TOPIC 2 – THE COST CLASSIFICATION

2.1 Provide the costing for materials and store organization

2.1.1 Describe the materials control – Inventory control is the
systematic control and regulation of purchase, storage and usage
of materials in such a way as to maintain an even flow of production
and at the same time avoiding excessive investment in materials.
Efficient material control reduces loses and wastages of materials
that otherwise pass unnoticed. Material control is a planned
method of determining what to indent, so that purchasing and
storing costs are minimum without affecting production or sales.
2.1.2 Explain purchasing department’s functions, purchasing
procedures, storing control and raw material issuing procedures.
The routine followed for the purchase of materials are usually as
follows: indenting for materials; issuing of tenders and receiving
quotations; placing of order; inspecting stores received; receiving
the stores accepted in inspection; and checking and passing bills
for payment.
Among the functions of store control: receipt of material into
storage; record keeping; storage of materials; maintaining stores;
issuing stores; and coordinating materials control.
Procedures in issuing raw materials include: planning of material
requirement; requisition of materials; internal audit of issues;
control of wastage; and issue of sundry items.
2.1.3 Economic Order Quantity, Inventory control levels and
inventory turnover ratio.
Economic Order Quantity - is the order quantity that minimizes the
total holding costs and ordering costs.
EOQ = 2CoD
Cs
Where Co = cost of placing and receiving order
Cs = carrying cost per unit
D = total quantity demand (quantity required annually)

Example : Soapy Sip is a detergent manufacturer. The cost per

order for product SS1 is RM40 and its carrying cost per unit is
RM10 per annum. There is a demand for 3000 units per month.
Calculate : a. EOQ = 2 x 40 x (3000 x 12) = 537 units
10
b. Number orders required per annum = 36 000= 67 orders
537

Stock level – its objective is to ensure that overstocking and

understocking does not occur.
Re-order level – the minimum amount of an item/stock that a
company or department holds before replenishing the stock.
Re-order level = maximum usage x maximum re-order period

Maximum stock level – the largest amount of stock that a

company/department is allowed to keep/hold at any time.
Max stock level = re-order level + EOQ – (minimum usage x
minimum re-order period)
Minimum stock level – also known as safety stock, the lowest
level the stock
Minimum stock level = re-order level – (average usage x
average re-order period)

Stock turnover ratio – shows how many times a company’s

inventory is sold and replaced during a certain period.
Stock turnover ratio = Cost of material used during a period
Average stock of materials held during a period

Illustration:
Two Components, A and B are used as follows:
Normal usage 50 units per week each
Maximum usage 75 units per week each
Minimum usage 25 units per week each
Re-order quantity A : 300 units; B : 500 units
Re-Order period A : 4 to 6 Weeks; B: 2 to 4 weeks

Calculate for each component

(a) Re-ordering level,
(b) Minimum level,
(c) Maximum level
(d) Average Stock level.
Solution:
(a) Re-ordering level: Maximum usage per week x Maximum
re-order period.
Re-ordering level for component A = 75 units x 6 Weeks = 450
units
Re-ordering level for component B = 75 units x 4 Weeks = 300
units
(b) Minimum level : Re-order level – (Normal usage x
average period)
Minimum level for component A = 450 units - 50 units x 5
weeks = 200 units
Minimum level for component B = 300 units - 50 units x 3
weeks = 150 units
(c) Maximum level : ROL + ROQ – (Min. Usage x Minimum
period)
Maximum level for component A = (450 units + 300 units) –
(25 units x 4weeks) = 650 units
Maximum level for component B = (300 units + 500 units) –
(25 units x 2 weeks) = 750 units
(d) Average stock level : ½ (Minimum + maximum) Stock
level
Average stock level or component A = ½ (200 units + 650
units) = 425 units.
Average stock level for component B = ½ (150 units + 750
units) = 450 units.

2.1.4 Perpetual Inventory System – is intended as an aid to

material control where information about each receipt, issue and
current balance of stock is always available.
Example: The following is a summary of the receipts and issues of
materials in a factory during January 2020. Calculate the value of
the closing stock using FIFO, LIFO and Weighted Average.
Date Receipt (kg) Price/kg Issuing (kg)
January 1 100 RM 1.00
5 26 RM 1.05
6 70
12 40 RM 1.15
20 30 RM 1.20
24 60
25 20

Solution: FIFO
Date Receipt Issued Balance RM
Jan 1 100 @ 1.00 100 @ 1.00
Jan 5 26 @ 1.05 100 @ 1.00
26 @ 1.05
Jan 6 70 @ 1.00 30 @ 1.00
26 @ 1.05
Jan 12 40 @ 1.15 30 @ 1.00
26 @ 1.05
40 @ 1.15
Jan 20 30 @ 1.20 30 @ 1.00
26 @ 1.05
40 @ 1.15
30 @ 1.20
Jan 24 60 : 36 @ 1.15
30 @ 1.00 30 @ 1.20
26 @ 1.05
4 @ 1.15
Jan 25 20 @ 1.15 16 @ 1.15 18.40
30 @ 1.20 36.00
=
54.40
Solution : LIFO
Date Receipt Issued Balance RM
Jan 1 100 @ 1.00 100 @ 1.00
Jan 5 26 @ 1.05 100 @ 1.00
26 @ 1.05
Jan 6 70 : 56 @ 1.00
26 @ 1.05
44 @ 1.00
Jan 12 40 @ 1.15 56 @ 1.00
40 @ 1.15
Jan 20 30 @ 1.20 56 @ 1.00
40 @ 1.15
30 @ 1.20
Jan 24 60: 56 @ 1.00
30 @ 1.20 10 @ 1.15
30 @ 1.15
Jan 25 20: 46 @ 1.00 46.00
10 @ 1.15
10 @ 1.00

Solution: WA
Date Receipt Issued Balance RM
Jan 1 100 @ 1.00 100 @ 1.00
Jan 5 26 @ 1.05 100 @ 1.00 100.00
26 @ 1.05 27.30
126 @ 1.01 127.30
Jan 6 70 @ 1.01 56 @ 1.01
Jan 12 40 @ 1.15 56 @ 1.01 56.56
40 @ 1.15 46.00
Jan 20 30 @ 1.20 56 @ 1.01 56.56
40 @ 1.15 46.00
30 @ 1.20 36.00
126 @ 1.10 138.56
Jan 24 60 @ 1.10 66 @ 1.10
Jan 25 20 @ 1.10 46 @ 1.10 50.60

2.2 Provide the costing for labour costs

2.2.1 Direct Labour: Labour which can be conveniently
identified with a particular cost centre or cost unit, the
remuneration which is payable to direct workers is direct
wages. Ex- wages paid to machine operators, furniture maker,
shoe maker, tailor etc.
Indirect labour: Such cost cannot be conveniently
identified with a specific job, product or process but can be
apportioned to or absorbed by cost centres or cost units. The
remuneration which is paid to indirect workers is known as
indirect wages. Ex- Services of supervisor, inspector,
foreman, time keeping officers, cleaners, general managers
etc.
2.2.2 It has been stated above that labour is an essential
element of the process of production, and it also plays a vital
role in producing a product. In large organisation or concerns,
labour is controlled by following five departments :
1. Personnel Department: In personnel department, selection,
appointment and placement of workers after a suitable
training is made.
2. Work Study and Engineering Department: In work study
and engineering department, work study related activities
such as planning, job specification, job analysis, time and
motion study, safe working conditions and supervision of the
production process are performed.
3. Time-keeping Department: In time-keeping department,
attendance of workers and calculation of wages of workers
are recorded.
4. Payroll Department: In this department, payroll, wages
sheet and distribution of wages are recorded.
5. Cost Accounting Department: In this department,
accounting for all labour cost is recorded.
2.2.3 a. Time based scheme – the worker is paid at an
hourly, daily or weekly rate, most commonly used is day rate
system, and wages are calculated using the formula below:
Wages = hours worked X rate per hour
b. Piecework scheme – the worker is paid on the basis
of output, the more he produces, the more pay he will get.
Wages = units produced X rate per unit
c. Bonus scheme – workers qualify for a bonus on top of
their basic wage by working at an above target standard of
efficiency. Bonus is paid on time saved ( difference between
time allowed and time taken; where time taken is lesser than
time allowed).
Halsey bonus scheme : Bonus = ½ x time saved x
basic day rate
Halsey Weir bonus scheme : Bonus = 1/3 x time saved
x basic day rate
Rowan bonus scheme : Bonus = Time taken x time saved x basic
Time allowed day rate
Example: the following information is related to two workers,
Ali and Abu who work at Zee Sdn Bhd for the month of
September 2020:
Ali Abu
Time taken 62 hours 60 hours
Time 12% more than 25% more than
allowed/Standard time taken time taken
time
Rate per hour RM 2.50 RM 3.00
Rate per unit RM 0.20 RM 0.50
Units produced 180 units 240 units
Damaged units 8 units 5 units
Additional information:
a. Normal working time starts at 8.00 am until 6.00 pm, 5 days
a week.
b. The company has decided to pay for the damaged units
because the raw materials used were not of high quality.
You are required to calculate the total wages received by each
worker using the Halsey, Halsey Weir and Rowan bonus
scheme and also piecework scheme.
Ali Abu
Time allowed 62 x 112% = 69.44 60 x 125% = 75
hours hours
Time taken 62 hours 60 hours
Time saved 7.44 hours 15 hours
Basic pay Time taken x rate per hour
62 hours x RM 60 hours x RM
2.50 3.00
= RM 155.00 = RM 180.00
Bonus Halsey ½ x 7.44 hours x ½ x 15 hours x RM
RM 2.50 3.00
= RM 9.30 = RM 22.50
 Total pay with RM 164.30 RM 202.50
Halsey bonus
Bonus Halsey 1/3 x 7.44 hours x 1/3 x 15 hours x
Weir RM 2.50 RM 3.00
= RM 6.20 = RM 15
Total pay with RM 161.20 RM 195
Halsey Weir bonus
Bonus Rowan 62/69.44 x 7.44 x 60/75 x 15 x RM
RM 2.50 3.00
= RM16.71 = RM 36
Total pay with RM 171.71 RM 216
Rowan bonus
Piecework scheme (180 + 8) x RM (240 + 5) x RM
0.20 0.50
= RM 37.60 = RM 122.50

2.3 Provide the costing for overheads

The concept of overhead - Overhead costs refer to those
items of cost which cannot be identified with particular
products or processes or specific jobs or work orders. These
are neither direct material nor direct wages, nor are these
expenses of a direct nature, so these cannot become the
direct cost of manufacturing.
CIMA defines overhead cost as “The total cost of indirect
material, indirect labour and indirect expenses.
Classification of Overheads
Overheads : i.Production/Manufacturing/Factory
overheads
ii. Administrative overheads
iii. Selling and Distribution overheads
CIMA defines classification as “the arrangement of items in
logical groups having regard to their nature (subjective) or the
purpose to be fulfilled (objective classification)” It is the
process of arrangement of items into groups according to their
degree of similarity.
Allocation - Primary Distribution Certain items of overheads
can be clearly identifiable to the related job or cost unit e.g.
repairs and maintenance incurred for specific department,
indirect wage or other expenses for particular department etc..
Allotment of such items to specific department is known as
allocation. Thus, charging the whole amount of particular
expense to particular department or cost centre is called as
allocation of overheads.
Apportionment of overheads - Certain items of overheads
cannot be clearly allocated to any particular department or
cost centre. In fact, these are combined expenses or
overheads. Distribution of these combined overheads to
various departments is known as apportionment of
overheads. This is an indirect process to proportionate the
amount of overhead on some equitable basis. This is also
called as primary distribution of overheads, because in this
distribution all the overhead cost should be allocated or
apportioned to the production and service departments.
Re-apportionment of overheads – in this process, the
service department overheads are re-apportioned to the
production departments based on the proportionate benefit
derived by those production departments, so that their
overhead costs can be absorbed into the final product. The
overhead costs of the service departments should be
assigned to production departments because service
 departments do not work directly on producing the final
product.
Two common ways to re-apportion overhead costs are:
a. Simultaneous equation method – overheads are allocated
to the production and service department according to an
equation given.
b. Repeated distribution method – overheads of service
department are re-apportioned to other service and
production cost centres based on percentage.
Excellent Limited has two production departments, Dept A and
Dept B, and two service departments, Dept X and Dept Y. The
following data was given:
Total Dept A Dept B Dept X Dept Y
(RM) (RM) (RM) (RM)
Indirect 75 000 20 000 30 000 15 000 10 000
wages
Indirect 17 500 5 000 5 500 3 000 4 000
material
Machine 8 000
insurance
Rent and 21 000
rates
Canteen 14 000
Additional details are also given:
Dept A Dept B Dept X Dept Y
(RM) (RM) (RM) (RM)
Floor area 3 000 1 500 600 400
occupied (m2)
Direct labour 20 000 10 200
hours
Machine hours 40 000 30 500
 Direct labour 4 3
rate (RM)
Machine value 30 000 20 000
No.of employees 60 40
The overhead costs in the service department are re-apportioned
according to the table below:
a.
Dept A Dept B Dept X Dept Y
Dept X 40% 60% - -
Dept Y 60% 40% - -
b.
Dept A Dept B Dept X Dept Y
Dept X 30% 60% - 10%
Dept Y 60% 30% 10% -
REQUIRED:
Allocate the overhead costs for each department and also re-
apportion the overhead costs for each department.
Suggested basis for overhead apportionment:
Overhead costs Suitable basis
Rent, rates, air-conditioning, Floor area
lighting, electricity, depreciation of
building, insurance of building
Depreciation and insurance of Book value of asset
machine, equipment, building,
vehicle
Any expenses associated with Number of employees
employees such as supervision,
canteen costs, welfare costs, office
expenses
Machine department costs Machine hours
Power for machinery Kilowatt hours

Solution:
Basis Dept A Dept B Dept X Dept Y
Allocation of
overheads:
Indirect 20000 30000 15000 10000
wages
Indirect 5000 5500 3000 4000
material
Total 25000 35500 18000 14000
allocation
Apportionme
nt of
overheads:
Machine Machin 30000/50 20000/50 - -
insurance e value 000 x 000 x
RM8000 8000 = 8000 =
4800 3200
Rent and Floor 3000/550 1500/550 600/55 400/55
rates area 0 x 21000 0 x 2100000 x 00 x
RM 21 000 occupie = 11455 = 5727 21000 21000
d = 2291 = 1527
Canteen No.of 60/100 x 40/100 x - -
RM 14 000 employ 14000 = 14000 =
ees 8400 5600
Total 24655 14527 2291 1527
apportionme
nt
TOTAL 49655 50027 20291 15527
OVERHEAD
S
Re-apportionment (a):
Dept A Dept B Dept X Dept Y
Total 49655 50027 20291 15527
overheads
Re-apportion 40% x 60% x (20291) -
Dept X 20291 = 20291 =
8116.40 12174.60
Re-apportion 60% x 40% x - (15527)
Dept Y 15527 = 15527 =
9316.20 6210.80
Total 67087.60 68412.40 - -
overhead after
re-
apportionment

Dept A Dept B Dept X Dept Y

Total 49655 50027 20291 15527
overheads
Re-apportion 30% x 60% x (20291) 10% x
Dept X 20291 = 20291 = 20291 =
6087.30 12174.60 2029.10

17556.10
Re-apportion 60% x 30% x 10% x (17556.10)
Dept Y 17556.10 17556.10 17556.10
= = 5266.83 = 1755.61
10533.66
1755.61
 Re-apportion 30% x 60% x (1755.61) 10% x
Dept X 1755.61 = 1755.61 = 1755.61 =
526.68 1053.37 175.56
175.56
Re-apportion 60% x 30% x 10% x (175.56)
Dept Y 175.56 = 175.56 = 175.56 =
105.34 52.67 17.56
17.56
Final re- 50% x 50% x (17.56)
apportion 17.56 = 17.56 =
8.78 8.78
Total 66916.76 68683.25
overhead after
re-
apportionment

Overhead absorption
Is the process to assign overheads accumulated against
production cost centres to the cost units. Overhead absorption rate
(OAR) is a base rate to absorb overhead into cost units.
OAR = Production overhead
Amount of allocation base

Pre-determined overhead rate=Budgeted production overhead

(POR) Budgeted amount of allocation base
Absorbed overhead=POR x amount of allocation base incurred

Over or under absorbed overhead

Over absorbed = absorbed overhead > actual overhead
Under absorbed = absorbed overhead < actual overhead

Example:
Below is the budgeted data for BR Ltd for September 2020:
Factory overheads RM 55 000
Machine hours 17 500 hours
Direct labour hours 12 000 hours
The actual results for September 2020 are as follow:
Factory overheads RM 65 000
Machine hours 15 500 hours
Direct labour hours 18 000 hours
Calculate the under or over absorbed overhead for BR Ltd.
Solution:
a. Machine hours
POR = RM 55 000 = RM 3.14 per machine hour
17 500 hours
Absorbed overhead = RM 3.14 x 15 500 hours
= RM 48 670
Actual overhead RM 65 000
Absorbed overhead RM 48 670
Under absorbed RM 16 330
 b. Direct labour hours
POR = RM 55 000 = RM 4.58 per direct labour hour
12 000 hours
Absorbed overhead = RM 4.58 x 18 000 hours
= RM 82 440
Actual overhead RM 65 000
Absorbed overhead RM 82 440
Over absorbed RM 17 440

ACTIVITY BASED COSTING (ABC)

Activity based costing focuses on the need for better understanding
of the overhead costs behavior so it helps to ascertain causes of
costs and how they relate to product or services.
Process of Activity Based Costing
ABC is the process of tracing cost just from resources to activities
through the activity drivers and then partner from activities to
specific products on the basis of cost drivers. The following steps
are involved to conduct the activity based costing:
1) Identification and Classification of the Activities: Activities are
identified and then classified into different categories that have
relationship with different parts of the production process for e.g.
machine related activities, labour related activities and various
supporting activities.
2) Creation of Cost Pools for Each Activity: To compute and classify
overhead cost of different activities into homogenous cost pools is
the second step in the ABC system.
3) Identification of Cost Drivers: After the second step the next step
is to determine the cost drivers for every activity that can be used
to select the costs collected in cost pools to the cost objective. This
is based on the factor that drivers are the consumption of the
activity.
4) Calculation and Interpretation of Cost of Earn Activity: the next
step in ABC system is to determine the resource and cost of each
activity. It is already known that each activity consumes resources
which increase the cost of the product.
5) Assigning Activity Cost to Products: The final step in the ABC
system is the assigning or tracing activity cost to products or
outputs using activity drivers which requires calculation of activity
'cost driver state' or 'pool state' for each activity. This is determined
by dividing the actual cost of cost pool by actual activity level of
cost driver. Activity driver assign activity cost to product which is
based on consumption of individual products and calculated by
multiplying the actual activity level on quantity consumed by cost
driver state.
Recognize the difference between traditional costing and
activity - based costing.
Activity: any event, action, transaction, or work sequence that
incurs cost when producing a product or providing a service.
Activity Cost Pool: the overhead cost attributed to a distinct type
of activity For example: ordering materials or setting up machines
Cost Drivers: any factor or activity that have a direct cause-effect
relationship with the resources consumed.

ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: The overhead costs allocated to the cost pools is
assigned to products using cost drivers.
The more complex a product’s manufacturing operation, the more
activities and cost drivers likely to be present.

ILLUSTRATION
Lift Jack Company has seven activity cost pools and two products.
It expects to produce 200,000 units of its automobile scissors jack
and 80,000 units of its truck hydraulic jack. Having identified its
activity cost pools and the cost drivers for each cost pool, Lift Jack
Company accumulated the following data relative to those activity
cost pools and cost drivers.

Annual Overhead Data Expected Use of

Cost Drivers per
Product
Activity Cost Estimate Expecte Scissor Hydrauli
Cost Pool Drivers d d Use of s Jacks c Jacks
Overhea Cost
d Drivers
(RM) per
Activity
Ordering Purchas 200 000 2 500 1 000 1 500
and e orders orders
Receiving
Machine Setups 600 000
1 200 500 700
setup setups
Machining Machine 2 000 000 800 000 300 000 500 000
hours hours
Assemblin Parts 1 800 000 3 000 1 800 1 200
g 000 000 000
parts
Inspecting Tests 700 000 35 000 20 000 15 000
and tests
testing
Painting Parts 300 000 3 000 1 800 1 200
000 000 000
parts
Supervisin Direct 1 200 000 200 000 130 000 70 000
g labour hours
hours

Using the previous data, do the following:

a. Prepare a schedule showing the computations of the activity-
based overhead rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead cost to
the two products.
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit
a. Prepare a schedule showing the computations of the activity-
based overhead rates per cost driver.
Activity cost Estimated ÷ Expected = Activity
pools overhead use of cost based
(RM) drivers per overhead
activity rates (RM)
Ordering and 200 000 ÷ 2 500 orders = 80 per order
receiving
Machine set 600 000 ÷ 1 200 set-ups = 500 per set
up up
Machining 2 000 000 ÷ 800 000 = 2.50 per hour
hours
Assembling 1 800 000 ÷ 3 000 000 = 0.60 per part
parts
Inspecting 700 000 ÷ 35 000 tests = 20 per test
and testing
Painting 300 000 ÷ 3 000 000 = 0.10 per part
parts
Supervising 1 200 000 ÷ 200 000 = 6 per hour
hours

b. Prepare a schedule assigning each activity’s overhead cost to

the two products.
Scissors Jacks
Activity cost Expected X Activity = Cost
pools use of cost based assigned
drivers per overhead (RM)
product rates (RM)
Ordering and 1 000 80 per order 80 000
receiving
Machine set 500 500 per set 250 000
up up
Machining 300 000 2.50 per hour 750 000
Assembling 1 800 000 0.60 per part 1 080 000
Inspecting 20 000 20 per test 400 000
and testing
Painting 1 800 000 0.10 per part 180 000
Supervising 130 000 6 per hour 780 000
Total Assigned Costs 3 520 000

Hydraulic Jacks
Activity cost Expected X Activity = Cost
pools use of cost based assigned
drivers per overhead (RM)
product rates (RM)
Ordering and 1 500 80 per order 120 000
receiving
Machine set 700 500 per set 350 000
up up
Machining 500 000 2.50 per hour 1 250 000
Assembling 1 200 000 0.60 per part 720 000
Inspecting 15 000 20 per test 300 000
and testing
Painting 1 200 000 0.10 per part 120 000
Supervising 70 000 6 per hour 420 000
Total Assigned Costs 3 280 000

c. Compute the overhead cost per unit for each product.

Scissors Jacks Hydraulic Jacks
Total costs assigned RM 3 520 000 RM 3 280 000
Total units 200 000 80 000
produced
Overhead cost per RM 17.60 RM 41.00
unit
d. Comment on the comparative overhead cost per unit
These data show that the total overhead assigned to 80,000
hydraulic jacks is nearly as great as the overhead assigned to
200,000 scissors jacks. However, the overhead cost per hydraulic
jack is RM41, but it is only RM17.60 per scissors jack.