Management Accounting 1A

CAAM3651
Presented by: Michelle //Naobes
Part-time lecturer
Email: khomxate@gmail.com
Try out the following website for
management accounting:
www.accountingformanagement.com
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Meaning of Management Accounting
It is the process of preparing management accounts that provide accurate and timely
key financial and statistical information required by managers to make day-to-day short
term decisions.

The objectives of a management accounting system are much more complex than
those of a financial accounting system and include quantification and analysis of the
strategic qualities of past, present and future expected relevant costs and revenue
generating activities.

Financial Accounting
The objective of financial accounting is to provide information that is useful for external
users to make decisions relating to their investment in a particular company and to
analyse how the company is performing.

The objective of a financial accounting system is to classify ad accumulate revenue and

cost (cost of sales) and expenses (administration and selling) on an absorption cost
basis and calculating the net profit before taxation.

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A typical financial Accounting costing exercise will involve the
following:

Financial Accounting System

Absorption costing

Product Costing

Allocate costs to Production and

Service Department
Allocate costs from Service
to Production Departments
Select an Activity Base
Calculate an overhead recovery rate

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A typical financial Accounting costing exercise will involve the
following:

Management Accounting System

Variable costing

Performance Analysis

Relevant Costing

Contribution
Cost Volume Profit (CVP)

Limiting factors
Probability estimates
Cost estimates
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 Difference between management accounting
and financial accounting
Financial Accounting
• Statements are useful to external users
• Groups costs by expense nature or
function to arrive at cost of sales and gross
and net profits
• Financial reports are periodic and based
on formal external statutes
• Reports are based on accurate historical
costs and accrual concept
• and Value Added Management (VAM) (cost-benefit
Is reactive and reports overall results and
overall financial information/analysis
• Follows rules, standards and conventions
to fairly present financial position and
results to shareholders
• Financial reports ignores risk
Management Accounting
• Reports are useful for internal users/management
• Uses variable and relevant cost to determine
product cost and a basis for management decisions
• Reports are frequent, based on informal
management needs and decision-relevant costs
• Reports are mostly future-orientated and based on
cost estimates, standards and cash flows
• Proactively seeks to maximise product contribution
analysis)
• Records, measures, determines and analyses costs
and revenues towards effective situation-specific
decision making and performance evaluation
• Risk forms part of all management decisions
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 Cost behaviour and systems for recording and controlling costs
• Very important terminology used in Management Accounting (Refer to pages 19-21 of
Managerial Accounting by Prof. F Vigario).
• Specifically look at product costs, period costs, prime costs and conversion costs and know
the difference between these costs. Prime costs and products costs are almost similar, but do
not confuse the two. (Prime cost = unit of production, Product cost = all products
manufactured). (Also see pages 28-34 of Drury).
• Absorption costing
• Know and understand the definitions of cost allocation, cost objective, direct costs, indirect
cost and cost absorption rate.
• Valuation of inventory = inventory is valued at the lower of cost or net realisable value.
- Cost includes the cost to purchase, cost of conversion and other costs incurred in bringing the
inventory to its present location and condition.
- Conversion costs include direct labour.
- Fixed production overheads allocated to the cost of products are allocated on the basis of
normal production capacity. (FOR Rate)
- Un-allocated overheads are recognised as an expense in the period in which they are
incurred.

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 Cost behaviour and systems for recording and controlling costs
• Absorption costing
• Cost allocation (steps)
1. Allocate relevant production overheads to the production and service department.
2. Reallocate service department costs to the production departments. Methods include:
- Direct allocation method
- Step cost allocation method
- Reciprocal allocation method
3. Identify the activity most common to a specific production department and use that activity to determine
the cost recovery rate.
4. Lets go through the examples 1 and 2 in Vigario on pages 27-31.
Pre-determined Overhead Rates
- Indirect overhead costs are also allocated to the job/product.
- The problem with this is that the actual costs can only be calculated long after the job is completed.
- Using pre-determined overhead rates solves this problem.
- Example in Vigario, pages 33-37.
- Under / over recovery
- This can only occur in a fully-integrated absorption costing system.
- It is caused by: - actual overhead incurred being different to budget overhead.
- actual activity volume being different to the budget activity volume.
- Go through the example on page 38 of Vigario.

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 Material and Labour costs
• Raw material costs
- It is assumed that the material are not used from existing inventory but would be purchased.
- Thus the estimated cost of the material would be the relevant material cost.
- Where materials are taken from the existing inventory, the original purchase price represents a past or
sunk costs and is irrelevant for decision-making.
- Material would then be purchased and additional acquisition costs would be incurred.
- These costs are replacement costs and is the relevant cost of the material.
• Inventory levels
- Since inventory carrying costs can contribute significantly to total costs, there is a need to carry just about
enough inventory to satisfy the customer demands.
- Inventories held in a supply chain belong to four categories: Raw materials, work-in-process (unfinished
and semi-finished parts), finished goods inventory, and spare parts.
- Each type of inventory is held for different reasons and there is a need to keep optimal levels of each type
of inventory.
- Thus measuring the actual inventory levels will provide a useful picture of system efficiency.
- First, you must know how much inventory to have on hand to ensure continuity of supply in the event of
an uncharacteristic increase in either demand and/or lead time. This quantity of inventory is called the
safety stock.

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 Material and Labour costs
• Inventory management
- Managing inventory is vital in saving costs.
- First, you must know how much inventory to have on hand to ensure continuity of supply in the event of an uncharacteristic
increase in either demand and/or lead time. This quantity of inventory is called the safety stock.
- Second, you must know when to reorder materials for inventory. Generally, this point in time is determined when the quantity
of materials in stock decreases to a certain level, called the reorder point.
- Third, you must know how much to order. A complex mathematical equation determines the Economic Order Quantity, or
EOQ.
- The equation recognizes the tug of war between acquisition costs and inventory carrying costs: when you order bigger
quantities less frequently, your aggregate acquisition costs are low but your inventory costs are high due to higher inventory
levels.
- Conversely, when you order smaller quantities more often, your inventory costs are low but your acquisition costs are higher
because you are expending more resources on ordering.
- The EOQ is the order quantity that minimizes the sum of these two costs.

ROP = SSQ + (QUD x ALT)

Where,

ROP = Reorder Point

SSQ = Safety Stock Quantity

QUD = Quantity Used Daily

ALT = Average Lead Time (in days)

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 Material and Labour costs
• Purchasing and storage of inventory
- Inventory should be stored properly, to ensure that it is in a good condition when it is sold to the
customers.
- Proper storage will ensure that inventory is not broken or unusable.
• Selective inventory techniques
- JIT Analysis (We will focus on this one among all the others)
- ABC Analysis
- VED Analysis
- SOS Analysis
- HML Analysis

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 Material and Labour costs
• Just in time production (JIT)
- Just in time is a ‘pull’ system of production, so actual orders provide a signal for when a product should be manufactured.
Demand-pull enables a firm to produce only what is required, in the correct quantity and at the correct time.
- This means that stock levels of raw materials, components, work in progress and finished goods can be kept to a minimum.
This requires a carefully planned scheduling and flow of resources through the production process. Modern manufacturing
firms use sophisticated production scheduling software to plan production for each period of time, which includes ordering
the correct stock. Information is exchanged with suppliers and customers through EDI (Electronic Data Interchange) to help
ensure that every detail is correct.
- Supplies are delivered right to the production line only when they are needed. For example, a car manufacturing plant might
receive exactly the right number and type of tyres for one day’s production, and the supplier would be expected to deliver
them to the correct loading bay on the production line within a very narrow time slot.

• Advantages of JIT
- Lower stock holding means a reduction in storage space which saves rent and insurance costs
- As stock is only obtained when it is needed, less working capital is tied up in stock
- There is less likelihood of stock perishing, becoming obsolete or out of date
- Avoids the build-up of unsold finished product that can occur with sudden changes in demand
- Less time is spent on checking and re-working the product of others as the emphasis is on getting the work right first time

• Disadvantages of JIT
- There is little room for mistakes as minimal stock is kept for re-working faulty product
- Production is very reliant on suppliers and if stock is not delivered on time, the whole production schedule can be delayed
- There is no spare finished product available to meet unexpected orders, because all product is made to meet actual orders –
however, JIT is a very responsive method of production.

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 Material and Labour costs
• Economic Order Quantity
• Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and
ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost.
• In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of
minimizing annual inventory cost.
• The quantity to order at a given time must be determined by balancing two factors: (1) the cost of possessing or carrying
materials and (2) the cost of acquiring or ordering materials. Purchasing larger quantities may decrease the unit cost of
acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time.
• The carrying cost of inventory may include:
- Interest on investment of working capital
- Property tax and insurance
- Storage cost, handling cost
- Deterioration and shrinkage of stocks
- Obsolescence of stocks.

• Underlying Assumptions of Economic Order Quantity:

- The ordering cost is constant.
- The rate of demand is constant
- The lead time is fixed
- The purchase price of the item is constant i.e no discount is available
- The replenishment is made instantaneously, the whole batch is delivered at once.

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 Material and Labour costs
• Formula

EOQ =

Where: Where:
A  =  Demand for the year S = Annual sales in units
Cp  =  Cost to place a single order OR F = Fixed costs of placing and receiving an order
Ch  =  Cost to hold one unit inventory for a year C = Carrying cost of one unit of inventory for one year
* =×
• Example:
• Pam runs a mail-order business for gym equipment.  Annual demand for the TricoFlexers is 16,000.  The
annual holding cost per unit is $2.50 and the cost to place an order is $50. 
• Calculation:

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 Material and Labour costs
• Example
ABC Ltd is the publisher of a series of ‘keep-fit’ books. One of their production is a book on body building. The
book sells for N$40 and costs ABC Ltd N$20 to purchase if from the printers. The ordering is N$12.50 and the
carrying cost is N$5 per unit per annum. The ‘lead time’ from the time of ordering to the time of delivery is
seven days. Annual demand in the past has been constant at 2000 units per annum.

• Payroll accounting
The computation of gross pay for each employee and the calculation of payments to be made to employees,
government, pension funds and social security is payroll accounting.

Now read through the attached pages 84-87 from Management and Cost Accounting (latest edition (7th
edition ), Author(s): Colin Drury.

NOTE: WE WILL ONLY GO THROUGH THESE PAGES DURING THE LECTURE TO GIVE YOU A BRIEF OVERVIEW OF
THE TOPIC AND TO DO THAT EXAMPLE ON PAGES 86-87.

• Methods of compensation
- Cost plus fixed-fee
- Lump sum payment
- Cost per unit or work

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 Material and Labour costs
• Individual and group incentive plans
• Types of Individual Incentive Plans
- Piecework plans
- Management incentive plans
- Behavior encouragement plans
- Referral plans

Advantages

• Helps relate pay to performance

• Promotes equitable distribution of compensation
• Helps retain best performers

• Types of Group Incentive Plans

- Rewards employees for their collective performance
- Use has increased in industry
- 2 types
– Team - based or small group
– Gain/profit sharing

• Allocation Methods
- Equal incentive payments
- Differential payments based on contribution to goals
- Differential payments according to base pay

• Profit Sharing Plans

- Current profit sharing plans
- Deferred profit sharing plans

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 Material and Labour costs
• Fringe benefits
• What are fringe benefits and why are they important?
In addition to salary, employers may provide fringe benefits. Benefits can include many perks that will
allow you to choose a job that has the most compensation for your work.  As you begin your job search,
you need to know what you should be looking for in a benefit package. It is important to keep in mind not
only benefits you will utilize now, but also those you will use in the future.

• What are examples of benefits?

The most common benefit packages include medical aid, disability insurance, paid vacation time, paid
holidays, paid sick leave and retirement plans. Many employers are beginning to lump all time off into one
group called paid time off, or PTO. A more comprehensive package may include child-care services, flexible
work schedule, maternity leave, relocation expenses, and education programs.  Benefits are most often
offered in packages, but there are also cafeteria style plans where employees choose the types of benefits
they want.  You need to decide which benefits are the most important to you.

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 Material and Labour costs
• Learning curves and cost estimation
NOTE: COST ESTIMATION WILL BE DONE IN THE FIRST LECTURE AFTER THE TEST WHICH WILL BE
ON 25 MARCH 2011 AND IS THEREFORE NOT IN THE SCOPE OF THE FIRST TEST.

Please read through and attempt the examples on pages 179-182 and the Appendix on page
184.

NOTE: THE MATHEMATICAL METHOD ON PAGES 182-183 WILL NOT BE EXAMINED IN THE TESTS
AND EXAMS.

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 Accounting for overheads costs
• Identification and coding of overheads
What are overheads costs
Overhead costs also called manufacturing overhead costs may be fixed or variable, but are not directly linked to the product
manufactured. They may vary, but not necessarily with production. In an absorption costing system, these costs are allocated to a
unit of production. Only manufacturing overheads may be included in the valuation of closing stock in an absorption costing
system. Variable costing would treat the cost as a period cost and write it off in the period that it is occurred. Administration
overheads or selling overheads must never be associated with production.

• What is manufacturing overhead and what does it include?

• Manufacturing overhead (also known as factory overhead, factory burden, production overhead) involves a company’s factory
operations. It includes the costs incurred in the factory other than the costs of direct materials and direct labour. This is the
reason that manufacturing overhead is often classified as an indirect product cost.
• Generally accepted accounting principles require that cost of direct material cost, direct labour, and manufacturing overhead
be considered as the cost of products for valuing inventory and for determining the cost of goods sold. (Expenses that are
outside of the factory, such as selling, general and administrative expenses, are not product costs and are not inventorial. They
are reported as expenses on the income statement in the accounting period in which they occur.)
• Examples of manufacturing overhead include the depreciation or the rent on the factory building, depreciation on the factory
equipment, supervisors in the factory, the factory quality control department, factory maintenance employees, electricity and
gas for the factory, indirect factory supplies, etc.
• Because manufacturing overhead is an indirect cost, management accountants are faced with the task of assigning or
allocating overhead costs to each of the units produced. This is a challenging task because there may be no direct relationship.
(For example, the property tax on the factory building is based on its assessed value and not on the number of units produced.
Yet the property tax must be assigned to the units manufactured.)

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 Accounting for overheads costs
• Identification and coding of overheads
What are overheads costs
Examples of manufacturing overhead include items such as indirect material, indirect labor, maintenance and repairs on production
equipment and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. Indirect materials are minor
items such as solder and glue in manufacturing industries. These are not included in direct materials costs. Indirect labor is a labor cost
that cannot be trace to the creation of products or that can be traced only at great cost and inconvenience. Indirect labor includes the
labor cost of janitors, supervisors, materials handlers and night security guards. Costs incurred for heat and light, property taxes,
insurance, depreciation and so forth associated with selling and administrative functions are not included in manufacturing overhead.

Definition and explanation of non-manufacturing cost:

- Non-manufacturing costs are those costs that are not  incurred to manufacture a product. Examples of such costs are salary of
sales person and advertising expenses. Generally non-manufacturing costs are further classified into two categories, namely:
• Marketing and Selling Costs
• Administrative Costs

Marketing or Selling Costs:

• Marketing or selling costs include all costs necessary to secure customer orders and get the finished product into the hands of
the customers. These costs are often called order getting or order filling costs. Examples of marketing or selling costs include
advertising costs, shipping costs, sales commission and sales salary.

Administrative Costs:
• Administrative costs include all executive, organizational, and clerical costs associated with general management of an
organization rather than with manufacturing, marketing, or selling. Examples of administrative costs include executive
compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration
of the organization as a whole.

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 Accounting for overheads costs
• Collection, allocation and apportionment and absorption of overheads
• Overhead: allocating your costs efficiently
• Cost allocation is one of the more difficult tasks in running your business. Accurately understanding your costs, however, are
imperative if you want your business to succeed. You have to price your products or services in a way to be profitable and
allocating costs is a major part of profitability.
• Costs are divided into three major categories of direct materials, direct labour, and overhead. Direct materials and labour
are easy to calculate because they are the core activities and substance of what your business does. If you are in
construction then your direct materials are steel and concrete. Direct labour is the labour used to construct whatever it is
you are building. These costs are traceable. Overhead, on the other hand, is not so easily figured out.
• Overhead consists of every other activity or material that you use to do business. Overhead is your business’s indirect costs
and is not easily managed. Figuring out indirect costs is one of the biggest challenges in cost allocation and there are two
methods that are used to allocate overhead in today’s business world.

Allocation of overheads

Allocation of overheads are done on one of the following methods:

- Direct allocation method
- Indirect allocation method
- Reciprocal allocation method

REFER BACK TO SLIDES 7. Refer examples 1 and 2 in Vigario on pages 27-31 for an illustration of the 3 methods.

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 Accounting for overheads costs
• Cost drivers and overhead costs
• Ideally, a cost driver is an activity that is the root cause of why a cost occurs.
• In the past century, the root cause of indirect manufacturing costs has changed from a single cost driver
(such as direct labour hours) to several cost drivers. Due to sophisticated manufacturing and increased
demands from customers, direct labour is no longer the main cost driver of indirect manufacturing
overhead.
• In addition to direct labour, today’s drivers of indirect manufacturing costs include the number of machine
setups required, the number of engineering change orders, the demands from customers for special
inspections, handling and storage, the number of components in the units produced, and the number of
production machine hours.
• Manufacturers that want to know the true costs of their products need to know what is driving their
indirect manufacturing costs. For these companies it is not sufficient to merely spread overhead costs to
products by using a single factor such as direct labour hours or production machine hours.

REFER BACK TO SLIDES 7. Refer examples 1 and 2 in Vigario on pages 27-31 for an illustration of
how cost drivers are used.

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 Accounting for overheads costs
• Production, administration and marketing overheads
Production overheads

These are exactly the same as manufacturing overheads. Refer to slide 18.

Definition and explanation of non-manufacturing cost:

- Non-manufacturing costs are those costs that are not  incurred to manufacture a product. Examples of such
costs are salary of sales person and advertising expenses. Generally non-manufacturing costs are further
classified into two categories, namely:
• Marketing and Selling Costs
• Administrative Costs

Marketing or Selling Costs:

• Marketing or selling costs include all costs necessary to secure customer orders and get the finished product
into the hands of the customers. These costs are often called order getting or order filling costs. Examples of
marketing or selling costs include advertising costs, shipping costs, sales commission and sales salary.

Administrative Costs:
• Administrative costs include all executive, organizational, and clerical costs associated with general
management of an organization rather than with manufacturing, marketing, or selling. Examples of
administrative costs include executive compensation, general accounting, secretarial, public relations, and
similar costs involved in the overall, general administration of the organization as a whole.

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 Variable and Absorption Costing Statement

Variable Costing Statement Absorption Costing Statement

N$ N$

Sales xxx,xxx Sales xxx,xxx

Product cost (xxx,xxx) Product cost (xxx,xxx)

Direct/variable material xxx Direct/variable material xxx
Direct/varaible labour xxx Direct/varaible labour xxx
Variable manufacturing costs xxx Variable manufacturing costs xxx
All other variable costs xxx Fixed manufacturing costs xxx

Contribution xxx,xxx Gross Profit xxx,xxx

Fixed manufacturing costs (xxx) All other fixed costs (xxx)

All other fixed costs (xxx) All other variable costs (xxx)

Profit xxx,xxx Profit xxx,xxx

Note:
The profit in a variable costing statement and an absorption costing statement is the same ONLY when there are
no opening and closing stock/inventories.

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 Job order costing- Contract costing
• Main features of contracts and types of contracts
Contract costing is a form of specific order costing which applies where work is undertaken to customers specific requirements
and each order is of long-term duration (compared with those to which job costing applies). Contract costing is that method of
costing in cost accounting which is used to collect and identify all the expenses relating to a specific contract.

Features of contracts and types of contracts

- Construction activity
- Site work
- Long duration of work and difficulty in profit apportionment
- Risk and uncertainly
- Custom made work
- Cost are accumulated and ascertained contract-wise
- Identification at production stage

Some common types of contracts are used in the engineering and construction industry
- Lump Sum Contract
- Unit Price Contract
- Cost Plus Contract
- Incentive Contracts
- Percentage of Construction Fee Contracts

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 Job order costing- Contract costing
Features of contracts and types of contracts
- Construction activity – in a contract, the work mainly involved is construction activity. Generally the design, manufacture or
construction of a single substantial asset forms the heart of the contract.
- Site work – in the case of a manufacture concern, the manufacture is done at the manufacturer’s premises under one roof.
However, in the case of contracts, the work is done at the customer’ site away from the contractor’s premises.
- Long duration of work and difficulty in profit apportionment – the work undertaken is of long duration and extends beyond
one accounting period. This creates a special accounting problem in apportioning profit on a contract to different accounting
periods during the execution of the contract.
- Risk and uncertainly – unlike manufacturing, contract work involves a lot of risk and uncertainty.
- Custom made work – the work involved in a contract is carried out according to the tastes and requirements of the customers.
- Cost are accumulated and ascertained contract-wise – a job order number is allotted to each contract and costs are
accumulated and determined for each contact.
- Identification at production stage – it is possible to identify each contract from start to finish.

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 Job order costing- Contract costing
• Lump Sum Contract
With this kind of contract the engineer and/or contractor agrees to do the a described and specified project for a fixed price. Also named
"Fixed Fee Contract". Often used in engineering contracts. A Fixed Fee or Lump Sum Contract is suitable if the scope and schedule of the
project are sufficiently defined to allow the consulting engineer to estimate project costs.

• Unit Price Contract

This kind of contract is based on estimated quantities of items included in the project and their unit prices. The final price of the project is
dependent on the quantities needed to carry out the work. In general this contract is only suitable for construction and supplier projects
where the different types of items, but not their numbers, can be accurately identified in the contract documents. It is not unusual to
combine a Unit Price Contract for parts of the project with a Lump Sum Contract or other types of contracts.

• Cost Plus Contract

A contract agreement wherein the purchaser agrees to pay the cost of all labour and materials plus an amount for contractor overhead
and profit (usually as a percentage of the labour and material cost). The contracts may be specified as:

- Cost + Fixed Percentage Contract

- Cost + Fixed Fee Contract
- Cost + Fixed Fee with Guaranteed Maximum Price Contract
- Cost + Fixed Fee with Bonus Contract
- Cost + Fixed Fee with Guaranteed Maximum Price and Bonus Contract
- Cost + Fixed Fee with Agreement for Sharing Any Cost Savings Contract

This types of contracts are favoured where the scope of the work is indeterminate or highly uncertain and the kinds of labor, material and
equipment needed are also uncertain. Under this arrangement complete records of all time and materials spent by the contractor on the
work must be maintained.

• Cost + Fixed Percentage Contract

Compensation is based on a percentage of the cost.

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 Job order costing- Contract costing
• Cost + Fixed Fee Contract
Compensation is based on a fixed sum independent the final project cost. The customer agrees to reimburse the contractor's actual costs, regardless of amount,
and in addition pay a negotiated fee independent of the amount of the actual costs.

• Cost + Fixed Fee with Guaranteed Maximum Price Contract

Compensation is based on a fixed sum of money. The total project cost will not exceed an agreed upper limit.

• Cost + Fixed Fee with Bonus Contract

Compensation is based on a fixed sum of money. A bonus is given if the project finish below budget, ahead of schedule etc.

• Cost + Fixed Fee with Guaranteed Maximum Price and Bonus Contract
Compensation is based on a fixed sum of money. The total project cost will not exceed an agreed upper limit and a bonus is given if the project is finished below
budget, ahead of schedule etc.

• Cost + Fixed Fee with Agreement for Sharing Any Cost Savings Contract
Compensation is based on a fixed sum of money. Any cost savings are shared with the buyer and the contractor.

• Incentive Contracts
Compensation is based on the engineering and/or contracting performance according an agreed target - budget, schedule and/or quality.
The two basic categories of incentive contracts are:
- Fixed Price Incentive Contracts
- Cost Reimbursement Incentive Contracts

Fixed Price Incentive Contracts are preferred when contract costs and performance requirements are reasonably certain.
Cost Reimbursement Contract provides the initially negotiated fee to be adjusted later by a formula based on the relationship of total allowable costs to total
target costs. This type of contract specifies a target cost, a target fee, minimum and maximum fees, and a fee adjustment formula. After project performance,
the fee payable to the contractor is determined in accordance with the formula.

• Percentage of Construction Fee Contracts

Common for engineering contracts. Compensation is based on a percentage of the construction costs.

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 Job order costing- Contract costing
Methods for determining profit for incomplete contracts

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 Job order costing- Contract costing
• Contract cost accounts

• Contract Account
Contact account is that account who shows all the expenses in its debit side. Credit side of this account, we show value
contract price or work certified value. Difference between debit and credit side of will show notional profit or loss.
 
• Following are main Contract Expenses and Costs which shows in Contract Account under Contract Costing :
 
• 1. Material Cost 
Material or raw material which is used for construction is the main expense or contract cost and it will be debited in contract
account. It is supplied from store or purchased from market directly. If material is transferred from any other contract, then
its cost will be adjusted on the basis of material transfer note.

• 2. Labour Cost
On the basis of wages analysis sheet, labour cost is calculated for a specific contract order. If same labourer is used more than
one contract, then time devoted to each contract is calculated and on this basis, labour cost is allocated.

• 3. Direct Expenses
We also add direct expenses, if any.

• 4. Overheads
Overheads an be allocated on the basis of some % on cost of material, wages or prime cost.

• 5. Sub- Contract Cost

It will also include in contract cost, if to complete sub-construction for main construction.

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 Job order costing- Contract costing
There are no hard and fast rules for the calculation of the figures for profit to be taken to the credit of profit
and loss account. However, the following rules may be followed:

(a) Profit should be considered in respect of work certified only, work uncertified should always be valued at
cost.

(b) No profit should be taken into consideration if the amount of work certified is less than 1/4 of the contract
price because in such cases it is not possible to foresee the future clearly.

(c) If the amount of work certified is 1/4 or more but less than1/2 of the contract price, 1/3 of the profit
disclosed, as reduced but the percentage of cash received from the contractee, should be taken to the profit
and loss account. The balance should be allowed to remain as a reserve.

(d) If the amount of work certified is very much near completion, if possible the total cost of completing the
contract should be estimated The estimated total profit on the contract then can be calculated by deducting
the total estimated cost from the contract price. The profit and loss should be credited with that proportion of
total estimated profit on cash basis, which the work certified bears to the total contract price.

(f) The whole of loss, if any, should be transferred to the profit and loss account.

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 Job order costing- Contract costing
Work in Progress:
At the end of the accounting period a contract may still be in progress. The term work in progress refers to the
work done so for in respect of the contract, which is still incomplete. It consists of the following:

(1) Working Certified:

It refers to the work approved by the contractee. In case of contracts it is the useful practice for the contractor
to get the work approved from time to time from the contractee. This is helpful to the contractor in two ways;
first in case the contractee finds the work not up to specifications, he may ask the contractor to take corrective
actions in time.

Second, in contract accounts it is useful practice to have a system of progress payments, i.e., the contract agrees
to pay a certain percentage of the work certified (say, 80 or 90 percent). This is advantageous to the contractor
since he gets immediate liquid funds.

(2) Work Uncertified: It refers to the work which has been done by the contractor but not so far approved by the
contracted.

Work certified generally includes some profit element also while work uncertified is always valued at cost to the
contractor.

Sub Contracts:
The contractor may entrust some portion of the work to be done under the contract to a sub-contractor. Usually
work of a specialized nature, i.e., steel work, special flooring, etc., is done by sub-contractors, who are
responsible to the main contractor. The cost of such sub-contracts is a direct charge against the contract for
which the work has been done.

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 Job order costing- Contract costing
Worked example
Contract ABC started on 1 July 2002. Costs to 31 December 2002, when the company's accounting year ends, are
derived from the following information.
N$
Direct materials issued from store 40,000
Materials returned to the store 1,000
Direct labour 36,000
Plant issued, at book value 1 July 2002 50,000
Written down plant value as at 31 December, 2002 30,000
Materials on site, 31 December, 2002 3,000
Overhead costs 5,000

As at 31 December, 2002, certificates had been issued for work valued at N$100,000 and the contractee had
made progress payments of N$70,000. The company has calculated that more work has been done since the last
certificates were issued, and that the cost of the work done but not yet certified is N$14,000. The final contract
price is N$175,000 and the estimated total cost of the contract is N$130,000.

Solution to the worked example

Contract account Dr Cr
Materials 40,000 Contract price 130,000
Direct labour 36,000 Materials returned 1,000
Plant issued at book value 50,000 Plant written down (c/d) 30,000
Overheads 5,000 Materials )c/d) 3,000
Profit or loss account (Notional profit) 33,000
164,000 164,000
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 Job order costing- Contract costing
Total anticipated profit N$
Contract price 175,000
130,000
Costs incurred (14,000 + 83,000) 97,000
Estimated costs to complete
(130,000 - 97,000) 33,000

Estimated profit (175,000 - 130,000) 45,000

Estimated degree of completion

Therefore, profit to date:

sales basis = N$45,000 * 57.14% = N$25,714.29
cost basis = N$45,000 * 74.62% = N$33,576.92

ESTIMATED PROFIT METHOD (90% OR MORE COMPLETE)

Method Formula Workings To CPL To RUP
WC Accrual EP x WC/CP 45,000 x (100,000/175,000) 25,714.29 7,285.71
45,000 x (100,000/175,000) x
WC CASH EP x WC/CP x CR/WC (70,000/100,000) 18,000.00 15,000.00
CTD Accrual EP x CTD/ETC 45,000 x (97,000/130,000) 33,576.92 (576.92)
45,000 x (97,000/130,000) x
CTD CASH EP x CTD/ETC x CR/WC (70,000/100,000) 23,503.85 9,496.15

NOTIONAL PROFIT METHOD (90% OR MORE COMPLETE)

Method Formula Workings To CPL To RUP
< 25% NP x CR/WC 33,000 x (70,000/100,000) - 23,100.00
>= 25% but < 50% NP x 1/3 x CR/WC 33,000 x 1/3 x (70,000/100,000) 7,700.00 25,300.00
>= 50% but < 90% NP x 2/3 x CR/WC 33,000 x 2/3 x (70,000/100,000) 15,400.00 17,600.00
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 Process costing
• Cost of Production Report (CPR)

• Definition and Explanation of Cost of Production Report (CPR):

• A departmental cost of production report (CPR) shows all costs chargeable to a department. It is not only the source for
summary journal entries at the end of the month but also a most convenient vehicle for presenting and disposing of costs
accumulated during the month. A cost of production report shows:
• Total unit costs transferred to it from a preceding department.
• Materials, labor, and factory overhead added by the department.
• Unit cost added by the department.
• Total and unit costs accumulated to the end of operations in the department.
• The cost of the beginning and ending work in process inventories.
• Cost transferred to a succeeding department or to a finished goods storeroom.
• It is customary to divide the cost section of the report into two parts: one showing costs for which the department is
accountable, including departmental and cumulative total and unit costs, the other showing the disposition of these costs. A
quantity schedule showing the total number of units for which a department is accountable and the disposition made of these
units is also part of each department's cost of production report. Information in this schedule, adjusted for equivalent
production is used to determine the unit costs added by a department, the costing of the ending work in process inventory, and
the cost to be transferred out of the department.
• A cost of production report determines periodic total and unit costs. However, a report that would merely summarize the total
costs of materials, labor, and factory overhead and shows only the unit cost for the period would not be satisfactory for
controlling costs. Total figures mean very little; cost control requires detailed data. Therefore, in most instances, the total cost is
broken down by cost elements for each department head responsible for the costs incurred. Furthermore, detailed
departmental figures are needed because of the various completion stages of the work in process inventories.
• Either in the cost of production report itself or in the supporting schedules, each item of material used by a department is
listed; every labor operation is shown separately; factory overhead components are noted individually; and a unit cost is derived
for each item. To condense the illustrated cost of production reports, only total materials, labor, and factory overhead charged
to departments are considered; and unit costs are computed only for each cost element rather than for each item.

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 Process costing
• Example:
• The reports of The Clonex Corporation, which manufactures one product in three producing departments (Blending, Testing, and Terminal), are used to
illustrate the details involved in the preparation of cost of production reports. Click on a link to see the report of blending, testing or terminal department.
• The cost of production report of the Blending Department, the originating department of The Clonex Corporation, is shown below. It illustrates the detailed
computations needed to complete a cost of production report.

The Clonex Corporation

Blending Department (1st Dept.)
Cost of Production Report
For the Month of January, 2011
• Quantity Schedule:    

Units started in process   50,000

Units transferred to next department 45,000  
Units still in process (all materials - 1/2 labor and FOH) 4,000  
Units lost in process 1,000
50,000
Cost Charged To the Department:
Total Unit
Cost Cost

Cost added by the department:

Materials $24,500 $0.50
Labor $29,140 $0.62
Factory Overhead (FOH) $28,200 $0.60

Total cost to be accounted for $81,840 $1.72  

Cost Accounted for as Follows:    

Transferred to next department (45,000 × $1.72)   $77,400
Work in process - ending inventory: Materials (4,000 × $0.50) $2,000
Labor (4,000 × 1/2 × $0.60) $1,240
Factory Overhead (4,000 × 1/2 × $0.60) $1,200
$4,440
Total cost accounted for $81,840
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 Process costing
• Example (continued)

Additional Computations
• Equivalent Production:
• Materials = 45,000 + 4,000 = 49,000 units
Labor and factory overhead = 45,000 + 4,000 / 2 = 47,000 units

• Unit Costs:
• Materials = $24,500 / 49,000 = $0.50 per unit
Labor = $29,140 / 47,000 = $0.62 per unit
Factory overhead = $28,200 / 47,000 = 0.60 per unit

• Explanation:
• The quantity schedule of the cost report shows that Blending Department put 50,000 units in process, with units reported in terms of finished product.
Finished units could be stated in pounds, feet, gallons, barrels, etc. If materials issued to a department are stated in pounds and finished product is reported in
gallons, units in the quantity schedule will be in terms of the finished product, gallons. A product conversion table would be used to determine the number of
units for which the department is accountable. The quantity schedule of the Blending Department's report shows that of the 50,000 units for which the
department was responsible, 45,000 units were transferred to the next department (Testing Department - second department), 4,000 units are still in process,
and 1,000 units were lost in processing.

• Equivalent Production:
• Costs charged to a department come from an analysis of  materials used, payroll distribution sheets, and department expense analysis sheets. The Blending
Department's unit cost amounts to $1.72 ( $0.50 for materials, $0.62 for labor, and $0.60 for factory overhead).
• Calculations of individual unit costs requires an analysis of the ending work in process to determine its stage of completion. This analysis is usually made by a
supervisor or is the result of using predetermined formula. Materials, labor, and factory overhead have been used on the 4,000 units in the process but not in
an amount sufficient for completion. To assign costs equitably to in process inventory and transferred units, units still in process must be restated in terms of
completed units, which is 4,000 units for materials cost but less than 4,000 for labor and overhead costs. The figure for partially completed units in process is
added to units actually completed in order to arrive at the equivalent production figure for the period. This equivalent production figure represents the
number of units for which sufficient materials, labor, and overhead were issued or used during a period. Materials, labor and overhead costs are divided by the
appropriate equivalent production figure to compute unit costs by elements. Should a cost element be at a different stage of completion with respect to units
in process, then a separate equivalent production figure must be computed.
• In many manufacturing processes, all materials are issued at the start of production. Unless stated otherwise, the illustrations in this discussion assume such a
procedure. Therefore, the 4,000 units still in process have all the materials needed for their completion but not all labor and factory overhead (FOH). Only 50%
of the labor and factory overhead needed to complete the units has been used. In terms of equivalent production, labor and factory overhead in process are
sufficient to complete 2,000 units.
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 Process costing
• Example (continued)
• Units Costs:
• Departmental cost of production reports indicate the cost of units as they leave department. These individual departmental units costs are
accumulated into a completed unit cost for the period. The report for the Blending Department shows a materials cost of $24,500, labor cost
of $29,140, and factory overhead of $28,200. The materials cost of $24,500 is sufficient to complete 49,000 units (the 45,000 units
transferred out of the department as well as the work in process for which enough materials are in process to complete 4,000 units). The
unit materials cost is, therefore, $0.50 ($24,500 / 49,000). A similar computation determines the number of units actually and potentially
completed with the labor cost of $29,140 and the factory overhead of $28,200. The 2,000 equivalent units in process are added to the
45,000 units completed and transferred to obtain a total equivalent production figure of 47,000 units for both labor and factory overhead
(FOH). When the equivalent production figure of 47,000 units is divided into the monthly labor cost of $29,140, a unit cost for labor of $0.62
($29,140 / 47,000) is computed. The unit cost for factory overhead is $0.60 ($28,200 / 47,000). The unit cost added by the department is
$1.72, which is the sum of the materials, labor, and overhead unit costs - $0.50, $0.62, and $0.60. This departmental unit cost figure cannot
be determined by dividing the total departmental cost of $81,840 by a single equivalent production figure, because no such figure exists;
units in process are at different stages of completion as to materials, labor and factory overhead.
• Disposition of Departmental Costs:
• In the departmental cost report, the section titled "Cost Charged to the Department" shows a total departmental cost of $81,840. The
section titled "Cost Accounted for as Follows" show the disposition of this cost. The 45,000 units transferred to the next department have a
cost of $77,000 (45,000 × $1.72). The balance of the cost to be accounted for, $4,440 ($81,840 - $77,400), is the cost of work in process.
• The inventory figure must be broken down into its component parts: materials, labor, and factory overhead. These individual costs are easily
determined. The cost of materials in process is obtained by multiplying total units in process by the materials unit cost (4,000 × $0.50 =
$2,000). The costs of labor and overhead in process is sufficient to complete only 50 percent or 2,000 of the units in process. Therefore, the
cost of labor in process is $1,240 (2,000 × $0.62) and factory overhead in process is $1,200 (2,000 × $0.60).
• Units Lost in the First Department:
• Lost units reduce the number of units over which total cost can be spread, causing an increase in unit costs. The 1,000 units lost in the
Blending Department increase the units costs of materials, labor, and factory overhead. Had these units not been lost, the equivalent
production figure would be 50,000 units for materials and 48,000 for labor and factory overhead. The unit cost for materials would be $0.49
instead of $0.50; labor, $0.607 instead of 0.62; and factory overhead, $0.588 instead of $0.60. In the first department, the only effect of
losing units is an increase in the unit cost of the remaining good units. In this situation, the loss is assumed to apply to all good units and to
be within normal tolerance limits.
• KINDLY READ AND GO THROUGH PAGES TO 65 TO 74 UP TO JUST BEFORE ‘NORMAL AND ABNORMAL SPOILAGE’ OF
THE PRESCRIBED TEXTBOOK. 4 TH EDITION PLEASE.

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