Just - I n- Time (JI T) Syst ems

JI T syst ems aim at pr oducing t he r equir ed it ems at t he t ime when t hey ar e

r equir ed. I t involves t he pur suit of excellence at all st ages wit h a climat e of
cont inuous impr ovement . A JI T syst emis char act er ized by:
• A move t owar ds zer o invent or y
• Eliminat ion of non- value added act ivit ies

28
 • An emphasis on per f ect qualit y i.e. Zer o def ect s
• Shor t set - ups
• A move t owar ds a bat ch size of one
• 100% on t ime deliver ies
• a const ant dr ive f or impr ovement
• demand- pull manuf act ur e

I t is t his lat t er char act er ist ic which gives r ise t o t he name of Just - I n- Time.
Pr oduct ion only t akes place when t her e is act ual cust omer demand f or t he
pr oduct . JI T wor ks on a pull- t hr ough basis which means t hat pr oduct s ar e not
made t o go int o st ock.
JI T Pur chasing

This seeks t o mat ch t he usage of mat er ials wit h t he deliver y of mat er ials f r om
ext er nal supplier s. This means t hat mat er ials st ock can be kept at near zer o
levels. For JI T pur chasing t o wor k it r equir es:
i. Conf idence t hat supplier s will deliver exact ly on t ime.
ii. That supplier s will deliver mat er ials of 100% qualit y so t hat t her e will
be no r ej ect s, r et ur ns and consequence pr oduct ion delays.

The st r at egy employed in or der t o guar ant ee t imely supplies is t he maint enance
of f ewer supplier s and placing long t er m or der s in or der t hat t he supplier has
assur ed sales and can plan t o meet t he demand.
JI T Pr oduct ion

JI T pr oduct ion wor ks on a demand- pull basis and seeks t o eliminat e all wast e and
act ivit ies which does not add value t o t he pr oduct . The lead t ime associat ed wit h
making and selling a pr oduct includes:
• I nspect ion t ime
• Tr anspor t t ime
• Queuing t ime
• St or age t ime
• Pr ocessing t ime

Of t hese, only pr ocessing t ime adds value t o t he pr oduct wher eas all t he ot her
add cost , but not value. The ideal f or JI T syst ems is t o conver t mat er ials t o
f inished pr oduct s wit h a lead t ime equal t o pr ocessing t ime so as t o eliminat e all
t he act ivit ies t hat do not add value.

JI T ideally involves t he f ollowing:

• The pr oduct ion pr ocesses must be shor t ened and simplif ied. This r equir es
wor ker s t hat ar e mor e f lexible and adapt able.
• Def ect s should be avoided t o save t ime t hat would be lost in r ewor king

29
 • Fact or y layout s must be changed t o r educe movement s. Similar Jobs
should be gr ouped t oget her .
• Ther e must be a f ull employee involvement in sear ching f or impr ovement s
and t he successf ul implement at ions of t hose impr ovement s.

The applicat ion of JI T comes wit h benef it s such as lower invest ment r equir ement
on invent or y, less st or age space needed, gr eat er cust omer sat isf act ion, and
eliminat ion of wast es hidden in invent or ies, f lexibilit y in adapt ing t o changed
mar ket r equir ement s.
Mat er ials Requir ement Planning (MRP)

MRP is a comput er ized inf or mat ion, planning and cont r ol syst emwhich has t he
obj ect ive
of maint aining a smoot h pr oduct ion f low.
MRP involves:
• Maximizing ef f iciency in t iming of or der s of r aw mat er ials or par t s t hat
ar e placed wit h ext er nal supplier s
• Ef f icient scheduling of t he manuf act ur e and assembly of t he f inal pr oduct .

Successf ul oper at ion of MRP r equir es t he f ollowing:

• A mast er pr oduct ion schedule showing t he quant it ies and t imings r equir ed
f or t he f inished pr oduct
• A bill of mat er ials (BOM) which shows t he br eakdown of each f inished
pr oduct int o sub- assemblies component s and r aw mat er ials
• An invent or y f ile cont aining t he balance on hand, scheduled r eceipt s and
number s alr eady allocat ed f or each sub- assembly, component and t ype of
r aw mat er ial.
• A par t s manuf act ur ing and pur chasing f ile cont aining lead t imes and
pr oduct ion sequence of all sub- assemblies and component s pr oduced
int er nally.

MRP has evolved int o MRPI I which int egr at es mat er ial r esour ce planning,
f act or y capacit y planning labor scheduling int o a single manuf act ur ing cont r ol
syst em.
3.4 St ock Recor ding and I nvent or y Cont r ol

St ock Recor ding

However sophist icat ed t he invent or y cont r ol syst em is in t he f ir m, a basic

pr er equisit e is t hat st ock movement s ar e accur at ely r ecor ded. I n addit ion t he
st ock r ecor d t ypically shows t he var ious cont r ol levels which r elat e t o t he
invent or y cont r ol syst em and which ar e explained lat er in t his lesson. I n some
f ir ms sever al st ock r ecor ds may be kept r egar ding a par t icular mat er ials, but in
pr act ice can int r oduce er r or s and discr epancies and has lit t le t o commend it .

The most f r equent ly encount er ed r ecor ds of st ocks in manual syst ems ar e bin
car ds and st ock r ecor d car ds.
Bin Car ds

These ar e car ds (usually har d paper ) at t ached t o or adj acent t o act ual mat er ials
and t he ent r ies made at t he t ime of issue eit her by t he st or e man or a st or e
cler k. They show only basic inf or mat ion r elat ing t o physical movement s. A t ypical
layout of a bin car d is shown below. Figur e3.3

Bin Car d

Par t No… … … … … … … … .. Locat ion… … … … … … … … ..

Dat e Ref er ence Receipt s I ssues Balance

Figur e 3.3 Bin Car d

• The r ef er ence column would be used f or inser t ing t he GRN or MR number

• The use of bin car ds is cur r ent ly on t he decline par t ly because of t he
dif f icult y of keeping t hem up t o dat e and par t y because of t he incr easing
int egr at ion of st ock r ecor ding and invent or y cont r ol pr ocedur es,
f r equent ly using comput er s.

St ock Recor d Car ds

To obt ain t he f ull pict ur e of t he st ock posit ion of an it emit is necessar y t o know
not only t he physical st ock balance, but also f r ee st ock balance. This is def ined as

Fr ee st ock balance = Physical st ock + out st anding r eplenishment

or der s - unf ulf illed r equir ement s or
allocat ions
 The f r ee st ock balance is a not at ional, not physical and is t he key f igur e in
invent or y cont r ol. I t is necessar y t o know physical st ock f or issue pur poses, f or
st ock t aking, and f or cont r olling maximum and minimum st ock levels and it is
necessar y t o know t he f r ee st ock posit ion f or r eplenishment or der ing. An
example of a st ock r ecor d car d is shown as f igur e 3.4
St ock Recor d Car d
Cont r ol Quant it ies
Maximum
I t emdescr ipt ion… … … … … … … … … … … … … … … level.................................................
Mat er ial code… … … … … … … … … … … … … … … … Maximumlevel… … … … … … … … … … … … ..
St or es locat ion r ef … … … … … … … … … … … … … … . R- or der level… … … … … … … … … … … … … ...
Special r equir ement s… … … … … … … … … … … … … . Re- or der quant it y… … … … … … … … … … … …
Receipt s I ssues Physical Allocat ions Or der s Fr ee
St ock Sock
Balance
Dat e Ref Qt y pr ice Dat e Ref Qt y pr ice Dat e Ref Qt y Dat e Ref Qt y

Figur e 3.4 St ock r ecor d car ds

• The ent r ies in t he Ref (r ef er ence) columns would be r eceipt s (GRN No),
issues (Mat er ial r equisit ion No), allocat ions (Job No or Cust omer s or der
No) and or der s (pur chase or der No.)
• The above illust r at ion shows a car d f or a manual or mechanized syst em,
but even when t he st ock r ecor ds ar e comput er ized, t he same t ype of
inf or mat ion is nor mally included in t he comput er f ile.
I nvent or y Cont r ol

This can be def ined as a syst emin a f ir mt o cont r ol t he f ir m’s invest ment in st ock.
This includes t he r ecor ding and monit or ing of st ock levels, f or ecast ing f ut ur e
demands and deciding how many and when t o or der . The over all obj ect ive of
invent or y cont r ol is t o minimize t he t ot al cost s associat ed wit h st ock. These
cost s can be cat egor ized int o t hr ee gr oups:

32
Car r ying Cost s

• I nt er est on capit al invest ed in st ock

• St or age char ges (r ent , light ing, heat ing, r ef r iger at ing, air condit ioning, et c.)
• St or es st af f ing, equipment , maint enance and r unning cost s.
• Mat er ial handling cost s
• Audit , st ockt aking, st ock r ecor ding cost s
• I nsur ance and secur it y
• Det er ior at ing and obsolescence
• Pilf er age evapor at ion, and ver min damage

Or der ing Cost s

• Cler ical and administ r at ive cost s of pur chasing, account ing and goods
r ecept ion.
• Tr anspor t cost s
• Set up and t ooling cost s associat ed wit h each pr oduct ion r un
• Planning, pr oduct ion cont r ol cost s associat ed wit h int er ior or der

St ock out Cost s

• Lost cont r ibut ion t hr ough lost sale

• Loss of f ut ur e sales f r omcust omer s who decide t o swit ch t o ot her supplier s
• Cost of pr oduct ion st oppages caused by st ock out s of W- I - P and r aw
mat er ials
• Ext r a cost s associat ed wit h ur gent and small quant it y r eplenishment

St ock out cost s is nor mally dif f icult t o quant if y but t heir consider at ion is impor t ant .

I nvent or y Cont r ol Ter minology

i. Lead or pr ocur ement t ime- t his is t he per iod of t ime bet ween or der ing
and r eplenishment . Not e t hat or der ing can be f r omext er nal or
int er nal sour ces.
ii. Economic or der quant it y (EOQ) or economic bat ch quant it y (EBQ) - t his
is t he opt imal r eor der quant it y which minimizes t he balance of cost
bet ween car r ying cost s and or der ing cost s.
iii. Buf f er st ocks or minimum st ock or saf et y st ock- a st ock allowance t o
cover er r or s in f or ecast ing t he lead t ime or t he demand dur ing t he lead
t ime. The availabilit y of buf f er st ocks minimizes t he possibilit y of
incur r ing st ock out cost s.
iv. Maximumlevel- a st ock level calculat ed as t he maximumdesir able which
is used as an indicat or t o management t o show when st ocks have r isen
t oo high.
v. Re- or der level- t he level of st ock at which a f ur t her r eplenishment
or der should be placed. The r eor der level is dependent on t he lead t ime
and t he r at e of demand dur ing t he lead t ime.
vi. Reor der quant it y- t he quant it y of r eplenishment or der , f r equent ly
but not always, t he EOQ.
 The Economic Or der Quant it y (EOQ)

Bef or e one at t empt s t o calculat e t he EOQ, it is necessar y t o f ind out t he maj or

cont r ol levels: r eor der level, minimumlevel, and maximumlevel.

I llust r at ion:
Assume you ar e given t he dat a below of st ock r equir ement f or a cer t ain
f ir m

Aver age usage 100 unit s per day

Minimumusage 60 unit s per day
Maximumusage 130 unit s per day
Lead t ime 20- 26 days
Pr evious EOQ 4000 unit s

Fr omt hese f igur es, t he f ollowing calculat ions can be car r ied out

Reor der level = maximumusage x maximumlead t ime

= 130 x 26

= 3380 unit s

Minimumlevel = Reor der level - aver age usage in

aver age lead
t ime

= 3380 – (100 x 23)

= 3380- 2300

= 1080 unit s

Maximumlevel = Reor der level + pr evious EOQ – minimumant icipat ed

usage in minimumlead t ime

= 3380 + 4000 – (60 x 20)

= 6180 unit s

Recall t hat EOQ is a calculat ed or der quant it y t hat minimizes t he balance of cost
bet ween or der ing and car r ying cost s. To be able t o calculat e a basic EOQ cer t ain
assumpt ions ar e necessar y.

i. t hat t her e is a known const ant st ock holding cost

ii. t hat t her e is a known const ant or der ing cost
iii. t hat r at es of demand ar e known

34
 iv. t hat t he pr ice per unit is const ant and known
v. t hat r eplenishment is made inst ant ly ( t hat is t he whole bat ch is
deliver ed at once)

The above assumpt ions ar e her oic and it is unlikely t hat all could be made in
pr act ice. Never t heless t he EOQ calculat ion is a usef ul st ar t ing point in
est ablishing an appr opr iat e r eor der quant it y.

The EOQ f or mula is given below (you may r ef er quant it at ive t echniques books t o
know how it is der ived)
EOQ = √ 2CoD/Cc

Wher e: Co = or der ing cost per or der

D = Demand per annum
Cc = Car r ying cost per annum

I llust r at ion:

Find t he EOQ wher e t he f or ecast ed demand is 1, 000 unit s per mont h, t he

or der ing cost is Sh 350 per or der , t he unit cost Sh 8 each and it s est imat ed
car r ying cost s ar e 15% per annum.

Fr omt his example: Co = Sh 350

D = 1, 000 x 12 = 12, 000 unit s per
year Cc = Sh 8 x 15% = Sh 1.2 per
year

Ther ef or e: EOQ = √2 x 350 x 12, 000/1.2

= 2646 unit s.

3.5 Pr icing I ssues and St ocks

Obj ect ives of Mat er ial Pr icing

Ther e ar e t wo main obj ect ives of mat er ial pr icing:

i. To char ge t o pr oduct ion on a consist ent and r ealist ic basis t he cost of
mat er ials used.
ii. To pr ovide sat isf act or y basis of valuat ion of invent or y at hand.

These obj ect ives should be achieved by a mat er ial pr icing syst emwhich is t he
simplest ef f ect ive one and which is administ r at ively r ealist ic.

35
Pr oblems of Mat er ial Pr icing

I n pr act ice t he pr oblemof pr icing mat er ial issues, which t hus det er mine pr oduct
cost s, is complicat ed by sever al f act or s:
i. r apidly changing pr ices f or bought in mat er ials and component s
ii. The st ock of any mat er ial is usually made up of sever al deliver ies which
may have been made at dif f er ent pr ices.
iii. The f r equent impossibilit y of ident if ying it ems wit h t heir deliver y
consignment .
iv. The sensit ivit y of pr of it calculat ions t o t he pr icing met hod adopt ed
par t icular ly wher e mat er ials f or ma lar ge par t of t ot al cost .

No one pr icing met hod has all t he advant ages and it is necessar y t o use t he most
appr opr iat e syst em t o f ulf ill t he r equir ement s of a par t icular sit uat ion. The
f eat ur es of t he var ious pr icing syst ems ar e descr ibed below.
Gener al Feat ur es of Pr icing Syst ems

When an issue is made f r om st or es, t he mat er ial r equisit ion would be passed t o
t he cost depar t ment t o be pr iced and ext ended t o appr opr iat e ledger ent r ies t o
be made. At t he simplest t hese ent r ies would be:
Dr . Wor k in pr ogr ess cont r ol a/c (f or dir ect mat er ial issue)
Or Over head cont r ol a/c (f or indir ect mat er ial issue)
Cr . St or es ledger cont r ol a/c

To be able t o use some of t he pr icing syst ems, t he st ock r ecor ding syst ems has t o
be compr ehensive enough not only t o r ecor d over all quant it ies and pr ices, but
also t he number or quant it y r eceived in any one bat ch. This is so t hat issues can
be nominally ident if ied against bat ches which ar e necessar y t o est ablish t he
appr opr iat e pr ice t o be char ged.
St ock Recor ding Syst ems

Fir st in Fir st out (FI FO)

Using t his met hod issues ar e pr iced at t he pr ice of t he oldest bat ch in st ock unt il
all unit s of t he bat ch have been issued when t he pr ice of t he next oldest is used
and so on.

Char act er ist ics

i. it is an act ual cost syst em

ii. I t is a good r epr esent at ion of sound st or ekeeping pr act ice wher e t he
oldest it ems ar e issued f ir st .
iii. Unr ealized pr of it s or losses do not ar ise

36
 iv. The st ock valuat ion is based on t he mor e r ecent ly acquir ed it ems and
t hus mor e near ly appr oaches cur r ent mar ket values
v. Pr oduct cost s, being based on oldest mat er ial pr ices, lag behind
cur r ent condit ions.(in per iods of r ising pr ices, pr oduct cost s ar e
under st at ed and pr of it s over st at ed; in per iods of f alling pr ices,
pr oduct cost s ar e over st at ed and pr of it s under st at ed)
vi. The syst emis administ r at ively clumsy. I n necessit at es t hat each bat ch
is t r acked.
vii. Cost compar ison bet ween j obs is dif f icult because t he mat er ial issue
pr ice may var y f r ombat ch t o bat ch even wit h issues on t he same day.

Last in Fir st Out (LI FO)

I n t his met hod, issues ar e char ged out at a pr ice of t he most r ecent bat ch
r eceived and cont inue t o be char ged t hus unt il a new bat ch is r eceived.

Char act er ist ics

i. it is an act ual cost syst em

ii. LI FO will f r equent ly r esult in many bat ches being only par t ly char ged
t o pr oduct ion wher e a subsequent bat ch is r eceived.
iii. Pr oduct cost s will t end t o be based f air ly closely on cur r ent pr ices and
will t her ef or e be mor e r ealist ic.
iv. St ocks ar e valued at t he oldest pr ices
v. I t is administ r at ively clumsy
vi. I t r ender s cost compar ison bet ween j obs dif f icult
vii. I n per iods of r ising pr ices, LI FO, pr ovides a hedge against inf lat ion

Aver age Pr ice Met hod

The aver age pr ice met hod is a per pet ual weight ed aver age syst emwher e t he
issue pr ice is r ecalculat ed af t er each r eceipt t aking int o account s bot h
quant it ies and money value.

Char act er ist ics

i. alt hough r ealist ic, it is not an act ual buying pr ice except by coincidence
ii. it is less complicat ed and can be administ er ed easily t han t he LI FO or
FI FO met hods
iii. I t has an ef f ect on pr oduct cost s and st ock valuat ion appr oximat ing
t he aver age ef f ect s of LI FO and FI FO.
iv. Cost compar ison bet ween j obs using similar mat er ials becomes easier
v. Wit h const ant ly f luct uat ing mar ket pr ices of mat er ials, it gives bet t er
r esult s t han eit her FI FO or LI FO.
vi. Because it is based on act ual cost s, no unr ealized st ock pr of it s and
losses occur .

37
Ot her St ock Recor ding Syst ems

Specif ic or Unit Pr ice

Wher e t he it emissued can be ident if ied wit h t he r elevant invoice, t he act ual cost
can be char ged. This is only possible wit h special pur pose it ems bought f or a
par t icular j ob.

St andar d Pr ice

This is a pr edet er mined pr ice f ixed on t he basis of a specif icat ion of a pr oduct or
a ser vice and of all f act or s af f ect ing t hat pr ice.

I n ef f ect a st andar d or planned pr ice is an aver age pr ice f or a f ut ur e per iod and
all issues or r et ur ns would be made at t he st andar d pr ice f or t he per iod
concer ned.

Char act er ist ics

i. not an act ual cost , t her ef or e st ock pr of it s and losses may ar ise
ii. Administ r at ively simple. Only quant it ies issued and r eceived need be
r ecor ded not t he money values as t hey ar e pr edet er mined.
iii. Ther e is a pr act ical dif f icult y in det er mining an accept able st andar d
pr ice especially in volat ile condit ions.
iv. I f a r ealist ic st andar d pr ice can be est ablished, some guidance t o
pur chasing ef f iciency may be obt ained.
v. Because mat er ial pr ice var iat ions ar e eliminat ed, manuf act ur ing cost
compar isons can be made mor e easily.

Replacement pr ice

This met hod is somet imes known as t he mar ket pr ice met hod. I t char ges out
issues at t he buying pr ice on t he day of issue. Ther e ar e many var iant s t o t his
syst em. For example, buying in pr ices may be est ablished by means of a pr ice
index or act ual pr ices updat ed on a mont hly basis.

Char act er ist ics

i. I t is not an act ual cost pr ice, t her ef or e st ock pr of it s or losses may occur .
ii. I ssues would be pr iced at up t o dat e values
iii. Maj or administ r at ive pr oblems in keeping r eplacement pr ices up t o dat e.
iv. Replacement pr icing is mor e f r equent ly used in est imat ing r at her t han
in nor mal st ock issues
v. Cost compar ison bet ween j obs is dif f icult
Base St ock Met hod

This met hod assumes t hat init ial pur chases wer e meant t o pr ovide a buf f er st ock
and t hat t his base st ock would appear in all subsequent st ock valuat ions at it s
or iginal value. This met hod r esult s in t ot ally unr ealist ic values and t her ef or e not
r ecommended. I t exist s in books but not in pr act ice.
Compar ison of Pr icing Met hods

Because of t he ef f ect of pr oduct cost s and st ock valuat ions, t her e is a need f or
an or ganizat ion t o be consist ent in it s issue pr ice met hods. Account ing policies
demand t hat t he st ock valuat ion adopt ed by t he f ir m should be consist ent over
t he year s. Wher e t her e is need f or a swit ch f r om one syst em t o anot her , t he
f ir m should disclose t he r easons f or t he changes and t he possible ef f ect s on t he
account s of t he f ir m. I n pr act ice, t he use of FI FO or t he aver age pr ice syst ems
ar e common.

I llust r at ion:

The dat a below r epr esent s t he st ock quant it ies and values of Sambasa Company.
You ar e r equir ed t o value t he st ocks using FI FO, LI FO, Aver age pr ice, and
St andar d pr ice met hods. Assume t hat t he st andar d pr ice is Sh 4.50 per unit .

Dat e Receipt s Pur chase I ssues

Pr ice
1/10 150 unit s 4.00
5/10 100 unit s 4.50
6/10 80 unit s
100
12/10 unit s
20/10 90 unit s 4.80
24/10 80 unit s
Solut ion

The FI FO met hod

Receipt Qt y Pr ice Tot al I ssue I ssue det ails Balance
dat e dat e
Qt y Pr ice Value Qt y pr ice Value
4.0
1/10 150 4.00 600 150 0 600

5/10 100 4.50 450 250 1050

70*4.0
6/10 80 4.00 320 170 0 730
100*4.
5

12/10 100 70*4.00 415 70 4.50 315

60*4.50

20/10 90 4.80 432 160 70*4.5

90*4.8 747
24/10 80 70*4.50
10*4.80 363 80 4.80 384

340 1482 340 1482

BAL C/F 80 @ 4.80 384.00

The LI FO Met hod

Receipt Qt y Pr ice Tot al I ssue I ssue det ails Balance
dat e dat e
Qt y Pr ice Value Qt y pr ice Value
1/10 150 4.00 600 150 4.00 600
150*4.0
5/10 100 4.50 450 250 0 1050
100*4.5
0
150*4.0
6/10 80 4.50 360 170 0 690
20*4.50

12/10 100 20*4.50 410 70 4.00 280

80*4.00

20/10 90 4.80 432 160 70*4.00

90*4.80 712

24/10 80 80*4.80 384 80 70*4.00 328

10*4.80

340 1482 340 1482

BAL C/F 80 unit s 328.00
The Weight ed Aver age Met hod
I ssue
Receipt Qt y Pr ice Tot al I ssue det ails Balance
dat e dat e
pr ic
Qt y Pr ice Value Qt y e Value
1/10 150 4.00 600 150 4.00 600

5/10 100 4.50 450 250 4.20* 1050

6/10 80 4.20 336 170 4.20 714

12/10 100 4.20 420 70 4.20 294

20/10 90 4.80 432 160 4.54** 726

24/10 80 4.54 363 80 4.54 363

340 1482 340 1482

BAL C/F 80 @ 4.54 363.00

Aver age pr ice calculat ions

• *150 unit s at Sh 4.00 = 600

Plus 100 unit s at Sh 4.50 = 450

Tot al 250 unit s valued at Sh 1050

Aver age pr ice = 1050/250 = Sh 4.20

• **70 unit s at Sh 4.20 = 294

90 unit s at Sh 4.80
Plus = 432
160 unit s valued
Tot al at Sh 726
Aver age pr ice = 726/160 = Sh 4.54
 The St andar d Pr ice Met hod
Receipt I ssue I ssue
dat e Qt y Pr ice Tot al dat e det ails Balance
Qt y Pr ice Value Qt y pr ice Value
1/10 150 4.50 675 150 4.50 675

5/10 100 4.50 450 250 4.50 1125

6/10 80 4.50 360 170 4.50 765

12/10 100 4.50 450 70 4.50 315

20/10 90 4.50 405 160 4.50 720

24/10 80 4.50 360 80 4.50 360

340 1482 340 1482

Bal C/F 80 @ 4.50 363.00

TOPI C 5

LABOR COSTI NG

4.1 Remuner at ion Met hods

Tr ends in Employment and Remuner at ion

At pr esent Manual wor ker s ar e paid by some f or m of incent ive scheme. This
over all per cent age masks ext r emely wide var iat ion f r om indust r y t o indust r y.
For example in gener al engineer ing ar ound 80% of t he wor ker s ar e paid wholly or
par t ly by some f or m of incent ive scheme, wher eas in pr ocess indust r ies t he
f igur e is as low as 15%.

Ther e has been a gener al t endency f or lar ger f ir ms t o move away f r om dir ect
incent ive schemes t o schemes such as measur ed day wor k. Ther e is also a
t endency f or wor ker s t o become salar ied employees which has clear cost ing
implicat ions as dir ect labor cost s become mor e f ixed in nat ur e r at her t han
var ying wit h out put .

The t r end evident in most par t s of t he wor ld is t hat pat t er ns of employment ar e

changing f r om f ull t ime employment t o par t t ime employment . Ther e is less j ob
secur it y and mor e self employment . I n Kenya, t he gover nment is st ar t ing t o
move away f r om per manent employment schemes t o r enewable cont r act ual
schemes. The ult imat e goal is t o have a f lexible employment syst em wher e
demand f or labor is mat ched wit h availabilit y of wor k. However , t his does not
mean t hat f ull t ime employees will be eliminat ed. Companies will want t o maint ain
a small cor e of f ull t ime employees wit h a lar ge pool of par t - t imer s or
cont r act or s. I n ef f ect f ir ms will be oper at ing Just in Time syst em f or labor . The
new development s ar e not wit hout disadvant ages as it may r esult int o social
oppr essions, low and ir r egular ear nings, and biased dismissals in t he pr et ext of
no wor k or poor per f or mance.

46
Remuner at ion Met hods

The t wo main cat egor ies of r emuner at ion ar e:

i. Time based
ii. Remuner at ion r elat ed t o out put or per f or mance.

Wit hin t hese t wo cat egor ies t her e ar e innumer able var iat ions some of which
have gener al applicabilit y whilst ot her s ar e of a local and specialized nat ur e.
Remuner at ion syst ems ar e f r equent ly complex and administ r at ively cumber some,
but because t he syst emis t he r esult of negot iat ions, disput es and disagr eement s
over t he year s, at t empt s t o r at ionalize and simplif y ar e f r equent ly met wit h
host ilit y and suspicion.

The newer f or ms of pr oduct ion or ganizat ion, such as Just I n Time syst ems mean
mor e and mor e wor ker s will be paid t ime r at es and will not have t heir pay
dependent on individual out put levels. Ther e ar e t wo r easons f or t his: f ir st ,
par t s ar e only pr oduced as and when r equir ed. This means t hat t he r epet it ive
pr oduct ion of component s t hat move int o st ock is avoided as one of t he key
obj ect ives of JI T. Secondly, what count s in JI T is t he out put of t he gr oup
(known as a pr oduct ion cell) as a whole. As a consequence wor ker s have t o be
f lexible and adapt able so t hat t hey can move f r om t ask t o t ask accor ding t he
demand. I n such cir cumst ances individual incent ive schemes ar e of lit t le or no
value.

I n addit ion mor e and mor e wages and salar ies, t r adit ionally classif ied as
over heads, ar e now being t r aced t o pr oduct lines and classed as dir ect . Suppor t
f unct ions ar e also gr ouped ar ound specif ic pr oduct lines so t hat ident if icat ion of
cost s is mor e dir ect . This has led t o t he development and use of act ivit y based
cost syst em(ABC Syst em)
Time Based Syst ems

Basic Syst em

At t he simplest level wor ker s would be paid f or t he number of hour s wor ked at a
basic r at e per hour up t o, say, 40 hour s per week. Time wor ked in addit ion t o 40
hour s would be classed as over t ime and is usually paid at a higher r at e.

Alt hough wor ker s pay is not r elat ed t o out put , t his does not mean t hat t he
out put and per f or mance is unimpor t ant . Super vision and manager ial cont r ol
syst ems ar e employed so t hat wor ker s ar e paid f or act ually wor king and not
mer ely at t ending.

Advant ages

i. simple t o under st and and administ er

ii. I t simplif ies wages negot iat ions because only t he r at e needs t o be
det er mined unlike incent ive schemes wher e negot iat ions ar e
complicat ed.
Disadvant ages

i. it has no r eal incent ive t o incr ease out put

ii. all employees in t he same gr ade ar e paid t he same r at e r egar dless of
per f or mance
iii. const ant super vision may be necessar y

The t ime based syst ems ar e most appr opr iat e f or :

i. Wor k wher e qualit y, saf et y, healt h car e ar e all impor t ant e.g. t ool
making, nur ses, signal oper at or s et c.
ii. Wor k wher e incent ive schemes would be dif f icult or impossible t o inst all
e.g. dir ect labor , st or es assist ant s, cler ical wor k et c.
iii. Wor k wher e out put is not under t he employees cont r ol e.g. power
st at ion wor ker s, t eacher s, et c.
High Day Rat e Pay Syst em

This is a t ime syst em which is designed t o pr ovide a st r ong incent ive by paying
r at es well above nor mal basic t ime r at es in exchange f or above aver age out put
and per f or mance. For it s successf ul applicat ion it is necessar y t o ensur e t hat
t he out put levels ar e t he r esult of det ailed wor k st udies and t hat t her e is
agr eement f r om t he labor f or ce and t he unions involved on t he r equir ed
pr oduct ion level. A t ypical applicat ion of t his syst em is on assembly line
pr oduct ion in t he car indust r y and in t he domest ic appliance manuf act ur e.

Advant ages

ii. I t is claimed t o at t r act higher gr ade wor ker s.

iii. Pr ovides a dir ect incent ive wit hout t he complicat ions of individual
piecewor k r at es
iv. Simple t o under st and and administ er

Disadvant ages

i. May cause ot her employer s t o r aise t heir r at es t o at t r act bet t er

wor ker s t hus nullif ying t he or iginal ef f ect .
ii. Pr oblems occur when t he or iginal t ar get pr oduct ion f igur es ar e not met

48
Common Bonuses Found in Time Based Syst ems

I n addit ion t o t ime r at es explained above, bonuses or ext r a payment s ar e f r equent ly

made.
Some common examples ar e:

i. Shif t bonus- wher e a wor ker agr ees t o wor k shif t s, par t icular ly wher e
r ot at ing shif t s ar e used, he r eceives an ext r a amount .
ii. Time keeping bonus- wher e a per son’s t imekeeping has been good over
t he week a bonus may be paid.
iii. Cont inuous wor king bonus- wher e t he plant has achieved cont inuous
pr oduct ion wit hout st r ikes, go slows or st oppages a weekly bonus is
paid. This syst em appear s t o have had some successes in one of t he
lar ge car manuf act ur er s.

Not e: many var iat ions exist , f or example, many f ir ms which oper at e a t ime based
syst ems pay, in addit ion, some f or m of out put bonus and conver sely some of t he
above bonuses ar e f ound in f ir ms wher e t he main met hod of r emuner at ion is by
an incent ive scheme.
4.2 Gener al Feat ur es of I ncent ive Schemes

All incent ive schemes r elat e payment t o out put in some way or anot her . Ther e
ar e innumer able var iat ions; some schemes apply t o individuals whilst ot her s apply
t o gr oups of wor ker s, some have a dir ect and immediat e r elat ionship t o out put
whilst ot her s ar e mor e indir ect .

Fr om a pr oper ly or ganized and well planned syst ems bot h t he f ir m and t he

employees can benef it . The employee f r om t he ext r a income ar ising f r om
incr eased pr oduct ions, and t he f ir m f r om t he r educed over heads per unit of t he
incr eased pr oduct ion. Unf or t unat ely not all schemes achieve t his ideal, but
car ef ul at t ent ion t o t he f ollowing f act or s will help t o achieve t his obj ect ive.

i. Remuner at ion should r ef lect wor ker s ef f or t and per f or mance.

Payment should be made wit hout delay, pr ef er ably soon af t er t he
complet ion of t he t ask.
ii. The scheme should be r easonably simple t o assist administ r at ion and t o
enable employees t o calculat e t heir own bonuses.
iii. Per f or mance levels should be demonst r ably f air i.e., t hey should be in
r each of t he aver age wor ker .
iv. Ther e should be no ar t if icial limit and ear nings should be saf eguar ded
when pr oblems ar ise out side t he employee’s cont r ol.
v. The scheme should not be int r oduced unt il t her e has been f ull
consult at ion and agr eement wit h t he employees and t he union.
vi. The f ull applicat ion of t he scheme, per f or mance levels, r at es, et c.
must be consider ed so t hat it will have a r easonable lengt h of lif e.
Advant ages of I ncent ive Schemes

i. I t incr eases pr oduct ion t her eby incr easing wages but also r educing
over heads per unit .
ii. May enable t he f ir mt o r emain compet it ive in inf lat ionar y condit ions
iii. May impr ove mor ale by ensur ing t hat ext r a ef f or t is r ewar ded
iv. Mor e ef f icient wor ker s may be at t r act ed by t he oppor t unit y t o ear n
higher wages.

Disadvant ages of I ncent ive Schemes

i. Ther e ar e pr oblems in est ablishing per f or mance levels and r at es.

ii. Some incent ive schemes ar e complex and expensive t o administ er .
iii. Some gr oups of wor ker s, alt hough r elat ively unskilled, may ear n high
wages t hr ough incent ive schemes whilst ot her s engaged on skilled
wor k may become r esent f ul when dif f er ent ials ar e er oded.
I ndividual I ncent ive Schemes

These schemes r elat e t o an individual wor ker and has immediat e and dir ect
impact on t he wages r eceived by an individual employee. Ther e ar e sever al
individual incent ive schemes some of which ar e explained below:
St r aight Piecewor k

At it s most basic t he wor ker would be paid an agr eed r at e per unit f or t he
number of unit s pr oduced. On occasions t he number of oper at ions would be t he
basis of payment or , wher e var ious t ypes of ar t icles ar e pr oduced, a piecewor k
t ime allowance per ar t icle would be sent t o and t he wor ker paid f or t he
piecewor k hour s pr oduce. For example, assume t hat t he dat a in t he f ollowing
f igur e 4.1

50
 Week No.
37

Employee No.
5872

Clock hour s.
40

Out put : 300 unit s of A, piecewor k t ime allowance 1.8 mins/

unit 150 unit s of B, piecewor k t ime allowance 1.5
mins/ unit 100 unit s of C, piecewor k t ime allowance
2.2 mins/ unit

Piecewor k r at e.
20 Ct s. Per minut e pr oduced

Tot al pr oduct ion

= (300 x 1.8) + (150 x 1.5) + (100 x 2.2) piecewor k minut es
= 985 piecewor k minut es

Gr oss wages
= 985 x 20 Ct s.
= Sh. 197.00
Figur e 4.1 wage det er minat ion

Not e:

i. Piecewor k t ime pr oduced is not equivalent t o act ual clock hour s.

Piecewor k t ime allowance is mer ely a device f or measur ing t he wor k
cont ent of dissimilar it ems.
ii. Piecewor k wit h guar ant eed day r at es is inst it ut ed t o saf eguar d
ear nings f r om f alling below nor mal day r at es. The wor ker will
t her ef or e be paid t he higher of piecewor k r at e or day r at e. The r eason
f or t he guar ant ee is because of unf or eseen int er r upt ions t hat may
occur such as delays, shor t ages, t ool br eakages et c. t hat can not be
blamed on t he wor ker .
iii. Wor ker s t r ansf er r ed t o ar eas wher e t hey will no longer enj oy t he
incent ive schemes like t he ot her wor ker s should be paid ext r a amount s
in lieu of t he bonuses f or f eit ed.
Dif f er ent ial Piecewor k

One obj ect ion t o st r aight piecewor k syst ems is t hat , because a f lat r at e per unit
is paid, t he incent ive ef f ect at higher pr oduct ion levels declines. Dif f er ent ial
piecewor k seeks t o over come t his by incr easing t he r at e pr ogr essively at var ious
pr oduct ion levels, e.g.

Up t o 100 unit s per day 10 Ct s / unit

101- 150 unit s per day 15 Ct s / unit
151- 200 unit s per day 20 Ct s / unit
On occasions in dif f er ent ial schemes t he whole of t he out put is paid at t he higher
r at e when t he next pr oduct ion t hr eshold is r eached.
Gr oup I ncent ive Schemes

Alt hough individually based incent ive schemes ar e common, on occasions t hey ar e
inappr opr iat e and some f or m of gr oup scheme is used. These schemes ar e mor e
appr opr iat e in:

i. Wher e pr oduct ion is based in gr oup e.g. r oad sur f acing, Van selling.
ii. Wher e pr oduct ion is int egr at ed and all ef f or t s ar e dir ect ed t owar ds
t he same end, e.g. in line pr oduct ion.
iii. Wher e t he pr oduct ion met hods or pr oduct makes it inf easible t o
measur e individual per f or mance.

The shar ing of bonus amongst t he gr oup should be decided by management in f ull
agr eement wit h t he gr oup member s and possibly t he union.

Advant ages of Gr oup Schemes

i. I t engender s closer cooper at ion in t he gr oup leading t o t eamspir it .

ii. Administ r at ively simpler wit h f ar less r ecor ding of labor t imes,
pr oduct ion r at es et c.
iii. Suppor t wor ker s not dir ect ly associat ed wit h pr oduct ion can
easily be included in t he scheme.
iv. I t gr eat ly r educes t he number of r at es t o be negot iat ed.
v. I t leads t o mor e f lexible wor king ar r angement s wit hin t he gr oup.

Disadvant ages of Gr oup Schemes

i. I t is less dir ect t han individual schemes and so may not pr ovide t he
same incent ive.
ii. Less har dwor king member s of t he gr oup r eceive t he same bonus wit h
t hose wor king har d and t his may cr eat e f r ict ion.
iii. I t is not always easy t o obt ain agr eement on pr opor t ions of bonus
which gr oup member s will r eceive.
4.3 I ncent ive Schemes in Pr act ice

A signif icant por t ion of pr oduct ion wor ker s ar e paid under some f or m of
incent ive or bonus scheme and t her e is no doubt t hat some schemes ar e
ext r emely ef f ect ive. Many ot her s ar e not and r ecognit ion of some of t he
f ollowing pr oblems will help t o ensur e a wor kable and ef f icient scheme.

52
 i. An incent ive scheme will not solve t he pr oblems of badly managed,
poor ly or ganized, ill- equipped f ir ms.
ii. To ensur e only good pr oduct ion is paid f or , sound qualit y cont r ol and
inspect ion pr ocedur es ar e vit al.
iii. All incent ive schemes should be based on ef f icient wor king met hods
f ollowing compr ehensive wor k st udies
iv. Car e should be t aken not t o ent er int o shampr oduct ivit y schemes
wher e pay incr eases does not r esult int o impr oved pr oduct ivit y.
Pr of it Shar ing

Pr of it shar ing is par t of t he benef it s package t hat employees could r eceive. The
amount s r eceived by individuals ar e usually r elat ed t o t heir salar y or wages and
t he pr of it shar e may be given in cash or shar es of t he company. I n t he lat t er
case t he syst em becomes a f or m of co- owner ship. Pr of it shar es ar e somet imes
huge and lar ger t han t he employees’ nor mal salar ies.

4.4 Tr ends in Labor Cost ing

I n t he past cost s was a maj or pr opor t ion of t ot al cost . This meant t hat it was
wor t hwhile car r ying out a t hor ough analysis of labor cost s and making necessar y
det ailed account ing ent r ies.

The posit ion t oday is ver y dif f er ent , f act or ies ar e highly aut omat ed and labor is
a small (and r educing) pr opor t ion of t ot al cost . I n t his cir cumst ance simpler
syst ems ar e being used f or labor wit h some companies eliminat ing dir ect labor
account ing complet ely and showing labor cost s t oget her wit h dir ect over heads.
4.5 Labor Recor ding, Cost ing and Allied Pr ocedur es

Labor Recor ds

I n most manuf act ur ing companies and f or many in t he ser vice sect or , r ecor ds of
at t endance t ime f or each wor ker ar e r equir ed what ever t he syst em of
r emuner at ion. I n addit ion, if an incent ive scheme is used, r ecor ds may be
r equir ed f or oper at ions, pr ocesses, par t s, t ime, quant it ies, sales made,
enquir ies handled or what ever is used as t he basis f or t he incent ive scheme.

These r ecor ds f or t he basis of wage calculat ions and f or such cost ing dat a as:
dir ect and indir ect labor cost s, over head build- up, labor cost cont r ol. I n many
cases now days t he r ecor ding is done elect r onically and not by using t r adit ional
f or ms and paper wor k. The r ecor ding may be done by ent r ies on t er minals,
aut omat ic count ing or weighing or by var ious f or ms of scanning using bar codes.
What ever t he r ecor ding met hods used t he pr inciples and obj ect ives r emain t he
same.

53
The t wo t ypes of r ecor ds; t hose f or at t endance and t hose f or out put ar e descr ibed
below:

At t endance Recor ds

I n all but ver y small concer ns t his is done by use of clock car ds, one f or each
wor ker , and a t ime r ecor ding clock usually based at t he ent r ance t o t he pr emises.
The clock car d is t he basis of t ime r ecor ding and what ever addit ional t ime
r ecor ds ar e kept , t hey must be r econciled wit h t he t ot al at t endance and t ime
r ecor ded on t he clock car d by t he t ime r ecor ding clock.

Wit h t he incr eased use of t echnology mor e r ecor ding syst ems ar e now elect r onic
inst ead of mechanical but , of cour se, have similar obj ect ives. Elect r onic syst ems
ar e based on t he use of plast ic car ds wit h magnet ic st r ips which ar e issued t o
employees. These car ds ar e suit able f or f ir ms which adopt f lexible- t ime wor king.
This is wher e employees ar e r equir ed t o at t end f or a minimum number of hour s
each day- of t en wit hin specif ied hour s- but out side of t his t hey may wor k at
t imes t o suit t hemselves pr ovided t hey accumulat e t he agr eed number of hour s
per per iod. Obviously, f lexible- t ime wor king is mor e suit ed t o cler ical and
administ r at ive st af f r at her t han pr oduct ion wor ker s.

Out put Recor ds

The r ecor ds necessar y must be t ailor ed t o t he r equir ement s of incent ives and
labor cost cont r ol syst ems in oper at ion. Unnecessar y r ecor ding incur s ext r a
cler ical cost s and may slow down pr oduct ion and should be avoided. The f ollowing
ar e t ypical r ecor ds f ound in many manuf act ur ing companies:

• Daily and weekly t ime sheet s

• Job car ds
• Oper at ion car ds

Daily and Weekly Time Sheet s

These ar e r ecor ds, f illed in by t he wor ker and count er signed, which show how he
spent his t ime dur ing t he day or week. The gener al obj ect ive is t o r econcile all
t he t ime in at t endance wit h t ime bookings eit her t o j obs or oper at ions.

Weekly t ime sheet s t end t o be less accur at e but r equir e less cler ical ef f or t . I t
r eally depends on whet her t he wor ker deals wit h number s of small j obs, when
daily t ime sheet s would be pr ef er r ed, or is employed on j obs which last a
consider able t ime when weekly sheet s may be adequat e.

Job Car ds

Unlike t ime sheet s which r elat e t o individual employees and may cont ain bookings
r elat ing t o numer ous j obs, a cob car d r elat es t o a single j ob or bat ch and is likely
t o cont ain ent r ies r elat ing t o numer ous employees.

54
 On complet ion of t he j ob it will cont ain a f ull r ecor d of t he t imes and quant it ies
involved in t he j ob or bat ch. The use of j ob car ds, par t icular ly f or j obs which over
sever al weeks, makes r econciliat ion of wor k t ime and at t endance t ime a dif f icult
t ask. These car ds ar e dif f icult t o incor por at e dir ect ly int o wages calculat ion
pr ocedur es.

Oper at ion Car ds

These car ds, somet imes known as piecewor k t icket s, ar e pr ovided f or each
oper at ion or st age of manuf act ur e so t hat each oper at ion will have at least one
car d. I n t his way a j ob will have a number of oper at ion car ds and alt hough t his
incr eases t he paper wor k, it does enable t he oper at ion car ds t o be used dir ect ly in
t he wage calculat ion pr ocedur es.

Wages Pr ocedur es

The f lowchar t below shows an out line of wages pr ocedur es f r om t he or iginal

clock car d t o basic cost account ing ent r ies.

55
 Clock
Car d

Reconcile at t endance t imes, ver if y

aut hor izat ions f or quant it ies, j ob
t imes

Calculat e gr oss pay Employee r ecor d

car d f or det ails
of r at es,
allowances, t ax
Gr oss t o net comput at ions involving deduct ions, et c.
st andar d deduct ions, income t ax, et c.

Payr oll / pay slip pr epar at ion

Wage payment - Post ing of t ot als Wages analysis

cash analysis, f r ompayr oll t o using payr oll and
packet
pr epar at ion, ledger account s j ob car ds or t ime
- Cash a/c f or
and payment net sheet s
wages - WI P a/cs f or
- PAYE dir ect wages
- NSSF - Over head a/cs
- NHI F f or indir ect
- SACCO et c. wages.

Cost ing of Labor

Using j ob car ds and / t ime sheet s or out put r ecor ds and t he payr oll, t he cost
depar t ment car r ies out a det ailed analysis of all wages paid t o enable t he labor
cost s f or pr oduct s,
oper at ions, j obs, cost cent er s and depar t ment s t o be est ablished. This is done
f or cost ascer t ainment and cost cont r ol pur poses.

Dir ect wages- t hat pr opor t ion of wages of pr oduct ion employees dir ect ly
at t r ibut able t o pr oduct ion is char ged t o t he j ob or oper at ion in which engaged
and t he t ot al of dir ect wages f or t he per iod is char ged t o a depar t ment al W- I - P
cont r ol A / C.

Dir ect wages would nor mally exclude over t ime and shif t pr emiums. The r eason
f or t his is t hat such pr emiums, if classed as dir ect , would be char ged only against
t he j ob done dur ing t he over t ime per iod which is unj ust because it is f or t uit ous
which j obs ar e done dur ing or dinar y or over t ime.

I ndir ect wages- t he wages of such people as inspect or s, st or es assist ant s,

cler ks and labor er s would be coded t o t he appr opr iat e depar t ment t o f or m par t
of over heads of t hat depar t ment . I n addit ion, t he pr opor t ion of pr oduct ion
wor ker s wages which can not be classed as dir ect , e.g. idle t ime, over t ime and
shif t pr emium would also be classif ied as indir ect included in over heads and
subsequent ly absor bed int o pr oduct ion cost s via t he appr opr iat e over head
absor pt ion r at es.

Labor cost cont r ol- t he cost depar t ment act ivit ies descr ibed above pr ovide t he
r aw dat a f or cost ascer t ainment and also f or cost cont r ol pur poses. Cost cont r ol
at it s simplest will show var ious compar isons, f or example, dir ect and indir ect
wages, compar ed wit h t he same classif icat ions in pr evious per iods. The simplest
way t o analyze is t o use r at ios. I n t his way, t he t r ends of labor cost s will be
shown and may give some guidance t o management on cost cont r ol.
Ot her Fact or s Relat ed t o Labor Cost ing

Wages Det er minat ion

I n det er mining t he appr opr iat e wages, numer ous f act or s ar e involved. The
weight of t hese f act or s var ies f r omFir mt o Fir mand includes:

i. gener al economic condit ions in indust r y

ii. gover nment policy, e.g. t he minimumwages accept able
iii. pr of it abilit y of t he f ir m
iv. t he union st r engt h
v. Employment condit ion of t he count r y.
vi. Cost st r uct ur e of t he f ir mand indust r y. I f labor cost s const it ut e a
high pr opor t ion of t he t ot al cost , t he f ir mmay not be willing t o pay
higher wages.
vii. St r at egic impor t ance of t he f ir mor indust r y.
viii. Availabilit y of wor ker s wit h r equir ed skills.
ix. The nat ur e of t he j ob envir onment . Hazar dous or danger ous wor king
condit ions might f or ce t he Fir m t o pay higher wages. I n Japan, f or
example, Jobs labeled as 3K (i.e. Danger ous, Dir t y, and Dif f icult ) cost
mor e wages on aver age.
 x. Wages pr evailing locally and nat ionally.

Job Evaluat ion

This is a t echnique which seeks t o show in a r easonably obj ect ive manner t he
r elat ive wor t h of j obs. I t at t empt s t o do t his by analyzing t he cont ent of each
j ob under var ious cat egor ies, e.g. t r aining r equir ed, degr ee of r esponsibilit y,
wor king condit ions, and t ypes of decisions involved and so on. Scor es or point s
ar e given f or each f act or . The t ot al of t he point s f or each j ob is t hen used t o
est ablish t he r anking of one j ob t o anot her and, by r ef er ence t o pay scales.

Advant ages

i. I t makes an at t empt t o be obj ect ive in r anking j obs.

ii. I t is r easonably ef f ect ive wit hin an or ganizat ion at r anking j obs.

Disadvant ages

i. I t is not suit able f or r anking widely dif f er ent j obs.

ii. The j ob evaluat ion pr ocess is
subj ect ive. Not e:
• Job evaluat ion st udies t he j ob and not t he per son doing t he j ob.
• Job evaluat ion is only one f act or amongst many in det er mining t he
act ual pay f or t he j ob.

Mer it Rat ing

Unlike j ob evaluat ion, mer it r at ing is concer ned wit h t he individual employee. I t
seeks t o r at e t he employee’s per f or mance t o assist in det er mining whet her a
per son should r eceive a mer it awar d, pr omot ion, or demot ion. I t does t his by
consider ing per f or mance and at t r ibut es of an employee under var ious cat egor ies,
f or example, init iat ive, at t endance, accur acy, willingness, et c. and giving t he
number of point s f or each f act or . Mer it r at ing under var ious guises is
f r equent ly encount er ed in st af f appr aisal schemes, par t icular ly in lar ge f ir ms,
and is consider ed t o be of value in pr oviding a r easonably st andar d basis t o
dif f icult t ask of individual appr aisal.

The Human Resour ce Funct ion

Most f ir ms have human r esour ce depar t ment s. These depar t ment s nor mally
per f or mt he f ollowing f unct ions:

58
 i. Adver t ising, r ecr uit ing, and engaging labor .
ii. Dischar ge, t r ansf er , administ r at ion of appr aisal schemes.
iii. I ndust r ial r elat ions and union negot iat ions.
iv. Maint enance of per sonnel r ecor ds and pr ovision of st at ist ical
inf or mat ion t o gover nment depar t ment s, t r ade associat ions, et c.
v. Pr ovision of inf or mat ion t o management on such mat t er s as
absent eeism, lat eness, labor t ur nover , nor mal and over t ime wor ked,
et c.
vi. St af f development , t r aining, educat ional schemes, and appr ent iceships.
vii. Welf ar e, spor t s and social f acilit ies.
viii. Saf et y and medical f acilit ies.
ix. Manpower planning and f or ecast ing

I n gener al, t he per sonnel f unct ion has t he r esponsibilit y of pr oviding an

ef f icient labor f or ce which is cost ef f ect ive and keeping labor t ur nover t o a
minimum.
Labor Tur nover and it s I mplicat ion

Labor t ur nover (LT) is usually expr essed as a r at io:

LT = Number of employees r eplaced per per iod

Aver age t ot al number of employees in t he per iod

Alt hough some labor movement s ar e of value, high LT r at es dest r oy mor ale,
incr eases cost s and r educe pr oduct ivit y. People leave j obs f or a var iet y of
r easons, some of which ar e avoidable, and it is imper at ive t o analyze t he r easons
f or labor t ur nover . The causes may be one or a combinat ion of t he f ollowing
f act or s:
• Redundancy
• Dissat isf act ion over pr ospect s, pay, hour s, condit ions.
• Lack of car eer st r uct ur e.
• Lack of t r aining or day r elease.
• Per sonal advancement .
• Mar r iage, pr egnancy.
• Ret ir ement .
• Dischar ge.
• Move f r omlocalit y.
• Changes in domest ic cir cumst ances.

The implicat ion of high labor t ur nover higher cost s in t er ms of :

• Leaving cost s- t he cost s of conduct ing f r esh int er views, and
disr upt ion of out put .
• Replacement cost s- t he cost s of adver t ising select ion, per sonnel
depar t ment pr ocedur es.
• Tr aining cost s- t he cost s of r equir ed int er nal and ext er nal cour ses.
 • Lear ning cost s- slower init ial pr oduct ion, incr eased wast ages of
mat er ial, t ool br eakages, incr eased accident r at es, and poor
ser vice.

TOPI C 6

OVERHEAD COSTI NG

5.1 Over head Absor pt ion

Over head absor pt ion is t he pr ocess by which over heads ar e included in t he t ot al

cost of a pr oduct . I t is a means of at t r ibut ing over heads t o a pr oduct or ser vice
based on dir ect labor hour s, dir ect labor cost or machine hour s.

The t er minology def init ion given above r elat es t o t he t r adit ional pr oduct ion
volume based appr oach t o over head absor pt ion not t o act ivit y- based appr oach.
The t r adit ional appr oach is descr ibed f ir st and af t er war ds act ivit y- based cost ing
will be discussed.

Over head absor pt ion becomes of gr eat impor t ance when dissimilar pr oduct s ar e
made which r equir e dif f er ent pr oduct ion pr ocesses or f or j obs which, alt hough
using ident ical f acilit ies, occupy t he f acilit ies f or var ying lengt h of t ime. I t is of
impor t ance in t hese cir cumst ances because t he over heads absor bed int o t he
pr oduct or j ob places upon t he pr oduct ion f acilit ies.

To det er mine t he over head t o be absor bed by a cost unit , it is necessar y t o

est ablish an over head absor pt ion r at e (OAR) which is calculat ed by using t wo
f act or s: t he over heads at t r ibut able t o a given cost cen6t r e and t he number of
absor pt ion base (labor hour s, machine hour s, et c.) t hat is deemed most suit able;
t hus

OAR f or cost cent r e

= Tot al over heads of cost cent r e
Tot al number of unit s of absor pt ion base applicable t o cost
cent r e

The t ot al over head of a cost cent r e ar e est ablished by t he pr ocesses of a cost

allocat ion and cost appor t ionment . The var ious absor pt ion bases ar e descr ibed
below:

62
5.2 Bases of Absor pt ion

The obj ect ive of over head absor pt ion pr ocess is t o include in t he t ot al cost of a
pr oduct an appr opr iat e shar e of t he f ir m’s t ot al over heads. An appr opr iat e shar e
is gener ally t aken t o mean an amount which r ef lect s t he ef f or t s and t ime t aken
t o pr oduce a unit or complet e a j ob. I n t he unlikely event of ident ical pr oduct s
being pr oduced by ident ical pr ocesses f or t he whole of a per iod. t he t ot al
over heads could be shar ed equally amongst t he pr oduct s. To cope wit h t he
pr act ical sit uat ions var ious absor pt ion bases have been developed.

I llust r at ion:

Assume t he f ollowing inf or mat ion r elat e t o t he pr oduct ion cost cent r e of a
cer t ain pr oduct :

Tot al over heads f or t he per iod Sh. 12, 000

Tot al dir ect labor hour s f or t he per iod 1, 600
Tot al dir ect wages 3, 200
Tot al dir ect mat er ials used 6, 000
Tot al machine hour s 2, 400
Tot al unit s pr oduced 90

Using t hese dat a t he f ollowing absor pt ion r at es could be calculat ed using t he OAR
f or mula.

Dir ect labor hour OAR = Sh. 12, 000

1, 600 hr s
= Sh. 7.50 over heads per labor
hour

Dir ect wages OAR = Sh. 12, 000

Sh.
3, 200

= Sh. 3.75 over heads per Sh. of wages.

Dir ect mat er ial OAR = Sh. 12, 000

Sh.
6, 000
= Sh. 2.00 over heads per Sh. of
mat er ials.

Pr ime cost OAR = Sh. 12, 000

Sh.
9, 200

= Sh. 1.30 over heads per Sh. of pr ime cost .

Machine hour OAR = Sh. 12, 000
2, 400hr s
= Sh. 5.00 over heads per machine
hour .

Cost unit OAR = Sh. 12, 000

90 unit s
= Sh. 133.00 over heads per unit
pr oduced.

Using t he Calculat ed OAR

When it has been decided what is t he most appr opr iat e r at e t o use f or a given
cost cent r e, t he OAR is used t o calculat e t he cost of a cost unit as in t he
f ollowing example.

A cost unit X has been pr oduced in a cost cent r e and t he f ollowing det ails r ecor ded.

Cost unit X
Dir ect mat er ials used Sh. 23.00
Dir ect wages 27.50
Dir ect labor hour s 12.00
Machine hour s 17.00

Assuming t hat it has been decided t hat t he dir ect labor r at es is t he most
appr opr iat e met hod t o use, calculat e t he cost unit using t he dat a given.

Solut ion:
Sh.
Dir ect mat er ials used 23.00
Dir ect wages 27.50
50.5
Pr ime cost 0
Over heads (12 hr s @ Dir ect labor hour s
Labor hour OAR of Sh. 7.50 per hour 90.00
140. 50

I n pr act ice, t he most appr opr iat e OAR f or a given cost cent r e is decided upon and
used f or all t he cost calculat ions of unit s passing t hr ough t hat cost cent r e.
Dif f er ent cost cent er s may well have dif f er ent absor pt ion bases and t he f act or s
inf luencing t he choice will depend on cir cumst ances sur r ounding each case.

Not e:
• I n pr act ice only one base of over head absor pt ion is used. (one t hat is
viewed t o be t he most appr opr iat e)
• The var ious absor pt ion bases pr oduce subst ant ially dif f er ent amount s of
over heads t o be absor bed int o cost unit .
 • The wide r ange of over heads possible shows t hat t her e is no single,
accur at e cost . All cost s ar e based on convent ions and j udgment .

For pr oduct X, t he f ollowing dif f er ent over heads can be obt ained using t he
var ious OARs based on dir ect labor , dir ect wages, dir ect mat er ial, pr ime cost ,
machine hour , and cost unit .
over head
Absor pt ion base OAR unit s calculat ion absor bed

Dir ect labor hour 7.50 per hr 12 12*7.5 Sh. 90

Dir ect wages 3.75 per Sh. 27.5 27.5*3.75 Sh. 103.125

Dir ect mat er ial 2.00 per Sh. 23 23*2 Sh. 46

Pr ime cost 1.30 per Sh. 50.50 50.5*1.3 Sh. 65.65

Machine hour 5.00 per hr 17 17*5 Sh. 85

Cost unit 133 per unit 1 1*133 Sh. 133

Dir ect Labor Basis

Over head absor pt ion r at e based on dir ect labor is most appr opr iat e in a labor
int ensive cost cent r e and, pr oviding t he t ime booking syst emis good, easy t o use.
However , most pr oduct ion now days involve subst ant ial use of machiner y so t he
labor hour met hod may become incr easingly inappr opr iat e.
Machine Hour Basis

This met hod is most appr opr iat e in mer chandised cost cent er s. I n such cost
cent er s many of t he over heads ar e r elat ed t o machiner y (power , r epair s,
depr eciat ion, et c.), so a machine hour basis r at e should r ef lect f air ly accur at ely
t he incidence of t he over heads.
Dir ect Wages Basis

This is a f r equent ly used r at e in pr act ice and is easy t o apply. Dir ect wages paid
ar e r elat ed t o t ime, but because of var ying r at es paid t o dif f er ent per sonnel,
piecewor k, and bonus syst ems, t her e is no exact cor r elat ion bet ween wages paid
and t ime elapsed. I f t her e was only one r at e per hour paid t hr oughout a cost
cent er and no f or m of incent ive scheme, and t hen dir ect s wages syst em would
give ident ical r esult s t o t he labor hour basis. This is r ar ely t he case.

65
Dir ect Mat er ial Basis

This met hod if used could lead t o absur d anomalies. Dif f er ent qualit y of mat er ial
has dif f er ent pr ices yet t hey under go vir t ually t he same pr ocessing pr ocedur es.
I f over heads ar e absor bed based on t he dir ect mat er ial cost , mor e over heads will
be allocat ed t o high qualit y mat er ial even if t hey under go t he same pr ocesses as
t he low qualit y mat er ial.
Pr ime Cost Basis

Alt hough par t of t he pr ime cost is t ime r elat ed (dir ect wages), t he inclusion of
t he dir ect mat er ial element would lead t o possible anomalies pr evalent in t he
dir ect mat er ial met hod.
Cost Unit Basis

Pr ovided all t he unit s pr oduced ar e ident ical, wit h ident ical pr oduct ion pr ocesses
and t ime, t his absor pt ion met hod would give accur at e r esult s. However , such
cir cumst ances ar e unlikely; t her ef or e, t he use of t his met hod is limit ed.
Choosing t he Appr opr iat e Base

The f act or s t o be consider ed in t he choice of an appr opr iat e base ar e given below,
but it should be not ed t hat t he f inal choice is a mat t er of j udgment and common-
sense. Ther e is no r ule of t he t humb r egar ding what OAR should be applied in a
given sit uat ion. What is r equir ed is an absor pt ion r at e which r ealist ically
r ef lect s t he char act er ist ics of a given cost cent r e and which avoids undue
anomalies.

Ther e is gener al accept ance t hat t he t ime based met hod (labor hour s, machine
hour s, and t o a lesser ext end dir ect wages) ar e mor e likely t o r ef lect t he load on
a cost cent r e and hence t he incidence of over heads.
Pr edet er mined Absor pt ion Rat e

Absor pt ion r at es of over heads ar e always pr edet er mined. This means t hat t he
over head absor pt ion r at e (OAR) is calculat ed pr ior t o t he account ing per iod,
using est imat ed or budget ed f igur es f or over heads and unit s of absor pt ion base
chosen. Thus t he f or mula f or pr edet er mined OAR will be:

Pr edet er mined OAR f or cost cent r e = Budget ed t ot al over heads f or cost cent r e
Budget ed t ot al number of unit s of
absor pt ion base

The maj or r eason f or t his pr ocedur e is t hat t he act ual over heads and act ual
number of base unit s ar e not known in t ot al unt il t he end of t he per iod and t he
act ual OAR could not be calculat ed unt il t hen. This would mean t hat t he pr oduct
cost s could not be calculat ed unt il t he end of t he per iod. This would in t ur n
cr eat e delays int o pr ocedur es such as
invoicing and est imat ing. Because of t his disadvant age, absor pt ion r at es ar e
based on pr edet er mined r at es.
Under or Over Absor pt ion

Using pr edet er mined r at es, over heads ar e absor bed int o act ual pr oduct ion
t hr oughout t he account ing per iod. Because pr edet er mined r at es ar e based on
est imat ed pr oduct ion and est imat ed over heads, t he over heads absor bed by t his
pr ocess do not agr ee wit h t he act ual over heads incur r ed f or t he per iod. I f t he
over heads absor bed ar e gr eat er t han act ual over heads, t his is known as over
absor pt ion. Conver sely, if absor bed over heads ar e less t han act ual over heads,
t his is known as under absor pt ion. The f ollowing example shows how t o calculat e
t he amount of over heads under or over absor bed.

Following dat a r elat e t o pr oduct ion at a cost cent r e Q12:

Budget ed Act ual

Sh.
Over heads Sh. 12, 000 12, 624
Dir ect labor hour s 1, 600 1, 584
Dir ect wages Sh. 3, 200 Sh. 3, 410
Dir ect mat er ials Sh 6, 000 Sh. 5, 984
Machine hour s 2, 400 2, 344
Unit s pr oduced 90 92

The pr edet er mined over head absor pt ion r at e f or dir ect labor hour s is Sh. 7.5 per
hour (r ef er pr evious example on calculat ion of over heads absor pt ion r at es). The
t ot al over heads absor bed by act ual act ivit y of 1, 584 labor hour s = 1, 584 * 7.5 =
Sh. 11, 880 of over heads absor bed int o pr oduct ion, but act ual over heads wer e Sh.
12, 624 t hus in t his example, over heads wer e under absor bed.

Under absor bed over heads = 12, 624 – 11, 880

= Sh. 744

not e:
I t will be obser ved t hat under (or over ) absor pt ion can ar ise f r om eit her act ual
over heads dif f er ing f r om budget or a dif f er ence bet ween t he act ual and
budget ed amount of t he absor pt ion base or a combinat ion of t hese t wo f act or s.
Dealing wit h Under and Over Absor pt ion

The budget ed f igur es used f or calculat ing t he pr edet er mined OAR’s ar e based on
t he expect ed levels of pr oduct ion and over head. Ther e ar e many f act or s which
cause act ual r esult s t o dif f er f r omt hose expect ed and it must be r ealized t hat it
is t he act ual cost s and over heads which det er mine t he f inal pr of it . This means
t hat t he t ot al of act ual cost s must appear in t he f inal pr of it and loss account
and not mer ely t hose calculat ed pr oduct cost s which include pr ime cost plus
over heads based on pr edet er mined OAR. Accor dingly, t he amount of under
absor bed over heads should be added t o t ot al cost s bef or e t he pr of it is
calculat ed and conver sely t he amount of over absor bed over heads should be
subt r act ed f r omt ot al cost .

Tot al = Act ual dir ect + act ual dir ect + absor bed + under absor pt ion or
Pr oduct ion Mat er ial labor over heads - over absor pt ion
Cost

Using t he example of pr oduct ion cent er Q12, t he t ot al pr oduct ion cost will be:

5, 894 + 3, 410 + 11, 880 + 744 = 21, 928 (t o be post ed t o t he P&L a/c)
not e:
• The act ual dir ect cost s f or each cost unit would be immediat ely available
f r omt he labor and mat er ial booking syst emf or t he j ob car d.

• The under or over absor pt ion of over heads can only be est ablished when
t he act ual over heads will be known.

• Alt hough event ually appear ing in a pr of it and loss account or oper at ing
st at ement , t he under or over absor pt ion is somet imes put t o a mont hly
suspense account as an int er mediat e st age and t he net balance t aken t o
P&L at t he year end.
Absor bing Non- Pr oduct ion Over heads

The example of absor pt ion bases discussed so f ar r elat es t o pr oduct ion

over heads. However , a signif icant pr opor t ion of over heads of a t ypical company
ar e non pr oduct ion over heads, e.g. selling and mar ket ing over heads, r esear ch
and development over heads, dist r ibut ion over heads, administ r at ive over heads,
et c. t hese over heads also f or par t of t ot al cost of a cost unit and have t o be
absor bed or char ged int o t he pr of it and loss account . Alt hough t he absor pt ion
bases f or pr oduct ion over heads appear t o have some r at ionale, t he met hods in
common use f or non- pr oduct ion over heads unf or t unat ely ar e somewhat
ar bit r ar y. The dif f er ent met hods used ar e given below, but it must be
emphasized t hat pr ovided a given met hod is used consist ent ly by an or ganizat ion,
t he choice of t he met hod is pr obably not impor t ant except wher e cost s ar e used
as t he basis of pr icing. I n such cases t he choice of met hod may be impor t ant . The
common bases of absor bing non pr oduct ion over heads ar e shown below:

Type of over head Absor pt ion base(s) used

Selling and mar ket ing sales value or pr oduct ion cost
Resear ch and development pr oduct ion cost or conver sion cost or
added value
Dist r ibut ion pr oduct ion cost or sales value
Administ r at ion pr oduct ion cost or conver sion cost or
added value

Conver sion cost - pr oduct ion cost less t he cost of dir ect mat er ials.
Added value- sales value of a pr oduct less cost of bought mat er ials and ser vices.
 The calculat ion pr ocedur e f or non pr oduct ion over head r at es is t he same as
t hose of pr oduct ion over head

I llust r at ion
The f ollowing est imat ed f igur es have been est ablished f or pr oduct X.

Est imat ed selling and mar ket ing over heads Sh. 100, 000
Sh.
Est imat ed t ot al sales value 1, 000, 000

Selling and mar ket ing pr edet er mined OAR = Est imat ed over heads / Est imat ed sales value

= Sh. 100, 000 / 1, 000, 000

= 10 ct s / Sh. of sales or 10% of sales value.

Recor ding Over heads t o Pr oduct ion

The pr ocess wher e t ot al over heads ar e absor bed int o pr oduct ion is known as
absor pt ion cost ing. The absor pt ion of t ot al over heads int o pr oduct cost s has
implicat ions f or per f or mance measur ement , cost cont r ol, and st ock valuat ion.
The pr ocess of absor pt ion cost ing has been subj ect ed t o cr it icism by manager s
and account ant s. The cr it icismar ises f r omt he f act t hat over heads cont ain f ixed
cost s which do not change when t he level of act ivit y changes and which would st ill
have t o be paid if t her e was no act ivit y. To over come some of t he dif f icult ies, an
alt er nat ive met hod of cost ing has been developed, known as mar ginal cost ing,
which, alt hough using t he pr ocess of absor pt ion, excludes f ixed cost s f r om t he
absor pt ion pr ocess.

The convent ional met hod of est ablishing over heads and absor bing t hem int o
pr oduct ion f ollow t he f ollowing st ages:

St age Cost element s

1. The r aw dat a r elat ing t o labor , mat er ials, and expenses ar e gat her ed
f r om
invoices, payr oll, goods issued not es and r equisit ions.

St age Coding
2. All t he r aw cost dat a needs t o be classif ied and t hen coded in r espect
of
t he t ype of expense and locat ion. This pr ocess is f undament al t o all t he
cost ing and management account ing pr ocedur es.

St age Cost Analysis

3. Wher e discr et e it ems of cost can be allot t ed t o cost cent er s t his is
t er med
as allocat ion. Wher e t he cost has t o be spr ead or shar ed over sever al
cost
cent er s, t his is known as appor t ionment . The bases of appor t ionment
 be t he f loor ar ea, volume or space occupied, number of employees in
each cost cent r e, weight s of mat er ial, et c.

St age 4. Ser vice Cost Cent er s

These ar e cost cent er s which pr ovide a ser vice t o pr oduct ion cost
cent er s. Examples ar e maint enance, st or es and boiler house, . Their
cost s ar e building up by t he usual pr ocess of allocat ion and pr imar y
appor t ionment and t hen t heir t ot al cost s ar e appor t ioned
(secondar y appor t ionment ) over t he pr oduct ion cost cent er s, t hus
f or ming par t of t he pr oduct ion over heads which ar e absor bed int o
t he cost unit s pr oduced.

St age 5. Pr oduct ion Cost Cent er s

These ar e cost cent er s involved dir ect ly in pr oduct ion pr ocesses.
For example t he assembly shops, dr illing machines, spr ay shop, et c.

St age 6. Over head Absor pt ion

The over heads of each cost cent r e ar e absor bed int o t he cost s of
t he unit s pr oduced, usually in pr opor t ion t o t he t ime involved i.e. by
t he labor hour or t he machine hour r at e.
Ser vice Cost Cent er s

Since no pr oduct ion cost unit s pass t hr ough t he ser vice cost cent er s, it is
necessar y t o appor t ion t he ser vice depar t ment cost s t o t he pr oduct ion cost
cent er s so t hat all pr oduct ion cost s ar e absor bed int o pr oduct ion. The bases f or
appor t ioning ser vice cost s t o pr oduct ion depar t ment s ar e as f ollows:

Ser vice depar t ment possible bases of appor t ionment t o pr oduct ion cost
cent er s
Maint enance Maint enance labor hour s
Maint enance wages
Plant values

St or es No. of r equisit ions

Weight of mat er ials issued

I nspect ion No. of pr oduct ion employees per cost cent r e

No. of inspect ion t icket s
No. of j obs

Pr oduct ion cont r ol No. of pr oduct ion employees per cost cent r e
No. of j obs

Power gener at ion Mat er ial usage

Not ional capacit y
Technical est imat e

70
Per sonnel depar t ment No. of employees per depar t ment

Not e:
• The basis chosen should be one t hat is j udged t o be t he most equit able way
of shar ing t he ser vice depar t ment ’s cost s over depar t ment s which use t he
ser vice. This May mean t hat a par t icular and unique basis of
appor t ionment may have t o be der ived. I t must r ef lect t he use made of
t he ser vices pr ovided.
• Wher ever possible, ser vice depar t ment cost s should be char ged dir ect ly
(allocat ed). For example t he cost s of maint enance wages and mat er ials.
When a maint enance j ob is done f or a depar t ment , t he wages and
mat er ials used would be char ged dir ect ly t o t he depar t ment concer ned. I n
t his way only t he unallocat ed ser vice depar t ment cost s need t o be
appor t ioned.

77
Over head Pr oblems

Ther e ar e some it ems t o which special consider at ion should be given as t o

whet her t hey f or mpar t of over heads or not .

i. Taxat ion
Taxat ion is r egar ded as an appr opr iat ion of pr of it and is omit t ed f r om
r out ine cost ing syst ems. However , f or many decision and planning pur poses
t he ef f ect s of t axat ion ar e cr ucial. Ther ef or e, t axes should be included in
special st udies and r epor t s wher e appr opr iat e.

ii. Value added Tax

VAT can be claimed (unless one is not r egist er ed) and t her ef or e it should not
be included in t he case of r egist er ed f ir ms. Wher e t he f ir m is not r egist er ed,
VAT paid f or ms par t of t he cost .

iii. I nt er est
Ther e ar e pr oblems in devising a pr act ical scheme on how int er est is t o be
calculat ed and included. Because of t his, int er est is nor mally not included in
cost ing syst em.
5.4 Over heads and Act ivit y Based Cost ing (ABC)

ABC has developed t o deal wit h t he shor t comings associat ed wit h convent ional
absor pt ion cost ing. Tr adit ional cost ing syst em absor bs over heads t o
pr oduct ion based on labor or machine hour s even t hough many over heads var y,
not wit h pr oduct ion volume but wit h t he r ange and complexit y of pr oduct ion.

Wher e over heads f or m a lar ge pr opor t ion of t ot al cost s (a t r end t hat is

exper ienced cur r ent ly), it is t her ef or e impor t ant t o t r ace over heads t o
pr oduct ion in a mor e r ealist ic manner . This is done by collect ing over heads
int o cost pools and using cost dr iver s t o char ge t he pr oduct wit h a suit able
amount of over heads in or der t o r ef lect it s usage in suppor t ing t he
pr oduct ion.

Under ABC, cost s can be classif ied int o:

• Shor t t er mvar iable cost s
• Long t er mvar iable cost s
• Fixed cost s

Shor t Ter mVar iable Cost s

These ar e cost s t hat var y wit h pr oduct ion volume such as power cost s. The
var iabilit y of t hese cost s is dir ect ly r elat ed t o pr oduct ion volume. These
over heads should be t r aced t o pr oduct s using pr oduct ion volume based cost
dr iver s as appr opr iat e. For example, allocat ing of such over heads based on dir ect
labor hour s, machine hour s, dir ect mat er ial cost or weight . Ther e could be
sever al cost dr iver s whenever labor hour s, machine hour s, and mat er ial cost ar e
used in dif f er ent pr opor t ions.
Long Ter mVar iable Cost s

These ar e over head cost s which do not var y wit h pr oduct ion volume but do var y
wit h ot her measur es of act ivit y. For example, cost s f or suppor t act ivit ies such
as st ock handling, pr oduct ion scheduling, set - ups et c, ar e f ixed in t he shor t er
t er m but var y in t he longer t er m accor ding t o t he r ange and complexit y of
pr oduct s manuf act ur ed. I n ABC t hese cost s ar e t r aced t o pr oduct s by
t r ansact ion based cost dr iver s.
Fixed Cost s

These ar e classif ied as cost s which do not var y f or a given t ime per iod wit h any
act ivit y indicat or . For example, t he salar y of t he CEO, r ent , secur it y, et c.
Cost Pools and Cost Dr iver s

ABC f ocuses on what f act or s cause or dr ive cost s. Cost dr iver s ar e any f act or s
which cause a change in t he cost of act ivit y. For example, t he qualit y of par t s
r eceived by an act ivit y is a det er mining f act or in t he wor k r equir ed by t hat
act ivit y and t her ef or e af f ect s t he r esour ces. An act ivit y may have mult iple cost
dr iver s associat ed wit h it . Because of t he possibilit y of mult iple cost dr iver s,
t her e is a dif f icult y in choosing t he appr opr iat e cost dr iver . No single r ules exist
per t aining t o t he select ion of cost dr iver s and t he best appr oach is t o ident if y
t he r esour ces t hat const it ut e a signif icant por t ion of t he pr oduct .

Cost pools ar e point of f ocus f or t he cost s r elat ing t o a par t icular act ivit y. They
ar e similar in pr inciple t o cost cent er s in t r adit ional syst ems. Cost s ar e pooled
(collect ed) on t he basis of t he act ivit y t hat dr ives t he cost s r egar dless of t he
depar t ment al boundar ies. For example, if t he cost dr iver is t he number of set -
ups’ t hen all t he cost s r elat ing t o set t ing- up will be pooled t oget her . Cost pools
ar e t her ef or e not r elat ed t o depar t ment al boundar ies and do not encompass t he
act ivit ies of one depar t ment only. Thus, cost pools ar e mor e t han t he number of
depar t ment s pr esent in an or ganizat ion.

I llust r at ion:

Depar t ment s Maj or act ivit ies

Manuf act ur ing dr illing,
For ming,
Assembly.

Engineer ing maint enance,

Pr oduct design,
Tool design.

Qualit y cont r ol inspect ion,

The development of ABC and t he designat ion of cost pools and appr opr iat e cost
dr iver s ar e not mer ely a cost r ecor ding and cost at t r ibut ion pr ocess. The syst em
enables t he management answer t he f ollowing quest ions:
• What does t he depar t ment achieve? Does it add value or it simply adds cost ?
Why is it needed? Can t he f ir mdo wit hout t he depar t ment ?
• What causes t he act ivit y f or which t he depar t ment is r esponsible?

The appr eciat ion of t he ABC syst em is t he f act t hat people can not manage cost s
but t hey can manage t he act ivit ies t hat cause cost s.
Select ing Cost Dr iver s

Ther e should be a dir ect cause- ef f ect r elat ionship bet ween consumpt ion of
over heads and t he chosen cost dr iver . This r elat ionship is not necessar ily a shor t
t er mone. Cost s such as salar ies make up a signif icant por t ion of t ot al over heads
but ar e not easily adj ust ed in t he shor t r un. The number and t ype of cost dr iver s
chosen will depend on sever al f act or s such as:
i. t he r equir ed accur acy of pr oduct cost ing
ii. The ext end t hat a given cost dr iver capt ur es t he act ual consumpt ion
of an act ivit y by a pr oduct .
iii. The ext end t o which a cost dr iver can be r elat ed t o many act ivit ies or
cost pools. The cost pool should be homogenous (f air ly r epr esent ed by
one cost dr iver ). Wher e t his is not possible t he pool may need t o be
subdivided and numer ous cost dr iver s used. (of cour se t his will
complicat e t he syst em).
iv. The ext end t hat one cost can be f air ly applied t o diver se pr oduct s. For
example if t he cost dr iver , ‘number of inspect ions’ wer e used t o t r ace
inspect ion cost s t o pr oduct s, dist or t ions will occur if inspect ions t ake
var ying amount s of t ime f or dif f er ent pr oduct s.

Cost dr iver s and cost pools chosen must suit t he or ganizat ion. The choice of
dr iver s and pools will t her ef or e var y f r omone or ganizat ion t o anot her . The t able
below shows t he act ivit ies and cost dr iver s t hat can be ident if ied in an
or ganizat ion.

Act ivit y Cost dr iver

Cust omer or der pr ocessing No of or der s
No of cust omer s
Size of or der s
No of cust omer visit s.

Pr oduct ion cont r ol No of engineer ing changes

No of machine layout changes
No of oper at ional par t s
No of per sonnel
No of schedule changes
Deliver y per f or mance
No of pr oduct ion bat ches
 No of set - ups
No of wor k or der s

Mat er ial planning/I nvent or y cont r ol No of par t s

No of deliver ies
No of mat er ial movement
No of st ock discr epancies
No of shor t ages
No of on- t ime movement s
No of schedule movement s
No of r eceipt s
Mat er ial weight /volume

Engineer ing suppor t No of set - ups

No of engineer ing changes
No of pr oduct changes
No of pr oduct ion hour s
No of def ect s
No of t ool changes
No of change not ices
No of br eakdowns

I nspect ion and Qualit y cont r ol No of inspect ions

No of r ej ect s
Checking f r equency
No of par t s
No of supplier s
No of r eceipt s
No of pr oduct changes
Bat ch sizes
No of cust omer s
Gener al account ing

Number of supplier s or cust omer sFr equency of dispat ches

Fr equency of deliver ies
No of invoices
No of pur chase/sales or der s
No on payr oll
No of account ing changes

TOPI C 7

COSTI NG TECHNI QUES

Cost ing t echniques ar e met hods used t o assign cost s t o pr oduct s or invent or y.
Ther e ar e t wo maj or met hods of cost ing:
i. mar ginal cost ing, and;
 ii. Absor pt ion cost ing.

6.1 Mar ginal (Var iable) Cost ing

Mar ginal cost means var iable pr oduct ion cost . They ar e cost s t hat var y dir ect ly
wit h t he level of pr oduct ion. I f an ext r a unit of out put is pr oduced, t he cost s
which could be incur r ed f or pr oducing t his ext r a unit will only be mar ginal
(var iable) cost s since f ixed cost s r emain const ant . Mar ginal cost ing is also called
dir ect cost ing or cont r ibut ion appr oach.

Mar ginal cost ing is a cost ing t echnique in which only var iable manuf act ur ing
cost s ar e consider ed and used while valuing invent or ies and det er mining cost of
goods sold. That is, only var iable manuf act ur ing cost s ar e consider ed pr oduct
cost s and ar e allocat ed t o pr oduct s manuf act ur ed. These cost s include di5r ect r
mat er ials, dir ect labor and var iable f act or y over heads. Fixed f act or y over heads
ar e not consider ed pr oduct cost s and ar e not used t o value invent or ies and
det er mine t he cost of goods sold. Fixed manuf act ur ing over heads ar e t r eat ed as
per iod cost s in mar ginal cost ing and ar e wr it t en of f t o t he pr of it and loss
account in t he per iod when t hey ar e incur r ed.

6.2 Absor pt ion Cost ing

Absor pt ion cost ing (f ull cost ing) is a cost ing t echnique in which all
manuf act ur ing cost s, var iable and f ixed, is consider ed as cost s of pr oduct ion and
is used in det er mining t he cost of goods manuf act ur ed and invent or ies. All
manuf act ur ing cost s ar e f ully absor bed int o f inished goods.

Dif f er ence bet ween mar ginal cost ing and Absor pt ion cost ing
The f ollowing dif f er ences bet ween mar ginal cost ing and Absor pt ion cost ing exist :
i. Cost element in pr oduct cost - t he t r eat ment of f ixed f act or y
over heads is dif f er ent in t he t wo t echniques. Absor pt ion cost ing
includes f ixed f act or y over heads while mar ginal cost ing does not .
ii. I nvent or y values- mar ginal cost ing and Absor pt ion cost ing do
inf luence invent or y values dif f er ent ly. The values of invent or y under
mar ginal cost ing ar e r elat ively at a lower f igur e as invent or ies values
exclude t he cost of f ixed f act or y over heads.
iii. Dif f er ence in net income- t he dif f er ences of invent or y values bet ween
t he t wo met hods will also lead t o dif f er ent income r epor t ed.

86
6.3 I ncome St at ement under Mar ginal Cost ing and Absor pt ion Cost ing

Under absor pt ion cost ing all cost s ar e divided int o t hr ee cat egor ies:
manuf act ur ing, selling and administ r at ive cost s. I n t he income st at ement , all
manuf act ur ing cost (var iable and f ixed) is subt r act ed f r om t he sales r evenue t o
get a gr oss mar gin on sales. Selling and administ r at ive expenses ar e t hen
deduct ed t o get t he net pr of it .

Under mar ginal cost ing, only var iable pr oduct ion (dir ect mat er ial, dir ect labor ,
and var iable manuf act ur ing) ar e subt r act ed f r omt he sales r evenue t o det er mine
t he mar ginal cont r ibut ion (or mar ginal pr of it ). All f ixed cost s and var iable selling,
dist r ibut ion and administ r at ive cost s ar e deduct ed f r omt his balance t o ar r ive at
t he net income. The t wo met hods can be illust r at ed below.

I ncome St at ement
Absor pt ion Mar ginal
Cost ing Cost ing
Sh Sh Sh Sh
Sales XXX XXX

Less: manuf act ur ing cost s:

Var iable pr oduct ion cost s:
Dir ect mat er ial cost XX XX
Dir ect labor cost XX XX
Var iable f act or y over heads XX XX
Fixed f act or y over heads XX *
Cost of goods manuf act ur ed XX XX

Add: beginning invent or y XX XX

Cost of goods available f or sale XX XX

Less: Closing I nvent or y XX XX

Cost of sales XX (XX)
(Over )/Under absor pt ion XX *
Act ual Cost of Sales (XX) *
Cont r ibut ion Mar gin/Gr oss pr of it XX XX

Less: Fixed manuf act ur ing over heads * (XX)

Selling and administ r at ive expenses (XX) (XX)
Net I ncome XX XX

* Not applicable under t he cost ing met hod.

Not e: mar ginal cost ing or absor pt ion cost ing is designed f or management use
and not f or ext er nal r epor t ing.

87
Advant ages of Absor pt ion Cost ing

i. Fixed cost s ar e r elat ed t o pr oduct ion.

ii. I t is mor e r ealist ic when f ixing selling pr ices.
iii. Pr of it s can be calculat ed mor e accur at ely.

Advant ages of Mar ginal Cost ing

i. Under or over absor pt ion of over heads does not ar ise.

ii. I t is simpler t o apply.
iii. I t helps in appr aising dif f er ent policies.

Not e: t he advant age of one met hod is t he disadvant age of t he ot her met hod
and vice ver sa. Management r equir ement is consider ed when choosing t he
met hod t o apply.
Br eak- Even Point

Br eak- even point is t hat level of act ivit y at which sales r evenue is equal t o t ot al
cost . At br eak- even point , t her e is no pr of it or loss. I f t he pr oduct ion of t he
company is mor e t han t he br eak- even point , it means t he company is oper at ing
at a pr of it . The br eak- even point can be expr essed in t er ms of pr oduct ion
volumes (physical unit s) or in t er ms of sales.

Br eak- even (unit s) = Tot al f ixed cost /Cont r ibut ion per unit

Br eak- even (sales) = [ Tot al f ixed cost /Cont r ibut ion per unit ] X Selling pr ice per unit

Cont r ibut ion t o Sales r at io (C/S r at io)

This r at io expr esses t he r elat ionship bet ween “ cont r ibut ion” and “ sales”. As a
per cent age, it shows t he per cent age at which cont r ibut ion changes due t o
change in sales. C/S r at io is also known as Pr of it /Volume r at io (P/V r at io). The
incr ease in C/S r at io over t ime indicat es t he impr ovement in t he per f or mance of
a company and vice ver sa.

I llust r at ion:

A manuf act ur ing f ir m pr oduced and sold 10, 000 unit s dur ing t he mont h of Apr il.
The f ollowing addit ional inf or mat ion was also pr ovided:

Dir ect mat er ials Sh 16 per unit

Dir ect labor Sh 8 per unit
Var iable over heads Sh 4 per unit
Fixed over heads Sh 72, 000

Selling pr ice per unit is Sh 40.00

Requir ed:
A st at ement showing t he mar ginal cost and pr of it or loss f or t he mont h of Apr il.
Calculat e t he br eak- even point .

Solut ion:
Unit s S.P Value
400, 00
Sales 10, 000 40 0
Less: Mar ginal
cost s:
(160, 000
Dir ect mat er ial 10, 000 16 )
(80, 000
Dir ect labor 10, 000 8 )
Var iable (40, 000
over heads 10, 000 4 )
Tot al mar ginal (280, 00
cost s 0 )
120, 00
Cont r ibut ion 0
(72, 000
Less Fixed cost s )
Pr of it 48, 000

Br eak- even (unit s) = Tot al f ixed cost /Cont r ibut ion per unit
= Sh 72, 000/ (120, 000/10, 000)
= 72, 000/12
= 6, 000 unit s.

Br eak- even (sales) = [ Tot al f ixed cost /Cont r ibut ion per unit ] X Selling pr ice per unit
= [ 72, 000/12] X 40
= 6, 000 X 40
= Sh. 240, 000

I llust r at ion:
A manuf act ur ing company pr oduces ir on sheet s. I n t he year 2004, 10, 000 ir on
sheet s bundles wer e pr oduced but only 90, 000 of t hem wer e sold. Ther e wer e no
opening and closing st ock of wor k in pr ogr ess.

Pr oduct ion cost s wer e as f ollows:

Sh 000’s
Mat er ials 28, 000
Labor 8, 000
Pr oduct ion over heads 10, 000
Tot al 46, 000

You ar e also inf or med t hat 60% of pr oduct ion over heads ar e f ixed. The ir on
sheet s ar e nor mally sold in bundles of 19 Sheet s. The aver age selling pr ice of
each bundle was Sh
600. Selling and administ r at ive expenses f or t he year amount ed t o Sh 3, 000, 000
of which 1, 200, 000 wer e f ixed.
Requir ed:
a) Pr of it and loss account on mar ginal cost ing

basis 89
 b) Calculat e t he br eak- even out put in unit s and shillings
c) Suppose t he company want t o make pr of it s of Sh 6, 300, 000 t hen f ind out
t he level of out put in unit s

Solut ion:
a)
Mar ginal cost ing
Pr of it and loss account
For t he year ended 2004

Unit s S.P Value (Sh 000’s)

Sales 90, 000 600 54, 000
Less: mar ginal
cost s
(28, 000
Dir ect mat er ials )
(8, 000
Labor )
(4, 000
Pr oduct ion Over head (40% var iable) )
Tot al mar ginal (40, 000
cost s )
*
(36, 000
Less: closing st ock of f inished goods 4, 000 )
Gr oss cont r ibut ion 18, 000
Selling and admin. Expenses (1, 800)
16, 20
Net cont r ibut ion 0
Less f ixed cost s:
(6, 000
Pr oduct ion over heads )
(1, 200
Selling and admin. Expenses ) (7, 200)
Net Pr of it 9, 000

* Mar ginal cost of 100, 000 ir on bundles = 40, 000, 000

Mar ginal cost per unit =
40, 000, 000/100, 000
= Sh400.

=
Unit s pr oduced 100, 000
Unit s sold = 90, 000
Closing st ock (unit s) = 10, 000
Value of closing st ock = 10, 000 X 400
= 4, 000, 000

b) Br eak- even level of out put

Sh.
Fixed cost
Pr oduct ion over heads 6, 000, 00
 0
1, 200, 00
Selling and administ r at ion 0
7, 200, 00
Tot al 0

Br eak- even (unit s) = Tot al f ixed cost /Cont r ibut ion per unit

90
 = Sh 7, 200, 000/ (16, 200, 000/90, 000)
= 7, 200, 000/180
= 40, 000 unit s.

Br eak- even (sales) = [ Tot al f ixed cost /Cont r ibut ion per unit ] X Selling pr ice per unit
= [ 7, 200, 000/180] X 600
= 40, 000 X 600
= Sh 24, 000, 000

c) Level of out put f or Sh 6, 300, 000

Tot al f ixed cost Sh 7, 200, 000

Pr of it r equir ed Sh 6, 300, 000
13, 500, 00
Tot al cont r ibut ion r equir ed Sh 0
= Sh
Requir ed level of out put 13, 500, 000/180
= 75, 000 unit s.

I llust r at ion- Absor pt ion cost ing

Millan company lt d. Pr oduces t ubes f or mot or vehicles. The f ollowing inf or mat ion
is available f or t he year 2004.

20, 000
Pr oduct ion t ubes
15, 000
Sales t ubes
Pr oduct ion Cost
Dir ect mat er ials 2, 400, 000
Dir ect labor 600, 000
Var iable over heads 500, 000
Fixed over heads 900, 000

Selling and admin. Expenses

Sales commission 250, 000
Gener al expenses 160, 000
Over heads (f ixed) 240, 000

The company sells each t ube at a pr ice of Sh 300

Requir ed:
a) Pr of it and loss account on t he basis of absor pt ion cost ing.

Solut ion:
st
Absor pt ion cost ing pr of it and loss account f or t he year ended 31 December
2004

Unit s S.P Value Value

Sales 15, 000 300 4, 500, 000
 91
Less: Cost of sales
2, 400, 00
Dir ect Mat er ials 0
600, 00
Dir ect labor 0
500, 00
Var iable Over heads 0
900, 00
Fixed Over heads 0
4, 400, 00
Cost of goods available f or sale 0
1, 100, 00 3, 300, 00
Less Closing st ock 0 0
1, 200, 00
Gr oss pr of it 0
Less Selling and admin. Expenses
Sales commission 250, 000
160, 00
Gener al expenses 0
240, 00 650, 00
Over heads (Fixed) 0 0
550, 00
Net pr of it 0

94
 REFERENCES
nd
Deakin E., and Maher M. (1987) “ Cost Account ing” 2 Edit ion, I r win, I llinois.
th
Dr ur y C., (2004) “ Management and Cost Account ing” 6 Edit ion, Book Power , London.

Hussain A., (1997) “ Cost Account ing Made Easy” East Af r ican Educat ional
Publisher s, Nair obi.
rd
Lal J. (2002) “ Cost Account ing” 3 Edit ion, Tat a McGr aw- Hill, New Delhi.
th
Lucey T. (2002) “ Cost ing” 6 Edit ion, Book Power , London.

Saleemi N., (1990) “ Cost Account ing Simplif ied” N.A Saleemi Publisher s, Nair obi.

95