December 16, 2021

Reasons for Absorption of Overheads The following are a list of situations where analysis of overheads will be useful in evaluation of the relevant cost data. These situations include: a. The control of overhead expenditures There must be a link between overhead costs and the manager responsible for its control. This is best achieved by having the planned level of overhead costs for each cost center compared to the actual cost incurred in order that any differences may be investigated and corrective measures taken. b. Charging of overheads to cost units Overheads relating to a specific job must be charged to that product, job or process in order to come up with the correct cost of the cost object or unit. Each product or job should share a part of indirect costs of the business. c. Valuation of work in progress Work in progress is partly completed goods in manufacturing industries. Such work in progress must be valued at the end of an accounting period to enable calculate profit and derive a balance sheet. For manufacturing firms, work in progress (work in process) forms part of the inventory. Therefore, it becomes necessary to deter- mine with accuracy the value of the work in process which comprises prime cost and manufacturing overheads. d. Valuation of abnormal losses Abnormal losses arise when the actual output given the budgeted input yields less than the expected output. (Abnormal loss = Expected output – actual output). That is, the actual loss incurred exceeds the expected or normal loss. (Abnormal loss = Actual loss – Normal loss). They arise due to unanticipated inefficiencies in production. Such losses need to be charged to the departments that incur them for efficiency analysis purposes. e. Profit measurement The valuation of work in progress and finished goods stock will affect the profit reported. The basis on which production overhead has been absorbed by cost units will, therefore, have a direct influence on the level of profit reported during the period. f. Decision making Relevant costs are the only ones that trigger decision making process. Production overhead costs may be allocated to a department (cost center) or apportioned to it using some arbitrary apportionment basis. In other cases, overhead cost may be a fixed or variable behavior pattern as activity changes. The total costs associated with cost center and the organization as a whole affect the kind of decisions made by the management. But such relevant costs need to be incremental and future costs (not sunk costs) that are controllable by management.  

MATERIAL/INVENTORY COSTING Introduction Materials are the tangible inputs into the process of producing useful output. Materials apply to firms that undergo manufacturing processes as part of their operations. Material costs form a large percentage of the cost of production and this is why they are normally incorporated under prime costs. Definition of Key Terms Materials: Materials refer to physical substances used as inputs to production or manufacturing; they can also be defined as any substance used in construction such as building bricks, cement and concrete. Purchase cost This is the price charged by the supplier on an item of inventory. Maximum stock level This is the upper limit above which stock should not be allowed to exceed. Re-order level It is a point that lies between minimum and maximum stock levels at which purchase orders must be placed to ensure that goods ordered are received before the minimum stock level is reached. Purposes of keeping inventory by firms Buffer inventories Firms keep these inventories to protect themselves against the uncertainties of demand and supply. To meet these uncertainties, firms normally hold inventories in excess of average or expected demand. They may also keep excess stocks to meet requirements during the time for which lead-time goes beyond normal. Anticipation inventory Firms keep some items of stock in anticipation that future demand for the item will increase. The whole idea underlying anticipation inventory is to smoothen the production process. This is attained by producing for a longer duration for continuous basis rather than operating with excessive overtime in one period leaving the system to be idle or close down for reason of inad- equate or no demand. Appreciation inventory Firms hold inventory in anticipation of an increase in price. Some items of inventory such as wines and spirits and jewelry appreciate in value the longer they are kept in the warehouse. However, quantitative models do not take into account the appreciation inventory. Inventory Decisions Inventory management is important since most organizations like merchandising and manufacturing firms; inventory represents the largest single investment. The major types of inventory are raw materials, work in progress and finished goods. Majority of the decisions regarding the inventory are made by the manager in charge of inventory control and management. These decisions include: 1. The optimal quantity to order in order to minimize the inventory total costs. 2. When to make an order. 3. What commodities to stock. 4. The amount of safety stock to be kept in anticipation of variation in demand and supply among others. The overall objective of inventory control is to maintain stock levels that minimize the total costs. These costs include the holding costs, acquisition or purchase costs, stock out costs and ordering costs.

Elements of Cost and Cost Behavior Cost Classifications Cost classification is defined as the arrangement of cost items in a logical sequence having regard to their nature and purpose to be fulfilled. Costs are classified according to the cost objectives. Cost objective is the activity for which a separate measure of cost is desired. They include, cost stock valuation, cost for decision-making and cost for control purposes. The most common cost classifications include: Classification based on cost behavior Cost behavior means how costs will respond or react to changes in the activity level, that is, as we increase output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can be used to produce various classifications of costs such as: Variable costs These are costs that increase or decrease, in total, in direct proportion to changes in the total level of activity or number of units produced i.e. that portion of the cost of an activity that change with the level of output. Examples of variable costs include wages paid to casual employees paid on an hourly basis and fuel cost based on mileage. With variable costs, the cost level is zero when production is zero. With variable costs, the cost level is zero when production is zero. For a cost to be variable there should be an activity base which drives it. This activity base is a measure of effort that operates as a casual factor in the incurrence of variable costs. Thus to control these costs, cost accountants should be well acquainted with the various cost drivers (activity bases) within the organization. Semi variable costs These are costs with both a fixed and variable cost component. The fixed component is that portion which is constant irrespective of the level of activity. They are variable within certain activity levels but are fixed within other activity levels. Fixed Costs These are costs that do not change with the level of output. They are also called autonomous costs, as they remain the same irrespective of the activity level. Fixed costs can be taken to be either committed fixed costs or discretionary fixed costs. Fixed costs that cannot be avoided in the short run are called committed fixed costs. They sometimes are also referred to as capacity costs. Such costs concern senior  managers for strategic decision making. Discretionary fixed costs are those that can entirely be avoided without having an immediate impact on the level of activity. These costs are subject to management decision e.g. advertisement costs. Semi fixed costs These are costs that are fixed only within a relevant range of activity level beyond which they rise to a higher fixed level. They are sometimes referred to as step costs. Semi variable costs These are costs that are variable only within a relevant range of activity level beyond which they may remain fixed before assuming variability again.

Characteristics of an efficient Cost Accounting system An efficient cost accounting system should meet all its objectives and achieve all the advantages of a good cost accounting system. It should possess the following characteristics and should be taken into consideration at the time of installation of a cost accounting system. 1. Suitability to the business: Cost accounting system should be made to suit the specific needs of an organization, division department even a product line. The system should be designed according to the needs, requirements and size of the business. It should supply the necessary information for running the business efficiently. 2. Simplicity: The system should not be complicated. It should be simple and capable of being understood by the costing staff without much difficulty. 3. Flexibility: The cost accounting system should be designed in such a way that it may be flexible enough to be changed according to the fast changing conditions and circumstances of business and industry. Thus, the system must have the capacity of expansion or contraction without much difficulty. 4. Cost Effective: The system should be economical both in installation and operation. The benefits to be derived from the system must be more than the costs involved. It must be adapted according to the financial capacity of the business. 5. Comparability: The costing system should provide all the necessary facts and figures to the management for evaluating the performance by making a comparison of these figures with the past figures of the same concern or those of other concern or against industry as a whole or other departments of the same concern. 6. Timely presentation of information: The system should be capable of providing accurate and timely information so that the management can make decisions for effective cost control. 7. Minimum changes in the existing organization structure: The costing system must not disturb much the existing system of delegation and division of authority and responsibility. The system should be designed in such a way that it requires as minimum changes as possible in the organizational set-up. 8. Uniformity of forms: All the forms, proformas, procedures etc. used throughout the organization should be uniform in size and quality of paper. This avoids confusion and leads to quicker and better understanding of cost data by staff in different departments. 9. Minimum clerical work: Since most of the workers are not well educated, forms and procedures should be designed in such a way that clerical work is reduced to the minimum. 10. Effective control on materials: As materials usually account for a greater proposition of the total cost, there should be an efficient system of stores control. 11. Adequate control on labour cost: There should be well defined procedures for recording of time, preparation of wage sheets and disbursement of wages. There should be strict control on idle time, holiday with pay and overtime. 12. Departmentalization of overheads: There should be an effective system of collection, allocation, apportionment and absorption of overheads so that ascertainment of accurate cost is possible. 13. Reconciliation of cost and financial Accounts: Cost accounting should be designed in such a way that it is possible of integrate or reconcile both cost accounting and financial accounting systems. This can be done through control accounts. 14. Defining duties and Responsibilities of Cost Accountant: Under a good system of cost accounting the rights, duties and responsibilities, of the cost accountant should be clearly defined. Because of this, he is able to know clearly whom he should approach, which information and which cost reports are to be made ready for whom by what time. 15. Timely availability of cost reports: The system should be designed in such a manner that cost reports and other cost information are made available as and when required.

Differences between Cost Accounting and Financial Accounting Financial accounting is the preparation and communication of financial information to owners to provide information about how management of the enterprise has discharged its stewardship and custodial responsibilities for the use of resources entrusted to it. Cost accounting can be distinguished from financial accounting in various perspectives as considered below: a) Legal requirements There is a statutory requirement for public limited companies (Company’s Act Cap. 486 of the laws of Kenya) to provide annual financial accounting reports regardless of whether or not the management of the company regard this information as important. The reports are usually in the form of a balance sheet, an income statement, a cash flow statement and a statement of changes in equity position of the enterprise. However, cost accounting information is entirely optional and information should only be produced if it is considered to be cost beneficial to the organization, that is, the benefits to be derived from such information should exceed the cost of providing the information. b) The role of the GAAPs Financial accounting statements must be prepared and published in conformity with the legal requirements and the generally accepted accounting principles (GAAPs) established by the regulatory bodies such as FASB and IASC. Cost accountants are not required to adhere to the GAAPs when providing managerial information for internal purposes. The focus is on servicing management needs and providing information useful to managers relating to their decision making, planning and controlling functions. c) Time dimension Financial accounting incorporates historical cost accounting. It reports what has already happened in the past in an organization. Cost accounting is both historical and futuristic. It is concerned with future events and therefore the management requires details of expected future costs and revenues. d) Report frequency Financial accounting requires that a detailed set of financial accounts is published annually. Less detailed accounts can be obtained on a semiannual or quarterly basis. On the other hand, cost accounting information reports are prepared on a daily, weekly or other more frequent basis than the financial accounting reports depending on the management needs for such reports in order to trigger decision making processes. e) Focus of individual parts or segments of the business Financial accounting reports describe the entire business whereas cost accounting  focuses on small parts of the organization such as cost and profitability of products, services, customers and activities. This shifts the focus on analysis of segments of the business in order to allow examination by job, process, product or service. f) Outward versus inward focus Cost accounting is inwardly focused because it aims at providing information to internal users, the managers and employees. Financial accounting on the other hand is mostly outward focused as it aims at providing information mostly to outside users including shareholders, the government and competitors. g) Incorporation of non-monetary measures In financial accounting the monetary base is predominant. However, non-monetary measures are used in the interpretation of cost accounting statements. For example, the act expressing net profit as a percentage of sales revenue. In cost accounting there is greater use of non-monetary measures. Quantitative information may be useful in areas such as material losses (kilos or as a percentage input), machine efficiency (as a percentage of a predetermined standard).