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Process costing: Weighted average approach and first-in-first-out approach
Weighted Average Method– It is used in such companies wherein inventories are difficult to be distinguished. For example, chemicals that are bought two months back cannot be differentiated from the one bought today as they are mixed well. So we work out an average cost for all chemicals that we have in our possession. The method specifically involves working out an average cost per unit at each point in time after purchase.
FIFO– It is one of the common methods used to calculate inventory at the end of the year. In this method, inventory purchased first is sold out first rather than inventory purchased last. For example, inventory purchased on Jan 1, 2018, will be sold first rather than inventory purchased on Jan 20, 2018. Thus, the cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory.
Process costing: Spoilage, scrap and reworked products
Spoilage– Spoilage is the waste that is generated in the process of production. The term is most commonly applied to raw materials that have a short life span, such as food used in the hospitality industry. Normal spoilage is generally unavoidable and it is the standard amount of waste generated in the process. Whereas abnormal spoilage exceeds the normal spoilage and it is avoidable.
Scrap– There are 3 options for the accounting treatment of Scrap
1- Nominal sales price realized out of negligible scrap is treated as other income in cost account.
2- A scrap account is opened with the full amount of a scrap of the process or job if such a scrap value is significant. Process account or job account is given credit by the value of scrap. The scrap account is closed by the balance either of profit or loss to the profit or loss account.
3- Net sales value of scrap after deduction of selling and distribution costs is deducted either from the overhead amount or from the material cost. Deduction out of overheads is made to adjust the overhead ratio if scrap is not possible to identify in relation to a process or a job.
Cost Allocation: Allocating cost of service Departments
There are two methods of allocating the cost of service departments. One is, Direct Method and the other one is, Step method.
Direct method– In this method, service department cost is directly transferred to a productive department and these productive departments are those departments which rely on the service department. Allocation is based on the logical benchmark. For example- Cafeteria cost may be allocated on the basis of a number of employees.
Step Method– Many times a service department provide services to another service department. A service department’s cost is first allocated to other units, including other service departments. Then the cost is finally added to the production department.
Cost Allocation: By Product Costing and Joint Product Costing
A joint cost is a cost that benefits more than one product, while a by-product is a product that is a minor result of a production process and which has minor sales. It is used when the final products are split off during the last stage of production.
a) Meaning- When the production of two or more products are made with the same input and process, it is known as Joint Product. Whereas, by product is accidentally produced product during the operation of other product.
b) Economic Value- Economic value of the joint product is the same whereas the economic value of by-product is lower than the main product.
c) Input- Input in case of Joint Product is Raw material and in case of by-product, it is waste or scrap of the main product.
d) Further processing- It is not required in the case of by-product whereas required to turn the joint products into the finished product.
The process of Managerial Decision Making
a) Establishing objectives- Organization must define its goals and objectives that they want to achieve in the future.
b) Identify Alternatives- Management must identify all the alternatives that are available to achieve the objectives. They must not go for the right answer in this stage but should list down the possible alternatives of achieving an objective.
c) Exploring Alternatives- After identifying the alternatives, in this stage management must evaluate the alternatives on the basis of feasibility, risk, impact and benefit.
d) Selection of Alternatives- Management must rank alternatives after the evaluation and must choose the one with the higher ranking.
e) Keeping a check- Process doesn’t end with just selecting an alternative. Management must keep a check on the decision and must make necessary actions to keep the deviation away.
a) Strategy- If a company has an objective of maximizing profit, it will tend to keep a higher price whereas a company with social maximization objective will keep low price.
b) Cost-Based Pricing- In this method, a markup value is added in the cost. It makes sure that the cost of the product is fully recovered.
c) Value-Based Pricing- Value-based pricing is a pricing method wherein prices are set based on the buyer’s perceived value.
d) Competition Based Pricing- In this type of method, the organization will take into account the prices that are set by the competition for the given product and on this basis; it will keep the price of the product.
e) Penetration Pricing and Price Skimming- Penetration pricing involves setting low prices with the intention of quickly introducing a new product to the market. Price skimming involves setting high initial prices to make huge profits in the early stages of the product’s life cycle.
Fixed Cost- Fixed cost refers to that cost which also incurs at zero production and which doesn’t change in relation to change in quantity. For example, Gym membership amount is fixed. Even if the person goes there or not, it will incur.
Fixed cost is represented by F.
In business, there are many examples of fixed costs. The cost of a building or equipment and the cost of equipment are typically considered to be variable because a specific amount is spent, and the amount of activity follows.
Variable Cost- Variable cost refers to that cost which changes with the change in production. Average cost per unit remains constant because it varies in direct proportion.
Total Variable Cost = Variable Cost per unit X Units of a product
Mixed Cost- Mixed cost refers to that type of cost which is both variable and fixed in nature. It is also known as the semi-variable cost. This means that a mixed cost increases as quantity increases, but not proportionately. The average cost per unit decreases (eventually approaching the variable cost per unit) as quantity increases.
Total mixed cost = Variable Cost per unit X Units of a product + Fixed Cost
Inventory refers to finished goods, work in progress and raw materials. It means those goods which are used in the production process of the company. It is considered as an asset. So there must be a clear method which is used to ascertain cost to the inventory to record it as an asset.
The valuation of inventory is not a minor issue, because the accounting method used to create a valuation has a direct bearing on the amount of expense charged to the cost of goods sold in an accounting period, and therefore on the amount of income earned.
Not always it happens that prices remain constant. It changes over the period so an organization ends up having the same type of goods with different prices. When an organization sells these, they have to decide at what prices they are going to sell these inventories. There are various methods to value inventory and they are:
a) FIFO- It refers to First in First out. It assumes that an organization must sell the items which are bought first, so the remaining items are the newest ones.
b) LIFO- It refers to last in First out. In this method, items which are bought last are sold first and remaining ones are the old items. This policy does not follow the natural flow of inventory in most companies; in fact, the method is banned under International Financial Reporting Standards.
c) Weighted Average Method
It refers to finding out deviation that occurs between planned and actual behavior. For example, an organization predicts 200 units’ sales in a given day, but it achieves 150. So, it will try to find out the reason for the deviation of 50 sales. Variance analysis typically involves the isolation of different causes for the variation in income and expenses over a given period from the budgeted standards.
Types of Variance-
a) Sales Volume
b) Sales Mix
c) Sales Quantity
d) Sales Price
e) Direct Material Price
f) Direct Material Usage
g) Direct Material Yield
h) Direct Labor
i) Variable Overhead
j) Fixed Overhead Total Variance
a) Planning, Standard and Benchmarks- It encourages forward thinking because to calculate the variance, an organization needs standards or planned behavior.
b) Control Mechanism- It highlights the variance which affects the financial performance of an organization. Thus, it also helps in making decisions regarding the financial stability of the organization.
c) Responsibility Accounting- It facilitates performance measurement and control at the departments, divisions, etc. For example, the procurement department shall be answerable in case of a substantial increase in the purchasing cost of raw materials.April 5, 2019 at 5:41 am in reply to: Activity Based Costing and Customer Profitability Analysis #16667
It is a method which precisely allocates the overheads to those items that actually use it. Activity-based costing is a method of assigning indirect costs to products and services which involves finding the cost of each activity involved in the production process and assigning costs to each product based on its consumption of each activity. It is a more refined approach than traditional costing. Process in ABC:
a) Identify those activities which are involved in the production.
b) Classification of each activity according to cost hierarchy.
c) Identify and accumulate the total cost of each activity.
d) Identify the most appropriate cost driver.
e) Calculation of total units of the cost driver relevant to each activity.
f) Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver.
g) Application of the cost of each activity to products based on its activity usage by the product.
Customer Profitability Analysis is best conducted with the ABC method. It let the company know about the profit that is coming from each customer. All the cost like manufacturing, selling, marketing, service and other costs are deducted from revenue to know the profit.
It is a framework used by the organizations to estimate the cost of their product or service for the use of profitability analysis, inventory valuation and cost control. Cost is a major part of any product or service, thus it becomes absolutely important for the firms to estimate the cost accurately for profitable operations. The firm must see whether the product is profitable or not. And it can only be ascertained when the accurate cost will be taken into account. Further, a product costing system helps in estimating the closing value of materials inventory, work-in-progress and finished goods inventory for the purpose of financial statement preparation.
Job Order Costing– This type of costing system accumulates manufacturing costs separately for each job. It is more useful to the firms which are into manufacturing unique products and special orders.
Process Costing– This type of costing system accumulates manufacturing costs separately for each process. It is appropriate for products whose production is a process involving different departments and costs flow from one department to another.
a) Cost Object- It is an activity, a product or a service, a customer, a project, a contract, a process or a department of the organization for which cost measurement is made.
b) Cost Unit- It is a device used for the purpose of breaking up or separating cost into smaller subdivisions. It is the unit of product or service in relation to which cost may be ascertained.
c) Cost Centre- It is the smallest segment of activity or area for which costs are accumulated. These cost centers are the departments or sub-departments of an organization with reference to which cost is collected.
d) Cost Accumulation- It refers to the systematic process engaged by the organizations to collect cost data of its operations by using an accounting system.
e) Cost Methods- These are the methods which are used to ascertain the cost of production. Costing methods differ from industry to industry.
There are two types of Costing:
1) Job Costing
2) Process Costing
a) Contract costing
b) Batch Costing
c) Multiple Costing
a) Service Costing
b) Operation Costing
c) Output CostingApril 5, 2019 at 5:36 am in reply to: The role of management accounting in the organization #16661
a) Formulate Financial Strategies– Financial strategies with the help of sales forecasts, budget, job costing techniques and other managerial tools can be formulated by the management accountants. Data can be taken from various financial statements to make strategies to enhance profit and earnings per share.
b) Financial Consequences of Decisions– When senior leaders make changes in the capital structure of the company; accountants can help the leader by telling them the advantages and disadvantages of adding debt or equity. Some of the decisions look good but they are really good or not is found when the company digs into the number.
c) Monitoring Expenses– Management accountant creates reports and budgets which helps the department heads about the allocation of the expenses. This is so important because all the operating expenses have a direct impact on the profit. Management can select optimal techniques which will help the company in running as efficiently as possible.
d) Maintenance of Profitability– There are various tools which help the management in keeping their business profitable. For instance, break-even analysis. With this analysis, the company measures sales against variable and fixed cost and determine a point where the company will be a balance.