Analyse data and assign costs

Cost Elements

Cost elements are factors in the cost of production or service delivery processes. These may be subdivided into material, labour, rent, and overhead.

Direct Materials

These are raw materials, either purchased from outside or manufactured in-house, which can be conveniently identified with and allocated to cost units.

Direct materials usually end up in the finished product. In many cases, however, a material becomes part of the finished product but is not considered as direct materials because the value of the material is small relative to the total cost of the product. Examples are nails in furniture, thread in garments, the cotton used in a textile firm, clay in bricks, leather in shoes, etc.

Direct Labour

This is identified with the cost centre and can be conveniently identified with a particular product, job or process and is incurred for those employees who are engaged in the manufacturing process.

Direct labour is commonly associated with job costing, which involves the cost of materials used, hours of work included, and the overhead costs involved in manufacturing a particular product.

Overhead

An overhead refers to a cost that cannot be directly identified with the cost of manufacturing a particular. This includes the following:

• Indirect materials: These are materials that assist the manufacturing process and do not become an integral part of finished goods. These are minor in terms of importance and are small and relatively inexpensive items. Examples include pins, screws, nuts, thread, bolts, etc.

Items which do not become part of the finished product but were essential in the production are classified as indirect materials. Examples include cotton, oils and lubricants, stationery material, sandpaper, etc.

• Indirect labour: These are costs that are incurred for those employees who only assist in the manufacturing process. Examples include wages paid to the foreman, the salary of the manager, the accountant, etc. 
• Indirect expenses: These are expenses that cannot be identified by individual cost centres and are incurred to operate the business. Examples of these include rent, advertising, utilities, telephone expense, etc.15

To illustrate:

Cost Drivers

A cost driver is an activity or transaction that causes costs to be incurred, e.g. the number of hours a machine or piece of equipment is used.

The basic calculation for a predetermined overhead rate is as follows:

Budgeted Factory Overhead ÷ Budgeted Activity Level

Formula: Predetermined overhead rate

Example: Overhead cost per hour

The budgeted overhead for the next year is $250,000, and the activity level of production is 100,000 direct labour hours. Determine the overhead cost per hour.

$250,000 ÷ 100,000 = $2.50 per hour

A business is required to determine the factors that will influence the application of the overhead rate, such as the following:

• Volume: Cost of materials, labour cost, direct labour hours, machine hours, actual units made.
• Activity: Knowledge check: The number of purchase requisitions or the number of inspections.
• Period: For example, monthly, quarterly, annually.
• Type of rate: Single rate for the whole factory, rate per department, or rates based on activities undertaken.

Estimating Overhead Costs

The top line of the overhead application rate requires a budget for the period of time selected. A flexible budget is a budget prepared for different levels of activity. It requires an analysis of all costs into fixed and variable elements as follows:

Example: Estimating overhead costs

A company has developed a formula for estimating the overhead recovery rate over a relevant range of production. Fixed costs are $120,000, and variable costs are $1.50 per direct labour hour. Direct labour is estimated at 40,000 hours.

Total expected overhead:
Direct labour hours: 40,000 x $1.50	$60,000
Fixed costs	$120,000
	$180,000

If it takes 2 hours to produce a finished product, the number of units produced will be 20,000: 40,000 ÷ 2

Cost per unit = $9 (180,000 ÷ 20,000)

If 50,000 direct labour hours were estimated, 25,000 units would be produced.

The cost per unit would be:

Total expected overhead:
Direct labour hours: 50,000 x $1.50	$75,000
Fixed costs	$120,000
	$195,000

$195,000 ÷ 25,000 = $7.80
The following example sets out a flexible budget based on three (3) levels of activity. The number of direct labour hours for each level of activity is 20,000, 30,000, and 40,000 hours respectively. It takes 30 minutes to produce each unit.

Example: Flexible budget based on different levels of activity

Total budgeted overhead	$120,000	$150,000	$160,000
Units produced	$40,000	$60,000	$80,000
Cost per unit	$3.00	$2.50	$2.00
(Note: 2 units are produced each hour.)

Cost Components

Prime Costs: Prime cost is the total cost of the direct manufacturing costs, which include direct materials and direct labour. The formula for prime costs is Prime Costs = Direct Labour + Direct Material.
Conversion Costs: Conversion costs are the costs of converting raw materials into a finished product and include direct labour and factory overheads. The formula for conversion costs is Conversion Costs = Direct Labour + Factory Overhead.

Example: Calculating prime costs and conversion costs

Simply Furnished is a small retailer and manufacturer of wooden furniture. For the month of October, they were able to produce 35 pieces of kitchen cabinets. They have incurred the following costs:

Opening stock of timber	$115.00
Timber purchased for the month (Oct)	$350.00
Closing stock of timber	$85.00
Metal handles purchased	$125.00
Labour hours worked	100
Wages per hour	$25.00
Indirect materials and utilities cost allocated to the job	$5,000.00

To calculate the prime cost and conversion costs, you first need to determine the costs for the direct material, direct labour, and factory overhead.

Materials used for production = Opening Stock + Purchased Stock – Closing Stock

$115 + $350 - $85 = $380

Total direct materials cost = Material used for production + Other direct materials used

$380 + $125 (metal handles) = $505

Direct labour cost = Hours worked x Hourly wage

100 x $25 = $2,500

Now that you have the values for direct materials and direct labour, you can calculate the prime cost. Using the formula:

Prime cost = Direct labour + Direct material

$2,500 + $505 = $3,005

To calculate the conversion cost, determine the values for direct labour cost and factory overhead. Factory overhead refers to all expenses which are indirectly used during production, such as operating expenses. For this example, the factory overhead is the indirect materials and utilities cost allocated to the job, which is $5,000. Using the formula:

Conversion costs = Direct labour + Factory overhead

$2,500 + $5,000 = $7,500 (for the production of 35 kitchen cabinets)

Where equipment is purchased to use in the business, this is regarded as a cost but is recorded in the accounting system as a non-current asset and not as an expense. Salaries and wages are recorded as expenses. Other costs adjusted at the end of the accounting period include prepaid and accrued expenses, e.g. insurance or wages. ¹

Cost Behaviour

Cost behaviour is associated with learning how costs change when there is a change in an organisation’s level of activity. Understanding the cost behaviour assists in creating budgets, preparing forecasts, and determining the possible profit to be generated from a new product. The costs that are proportionate to the changes in activity are variable costs, while the costs that are unaffected by the changes in activity are fixed costs.

The relevant range, on the other hand, is the limited amount of volume of activity. For example, the average monthly production volume of a business is between 3,000 to 5,000 units, with an estimated average of 4,000 to 6,000 machine operator hours. The budgeted production cost is $80,000. If the production volume below falls below the range, the business would have to reduce the monthly fixed costs. Whereas, if the production volume exceeds the range, the business will incur additional monthly fixed costs.

• Fixed costs: The total cost for these does not change despite the changes in the activity levels of the business. The fixed cost per unit, however, changes with an increase or decrease in the production volume. Examples of these include rent, administrative salaries, depreciation, and property taxes.

Fixed costs are classified as:

1. Committed fixed costs: These are expenses that are typically long-term or permanent to which a business has an obligation. Eliminating this cost can harm the business, for example, through legal penalties or consequences. Examples include rent, long-term lease, and maintenance of plants and machinery.
2. Discretionary/programmed fixed costs: These include expenses incurred for a certain period and can be reduced or eliminated without an immediate impact on the business. Discretionary fixed costs can be cut back by the company when it’s necessary, such as when there’s a shortfall in cash flow. Examples include advertising, employee training, employee incentives, marketing and research for specific products, etc. reduction in discretionary costs; however, they should be carefully considered, especially if it’s affecting the profitability of the business.16

• Variable costs: These are costs that change in total when there is an increase in produced or sold units from the relevant range. The cost per unit of a product does not change – only the total cost is affected by the increase in production or sales. Examples include direct materials, production supplies, piece rate labour, freight fee, etc.

For example, if the total materials cost for the production of one shirt is $6.00, then the total cost for 100 shirts is $600.00; 500 shirts will have a total cost of $3,000.00.

Variable cost and fixed cost can be graphically illustrated this way:

Note that in the figure above, the total fixed costs are constant while the total variable costs change with the number of units. However, the fixed cost per unit will change with the number of units, while the variable cost per unit will remain constant.

• Semi-variable (mixed) costs: Semi-variable or mixed costs have the characteristics of both fixed and variable costs. A cost is fixed until it reaches a set production volume. Once the production volume is exceeded, the cost becomes a variable. For example, the labour cost for a certain product is fixed. If, in a seasonal period, the production volume needs to be increased, the labour cost becomes a variable.
• To analyse the cost behaviour of mixed costs, the high-low method is typically used. This method is used to calculate the fixed and variable components of a product with semi-variable or mixed costs. The total value for the highest volume of activity and the total value for the lowest volume of activity are determined. It is assumed that at both points of the activity, the fixed cost is the same, and the variable cost changes in the number of units of activity.

Example: Calculating semi-variable (mixed) costs

Prime Shoes produced the following pairs of shoes for the last six (6) months:

Month	Units (in pairs) Produced	Total Cost $
July	35	450
August	40	600
Sep	30	405
Oct	55	750	Highest volume ↑
Nov	35	450
Dec	25	375	Lowest volume ↓

The highest volume of activity was in October, when most shoes were produced, while the lowest volume was in December. These values will be used to calculate the fixed and variable costs.

1. Calculate the variable cost per unit using the identified high and low activity levels. Variable cost = (Total cost of high activity – Total cost of low activity) / (Highest activity unit – Lowest activity unit Variable cost = (750– 375) / (55 – 25) = $12.50 per pair of shoes
2. Calculate the fixed costs by entering either the highest or lowest cost and the variable cost. Total cost = (Variable cost per unit x Units produced) + Total fixed cost Using the highest cost: 750=( 12.50 x 55) + Total fixed cost 750= 687.50 + Total fixed cost Total fixed cost = $62.50
3. Construct the total cost equation based on the high-low calculations above. Total cost = Variable cost per unit + Total fixed cost 12.50+ 62.50 = $75.00

The total cost of $75.00 from the above example can now be used to calculate the total cost of the various units of the shoe shop.

• Future costs: Future costs refer to an estimated amount of a future expense. This is based on a forecast by the management. When determining future costs, a record of past actual costs or historical costs is used as a comparison.
• Budgeted costs: These refer to costs that the business expects to incur in the future. Budgeted costs are based on future costs and are adjusted based on business trends. It allows the management to plan the operations of the business. For instance, a retail shop must set a budget based on its forecasted sales demand and revenue, considering all the costs involved in its operations. 

Quality Management and Internal Control Procedures

Quality management involves overseeing different aspects and activities within a company to ensure consistency in processes and the products and services offered.

The main focus of quality management (QM) is to change an organisation's culture and processes and guide organisation restructuring.

Quality management seeks to ensure that the contributions of all the organisation's stakeholders work toward objectives that contribute to long-term business growth through customer satisfaction.

Quality management requires determining the best practices a company follows to ensure that its products and services maintain the required standards or fit a given purpose.

Watch this video to learn more about some of the internal control procedures in accounting that contribute to Quality management systems:(7.32):

Quality management comprises four components, including the following.

Quality Planning	The quality management process focuses on determining quality standards that must be addressed when planning and devising ways to meet them
Quality Improvement	The purposeful alteration of a conducted process to enhance the confidence or reliability of the result
Quality Control	The ongoing work to maintain a process's integrity and reliability to achieve the desired outcome
Quality Assurance	Systematic or planned actions that are designed to guarantee adequate reliability to guarantee a particular service or product meets specific conditions

Quality management refers to the formation of a set of procedures by a team that helps ensure that goods and services meet the predetermined standards or satisfy a requirement.

The Quality management process begins when aims are agreed upon by the company, its component teams and relevant stakeholders. Next, the corporation defines the metrics used to measure quality. Next, it takes the steps required to assess quality. It then identifies any quality obstacles and initiates quality improvements. In the final stage, an overall appraisal is conducted.

Quality improvement methods consist of three categories: product improvement, process improvement, and people-based improvement. There are many quality methods and strategies that can be used to implement them effectively, including Kaizen, Zero Defects, Six Sigma, Quality Circle, Taguchi Methods, Toyota Production System, Kansei Engineering, TRIZ, BPR, OQRM, ISO, and Top-Down & Bottom-Up approaches.

Essentials of Quality Management for Management Accounting

Process Focused	In a process focussed approach, the performance of an organisation is paramount. Therefore, this approach emphasises achieving efficiency and effectiveness through organisational processes. The approach requires understanding that good processes result in increased consistency, faster delivery, reduced costs, and continuous improvement. An organisation will be improved when leaders manage and control the processes used, as well as the inputs and outputs of the organisation.
Continuous Improvement	Each organisation must adopt in its mission a commitment to be actively involved in continual improvement. Organisations that improve their abilities continuously notice performance, efficiency, and flexibility improvements, allowing them to respond to new situations. Companies should be adaptable and create new procedures in response to new circumstances.
Evidence-based Decision-Making	Every organisation should adopt a fact-based approach to decision-making. Organisations that make decisions based on the analysis of verified data will have an enhanced understanding of the markets in which they operate. As a result, they can perform tasks that produce desired outcomes justified and supported by their past actions. Fact-based decision-making is vital to help understand the cause-and-effect relationships of different things and explain possible unintended results and consequences.

You will need to confer with internal stakeholders to ensure the organisation has Quality Management Processes that establish and ensure that management accounting tasks are performed to the required quality standards.

Quality Management Processes in management accounting can include establishing management sign-offs to maintain quality standards. In addition, organisations may create checklists or policies to ensure that the way specific management accounting information and reports are prepared is consistent, reliable, accurate, complete and timely.

Watch this video from Business Queensland for a refresher on creating and maintaining good record-keeping practices in your business: (2.37):

The value of financial accounting is determined largely by its quality. The central concept of quality in accounting is that certain accounting information better communicates what it purports to communicate than others.

While accounting quality is of significant interest to those in the financial reporting supply chain, there is no single, broadly accepted definition of the phrase "accounting quality". It is interpreted differently by different organisations and industries. However, in the final analysis, all definitions of quality should facilitate value judgments about accounting information.

Cost-Benefit Analysis

A cost-benefit analysis is a systematic process used to analyse which decisions to make and which to forgo.  A cost-benefit analyst totals the potential rewards expected from a situation or action and subtracts the total costs associated with taking that action.

Watch this video for a refresher on Cost-benefit analysis: (4.07):

Some accountants build models to assign a dollar value to intangible items, like the benefits and costs of living in a certain area or the goodwill that may exist when purchasing a new business.

Watch this video for a quick guide to making Cost Benefit and Breakeven Analysis in Excel:(12.52):

CBA is a quick and simple method best used for non-critical financial decisions. However, when substantial amounts of money are involved, or when decisions are truly mission-critical, other approaches, such as Internal Rates of Return or Net Present Values, may be more appropriate.

Ensuring that your organisation's Quality Management and Internal Control Procedures include rules around quality and calculations checks, data integrity, decision-making criteria, and management sign-offs will ensure that your analysis is sound and evidence-based.

Internal Peer reviews

Your organisation's internal processes may require peers to check each other's work for quality benchmarks, including accuracy of calculations, analysis, data integrity, decision-making criteria and use of the correct management sign-off procedures.

External peer reviews

Larger international firms may be subject to the requirements for regular annual peer reviews of their accounting systems.

 Read more on External peer reviews.