CHAPTER TWO

COST DETERMINATION: THE COSTING OF RESOURCE INPUTS

2.1. Materials
Material is the most important element of cost. In most manufacturing organizations, 50% to
70% of the total cost of a product is represented by the cost of the material. Material cost was
defined by the Institute of Cost and Management Accountants as follows: “the cost of
commodities supplied to an undertaking for the purpose of consumption in the process of
manufacturing or of rendering service or for transformation into products.” Material is any
substance (Physics term) that forms part of or composed of a finished product. Materials are
either direct materials or indirect materials.
A. Direct Materials: The materials that go into the final product are called raw materials. It is
all materials that eventually become part an integral part of the finished product and that can
be traced to the cost object in an economically feasible way. The characteristics of direct
materials are the following:
 Directly related to and identified with cost centers or cost units. In other words, these are
the items that form part of the product itself (e.g., cotton used for spinning cotton yarn,
wood used in making furniture, or leather used in shoe-making).
 Purchased for a particular job, work order, or contract.
 Finished product of a particular process that forms the raw material of the succeeding
process (e.g., cost of yarn transferred from the spinning process to weaving process).
B. Indirect Materials: are materials that are used in the production process but that are not
directly traceable to the product. For example, glue, oil, tape, cleaning supplies, etc. The
characteristics of indirect materials are the following:
 Cannot be traced but can be apportioned to (or absorbed by) cost centers or cost units.
 Used in such small quantities that it is not possible to ascertain their per-unit cost exactly
(e.g., the cost of thread and nails used in shoe-making).
2.1.1. Accounting for stock (inventory) movements
Material cost 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.

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Objectives of Material Control System
The objectives of a system of material control are as following:
 To make continuous availability of materials so that there may be uninterrupted flow of
materials for production.
 To purchase requisite quantity of materials to avoid locking up of working capital and to
minimize risk of surplus and obsolete stores.
 To make purchase competitively and wisely at the most economical prices.
 To purchase proper quality of materials to have minimum possible wastage of materials.
 To serve as an information center on the materials knowledge for prices, sources of
supply, lead time, quality and specification.
2.1.2 Determination of optimum purchase quantities
The main functions of a purchase department are as follows:
 What to purchase? – Right Material with good quality
 When to purchase? – Right Time
 Where to purchase? – Right Source
 How much to purchase? – Right Quantity
 At what price to purchase? – Right Price
To perform these functions effectively, the purchasing department follows the following
procedure: Receiving purchase requisitions, exploring the sources of supply and choosing the
supplier, preparation and execution of purchase orders, Receiving materials, Inspecting and
testing materials, Checking and passing of bills for payment.
A. Purchase Quantity
The basic factors to be considered while fixing the ordering quantity are as follows:
 There should be no overstocking.
 Materials should always be available in sufficient quantity to meet the requirements of
production and to avoid plant shut down.
 Purchases should be made in economic lots.
Either the top management or by Materials department set the norms for inventories, the top
management usually sets monitory limits for investment in inventories. The materials department
has to allocate this investment to the various items and ensure the smooth operation of the

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concern. A number of factors enter into consideration in the determination of stock levels for
individual items for the purpose of control and economy.
Economic Order Quantity (EOQ)
The basic problems of material control are two viz., what quantity of an item should be ordered
at a time and when should an order be placed. While deciding economic ordering quantity, the
efforts are directed to ascertain the ideal order size. While deciding the ideal order size, factors
such as material carrying charges and the ordering cost associated with the placement of
purchase orders are to be considered; the total of both has to be minimized. The material carrying
charges include interest on the capital invested in the stores of materials, rent for the storage
space, salaries and wages of the store-keeping department, any loss due to pilferage and
deterioration, stores insurance charges, stationery, etc. used by the stores, taxes on inventories,
etc.
Economic Order Quantity is ‘The size of the order for which both ordering and carrying cost
are less’. The economic order quantity (EOQ) is a decision model that, under a given set of
assumptions, calculates the optimal quantity of inventory to order.
Ordering Cost is the costs which are associated with the ordering of material. It includes cost of
staff posted for ordering of goods, expenses incurred on transportation, inspection expenses of
incoming material etc.
Carrying Cost: the costs for holding the inventories and it include the cost of capital invested in
inventories. Cost of storage, Insurance etc.
The optimum ordering quantity, i.e., the quantity for which the cost of holding plus the cost of
purchasing is the minimum is known as Economic ordering Quantity and is calculated by the
following formula:
Relevant total costs = Relevant ordering costs + Relevant carrying costs
We use the following notations:
D = Demand in units for a specified period (one year in this example)
Q = Size of each order (order quantity)
Number of purchase orders per period (one year) = Demand in units for a period (one year) / Size
of each order (order quantity) = (D/Q)
Average inventory in units = Q/2, because each time the inventory goes down to 0, an order for
Q units is received. The inventory varies from Q to 0, so the average inventory is (0 + Q)/ 2.

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P = Relevant ordering cost per purchase order
C = Relevant carrying cost of one unit in stock for the time period used for D (one year). For any
order quantity, Q,
Annual relevant ordering costs = Number of purchase orders per year*Relevant ordering cost
per purchase order = (D/Q)* P
Annual relevant carrying costs = Average inventory in units *Annual relevant carrying cost
per unit = Q/2* C
Annual relevant total costs = Annual relevant ordering costs +Annual relevant carrying costs
RTC = (D/Q)* P + (Q/2)* C
Note: The EOQ model is solved using calculus, but the key intuition is that relevant total costs
are minimized when relevant ordering costs equal relevant carrying costs. If carrying costs are
less (greater) than ordering costs, the total costs can be reduced by increasing (decreasing) the
order quantity.
To solve for EOQ, we set D/Q)* P = (Q/2)* C and Multiplying both sides by 2Q/C,
The order quantity that minimizes annual relevant total costs is
Economic Order Quantity (EOQ) ¿ √ 2 AO /C
Where,
A = Annual demand /Consumption
O = Ordering Cost per order
C = Carrying Cost per unit per annum
The reorder point is the quantity level of inventory on hand that triggers a new purchase order.
The reorder point is simplest to compute when both demand and the purchase-order lead time are
known with certainty.
Reorder point = Number of units sold per time period* Purchase order lead time
The assumptions of Economic Order quantity (EOQ)
The calculation of economic order of material to be purchased is subject to the following
assumptions:
 Ordering cost per order and carrying cost per unit per annum are known and they are
fixed.
 Anticipated usage of material in units is known.
 Cost per unit of the material is constant and is known as well.

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  The quantity of material ordered is received immediately i.e. lead time (time taken to
place and receive an order) is Zero.
2.2. Labor (Employees cost)
Labor Cost is also called as Employee Cost. Employee cost is the benefits paid or payable in all
forms of consideration given for the service rendered by employee (including temporary, part
time and contract employee) of an entity. The cost of labor is the sum of all wages paid to
employees, as well as the cost of employee benefits and payroll taxes paid by an employer.

2.2.1. The difference between direct and indirect labor

The cost of labor is broken into direct and indirect (overhead) costs.
A. Direct Labor
Direct Labor Cost is the cost that can be identified with a product unit. It can also be described as
cost of all Labour incurred for altering the construction, composition or condition of the product.
The Direct Labor Cost can be charged directly to the job or product units and is included in the
prime cost. Direct Labour Cost is variable in nature and can be controlled by strictly adhering to
the norms and standards set by the management.
B. Indirect Labor
Indirect labor is the cost, which cannot be identified with a product unit. It represents the amount
of wages which is paid to the workers who are not directly engaged on the production but it
includes wages paid to the workers and assistants working in departments like purchasing, store
keeping, time office, maintenance, and other service and production departments. Indirect wages
are the wages paid to the workers who facilitate the production rather than actually engaged in
production.

2.2.2. Types of labor remuneration methods

The following items are to be ‘included’ for the purpose of measuring employee cost:
 Any payment made to an employee either in cash or kind
 Gross payments including all allowances payable and includes all benefits
 Bonus, remuneration payable to Managerial personnel including Executive Directors and
other officers
 Any amount of amortization arising out of voluntary retirement, retrenchment,
termination, etc.

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  Variance in employee payments/costs, due to normal reasons (if standard costing system is
followed)
 Any perquisites provided to an employee by the employer
The following items are to be ‘excluded’ for the purpose of measuring employee cost:
 Remuneration paid to Non-Executive Director
 Cost of idle time [ = Hours spent as idle time x hourly rate]
 Variance in employee payments/costs, due to abnormal reasons ( if standard costing
system is followed)
 Any abnormal payment to an employee – which are material and quantifiable
 Penalties, damages paid to statutory authorities or third parties
 Recoveries from employees towards benefits provided – this should be adjusted/reduced
from the employee cost
 Cost related to labor turnover – recruitment cost, training cost and etc.
 Unamortized amount related to discontinued operations.
2.3. Overheads
An overhead is the amount which is not identified with any product. The name overhead might
have come due to the reason of over and above the normal heads of expenditure. The generic
term used to denote indirect material, indirect labor and indirect expenses. Thus overheads forms
a class of cost that cannot be allocated or absorbed but can only be apportioned to cost units.
Classification of Overheads: Classification is made according to the following basis:
 Based on Elements: Indirect Materials: Indirect labor and indirect expenses
 Based on Functions of the organization: Manufacturing, overheads, Administrative
overheads, Selling and Distribution overheads, research & Development overheads.
 Based on the behavior: Fixed Overheads, Variable Overheads & Semi variable overheads.

2.3.1. Overhead cost analyses

The suggested overhead costs analysis method would determine the costs (especially,
management costs) at each point (we call it “profit point”) where a company and subcontractors
are interfaced.

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2.3.2. The apportionment and absorption of overhead costs, including allocation of service
department costs.
Allocation of Overheads: is ‘the charging of discrete, identifiable items of cost to cost centers or
cost units’. So the term allocation means allotment of whole item of cost to a particular cost
center or cost object without any division. For example, electricity charges can be allocated to
various departments if separate meters are installed, depreciation of machinery can be allocated
to various departments as the machines can be identified, salary of stores clerk can be allocated
to stores department, cost of coal used in boiler can be directly allocated to boiler house division.
Apportionment of Overheads: is the allotment of proportions of items to cost centers. In simple
word distribution of various items of overheads in portions to the departments or products on
logical or equitable basis is called apportionment.
 Distinction between Allocation & Apportionment
Although the purpose of both allocation and apportionment is identical, i.e. to identify or allot
the costs to the cost centers or cost unit, both are not the same. Allocation deals with the whole
items of cost and apportionment deals with proportion of items of cost. Allocation is direct
process of departmentalization of overheads, whereas apportionment needs a suitable basis for
sub-division of the cost.
Absorption of Overheads: Absorption of overheads refers to charging of overheads to
individual products or jobs. The overhead expenses pertaining to a cost center are ultimately to
be charged to the products, jobs etc. which pass through that cost center. For the purpose of
absorption of overhead to individual jobs, processes or products, overheads absorption rates are
applied. The overhead rate of expenses for absorbing them to production may be estimated on
the following three bases.
 The figure of the previous year or period may be adopted as the overhead rate to be charged
on production in the current year.
 The overhead rate for the year may be determined on the basis of the estimated expenses
and anticipated volume of production or activity.
 The overhead rate for the year may be determined on the basis of normal volume of output
or capacity of the business.
 Actual and pre-determined overhead rate: The overhead absorption rate may be computed
either based on actual cost or on the basis of estimated cost:

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2.3.3. Accounting for the over and under absorption of costs
Where the actual overhead of a period is absorbed at an absorption rate based on actual
production during that period, the overhead absorbed must, if all calculations have been correctly
made, exactly equal the overhead incurred. This is not so, however, when a predetermined rate is
used. The amount absorbed in cost accounts may not be equal to actual overhead relating to an
accounting period. The use of a predetermined rate may, therefore, result in under-absorption or
over-absorption.
When the amount absorbed is less than the actual overhead, there is under-absorption. Over
absorption arises when the amount absorbed is more than the actual overhead. In other words, if
the actual expenses fall short of the amount applied, there is said to be over-absorption of
overheads, and, conversely, if the actual expenses exceed the amount applied to production, it is
a case of under-absorption overheads.
2.3.4. IAS 2 inventories on Overhead allocations
IAS 2 defines inventories as assets which are: held for sale in the ordinary course of
business, in the process of production for such sale, or in the form of materials or supplies
to be consumed in the production or rendering of services.
The actual level of production may be used if it approximates normal capacity. The amount of
fixed overhead allocated to each unit of production is not increased as a consequence of low
production or idle plant. Unallocated overheads are recognized as an expense in the period in
which they are incurred.
Note; Inventories are to be measured at the lower of cost and net realizable value!
2.4. Recording of costs and schedule of cost of products
The Cost of Goods Manufactured and the Cost of Goods Sold section of the Income Statement
are accounting representations of the actual flow of costs through a production system.
 Cost Flow in an Accounting System for Manufacturing company

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The Balance Sheet: - The balance sheet or statement of financial position, of a manufacturing
company is similar to that of a merchandising company. However, their inventory accounts
differ. A merchandising company has only one class of inventory goods purchased from
suppliers for resale to customers. In contrast, manufacturing companies have three classes of
inventories. That is raw materials, work in process, and finished goods. Ordinarily, the sum total
of these three categories of inventories is the only amount shown on the balance sheet in external
reports. However, the footnotes to the financial statements often provide more detail.
XYZ Company
Income Statement
For the year ended Dec.31, xx
Revenue $xxx
Less: Cost of goods sold:
Beginning merchandise Xxx
Add: purchase Xxx
Goods available for sale Xxx
Deduct: Ending merchandise Xxx Xxx
Gross margin Xxx
Less: Selling and Adm, expense
Selling expense Xxx
Administrative expense Xxx Xxx
Net operating income Xxx
 Statement of Cost of Goods Manufactured

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In the income statement of a manufacturing company, cost of goods manufactured is computed
as follows
XYZ Company
Schedule of Cost of Goods Manufactured
For the year ended Dec.31, x1
Direct material
Beginning Direct Material inventory $xxx
Add: Purchase of direct material Xxx
Cost of direct material available for use Xxx
Less: Ending Direct Material inventory Xxx
Direct material used Xxx
Add: Direct manufacturing labor Xxx
Indirect manufacturing costs
Indirect manufacturing labor Xxx
Supplies Xxx
Heat, light and power Xxx
Depreciation-plant building Xxx
Depreciation-plant equipment Xxx
Miscellaneous Xxx
Manufacturing costs incurred during the year Xxx
Add: beginning work in progress inventory Xxx
Total manufacturing costs to account for xxx
Less: ending work in process inventory xxx
Cost of Goods manufactured $xxx
 Statement of Cost of Goods Sold
In the income statement of a manufacturing company, cost of goods sold is computed as follow
Beginning finished goods $ xxx
Add: cost of goods manufactured xxx
Cost of goods available for sale xxx
Deduct: ending finished goods xxx
Cost of goods sold xxx
Illustration 1

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Assume the following information is available for the XYZ Company for February 2022.
Beginning inventories:
Direct materials $15,000
Work in process 38,000
Finished goods 26,000
Ending inventories:
Direct materials 20,000
Work in process 40,000
Finished goods 28,000
Direct materials purchased 90,000
Direct labor used 100,000
Indirect manufacturing costs:
Indirect materials 15,000
indirect labor 40,000
Depreciation 50,000
Electric power 60,000
Property taxes & Insurance 5,500
Repair and maintenance 25,000
Miscellaneous 8,500
Selling and Administrative expenses 45,000
Sales 625,000

Required
Assume full absorption costing is used prepare an Income Statement and separate Schedule of Cost of
Goods Manufactured for the XYZ Company for February.

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