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COST ACCOUNTING

COST ACCOUNTING

Analysis and Control

W. ARMAND LAYNE Lecturer in Accounting, Cave Hill Campus, University of the West Indies

with contributions from

COLIN RICKWOOD Lecturer in Accounting, University of Birmingham, England

M MACMILLAN

© Dr W. Armand Layne and Mr Colin Rickwood 1984

All rights reserved. No part of this publication may be reproduced or transmitted, in any form or by any means, without permission

First published 1984 by Higher and Further Education Division MACMILLAN PUBLISHERS LTD Houndmills, Basingstoke, Hampshire RG21 2XS and London Companies and representatives throughout the world

British Library Cataloguing in Publication Data Layne, W. Armand Cost accounting. 1. Cost accounting I. Title II. Rickwood, Colin 657'42 HF 5686.C8 ISBN 978-0-333-36070-5 ISBN 978-1-349-17691-5 (eBook) DOI 10.1007/978-1-349-17691-5

To Professor Trevor E. Gambling

Contents

Preface xv

1 Introduction to Cost Accounting 1 1.1 Nature of cost accounting 1 1.2 Definition of a firm 1 1.3 Rationale for existence of the firm 2 1.4 The organisation chart 2 1.5 Purpose of cost accounting 3 1.6 Objectives of the firm 4 1. 7 Cost terminology 5 1.8 Direct and indirect cost 6 1.9 Elements of cost 6 1.10 Historical cost and standard cost 6 1.11 Absorption costing and marginal costing 7 1.12 Scope of cost accounting 7 1.13 Tools of cost accounting 7 1.14 Summary 8

Bibliography 8 Discussion questions 9

2 Material Control and Costing Methods 10 2.1 Introduction 10 2.2 Material control 10 2.3 Pricing issues 13 2.4 Evaluation of issue pricing methods 17 2.5 Summary 18

2* 2*.1 2*.2 2*.3 2*.4

Bibliography 19 Discussion questions 19 Problems 19

Introduction to Matrices 21 Introduction 21 Matrix definition 21 Vectors 22 Arithmetic operations on vectors 23

viii

2*.5 2*.6 2*.7 2*.8 2*.9 2*.10 2*.11 2*.12 2*.13

Subtraction of matrices 24 Matrix multiplication 24 Special features of multiplication 26 Transpose of a matrix 26 Identity matrix 27 Determinant of a matrix 27 Matrix inversion 28 Equation system and inverse system compared 30 Summary 31 Appendix 32 Bibliography 34 Problems 34

3 Direct Materials, Direct Labour, the Mechanics of Cost Allocation and Overhead Analysis 38

3.1 Introduction 38 3.2 Direct materials 38 3.3 Direct labour 39 3.4 Labour remuneration 40 3.5 Direct expenses 42 3.6 Overheads 42 3. 7 Purpose of overhead rates 42 3.8 Process of accumulating overhead cost 43 3.9 Apportionment 44 3.10 Cost allocation 46 3.11 Purpose of cost allocation 47 3.12 Use of multiple overhead rates 47 3.13 Overhead absorption rate 48 3.14 Arguments for and against absorption bases 50 3.15 Predetermined overhead absorption rate (POHR) 51 3.16 Absorption costing and direct costing 52 3.17 Summary 53

Bibliography 53 Problems 54

4 Job Costing, Unit Costing, Process Costing and Joint Product Costing-'The Quartet' 57

4.1 Introduction 57 4.2 Job costing 57 4.3 Job order cost system 58 4.4 Mechanics of job order system 58 4.5 Applying overhead to individual jobs 61 4.6 Use of direct, absorption or standard costing in job costing 61 4. 7 Reports on completed jobs 64 4.8 Evaluation of job costing 64 4.9 Process costing 64 4.10 Functions of process costing 65 4.11 Procedures of process cost accounting 65 4.12 Concept of equivalent production 69

Contents

4.13 Concept of losses in production 73 4.14 Application of standards to process costing 76 4.15 Summary of job costing and process costing 78 4.16 Joint product costing 78 4.17 Reasons for costing joint products 79 4.18 Joint products and decision-making 82 4.19 By-products 83 4.20 By-product costing 84 4.21 Summary 85

Appendix 86 Bibliography 89 Problems 89

5 Service Cost Allocation to Production Departments 97 5.1 Introduction 97 5.2 Methods of distributing service department expense 97 5.3 Extension of cost allocation via linear programming 103 5.4 Summary 105


6 Inventory Planning 109 6.1 Introduction 109 6.2 Inventory definitions 110 6.3 Cost associated with inventories 111 6.4 Derivation of EOQ model 111 6.5 EOQ and quantity discounts 114 6.6 Production runs 115 6. 7 Inventory planning under probabilistic demand 117 6.8 Summary 119


7 Analysis of Cost Behaviour 124 7.1 Introduction 124 7.2 Patterns of typical cost functions 124 7.3 Step costs 126 7.4 Fixed costs 126 7.5 Semi-variable cost 127 7.6 The learning curve 129 7.7 Summary 133


8 Cost Estimation 136 8.1 Introduction 136 8.2 Total cost function of firm 136 8.3 Engineering approach 137 8.4 Account analysis method 137

X

8.5 Derivation of accountant's cost function 8.6 High-low method 138 8. 7 Scatter charts 139 8.8 Regression analysis 8.9 Simple regression 8.10 Standard error

140 141

144

138

8.11 Further insights into regression theory 145 8.12 Derivation and use of variance/covariance matrix 146 8.13 Analysis of variance and the F test 147 8.14 Summary 147


9 Cost-Volume-Profit (C-V-P) Analysis 150 9.1 Introduction 150 9.2 Assumptions of accountant's break-even model 9.3 Marginal contribution to sales ratio (MCSR) 9.4 Variable cost ratio (VCR) 153 9.5 The multi-product case 153

151 152

9.6 Accountant's representation of break-even models 155 9.7 Utility of break-even analysis 156 9.8 Extension of break-even analysis 157 9.9 Short period economic model 159 9.10 Features of accountant's and economist's graph 9.11 Summary 162


10 Relevant Costs for Decisions 169 10.1 Introduction 169 10.2 Accept or reject decisions 169 10.3 Differential cost 169 10.4 Make or buy decisions 170 10.5 Mutually exclusive opportunities 10.6 Ranking decisions 170 10.7 Decisions with one scarce resource 10.8 Concept of internal opportunity cost

170

173 175

10.9 Relevant cost and book values 176 10.10 Relevance of fixed cost 180 10.11 Summary 180


11 Direct Costing and Absorption Costing 187 11.1 Introduction 187 11.2 Requirements of decision-maker 187 11.3 Report format 188 11.4 Contribution model 188 11.5 Report structures 188

160

Contents

Contents Xl

11.6 Further insights into contribution models 189 11.7 Inventory valuation 190 11.8 Inventory valuation problems 191 11.9 Direct costing model 192 11.10 Direct and absorption costing 193 11.11 Use of direct costing 194 11.12 Summary 195


12 Budgetary Planning 198 12.1 Introduction 198 12.2 The budget 198 12.3 Reasons for budgets 199 12.4 Preparation of budgets 199 12.5 Principal budget factor 199 12.6 Sales forecast 200 12.7 Sales budget 200 12.8 Selling and distribution cost budget 200 12.9 Production budget 200 12.10 Raw material purchasing budget 201 12.11 Labour budget 201 12.12 Factory expense budget 201 12.13 Inventory budgets 201 12.14 Capital expenditure budgets 201 12.15 Cash budget 202 12.16 Master budget 202 12.17 Summary 206


13 Budgetary Control 218 13.1 Introduction 218 13.2 Feedback information 218 13.3 Usefulness of feedback data 219 13.4 Usefulness of variance analysis 219 13.5 Report format of variance analysis 220 13.6 Controllable and uncontrollable cost 220 13.7 Management by exception 220 13.8 Variance analysis 220 13.9 Price and quantity variance 222 13.10 Nature of overhead variance 224 13.11 Variable overhead variance 224 13.12 Absorption of fixed overhead 225 13.13 Fixed overhead variance 225 13.14 Variance calculation by adjusting the budget 225 13.15 Marginal or direct costing method 226 13.16 Rationale of variance calculation 227 13.17 Causes of variance 228

xii

13.18 Evaluation of performance 228 13.19 Human problems of budgetary control 228 13.20 Summary 229

Bibliography 229 Discussion questions 230 Problems 230

14 Standard Costing 233 14.1 Introduction 233 14.2 Types of standard cost 233 14.3 Mechanics of standard costing 234 14.4 The standard hour 234 14.5 Reason for standard costing 234 14.6 Setting of standard cost 235 14.7 Standard direct material cost 235 14.8 Standard direct labour cost 236 14.9 Standard variable overhead cost 236 14.10 Causes of variance from standard 239 14.11 Nature of a flexible budget 240 14.12 Mechanics of a flexible budget 240 14.13 Measurement of activity 241 14.14 Fixed overhead analysis 241 14.15 Application of overhead in standard costing 243 14.16 Fixed overhead variance analysis 244 14.17 Control ratios 246 14.18 Variance analysis in technical firms 248 14.19 Variance analysis and 'blame laying' 250 14.20 Summary 251


15 Linear Programming and Cost Accounting 15.1 Introduction 257 15.2 Assumptions of linear programming 258 15.3 General form of linear programming model 15.4 Observations on linear programming solution 15.5 Simplex format 260 15.6 Procedures of simplex method 261 15.7 Insights into solution process 263 15.8 Algebraic method 263 15.9 The dual 264 15.10 The dual algorithm 265 15.11 Economic significance of the dual 267 15.12 Sensitivity analysis 267 15.13 Parametric programming 269 15.14 Summary 271


257

258 260

Contents

Contents xiii

16 Capital Budgeting 276 16.1 Introduction 276 16.2 Timing of capital projects 276 16.3 Compound interest 277 16.4 Future value of annuity 279 16.5 Sinking fund payments 280 16.6 Present value 280 16.7 Capital recovery 282 16.8 Summary 282


17 Project Financing and the Cost of Capital 284 1 7.1 Project financing 284 17.2 Cost of capital 284 17.3 The cost of equity 285 17.4 Retained earnings 286 17.5 The cost of debt 286 17.6 Calculating the marginal cost of capital 287


18 The Analysis of Capital Investment Decisions 290 18.1 Introduction 290 18.2 Pay-back 290 18.3 Accounting rate of return 293 18.4 Net present value (NPV) 294 18.5 Profitability index (PI) 296 18.6 Internal rate of return (IRR) 297 18.7 Unequal net cash flows 298 18.8 Multiple internal rates of return 299 18.9 Discounted pay-back 301 18.10 Summary 301


19 Risk and Uncertainty in Capital Budgeting 308 19.1 Introduction 308 19.2 Definition of risk and uncertainty 308 19.3 Expected value of probability distribution 308 19.4 Absolute measures of dispersion 309 19.5 Decision-maker's utility function 311 19.6 Summary 313


Appendix- Present Value Tables 317 Index 329

Preface

This book deals with cost accounting and control. In colleges and universities, the material can be used at the first- and second-year level in management accounting. The book is constructed not only for examination purposes but also to awaken curiosity in the reader for further research into this challenging area of accountancy. In this sense the book can be looked upon as a bridgehead to a broader and a deeper-oriented course.

The material in this book is concerned with quantitative decisionmaking, which involves the use of accounting data that decisionmakers will be called upon to analyse and use dynamically in the firm in resolving business problems. To resolve something, the decisionmaker must operate from a sensible framework and must have the requisite data and decision models from which to evaluate a decision. We therefore introduce the reader, for example, to the purpose of the firm; concepts of cost with its behavioural pattern under various operating conditions; service cost allocation; inventory planning; direct and absorption costing; capital budgeting; and analysis of capital investment decisions. We hope that the reader's analytical skill will be sharpened as he or she works through the examples in the text.

In the relevant chapters of this book can be found mathematical solutions which relate to the problems faced by the modern firm: (i) estimating the cost function; (ii) breakeven analysis; (iii) service cost allocation; (iv) stock control; (v) joint product allocation; (vi) budget construction; (vii) variance analysis; (viii) make or buy, add or drop a product, or replace equipment decisions; (ix) calculation of optimum product mix; (x) investment decisions.

We owe a particular debt to many accounting authors for the ideas contained in this book; the references at the end of each chapter attest to this fact. We must, however, express thanks to Professor T. E. Gambling, University of Birmingham, England, whose ideas were influential long before the book was ever dreamt of, and whose comments on the first draft of this work was encouraging. We also extend a hearty 'thank you' to an unknown professor who read the first draft, and whose comments were invaluable. Of course, for any mistakes which remain in the text, blame us.

We also appreciate the efforts of Monica Smith and Azena Louis, who typed the first draft of this work. The kind acts of Roy Daniel and Nigel Walrond were also appreciated.

In a very special way, Cynthia Layne is thanked for her patience and understanding. The following accounting bodies, (i) the Association of Certified Accountants (ACA), (ii) the

Institute of Cost and Management Accountants (ICMA), and (iii) the Institute of Chartered Accountants in England and Wales (ICA), who gave permission to reproduce their examination questions, are also thanked.

XV

W. ARMAND LAYNE

COLIN RICKWOOD

Acknowledgement

The authors and publishers are grateful to Van Nostrand Reinhold (UK) Co. Ltd for permission to reproduce tables from Management of Company Finance by J. M. Samuels and F. M. Wilkes.

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COST ACCOUNTING - Home - Springer978-1-349-176… · · 2017-08-27COST ACCOUNTING Analysis and Control ... or by any means, without permission ... 18.5 Profitability index (PI)