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MODULE 4
4.00 COSTING METHODS
4.01 Learning Outcomes
On successful completion of this Module, Students should be able to:
i. Analyze jib/batch costing service costing and process costing methods and circumstances
under which they can be applied;
ii. Appraise marginal costing and absorption costing and evaluate the similarities and differences
between them; and
iii. Evaluate contract costing and prepare accounting for contract with computation of notional
profit and work - in - progress.
4.02. Introduction
Do you ever imagine how the price of goods is fixed? You will always hear people complaining that “I
bought a bag of cement last week at N2000 and this week the cost has gone up to N2,500.”
It is also common with the prices of many other products. It should be noted that prices of products
are not fixed at random. To arrive at the price of any product, the unit cost of producing the
product/item is usually determined.
It is the efforts in ascertaining costs of products or services that is referred to as costing methods.
Costing method is therefore the system of finding and ascertaining of cost of a product; and the
method for job, batch, contract, process and marginal costing.
4.03 Job costing
Some business organizations carry out individual jobs based on customer specification. A customer
will demand that he wants this job done for him in a particular style.
For instance, Adogo came to Johnny Best furniture company and placed an order for dining table for
eight. He directed that the dining chairs should be armless and the back should be straight not
curved. The dining table should be four (4) feet high and 8 feet long. This type of work given by
Adogo to Jonny Best furniture falls under job order. Therefore job costing is a form of costing which
applies where job are carried out to a customer's specification. These types of jobs are common in
furniture, contract, printing, tailoring etc.
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Under job costing each job is a distinct cost unit. Separation of the direct cost of the job and indirect
cost of the business is very necessary. Where the job takes a long period of time to complete, the
costing method to apply will be the modified job costing approach known as contract costing. The
will be further treated in section 4.06 below.
Job costing is applied where jobs are not produced for stock. They are used for orders that can be
identified all through the various levels or stages of production.
Procedures followed in job performance
The following are normal procedures adopted in jobbing concern:
(i) A customer meets the supplier and tells him what he wants
(ii) An officer in charge discusses with the customer and they agree on the precise details
of what to be supplied. The areas of agreement could be; the quantity of delivery and
any other special requirements.
(iii) The department in charge of billing or estimating cost of jobs will cost the job based
on the requirements of the customer.
(iv) If the estimated cost is accepted by the customer, a deposit covering a specified
percentage of the cost has to be made and a job number is then assigned.
(v) The material necessary to commence work will be procured. The production
department will look at their production schedule and if not crowded will commence
work immediately.
Opening of job card
Each job must have a job card. It is essential that you know both the items that are contained in a
job card and the format of the job card. Although the format varies from organization to
organization but there are items that are common.
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FORMAT
Dispatch note No:
Price of the job:
Date Reference Materials Labour Overhead Other cost
Estimate Estimate Estimate Estimate
Cost Cum. Cost Cum. Cost Cum. Cost Cum.
Summary N
Materials xx
Labour xx
Overhead xx
Other charges xx
Invoice price xx
Add: VAT/WHT xx
Total invoice cost xx
Less: Actual cost of job xx
Profit
xx
Where jobs are completed the job cards are moved from the work-in-progress level to furnished
goods. When the customer takes delivery, the cost of the job becomes cost of sale.
Customer ----------------------------
Job Card
Job No. ----------------------------
Date of commencement --------------------- Description:
Delivery date:
4
Sometimes jobs may be made to be kept as a showroom product not specifically ordered for, the
quality of items produced and their value are record on finished goods ledger cards in the store.
Rectification costs
When jobs are completed and ready for delivery the company supervisor or the customer may
observe some defects on the job which requires rectification before delivery. The rectification involves
costs to the company
Rectification costs are treated in two ways depending on the circumstances in which the costs arise:
(i) If the cost is specifically traceable to a particular job then it should be charged to that
job as a direct cost.
(ii) If the rectification is a normal work generally carried out in the department then
the cost of the rectification should be charge to production overhead.
How jobs are priced
Companies are in business to make profit. Therefore when jobs are done, the pricing of the jobs
should take cognizance of profit margin.
To achieve this cost plus price system is adopted. When a desired profit margin is added to the cost of
a job, it is known as cost plus pricing.
However, cost plus pricing ignores demand. The economic law which states that the higher the price
the lower the demand and the lower the price, the higher the demand is ignored by cost plus pricing
method. Despite this weakness, the cost plus price is still very widely applied particularly where one-
off job are carried out.
Job costing of internal services
In order to control the cost of internal services department such as maintenance, transport
department etc., job costing system should be used so that costs traceable directly to such
departments are charged directly to them other than using arbitrarily appointment rates.
532
5
The merits of internal job costing system are:
(i) Realistic apportionment
Costs are identified with jobs and are subsequently charged to the department
concerned to ensure that costs are borne by those who incurred them
(ii) Control purposes: this system is capable of measuring the efficiency, standard costs
shall be set and regularly compared with actual cost incurred by the service department
concerned.
(iii) Creation of awareness and responsibility users departments will be more careful in the
use of facilities and resources since the costs of such facilities will be charged directly to
the department.
Example: 4.01
Hon. Ahaa Ikpa is a carpenter at high level Makurdi. He got an order for the construction of four sets of
upholstery chairs. On 1st June 2012 there was one set of such chairs yet to be completed the job sheet
of the work is summarized as follows:
Job sheet No. 999
N
Direct Materials 35,000
Direct Labour 30,000
Factory overhead 8,000
Factory cost 73,000
Two additional jobs were received within the month and work immediately commenced in the factory.
The cost of production was as follows:
Direct materials - Direct materials were issued to the following jobs
15,000
12,000
13,000
Job: 531
533
6
Some stock valued at N12,000 were damaged and written-off accordingly. Materials transferred
from
Job: 531 to 532 - 3000
532 to 533 - 2500
Material returned to stores:
Job 531
533
532
Direct labour hours incurred on the job
N
Job: 531 - 350 hrs.
532 - 375 hrs.
533 - 360 hrs.
Labour cost for the period was N35 per hour and production overhead is absorbed at the rate of N30
per direct labour hour. Production overhead for the period amounted to N54,000=
Jobs completed were delivered to the customers immediately and workers assigned to them were as
follows:
N
Job: 531 - 120,000
532 - 90,000
533 - 95,000
Administration and marketing overhead are charged to cost of sales at 15% of factory cost, actual cost
however, were N25000
Required:
(i) Prepare job account for each job (show production cost only)
(ii) Prepare summary job card and show profit on each completed job
(iii) The business cost control account.
N
2,000
3,500
4,000
7
Solution:
Hon. Ahaa Ikpa
Job Account
Dr Job 531 Cr
N
N
Balance b/f 73,000 Job 532(material Transfer) 3,000
Direct material
(Store a/c) 15,000 Stores a/c - material returned 2,000
Direct Labour
Cost of Sales a/c 105,750
(wages a/c) (350hrs x N35) 12,250
Production (O/h a/c) (350hrs x N30) 10,500
N110,750
N11575
Dr Job 532 Cr
N N Direct material
Job 533(material Transfer) 2,500 (Store a/c) 13,000
Direct Labour
Stores a/c - material returned 4,000 (wages a/c) (375hrs x N35) 13,125
Cost of Sales a/c 33,875
Production O/h
(O/h a/c) (N30 x 375 hrs.) 11,250
Job 531 material 3000
N40375
N40375
Dr Job 533 Cr
N N
Direct material
Material returned (stores)
(Store a/c) 12,000 Accounts 3,500
Direct Labour
(wages a/c) (N35 x 360hrs) 12,600 Cost of Sales a/c 34,400
Production O/h
(O/h a/c) (N30 x 360 hrs.) 10,800
Job 532 material transfer 2,500
N37,900
N37900
8
Summary of Job Cards Job 531 Job 532 Job 533
N N N
Materials (week 1) 45,000 9,500 11,000
Labour 42,250 13,125 12,600
Production O/h 18,500 11,250 10,800
Factory cost 105,750 33,875 34,400
Admin/marketing O/h
(15% of factory cost) 15,863 5081 5160
Cost of sales (89,887) (28,794) (29,240)
Invoice value 120,000 90,000 95,000
Profit 30,113 61,206 65,760
Workings:
Materials: Job 531 N50,000 - 3000 - 2000 = N45,000
Job 532 N13,000 + 3000 - 2,500 - 4000 = 9,500
Job 533 N12,000 + 2,500 - 3,500 = 11,000
Control Accounts
Dr Stores Control Account (Extract)
Cr
N N
Return to stores WIP
Job accounts (WIP alc) 40,000
(N2000 + 4000 + 3500) 9500 (15000 + 12000 + 13000)
Stock written off 12,000
9
Dr Work-in-progress control account Cr
N
N
Balance b/f 73000 Stores a/c (returns) 9,500
Stores control a/c 40,000 Cost of sales a/c:
(N105, 750 + 33875 + 34400) 174,025
Wages control a/c 37975
Production O/h control a/c 32,550
N183525
N183525
Dr Wages control account Cr
N
N
(WIP alc)
(12,250 + 13125 + 12600) 37,975
Dr Production Overhead control account Cr
N
N
Cost ledger control a/c 54,000 (WIP a/c) 32,550
Under absorbed O/head a/c 21.450
N54.000
N54,000
Dr Administration and marketing overhead account Cr
N
N
Cost ledger control a/c 25.000 Cost of sales a/c 26104
Over absorbed overhead 1,104 Under absorbed O/head a/c
N26.104
N26104
10
Dr Cost of sales control account Cr
N
N
Work-in-progress a/c 174,025 Profit and loss a/c 147,921
Admin. and marketing O/h 26,104
Dr Profit and loss a/c (Comp. Income Statement) Cr
N
N
Cost of sales 147,921 Sales 305,5000
Stock written off 12,000
Under absorbed O/head 20,346
Profit 124,733
N305,000
N305,000
Dr Under/Over ab sorbed overhead account Cr
N
N
Production overhead 21450 Admin. and marketing overhead 1104
Profit & Loss 20,346
N21450
N21450
4.04 Batch costing
Batch costing is a modified type of job costing
If a customer order goods which are identical at the same time, or where a job ordered by a customer
is made up of a number of units which are similar and it is on a single order, a batch costing method
would arise. For example, a customer placed an order for tables in his new hotel rooms in a single job
order number. Batch costing will be applied.
The total cost of the batch will be divided by the number of units in the job to arrive at the cost of one
unit.
A batch costing system will be identified through the following specific attributes:
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(a) Set-up costs: refer to costs of setting-up production facilities. For example in the case of a
carpenter's workshop, setting-up Benches, saw machines, consumable materials such as
plants, nails, plywood
(b) Unit costs: when the batch size increases the average cost per unit decreases since set-up
cost still remain unchanged irrespective of the increased batch size
(c) Batch of items that are not similar are sometimes brought together because the setup that
will be used in producing them is the same. In a furniture business, the same factory set-up
can produce tables, chairs and beds. So if there are orders for bed, chairs and tables, they
can be brought together.
The problem that will arise is how the associated costs will be apportioned. However,
equitable basis of appointment for common costs may be applied.
4.05 Service Costing
When one hears of costing, the mind goes straight to production (manufacturing) concern. It is the
general belief that costing is associated with goods (products) and does not concern services. People
believe that cost of services cannot be determined. However, this is just but the expression of
ignorance of what cost accounting does. Cost of services can be and are ascertained.
What are these services we are referring to here? The services are hotels, restaurants, laundries,
transport, banking, schools, hospitals, etc.
When costing principles are applied in costing a service, it is referred to as service costing. A
manufacturing concern may have a service cost centre. If a manufacturing company decides to carry-
out delivery of products to distributors, the delivery of products to distributors, the delivery unit is a
service unit and is a cost centre and is subject to costing.
There is no difference between the principles used in ascertaining costs in a manufacturing concern
and services concern. Costs are accumulated accordingly to arrive at total costs which are then divided
by total number of units of services rendered.
If the service is say conveying of cement from Gboko to Abuja, the units of services rendered might be
the number of trips or the tons of cement conveyed, or kilometers covered.
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If is health care, it may be the number of bed space or number of patients consulted, or number of in-
patient (i.e. sick people on admission in the hospital)
The manners in which costs are classified vary from one industry to the other. Where the service
provider is a hotel, the unit of service offered may be the number of rooms occupied and for a school
the number of students
Firms of professionals such as Accountants, Architects, Lawyers, Tax consultants, and Management
consultants render services which it may not be appropriate to apply the costing principles.
4.06 Contract costing
Attempts are made to believe that contract costing is similar to job costing. However, there are some
noticeable differences such as:
(i) Contract jobs take a very long time. Some may extend to more than one accounting
period.
(ii) Some contracts are carried out in locations outside the premises of the contractor. The
jobs may sometimes be on a site.
(iii) Sub-contracting may sometimes be necessary particularly where the job requires
special skilled manpower, for example, welding, plumbing, electrical installations and
so on.
(iv) A supervisor is usually engaged by the contractor. If the job is construction the
supervisor will be an architect or a civil/building engineer etc. The architect is the one
that gives the certificate of evaluation.
Accounting for contracts
Under contract accounting, an account is opened for each contract where costs are accumulated.
Complexity may arise where profits are to be computed where the contract is yet to be completed.
Contracts are of three types. These are:
o Contracts that are at the initial stage
o Contract that have reached an advanced stage, yet cost to complete the contract cannot
be estimated with certainty.
o Contracts that are nearly completed and cost of completion can be estimated.
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Accountants are advised that in all the three cases, contract accounts should first be opened and all
expenses arising therefrom should be recognized at the debit side of the account. Apportionment
should equally be treated as such. The purpose of posting all contract's account is to enable the
accountant ascertain up to date cost of the contract.
The next stage is now considered whether profit can be taken on the contract at the level of that
contract.
The procedure for ascertainment of the profit to be taken depends on the type of contract, whether it
is a contract where the job is at an advanced stage but it is not feasible to determine the cost of
completion with certainty, or a contract nearing completion and the cost of completion can be easily
ascertained.
(i) Contract at the early stage
Profit cannot be taken on a contract that is at this stage. The accountant will debit all
expenses incurred on the contract into the contract account and only carry forward as
cost of executing contract so far, or as the value of work-inprogress. This procedure is
similar to job costing.
(ii) Advanced stage of contract execution but the cost of completion not easily estimated.
Recognizing (taken) profit at this stage of the contract will depend on the value certified by the
architect over the contractor's cost to date.
A contract account is opened, all expenses to date are debited into it, and the architect's value of work
certified over the contractor's cost to date is adjusted for the cash actually received in compliance with
the prudence concept.
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The format for recognizing profit at this stage of the contract is:
(a) Calculation of notional profit
N
Value of work certified xxxx
Plus cost of work yet to be to be certified xxx
xxxx
Less: cost of work to date xxx
Notional profit xxx
Some times the cost of work certified may differ from cost of work to date as posted in the contract
account. If the contractor spent money (incur costs on a work which is yet to be certified by the
Architect supervising the work, then total cost of work to date will be different from cost work
certified.
(b) Calculate profit taken -
2/Q of notional profit x ' -J value of work certified
Example 4.02
Tile contractors Ltd have been awarded the contract by Doo state government to construct the road from Adikpo through Vandeikya Benue state to Obudu in Cross-River State at the cost of N2B (Two billion Naira) only. The company makes her accounts to 31st December annually. The contract which is number 211 was completed on 2nd July 2013. The following are the information extracted from the records of the contractor:
N Direct materials issued from store 18,000,000
Materials returned to store 400,000
Direct labour 15,500,000
Plant issue at book value 2/7/13 32,000,000
Net book value of plant 31/12/13 24,000,000
Materials on site 31/12/13 1,600,000
Overheads costs 2,000,000
cash received
15
As at 31/12/13 certificates had been issued for work value of N50,000,000 and the Contractee had
made progress payment amounting to N45,000,000. The contractor calculated that more work has
been done which were yet to be certified amounting to N8,000,000.
Required: Prepare contract account, compute notional profit and profit taken.
Solution: (a)
Contract 211 Account
N N N
Materials 18,000,000
Value of plant c/d 24,000,000
Less: returns 400,000
Materials on site c/d 1,600,000
17,600,000 Cost of work done c/d 41,500,000
Labour
15,000,000
Plant issued at :
Book value
32,000,000
Overhead
2,000,000
67,100,000
67,100,000
Cost of work done b/d
41,500,000 Work certified to date 50,000,000
Notional profit
16, 500,000 Work done not cert. 8,000,000
58,000,000
58,000,000
Material on site b/d
1,600,000
Work-in-progress b/d
Workings
(a) Computation of notional profit
N
Work certified to date
Add: Work not yet certified
Less: Cost of work done to date
Notional profit
50,000,000
8,000,000
58,000,000
41,500,000
16,500,000
16
(b) Profit taken
2 / cash received Profit taken = of notional profit x ------------------------------------------
' 3 value of work certified
45,000,000 x 16,500,000 x
50,000,000
N11,000,000 x 0.90
= N9,900,000
Where the contract is nearing stage of completion and estimated cost of completion made - In this
case profit is taken in line with the estimated total profit of the contract over the contracts life, while
adjusting whatever profit that was taken previously.
Example 4.03
Thus from our example let us assume that the contract 211 was nearing completion and the estimate
cost of completion is N64,000,000 and estimated profit on the contract is N40,000,000. Compute
profit taken
Solution:
Profit taken on contract nearing completion
(i) Computation of notional profit
Profit taken would be: N
Work certified to date 50,000,000
Add: Work not yet certified 8,000,000
58,000,000
Less: Cost of work done to date 41,500,000
Notional profit 16,500,000
First Method:
cost of worktodate Profit taken = x Estimated profit on the contract
estimated total cost of contract
50,000,000 + 8,000,000 = x 40,000,000
64,000,000
58,000,000 = x 40,000,000
64,000,000
= 0.91 x 40,000,0 = N36,400,000
17
= 0.03 x 40,000,000 = N1,200,000
Third Method:
= 0.02 x 40,000,000 = N800,000
It should be noted again that the profit taken on an incomplete contract is based on:
- The degree of completion
- The choice of formula
Profit taken and profit carried forward
Another problem the cost Accountant has with contract accounts is how the cost accounting system
differentiates between profit taken and profit carried forward.
Let us consider this example as an illustration to give us a clear understanding:
Example 4.04
Adamu company is in contract business on 1st April 2013 and was awarded a contract to construct a
local government secretariat at the cost of five hundred and fifty million Naira.
As at 31/12/2012 the accounting year end of the company, the sum of one hundred and fifty million
(N150m) Naira had already been expended on the contract which is number 351.
However, the cost of work certified to date stands at N142,000,000 and the value of work certified is
N172,000,000. The contractee retains 10% of the value of work certified and has made progress
payment of N157,500,000 by the end of the year,
Second Method:
Profit taken = Value of work certified todate
Contract Price x Estimated total profit
50,000,000
2,000,000,000 x 40,000,000
Profit taken = Cash received todate
Contract Price x Estimated total profit
45,000,000
2,000,000,000 x 40,000,000
18
The contract is about 60% complete, and it has been decided that the formula to calculate the profit
on the contract attributable to the year ended 31st December
2012 should be:
x national profit x ------------------------------------ Value of work Certified
Required
(i) Compute national profit
(ii) Compute value of uncertified work
(iii) Compute profit taken, and
(iv) Prepare contract account.
Solution:
(i) Notional profit
N
Value of work certified 175,000,000
Add: work not certified (N150,000,000 - N142,000,0000) 8,000,000 183,000,000
Less cost of work to date
Notional profit
ii) Value of work uncertified
Cost of work to date Less: work certified Value of
work uncertified
iii) Profit taken = x notional profit x Cash received Value of M.C
= 2 x N33,000,000 ■< N157,500,000 175,000,000
= N22,000,000 x 0.90
= N19,800,000
iv) Contract Account
Contract 351
N N
Cost to date 150,000,000 Value of work Certified 175,000,000
Profit taken
Work to be certified c/f 8000,000
Cash received
53,000,000
33,000,000
N
154,000,000
142,000,000
8,000,000
Profit taken
19
(P & L a/c) 19800,000
Profit not taken c/f 13,200,000
183,000,000
18,300,000
Cost of work not Certified b/f 8,000,000 Profit not taken b/f 13,200,000
The values of closing work-in-progress
When contracts are ongoing, at the end of accounting year of the contracting company (contractors),
there is the need to have work-in-progress. In a construction company this might be a complex
problem.
If we take the case of road construction for instance, there could be a portion of the road that has
been graded, laterite covered on the surface but coal tar is yet to be applied or clearing of the road by
removing debris and trees, while another portion of the same road is cleared, laterite applied and coal
tar also poured and the road shoulders completely covered up.
Under this contract, part of the road is fully completed while part of same road is yet to be fully
completed. It is the valuation of the uncompleted portion which though, work is ongoing but yet to be
completed that constitute work-in-progress. The problem is how work-in-progress will be valued.
Computation of work-in-progress will be done by adding profit taken to cost to date and subtracting
cash received from contractee.
That is;
20
computation of Work-in-progress
Cost-to-date
Add: profit taken on contract
Less: Cash received from contractee
Work-in-progress
Example 4.05
Rochas Uche ltd is a firm of contractors making their accounts to 31st December annually. The
company was awarded a 12 months contract valued at N140,000,000. Contract PK60 started on
February 5th 2011, the following costs were incurred:
N
Materials issued to site 35,000,000
Materials returned 6,000,000
Overheads 40,000,000
Labour 44,000,000
Plant transferred to site (10/2/11) 15,000,000
Net book value 31/12/11 7,000,000
Materials on site 5,000,000
The agreed contract price was N110,000,000
The value of work certified as at 31/12/11 was N94,000,000, while progress payment amounted to
N60,000,000.
Required:
a) Contract Account
b) Contractee Account
c) Calculate value of work-in-progress for statement of financial position purposes.
N
XX
XX
XX
XX
X
21
Solution
Contract Account (contract pk 60) as at 31/12/2011)
N N N
Materials to site 35,000,000
Plant c/d 7,000,000
Materials c/d 500,000
Less returns 6,000,000 29,000,000 Cost of work to date c/d 116,000,000
Overheads
40,000,000
Labour
44,000,000
Plant to site
15,000,000
N128,000,000
128,000,000
Cost of work to date b/d
116,000,000 Contract loss(WK1) 30,000,000
Work-in-progress 86,000,000
116,000,000
116,000,000
Workings (WK1);
Calculation of profit /(loss): N N
Contract price
110,000,000
Less: estimated cost of contract:
Cost of work to date 116,000,000
Add: Cost of completion (N140,000,000-116,000,000) 3,000,000 140,000,000
Profit /(loss)
(30,000,000)
Estimated total loss 30,000,000 The prudence principles requires that a provision be made
immediately for estimated total loss on a contract.
N N N
Value of work certified 94,000,000 Payment received 60,000,000
Balance c/d
34,000,000
94,000,000 94,000,000
b) Contractee Account
22
c) Work in-progress for statement of financial position purposes.
N
Work-in-progress as per contract a/c 86,000,000
Less: cash received 60,000,000
Work-In-Progress N26,000,000
4.07 Process Costing
Process costing is a costing technique used where series of separate stages are required to
manufacture a finished product, the output of one process becoming the input to the next
until a final output is made.
Features of Process Costing
i. Because of the contributory nature of products in many processes, there will always
be WIP which must be valued;
ii. There is often a loss in process due to spoilage, wastage, evaporation etc.;
iii. Output from production may be a single product, but there may also be a byproduct
or by-products and or joint products.
Purpose of process Costing
The aim of this costing is to derive a cost, or valuation for output and closing stock. This can be
complication in practice by: -
i. Deciding on a method of valuation for closing stock.
ii. Establishing a system of accounting for loss, scrap value of loss which will give a
realistic and fair value of units of output
iii. Establishing a cost for joint products.
WIP and Equivalent Units
In any accounting period, there may be opening and closing stocks as WIP. There is always the
problem of dividing cost incurred amongst finished products and those in progress. The answer is to
apportion the costs between finished output and closing stock on a fair basis.
Example 4.06
Ayakuku Ltd manufactures goods. There is no opening stock. However, 5000 units were introduced at
23
the cost of:
N
Direct material 16,560
Direct labour 7,360
Production overhead 5,520
N29,440 Out of the 5000 units introduced, 4000 were completed, while 1000 units were only 60% complete with respect to material and conversion costs.
Prepare a process costing.
Solution
First step Statement of equivalent units
Total units Completion level Equivalent
unit Fully worked units 4,000 100% 4,000
Closing stock 1,000 60% 600
5,000
4,600
Second step Statement of cost per equivalent units
Total cost = N29,440 Total equivalent units 4,600
Cost per equivalent unit = N6.40
Third step Statement of effective production
Equivalent Units
Unit Cost of Equivalent units
Effective production cost N
Fully worked units 4,000 6.40 25,600 Closing stock 600 6.40 3,840
equivalent units 4,600 6.40 29,440
Fourth step Process Account
Units N Units N
(Stock a/c) direct material 5000 16,560 Output to next process 4,000 25,600
(Wages a/c) direct labour - 7,360 Closing stock c/f 1,000 3,840
(Overhead a/c) production a/c - 5,520
5,000 29,440 5,000 29,440
24
Example 4.07
Aondongu Ltd is a manufacturer of goods which passes through many processes. The results in process
2 for the month of August, 20XY were as follows:-
Opening stock nil
Material input from process 1 4,000units
Costs of input: N
Material from process 1 6,000
Added material in process 2 1,080
Conversion costs (direct labour/overhead) 1,720
Output is transferred into the next process, process 3.
Closing work in process amounted to 800 units, complete as to:
Process 1 material 100%
Added materials
Conversion costs 30%
Prepare the account for process 2 for August, 20XY
50%
25
Solution a). statement of equivalent units
Completed production 3200 3200 100 3200 100 3200 100
Closing stock 800 800 100 400 50 240 30
4000
3,600
3,440
b). statement of cost per equivalent unit
Cost Equivalent Cost per unit
N production unit N
Process 1 material 6000 4000 1.50
Added materials 1,080 3,600 0.30
Labour and overhead 1,720 3,440 0.50
8,800
2.30
c). Statement of effective production (of finished work and closing stock)
Production Cost element Number of Cost per Total lent N
Cost N Equivalent
unit M
equiva units
Completed Process N
1 3200 2.30
7,360 production material 800 1.50 1,200
Closing stock Process 1 400 0.30 120
material 240 0.50 120 1,440
Added material
8,800
Labour&
overhead
Process Account 2
Units N
Units N
Process 1 a/c 4000 6,000 Process 3 a/c 3,200 7,360
(stock) added material - 1,080 Closing stock 800 1,440
(wages & overhead a/c)conversion 5,520
4,000 8,800
4,000 8,800
Opening WIP
The closing WIP of process II will become the opening WIP of process III. It follows therefore that if the
closing work in process for process II was 60% complete of 100 units (i.e. 60% x 100 = 60units) the
Total Equivalent Added process1
units % age
material mat. unit
units
Labour and % age % age overhead
26
opening WIP for process III will have an equivalent unit of 40% of 100 units i.e. 40 units
First-in-First-out (FIFO) Method in computing the value of work in-process/progress
This method assumes that production of WIP at the beginning of the period is completed first before
any other units.
Example 4.08 Adoo Ltd as a manufacturer of bread provided the following information relating to process 1 of the
bread production for the month of August, 20XY: -
Opening stock 500units 60% complete Cost to date N2,800
Cost incurred in Aug, 20XY N Direct material (2,500 units introduced) 13,200 Direct labour 6,600 Production overhead 6,600
26,400 Closing stock 300 units Degree of completion 80% There was no loss in process. Required: Compute the value of Work-in-Progress using FIFO method
Solution First step Statement of equivalent units
Total units equivalent unit of prod. in Aug, 20XY
Units Opening 500 40% 200
Add; fully worked units 2,200 100% 2,200
Output to process 2 2,700
2,400
Add: closing stock 300 80% 240
Actual units work 3,000
2,640
27
Adaa Maagbe Ltd processes Soya Oil at Tsar City, the following information relates to process 4 of a six (6) production process for the month of March, 20XY.
Opening stock Level of completion Cost Cost 300 units complete as to:
N N
Materials from process 3 100% cost 4,400 Added materials 90% cost 1,150 Labour 80% cost 540 Production overhead 80% cost 810
N6,900
Second Step Cost per Equivalent unit
Cost incurred Equivalent units
Third Step Statement of Effective production
Opening stock work done in Aug. Fully worked unit Closing stock
N26,400 = N10
2,640
Equivalent unit Effective production Unit cost N
200 N10 2,000 2,200 N10 22,000
240 N10 2,400
2,640
26,400
Computation of Fully worked (Effective) units:
Opening stock Add: units introduced
Less: Closing stock Actual units worked Less: opening stock Fully worked (Effective) units Step IV
500 2,500 3,000
300
2,700 500
2,200
Process I Account
Units N
Opening stock 500 2,800 Materials 2,500 13,200 Labour - 6,600 Overhead - 6,600
3000 29,200
Units N
Opening 500 4800
Fully worked 2,200 22,000
Closing 300 2,400
3000 29,200
Workings
28
In March 20XY, a further 1,800 units were transferred from process 3 at a valuation of N27,000. Added materials amounted to N6,000 and direct labour to N3,270. Production overhead is absorbed at the rate of 150% of direct labour cost. Closing stock at 31 March, 20XY amounted to 450 units, complete as to:
Process 3 materials Added materials Labour and overhead
100% 60% 50%
Required Prepare the process 4 account for March, 20XY using FIFO valuation principles.
Solution First step
Statement of equivalent units
Opening stock
Total Units 300
material process 1 30
added material 30
conversion cost
60
Fully worked units 1350 1350 1350 1350
Closing stock 450 450 270 225
1800 1650 1635
Step II Statement of cost per equivalent units
Equivalent unit cost units cost
Direct material 1800 27,000 15.00
Added materials 1650 6600 4.00
Direct labour 1635 3270 2.00
Production o/head 1635 4905 3.00
24.00 Step III Statement of Effective Production
Process material
2 Added materials
Direct labour
Production overhead
Total N
Opening stock b/f 4400 1150 540 819 6900 Added cost in Jan.
120 120 180 420
4400 1270 660 999 7320 Fully worked units 20250 5400 2700 4050 32400 Closing stock 6750 1080 450 675 8955
48675 Process IV Account
Units N Units N
29
Opening stock 300 6900 Opening stock 300 7320 Direct mat. 1800 27000 Process- finished good 1350 32,400 Added mat - 6,600
Direct labour - 3270 Closing 450 8955
Prod. Overhead - 4905
2100 48,675
2100 48,675
Workings
Computation of fully worked units using FIFO Method 1st find the fully worked units
i.e. Opening stock 300
add: material introduced 1800
2100
less closing stock 450
total output to process 3 1650
less opening stock 300 fully worked within the period 1350
Process III Account
Units N Units N
39720 Output to process 4 1650
Closing 450 8955
1,700 48,675
Weighted Average Method
This measures the weighted average cost of units produced from both opening stock and units
introduced in the current period.
Weighted average method does not show any distinction between opening stock and units introduced
to the process during the accounting period. In this method, opening stock units counts as a full
equivalent unit of production.
30
Example 4.09
Igyungu M Ltd manufacturers of fruit Juice called ‘Dooman' provided to the management accountant
the following information relating to process 3 during the month of June, 20XY
Opening stock 800units Degree of completion N
process 1 material 100% 4700
Added material 40% 600
Conversion cost 30% 1000
6,300
During June, 20XY 3000 units were transferred from process 2, valued at N18,100 Added materials
cost N9,600 and conversion cost N11,800
Closing stock 1000 units, degree of completion: 100% complete with respect to process 1 material;
60% complete with respect to added materials and conversion cost 40% complete Igyungu M. ltd uses
weighted average method. Prepare process 3 account for June, 20XY
Solution (a). Statement of equivalent unit
Total LOC(Level of Process 2 Added Conversion
Units completion) material LOC Material LOC cost Opening stock 800 100% 800 800 800 Fully worked units* 2000 100% 2000 2000 2000
Output to process 2 2800
2800 2800 2800 Closing stock 1000 100% 1000 60% 600 40% 400
3,800
3800 3400 3200
* To arrive at fully worked units 3,000 units from process 2 minus closing stock of 1,000 units
(b) . Statement of cost per equivalent unit
Process 2 Added Conversion
materials materials costs
N N N Opening stock 4700 600 1000 Added in Sept 18,100 9600 11800 Total cost (a) 22800 10200 12800 Equivalent units (b) 3800 3400 3200 Cost per equivalent
units © = (a) -:- (b)
N3 N4
N6
31
(c). Statement of effective production Output to finished goods (2800 units) 16800 8,400 11200 36400 Closing stock
6000 1,800 1600 9400
45,800 (d)
Process 2 Account
Units N
Units N
Opening stock b/f 800 6,300 finished goods a/c 2,800 36,400
Process 2 a/c/ 3,000 18,100 closing stock b/f 1,000 9,400
Added material
9,600
Conversion costs
11,800
3,800 45,800
3,800 45,800
Accounting for waste and loss - normal and abnormal loss
Loss that occur during processing may be either expected or unexpected or both. Expected loss
process is normal and the costs are spread over the total cost of output. Waste occurs when a material
is left in the production process or a residence without value results from it.
Example 4.10
Opening stock nil expected loss = 100 Units introduced 1000units actual loss = 140 Cost 4500 abnormal loss = 40 Output 900units units introduced 1000
Closing stock nil less. Exp. Loss 100
Loss 100units expected units 900
cost/unit = 4500
900 =5
Process Account
Units N Units N
Unit introduced 1000 4500 Normal loss 100 0
Abnormal loss 40 200
Output 860 4300
1000 4500
Where the loss of 100 units was expected, the cost per unit will be : N4500
900 = N5 and process A/c will be as follows: -
32
Process Account
Units N Units N
Materials 1000 4500 Normal loss 100 0
Output 900 4500
1000 4500 1000 4500
However, if loss is unexpected, the position/(cost per unit) shall be thus: N4500
1000 = N4.50
Process Account
Units N Units N
Materials 1000 4500 Abnormal loss 100 4.50 450
Output 900 4.50 4050
1000 4500 1,000
4500
Abnormal loss and Gain
It is almost inevitable that when there is an expected loss in a process, the actual loss which occurs will
not exactly be the same amount as the average or normal loss. If the actual loss is higher than normal
(expected) loss the difference is abnormal loss, and if the actual loss is less than expected (normal)
loss, the difference is abnormal gain.
Example 4.11 Expected loss = 100 units
Actual loss = : 80 units
Abnormal gain = 20
Units introduced = 1000
Expected loss = 100
Expected output = 900
Actual output = 920
33
Process Account
Units N Units unit cost N
Units intro. 1000 29070 Normal loss 100
0
Abnormal loss 50 32.3 1615
Output 850 32.3 27455
1000 29070
1000
29070
Period 4 workings
Normal loss 100 units
Actual loss 50 units
Abnormal gain 50 units
Units introduced 1000
Expected loss (10/100x1000) 100
Expected units 900
Therefore, cost per units = total cost N29070
900 = N32.3
Process Account
Units N
Units N
Units intro. 1000 29070 Abnormal loss 100 0
Abnormal gain 50 32.3 1615 Output 950 32.3 30685
1050 30685
1050 30685
20 Abnormal gain=
Total cost = N4500
Expected output = 900
Workings period 3 Expected loss (10/100 x1000)
Actual loss
Abnormal loss
Calculation of the cost per units
Units introduced
Expected loss Expected output
= N5
100 units
150 units
50 units
1000
100 900 that is cost 29070
900 = N32.3
34
Abnormal loss and gain
Units Costs units Costs
Process 50 1,615 process A/c 50 1,615
Scrap Value
Rules involved in treating scrap value in process account include: -
i. Revenue scrap value is treated not as an addition to sales revenue but reduction in cost
ii. The scrap value of normal loss is therefore used in reducing the material cost of process
iii. The scrap value of abnormal loss is used in reducing the cost of abnormal loss, that is,
Scrap A/c Dr Abnormal loss A/c; Cr
iv. Scrap value of abnormal gain
Dr Abnormal gain A/c; Cr Scrap A/c;
v. The scrap A/c is completed recording the cash received from the sale of scrap -
Cr Scrap A/c
Dr Cash;
Units
cost Unit introduced 100
1370 Normal loss 10 N2
20
Expected units/cost 90
1350 Cost per units = Expected cost = 1350
Expected units 90 = 15.00
Process A/c
Units cost
Units Unit Cost Costs Material 100 1,370 Normal loss 10 2 0
Output 90 15 135
100 1,370
100
1,370
Process 20 Cash 20
Example 4.12 Units introduced 100, normal loss 10% = 10 units normal loss scrap value is N2 per unit
Scrap A/c
35
Abnormal A/c
Process 10 20
Workings: process 1
Units
cost
Units introduced
2000
18100
Normal loss (10/100x2000)
200 50 100
Expected output/cost
1800
18000
Expected units cost = 18,000 = N10 per unit
1800
Normal loss = 200
Actual loss = 250
Abnormal loss = 50
Workings: process 2
Units
cost Units introduced
3000
41400
Normal loss (10/100x3000)
300 3 100
Expected output/cost
2700
40500
Expected unit cost = 40,500 = N15 per unit
2700
Normal loss = 300
Actual loss = 200
Abnormal loss = 100
Workings: process 1
Units
cost Units introduced
3000
1320 Normal loss (20%x3000)
600 20 120
Expected output/cost
2400
1200 = 1200 = N0.50 per unit Units cost 2400 Expected loss 600 Actual loss (3000-2300) 700 Abnormal loss = 100
Process I Account
Units N Units N
Material 3000 750 Normal loss 600 120
36
Labour - 120 Output 2,300 1150 Machine hour - 240 Abnormal loss 100 50
Overhead - 210
3000 1320
3,000 1,20
Workings: process 2
Total Units Normal loss (10/100x4300) Expected output/cost Expected Units cost (3870/2322) = Expected loss Actual loss (4300-4000) Abnormal gain=
Units N Units unit cost N
Process 1 2300 1150 Normal loss 430 30 129 Added material 2000 800 Output 4000 60 2400 Labour - 84
Machine hr.
270
Overhead - 147
4430
2529
4300 2451
Abnormal gain 130 78
4430 2529
4430
2529
Abnormal Gain/Loss Account
Process 1 a/c (100x50k) 50 Process 2(130x60k) 78
Scrap value of abnormal gain 39 Scrap value of abnormal loss 20 Bal to P&L 9
98 98
Scrap Account
Units N Units N
Process 1 600 20k 120 Scrap value abnormal gain 130 39 Process 1 430 129 Cash 1000 230 Abnormal loss 100 20
1130 269
1130 269
Normal loss (5/100x4000) = 200
Actual loss (4700-4300+300) 100
Abnormal gain 100
Units cost 4300 2451
430 30k 190
3870 2322 N0.60
430 300 130
Process 2 Account
37
Total units Opening stock 700 Fully worked units 3600 Output to next process 4300 Normal loss 200 Closing stock 300
4800 Abnormal gain (100)
4700 How to calculate output in FIFO Opening stock 700 Add input 4000
4700 Less closing stock 300 Abnormal gain (100) 400
400 4300 Less opening stock 700 Fully worked units 3600
Example of losses in a process having opening and closing WIP
1. Calculate fully worked units within the period (i.e. output - opening WIP)
That is 4300-700 = 3600
2. Statement of equivalent unit
Total units Direct Conversion
material cost Opening stock 700 0 490
Fully worked units 3600 3600 3600 Output 4300 3600 4090 Closing stock 300 300 120 Normal loss 200 0 0
4800 3900 4210 Abnormal gain (100) (100) (100)
4700 3800 4110
3. Statement of cost per units of equivalent Production
Material Equivalent units Total cost Cost per unit
3800
30400 N8
conversion 4110 16440
N4
38
4. Statement of effective Production
Material Conversion Total Opening stock b/f
6400 Add. during period - 1960 1960
8360 Fully worked units 2880 14400 43200 Normal loss 0 0 0 Closing stock 2400 480 2880
312200 16840 54440 Abnormal gain (500) (400) 1200
Where normal losses have scrap values and equivalent units are a different percent (%) to materials,
labour and o/head, the scrap value if the normal loss is deducted from the cost of materials before a
cost per unit is calculated.
Calculation of fully worked units (effective Production)
Units Opening WIP
600 Input materials
5000 5600
Less: opening stock completed 600
Normal loss 500
Abnormal loss (800-500) 300
Abnormal gain (0)
Closing stock 1000 2,400
Started and completed within period= 3,200 Calculation of out to next process or finished goods
Units Opening stock completed 600 Fully worked within the period 3200 Output 3800
Statement of equivalent units
Total units Process 1 materials
Added material
Labour Overhead
Opening stock 600 0 240 420 420 Fully worked units 3200 3200 3200 3200 3200
Output 3800 3200 3440 3620 3620 Normal loss 500 0 0 0 0 Abnormal loss 300 300 300 300 300 Closing stock 1000 1000 750 400 200
39
Statement of cost per equivalent unit
Equivalent units
Total cost
Cost/units
Material process 1 4500 9000 2.00 Added material 4490 2245 0.50 Labour 4320 4320 1.00 Overhead 4120 3090 0.75
4.25 Statement of effective Production
Total units Process1 materials
Added material
Labour Overhead Total
Opening stock b/f
945 180 405 135 1665 Opening stock 600 0 120 420 315 855
2520 Fully worked units 3200 6400 1600 3200 2400 13600
Output 3800 0 0 0 0 16120 Normal loss 0 0 0 0 0 p
Abnormal loss 300 600 150 300 225 1275
Closing stock 1000 2000 375 400 150 2925
Process 2 Account
Units N Units N
Opening stock 600 1665 Normal loss 500 50% 250 Material p1 5000 9250 Abnormal loss 300 1275 Added mat. - 2245 Opening stock fini . 600 2520
labour - 4320 Output (fully worked) 3200 13600 Overhead - 3090 Closing c/d 1000 2925
5,600 20,570
5,600 20,570
4500 4490 4320 4120
40
Abnormal loss Account
Unit N
Process 2 500 250
Abnormal loss 300 150 800 400
Using weighted average Statement of equivalent units
Total Process 1 Added Labour Overhead
units materials material
Opening stock
600 600 600 600 600 Fully worked
3200 3200 3200 3200 3200
3800 3800 3800 3800 3800 Normal loss
500 0 0 0 0 Abnormal loss
300 300 300 300 300 Closing stock
1000 1000 750 400 200
5100 4850 4500 4300 Cost per equivalent unit
Period 8 9000 2245 4320 3090 Value of stock 945
180 405 135
9945 2425 4225 3225 Equivalent units 5100 4850 4500 4300
Cost per eq, units 1.95 0.50 1.05 0.75
Where rejected items less were than 100% complete
In this case units of abnormal (loss) gain should count as a proportion of an equivalent unit
according to the volume of work done and materials adding up to the point of inspection.
Unit
Process 2 300
N
1,275 Scrap a/c
P & L
300 1,275
Unit N
300 50% 150
1,125
300 1,275
Scrap A/c Unit
41
Solution
Step 1 Calculation of fully worked units
Opening stock Material introduced
units 300
2000
2300 Less: opening stock completed
Abnormal loss Closing stock Fully worked within the period Add opening stock complete Output to next process
300 200 400 900
1400 300
1700
Opening stock 300 - 120 Fully worked 1400 1400 1400
1700 1400 1520 Abnormal loss 200 200 100
Closing stock 400 400 240
2300 2000 1860
210 1400 1610
60 120
1790
Equivalent units Total cost
Cost/units
Material process 1 2000 10000 5.00 Added material 1860 4650 2.50 Conversion cost 1790 3580 2.00
Total units
Process 1 material
s
Added material
Conversion Total cost
Opening stock b/f 300 0 0 0 2000 Process this period 0 0 300 420 720
2720 Fully worked units 1400 7000 3500 2800 13300
Abnormal loss 200 1000 250 120 1370
Step 2 Statement of equivalent units
Total units Process 1 Added Labour materials material
Step 3 Statement of cost per equivalent unit
9.50
Step 4 Evaluation of equivalent units
42
Closing stock 480 2000 600 240 2840
Process 2 Account
Units N
Units N
Opening stock 300 2000 Abnormal loss 200 1370 Material p1 2000 10000 Opening stock 300 2720 Added mat. - 2245 Fully worked 1400 13300 Conversion - 4370 Closing stock 400 2840
4.08 Marginal Costing
Introduction:
Marginal cost has to do with cost of additional unit of output. It is cost related to activity level.
To understand this topic very well, we have to look at certain terms used under cost behaviour.
Cost behaviour is the way in which costs per unit of output are affected by fluctuations in the level
of activity. Level of activity refers to the amount of work done, number of events that have
occurred. It may be the volume of production, sales, number of invoices issued/received, number of
units of electricity consumed or the labour turnover, etc.
It means therefore that such costs which are affected by level of activity would be variable; that is
varying with level of activity. However, those cost which do not change as activities change; those
cost which are not affected by fluctuation in activity level are fixed costs.
The problem accountants are faced with is how to determine for each item of cost:
(a) In what way do costs change (rise or fall)? and
(b) By how much, as the level of activities increase? or
(c) Decrease in activity level?
Definition of marginal cost and marginal costing
Marginal cost is the variable cost of one unit of a product or service. It is a cost which would be
avoided if the unit was not produced or provided. From the definition you can possibly identify the
marginal cost of an operation, process, or even the marginal cost of a batch of output.
Marginal costing is a principle whereby variable costs are charged to cost units and fixed cost
attributable to the relevant periods is written off in full against the contribution for the period.
43
Contribution is the difference between sales value and the marginal cost of sales. Contribution
means “contribution towards covering fixed overheads and making a profit”. CIMA, however, gave a
more comprehensive definition of contribution thus “the difference between sales value and the
variable cost of those sales, expressed either in absolute terms or as a contribution per unit".
Principles of marginal costing:
These are:
(a) Since period fixed costs are the same, no matter what the volume of sales and
production, it follows that by selling an extra item of product or service:
- Revenue will increase by the sales value of the item sold;
- Only variable cost per unit will increase;
- Increase in profit will equal the sales value minus variable costs;
(b) If the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item;
(c) Profit measurement should therefore be based on analysis of total contribution;
(d) When a unit of product is made, the extra costs incurred in its manufacture are the
variable production costs.
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, it is
the task of the accountant to identify the marginal cost of production and sales,
i. e.
(a) The variable cost of production, consisting of direct material cost, direct labour cost,
and variable production overhead;
(b) The variable cost of administration, sales and distribution.
The marginal cost per unit of production of an item usually consists of:
(a) Direct materials;
(b) Direct labour;
(c) Variable production overhead.
There might also be some variable direct expenses, although these are not common. Direct labour
costs might be excluded from marginal costs when the work force is a given number of employees
44
on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable
cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should
treat labour as a variable cost unless given clear indications to the contrary. Direct labour is often a
step cost, with sufficiently short steps to make labour costs act in a variable fashion, at least where
the workforce is quite large
The marginal cost of sales usually consists of the marginal cost of production plus the variable cost
of sales, which would include item such as sales commission, and possibly also some variable
distribution costs.
As the definition of marginal cost indicates, it is also possible to identify the marginal cost of an
operation or process, or even the marginal cost of a batch of output. It is useful exercise to study the
following example, taken from a past examination paper of the Chartered Association of Certified
Accountants (ACCA).
Example 4.13
Marginal Costs
Suggest how the following items should be treated, in order to determine appropriate product costs
in a company employing a marginal historic batch costing system and outline the reasons for each of
your recommended treatments:
(a) Cost of products scrapped at final inspection;
(b) The salary of a foreman in a production department;
(c) Carriage inwards;
(d) Cost of setting up time;
(e) The cost of the power generating plant providing heat, light and power throughout the
factory;
(f) Salesmen's salaries and travelling expenses.
Solution:
(a) If scrapped items are a normal feature of production work the variable cost of products
scrapped, or at least the variable cost of normal wastage, should be treated as a marginal
cost (i.e. as a variable expense of producing a batch).
45
If scrapped items are not normally expected, or if wastage is exceptionally high, the
excessive variable cost of scrapped items should be excluded from the marginal cost of a
batch, and written off as exceptional expense.
Example 4.14
Sesugh Nyam Ltd makes a product called Anget. The information relating to the product for
April 20X9 is as follows:
Opening Stock NIL
Production (units) 30,000
Sales (Units) 20,000
Sales price Per unit N40
Unit cost from direct material N16
Direct labour N8
Variable production overhead N4
Variable sales O/h N4 Fixed costs:
Production costs N20,000
Administration costs N30,000
Sales and distribution overhead be charged as a percentage of direct labour cost given that
production overhead budget is required. Using marginal costing approach, calculate the profit for
the month of April 20X9.
46
Solution:
Sesugh Nyam Ltd
(Makers of Anget Product)
Profit and Loss Account for the month of April 20X9.
N N
Sales (20,000 x N40)
800,000
Less Cost of sales
Direct materials (30, 000 x N16) 480,000
Direct labour (30,000 x N8) 240,000
Variable overhead (30,000 x N8) 120,000
Total production cost 840,000
Less closing stock (Wk1 ) 280,000
Production cost of sales 560,000
Varying sales volume (20,000 x N4) 80,000
Variable cost of sales
640,000
Contribution
160,000
Less fixed costs:
Production overhead 20,000
Administration o/h 30,000
Sales distribution o/h (N240000 x 0.833) 199,920 249,920
Profit/(Loss)
(89,920)
Workings
(i) Valuation of closing Stock = Production cost x units of closing stock Production in units = N840,000 x 10,000 units
30,000
= N28 x 10,000
= N280,000
(ii) Sales and distribution overhead = VSO + VPO x 10 DLC
= N80,000 + N120,000 x 100 N240,000
47
= 8.33%
Where:
VSO = Variable sales overhead = 20000 x N4 = N80,000
VPO = Variable Production overhead 30000 x 4 = N120,000
DLC= Direct labour cost = 30000 x 8 = N240,000
4.09 Marginal And Absorption Costing Compared
Most management accounting theories agree that marginal costing is more useful in decision-
making, where a choice has to be made between alternatives. Marginal costing would provide
information about differential costs, which would be most relevant to the situation.
However, a choice has to be made between marginal and absorption costing in the routine internal
cost accounting system. There is no straightforward answer as to which system should be used. The
system designer must consider all the advantages and disadvantages and what is required from the
system, before making a decision.
Remember these point if you are given a scenario in the examination or more importantly faced
with a real life situation and need to decide on the best option.
Arguments in favour of Absorption (Full) Costing
(a) When production is constant but sales fluctuate, absorption costing will cause fewer profit
fluctuations than marginal costing in periods when stocks are being built up to match future
increased sales demand.
(b) No output could be achieved without incurring fixed production costs, and it is therefore
logical to include them in stock valuations.
(c) If managers continually use marginal cost pricing, there is a danger that they may lose sight
of the need to cover fixed costs. Absorption costing values all production at full cost, so that
managers are always aware of fixed costs.
(d) SSAP 9 Stock and long-term contracts states that in order to match costs and revenues, the
cost of stock should include all costs incurred in bringing the stock to its present condition.
These costs should include all related production overheads, even if they accrue on a time
48
basis (i.e. do not fluctuate with the level of activity-fixed overheads)
Argument in Favour of Marginal costing
(a) When sales are constant but production fluctuates, marginal costing will give a more logical,
constant profit picture
(b) Since fixed costs accrue on a time basis, it is logical to charge them against sales in the period
in which they are incurred. The recommendations of SSAP 9 are for external profit reporting
purposes, but the internal costing system simply has to meet the information needs of
managers. The marginal costing system will also give a better indication of the actual cash
flow of the business.
(c) Under-or over-absorption of overheads is not a problem with marginal costing, and
managers are never working under a false impression of profit being made, which could be
totally altered by an adjustment for under-or over-absorbed overheads in absorption
costing.
Further Points
It is important to remember that the difference between absorption and marginal costing arises
from the treatment of the fixed costs of production. As direct material cost and direct labour cost
will always vary with production, it is the overhead cost which creates the difficulties.
In absorption costing all the overheads are absorbed using various logical bases. It is essential to
prepare an overhead summary prior to a period, dividing anticipated overheads into production and
service departments. The overheads allocated or apportioned to service departments are then
apportioned to production using the most logical basis; an absorption rate is calculated on the basis
of whether the production departments are labour, machines or material intensive.
In marginal costing, direct cost of production is calculated by adding direct material cost, direct
labour cost and overheads which can be related to one unit of production. By deducting this
marginal cost of production (cost to produce one extra unit) from the sales revenue, a contribution
towards fixed overheads from each unit of production is calculated. Total fixed overheads divided by
contribution per unit establishes the break-even point. This is the point where all fixed overheads
are recovered and the business starts making contribution towards profit.
49
Limitations of absorption costing
a. In absorption costing the main difficulty arises in dividing overhead expenses between
production and service departments. If they relate to one department they can be easily
allocated; but if they need to be apportioned between departments then the most logical
basis of apportionment has to be established.
b. The cost of production is calculated after the production has taken place. The profit or loss is
therefore calculated after the event, reducing any opportunity for the management to be
taken action to control the cost in order to improve profitability.
c. Because the absorption rate is calculated on the basis of anticipated production, and the
overheads themselves are estimated, at the end of the period there will always be over- or
under-absorption of overheads as actual production or actual overheads will be more or less
than the estimate.
d. Absorption costing does not assist management by giving accurate information that helps in
preparing quotations for future contracts or in establishing a correct selling price. This is
because the overheads in the following period may be different and they may change in
their variability.
Limitations of marginal costing
a. The main difficulty in marginal or direct costing is to establish variability of overhead
expenses. In reality most overheads are semi-variable. They are neither strictly variable with
production nor strictly fixed for any level of production. Their variability can be calculated
by techniques such as scatter-graphs, etc. therefore the basic argument in favour of
marginal costing is flawed.
b. In the case of a business producing more than one product, it is difficult to calculate break-
even points for each product. The best we can achieve is usually to calculate an overall
breakeven point based on the level of activity or total sales revenue. This again reduces the
usefulness of marginal costing.
Absorption costing is useful to management because it is easy to operate. Once the basis of
apportionment and rates of absorption are agreed, adjustments can be made annually to bring them
in line with the current situation. Marginal costing is very useful to management in making
decisions, e.g. on make or buy, levels of production, pricing of products.
50
In conclusion, both methods can and should be used by management - absorption costing for the
benefits it gives in cost accumulation and cost control, and marginal costing to assist in managerial
decisions.
Example 4.15
The following information relates to product J for quarter three, which has just ended:
Production
(Units)
Sales
(Units)
Fixed overhead
N'000
Variable cost
N'000
Budget 40,000 38,000 300 1,800
Actual 46,000 42,000 318 2070
The selling price of product J was N72 per unit.
The fixed overheads were absorbed at a predetermined rate per unit.
At the beginning of quarter three there was an opening stock of product J of 2,000 units valued at
N25 per unit variable costs and N5 per unit fixed overheads.
Required:
(a) (i) Calculate the fixed overhead absorption rate per unit for the last quarter, and present profit
statements using FIFO (first in, first out); and using:
(ii) Absorption costing, and
(iii) Marginal costing and
51
(iv) Reconcile and explain the difference between the profits or losses.
(b) Using the same data, present similar statements to those required in part (a), using the AVECO
(average cost) method of valuation, reconcile the profit or loss figures, and comment briefly on
the variations between the profits or losses in (a) and (b).
Solution
(a) (i) Fixed overhead absorption rate per unit
(iii) Absorption Costing (FIFO) Profit Statement
52.5
budget fixed overheadds
budget production
/V300,000
40,000
N'000 N'000
Sales (42000 x N72) 3,024
Less Cost of sales:
Opening stock (2,000 x N30)
Add Production (46,000 x N52.5) (W1)
Less closing stock (6,000 x N52.5)
60
2,415
2,475
315
Add Over-absorption (W2)
Profit
2160 864
27
891
Workings:
(1) Variable cost
Fixed overhead
Per unit N
45
7.5
(2) Fixed overhead absorbed: 46,000 x N7.5 345,000
52
Less actual overhead
Over-absorption
318,000
N27000
53
(iii) Marginal Costing (FIFO) Profit Statement
N'000 N000
Sales
3,024
Less Cost of sales:
Opening stock (2000 x N25) 50
Add Production (46,000 x N45) (W1) 2,070
2,120
Less Closing stock (6,000 x N45) 270 1850
Contribution
1,174 Less fixed overheads (actual)
318
Profit
856
(iv) Reconciliation profit
Absorption
891
Marginal
856
35
Fixed overheads in closing stock (6,000 x N7.50)
45
Less opening stock (2,000 x N7.50)
10
35
The difference is due to fixed overheads being carried forward in stock valuation. The figure
under absorption give a higher profit because more of the fixed overheads are carried forward
into the next accounting period than were brought forward from the previous one. The fixed
overhead absorption rate depends on estimates of both production units and fixed overheads,
and actual figure may vary. The over-absorption of fixed overheads is adjusted for at the end of
the period.
Under marginal costing, fixed overheads are treated as period costs and not carried forward in
stock valuations; under-or over-absorption does not arise. Marginal costing, by taking only the
variable costs, shows how much contribution is being made, and is regarded as giving more
useful figures for decision-making.
54
(b) Absorption costing (AVECO) Profit Statement
N'000 N'000
Sales
3,024
Less cost of sales:
Opening stock plus production (48,000 x N51.56) 2,475
Less closing stock (6,000 x N51.56) 309 2,166
858
Plus over-absorption
27
Profit
885
Marginal Costing (AVECO) Profit Statement
N'000 N'000
Sales
3,024
Less cost of sales:
Opening stock plus production (48,000 at N44.14) 2,120
Less closing stock (6,000 x N44.17) 265 1,855
Contribution
1,169
Less Fixed overhead
318
Profit
851
Reconciliation:
Difference in profit (885-851)
34
Absorption closing stock 309
Less marginal closing stock 265 44
Less fixed costs in absorption opening stock
10
34
The variations in the profits in (a) and (b) of N6,000 and N5,000 respectively are caused by using
different methods of valuation (FIFO and AVECO). The valuation method can affect profit/loss
for both absorption and marginal approaches, and could lead to much wider variations than we
have here.
55
4.10 Summary
Job costing is the costing method used in costing each unit separately identified. The
procedures involved are
- Each job is given a number to distinguish it from other jobs.
- Each job has cost card where costs of such job is accumulated.
- Material requisition notes are the sources where materials cost for each job are obtained.
- Labour costs are collected from job cards through job tickets
- Pre-determined overhead rates are used for absorbing overhead costs into jobs
Batch costing is similar to job costing because each batch of similar goods is identified
separately. The unit cost of goods manufactured in a batch is arrived at by dividing total cost of
a batch by the number of units.
Contract costing is a costing method where each contract is identified separately and is costed.
It is generally believed that contract costing is similar to job costing. However, the following are
the noticeable differences:
(i) Contract jobs take a very long time. Some may extend to more than one
accounting period.
(ii) Some contracts are carried out in locations outside the premises of the
contractor. The jobs may sometimes be on a site.
(iii) Sub-contracting may sometimes be necessary particularly where the job requires
special skilled manpower, for example, welding, plumbing, electrical
installations, and so on.
(iv) A supervisor is usually engaged by the contractor. If the job is construction the
supervisor will be an architect or building engineer. The architect is the one that issues
the certificate of evaluation.
Process costing is used where there is a continuous flow of identical units. Some of its attribute
include:
- The cost per unit in a process is calculated by dividing the total costs by the number of
units produced.
- When units are partly completed-calculate the equivalent units
56
- Stock in process can be valued using FIFO or Weighted Average (WA)
- Loss may occur in the process. Expected loss known as normal loss - unexpected loss =
Abnormal loss. Where expected loss is higher than actual, the difference is abnormal
gain.
- It is conventional for the scrap value of loss (normal) to be deducted from material cost
before calculating equivalent unit
- Abnormal loss/gain never affects the cost of good units of production.
- Scrap value of abnormal loss is not credited to process account.
Marginal costing is a principle whereby variable costs are charged to costs units and fixed costs
attributable to the relevant periods written-off in full against the contribution for the period.
Marginal cost on the other hand is the variable cost of one unit of a product or service. It is a
cost which will be avoided if the unit or service was not produced or provided.
In absorption costing, profit determination assumes more importance than the contribution
determination. In absorption costing, emphasis is not placed on fixed or variable cost unlike the
contribution approach in marginal cost.
4.11 Review Questions
1. Ankar limited manufactures a range of chemicals and fertilizers for agricultural purposes.
The manufacture of one of the company's products, “Nyambua”, involves three distinct
processes in which the output from process 1 is used as the input into process 2. Similarly, the
output from process 2 is used as input into process 3 by which stage the final product is
prepared and then packed for shipping.
The company has established standards for each process as follows:
Process 1 Process 2 Process 3
Normal loss(%) 5% 5% 5%
Sales value of each unit lost N1.83 N2.00 N4.00
Note: the normal loss for a process is calculated as a percentage of the units processed in that
process.
The following data is available for August 2016 in respect of each of the processes:
57
At the end of process 3, a total of 3,190 fully completed units was transferred to Finished Goods.
Requirement:
Prepare each of the process accounts for the month of August.
Solution
Ankar Ltd
Process 1
N Units N Units
Materials 1,200 600 normal loss 60 110
Labour
1,500 to process 2 1,150 4,025
Overheads
2,000
Abnormal gain 10 35
1,210 4,135 1,210 4,135
Process 2
Units N Units N
From process 1 1,150 4,025 Normal loss 158 316
Materials added 2,010 4,299 abnormal loss 22 88
Labour
1,800 to process 3 2,980 11,920
Overheads
2,200
3,160 12,324 3,160 12,324
Process 3
Units N Units N
Qty N Qty N Qty N
Units from previous process
1.150
2,980
Materials added 1,200 600 2,010 4,299 600 7,344
Labour incurred
1,500
1,800 900
Overheads incurred
2,000
2,200 600
Process 1 Process 2 Process 3
58
From process 2 2,980 11,920 Normal loss 358 1,432
59
2. Tor Bem Ltd manufacturer of a product, called Gbache recorded the following budgeted and
actual results for the year ended 31st December, 20X0.
Materials added 600 7,344 abnormal loss 32 192
Labour 900 to finished goods 3,190 19,140
Overheads 600
3,580 20,764 3,580 20,764
Calculations
Process 1
Normal loss units calculation
5% x 1,200
Abnormal loss /(gain) units
(1,200x95%)-1,150 = (10)
Process 2 5%x (1,150 + 2,010 (3,169x95%)-2,980=22
Process 3 10%x(2,980 +600) (3,580x90%) - 3,190 = 32
Value of good unit
4,100 - 110/(1,200x95%)
12,324 - 316/(3,160x95%)
20,764 - 1,432/(3,580x90%)
Opening stock
Budgeted production
Budget sales
Standard sales price
Standard costs:
Direct materials
Direct Labour
Variable production overhead
Variable marketing overhead
Budget fixed costs:
Production
Marketing and administration
Actual results:
Opening stock
Actual production
Actual sales
nil
6000 gbache
5.500 gbache
N3 per unit
N5 per unit
N4 per unit
N1 per unit
N2 per unit
N24,000
N10,000
nil
5,000 gbache
4.500 gbache valued N90, 000
60
Actual costs of production:
Direct materials N24,800
Direct labour N21,400
Production overhead: Variable N5,100
Fixed N22,600
Actual costs of administration N4,200
Actual costs of marketing N13,300
Required:
Calculate the actual profit or loss that would be attained by Tor Bem Ltd if the costing
techniques applied were:
(a) Standard absorption costing
(b) Standard marginal costing
(c) Normal absorption costing with output valued at a weighted average cost;
(d) Marginal costing with output valued at weighted average cost.
Solution
Tor Bem Ltd
Standard absorption costing: the fixed production overhead absorption rate will be
N24,000 = N4 per unit 6,000 units
The standard production cost is therefore (N5+4+1+4) = N14 per unit
Sales
Less standard production cost of sales
(4,500 units x N14)
Standard profit
Cost variances
Direct materials ((5,000 x N5)- N24,800)
Direct labour ((5,000xN4)- 21,400)
61
Variable prod. o/h ((5,000xN1)-5,100
200(F)
1,400(A)
100(A)
N
90,000
63,000
27,000
62
Fixed Prod. O/H: expenditure (24,000-22,600) 1,400(F)
Volume (1,000 units xN4) 4,000(A)
3,900(A)
23,100
Standard variable marketing o/h (4,500 x N2) 9,000
Budgeted fixed admin. & Mkt costs 10,000
19,000
Cost variance (balancing figure) (17,500-19,000) 1,500 (F)
Actual total admin & Mkt costs
17,500
Actual profit
5,600 b) Standard marginal costing
N Sales
90,000 Less standard variable cost of sales
(4,500 x N(5+4+1+2))
54,000
Standard contribution
36,000 Budgeted fixed costs
34,000 2,000
Cost variances
Direct materials
200(F) Direct labour
1,400(A) Variable production overhead
100(A) Fixed production overhead expenditure
1,400(F) Admin & Mkt costs
1,500(F) 1,600(F)
Actual profit
3,600
c). Normal absorption costing, using weighted average costs
The fixed overhead absorption rate is N4 per unit, as in (a)
N N Sales
90,000 Production costs
Variable (24,800 + 21,400 + 5,100) 51,300
Fixed costs absorbed (5,000 x N4) 20,000
71,300
Less closing stock: 500 units
Variable 10% of N51,300 plus
Fixed : 500 units x N4 7,130
64,170
63
25,830 Under-absorbed overhead (N22,600 - N20,000)
(2,600) Admin & Mkt costs
(17,500)
Profit
N5,730
d. Marginal costing, using weighted average costs
N N
Sales
90,000
Opening stock -
Variable costs of production 51,300
51,300
Less closing stock 5,130
46,170
Variable marketing costs -
Variable costs of sales
46,170
Contribution
43,830
Fixed costs
Production 22,600
Admin marketing 17,500
40,100
Profit
3,730
Variable marketing costs are not separately identified, and are therefore included in the total
for fixed costs.
3. Enumerate the prominent distinguishing factors between job costing and contract costing.
