Welcome to the World of Costing!
Hi there! Welcome to one of the most practical parts of your Accounting course. While financial accounting focuses on telling the "outside world" how the business is doing, Costing is all about looking inside. It’s like being a detective—we want to find out exactly how much it costs to make a product or provide a service. Why? So we can set the right price and make sure the business stays profitable!
Don't worry if some of these terms seem new. We’ll take it step-by-step, using everyday examples to make things clear.
1. Valuation of Inventory (Stock)
Imagine you own a small shop selling sneakers. You buy 10 pairs on Monday for \( \$50 \) each, and 10 more on Friday for \( \$60 \) each because the supplier raised the price. On Saturday, you sell one pair. Which cost do you record: the \( \$50 \) or the \( \$60 \)? This is what inventory valuation is all about!
Methods of Valuation
There are two main ways we track these costs:
1. FIFO (First-In, First-Out): We assume the oldest items are sold first. Think of a milk fridge in a supermarket—the oldest milk is at the front so it sells first.
2. LIFO (Last-In, First-Out): We assume the newest items bought are the first ones sold. Think of a pile of coal or a bin of nails—you naturally take from the top (the newest stuff).
What is Net Realisable Value (NRV)?
Sometimes, stock gets damaged or goes out of style. NRV is the actual money you expect to get from selling the item, after subtracting any costs to get it ready for sale.
The Golden Rule: According to the Prudence Concept, inventory should always be valued at the lower of its Cost or its NRV. We never want to look richer than we actually are!
Quick Review: FIFO vs. LIFO
In a world where prices are rising (inflation):
- FIFO gives a higher closing inventory value and a higher profit.
- LIFO gives a lower closing inventory value and a lower profit.
Common Mistake: Students often think FIFO and LIFO refer to the physical movement of goods. They don't! They are just accounting assumptions for calculating costs.
2. Labour Costs
How do we pay the people making our products? It’s not just about a monthly salary. In costing, we look at Productivity—how much work is getting done for the money we spend.
Methods of Remuneration (Paying Workers)
1. Day Work (Time Rate): Paying by the hour.
\( \text{Pay} = \text{Hours Worked} \times \text{Rate per Hour} \)
2. Piecework: Paying for what is actually made. This encourages speed!
\( \text{Pay} = \text{Units Produced} \times \text{Rate per Unit} \)
3. Bonus Schemes: Extra money given to individuals or groups for reaching a target or saving time. It’s a way to say "Thank you for working harder!"
Employer Cost vs. Employee Earnings
Did you know that a worker costs a business more than just their salary?
Employee Earnings: What the worker sees on their payslip (Gross pay minus taxes).
Employer Cost: The Gross pay plus extra costs like employer pension contributions and insurance.
Key Takeaway: Piecework motivates workers to produce more, but you must keep an eye on quality—if they go too fast, they might make mistakes!
3. Overhead Costs
This is where students often get a bit nervous, but let’s keep it simple. Overheads are all the "extra" costs that aren't direct materials or direct labour—like rent, electricity, and the manager’s salary.
Types of Overheads
- Fixed: Stay the same no matter how much you make (e.g., Factory Rent).
- Variable: Change exactly with production (e.g., Power to run the machines).
- Semi-Variable: Have a fixed part and a variable part (e.g., A phone bill with a line rental fee plus a charge per call).
The Three 'A's of Overheads
To find out the cost of one product, we follow this process:
1. Allocation: If a cost belongs only to one department (like a specific machine's insurance), we give it all to them.
2. Apportionment: If a cost is shared (like rent for the whole building), we split it using a fair "base."
Example: Split rent based on the floor space (square meters) each department uses.
3. Absorption: Finally, we "charge" the overheads to the products. We usually calculate a Predetermined Overhead Absorption Rate (OAR).
Calculating OAR
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity (Hours or Units)}} \)
Under and Over Absorption
Since we use estimates (budgets) to set our OAR, at the end of the year, we might find we charged too much or too little.
- Over-absorbed: We charged more to products than we actually spent. (Yay! Extra profit).
- Under-absorbed: We charged less than we actually spent. (Oops! Lower profit).
Memory Aid: Think of Apportionment as cutting a pizza. You share the total cost based on how many "slices" (space or people) each department gets!
4. Job and Batch Costing
How do we apply all this to real business orders?
Job Costing
This is used for unique, one-off orders.
Examples: A wedding cake, a custom-made suit, or a specific repair job on a car.
We track every cent of material, every hour of labour, and a share of overheads specifically for that one job.
Batch Costing
This is used when a group of identical items are made together.
Examples: A bakery making 50 loaves of bread at once, or a factory making 1,000 "Size Medium" blue t-shirts.
The total cost of the batch is calculated, and then we divide by the number of items in the batch to find the cost per unit.
Step-by-Step for Job/Batch Costing:
1. Identify Direct Materials.
2. Identify Direct Labour.
3. Add them together to get Prime Cost.
4. Add Overheads (using the OAR we calculated earlier).
5. This gives you the Total Production Cost.
Quick Review Box
- Inventory: Valued at lower of Cost or NRV (Prudence!).
- Labour: Productivity is key; piecework rewards speed.
- Overheads: Allocate, Apportion, and then Absorb.
- Job Costing: For single, unique items.
- Batch Costing: For groups of the same item.
Don't worry if this seems tricky at first! Costing is like a puzzle—once you figure out where the pieces (costs) go, the whole picture becomes clear. Keep practicing the OAR calculations, and you'll be a pro in no time!