Objectives: At the end of this tutorial students should be able to do the following:
Many businesses are involved in the production of goods for wholesaling or retailing. These businesses take raw materials and process them into finished goods. In order to determine the cost of producing these goods a manufacturing account is prepared, before this can be done all the elements of cost involved in the manufacturing process must be identified and classified.
The elements of cost in a manufacturing firm are material, labor and overheads. These costs can be classified as either direct or indirect and are then further analyzed into fixed costs, variable costs or semi-variable costs based on their sensitivity to changes in the level of production.
A direct cost is a cost that can be directly attributed to a unit of production. Examples of direct costs are direct materials and direct labor costs.
An indirect cost is a cost that cannot be linked directly to unit of production. Examples of indirect costs are administrative expenses and factory overheads.
Cost Behavioral Patterns
Fixed Costs or Period Costs
Fixed costs are costs that are not directly affected by changes in the level of production or other related activities, over a specified period of them. They remain constant over a period of time regardless of the level of business activity and are therefore referred to as period costs. Examples are rent, salaries, insurance and depreciation charges. Below is a graph that depicts the behavior of fixed costs:
Variable costs are costs that vary directly with the level of production, therefore as the level of output increases then the level of variable cost will also increase and vice versa. Examples of variable costs are direct material and direct labor. The graph below depicts the behavior of variable costs:
Semi-Variable costs include both a fixed and variable component. A semi-variable cost will vary based on the level of activity but not in direct proportion to the level of activity. An example of a semi-variable cost is electricity. An Electricity charge comprises of a fixed basic charge as well as a variable charge that is based on the level of usage. Below is a graph that depicts the behavior of semi- variable costs:
Semi-Fixed Costs or Step Costs
A semi-fixed cost or step cost, has both fixed and variable components. These types of costs are usually fixed for a set level of production or consumption and will vary once the production level is outside of the set range. If no production at all occurs, a fixed cost is still incurred and once the limit or range is exceeded the cost will increase by a constant level. For example: If a supervisor is paid $5,000 per month and one supervisor is needed to supervise ten (10) employees, then once the level of employees remain at ten (10) or less the cost of supervision will be $5,000. However if the company were to hire three(3) new employees, they would need another supervisor, at this point the cost of supervision would go up to $10,000 per month and remain at that level until the number of employees crosses twenty (20). Below is a graph that depicts the behavior of semi-fixed or step costs:
Once all the relevant costs has been identified and classified the manufacturing account can be prepared in order to determine the cost of production.
Steps in preparing the Schedule of Cost of Goods Manufactured or the Manufacturing Account:
1. Calculate Prime Costs
Prime Costs refer to the total of direct materials, direct labor and direct expenses. These three items are referred to as direct costs because they represent expenditure that can be traced directly to a unit of production. For example: If a company manufactures school uniforms then their direct costs will include fabric, buttons, thread and the wages of the tailors and seamstresses etc.
KEY POINT - Prime Costs equals Direct Materials plus Direct Labor plus Direct Expenses.
In order to determine the cost of direct materials, use the following format:
Opening stock of raw materials XX
Add: Purchases of raw materials XX
Add: Carriage inwards on raw materials XX
Less: Return outwards on raw materials (XX)
Cost of materials available for use XXX
Less: Closing stock or raw materials (XX)
Cost of raw materials consumed XXX
KEY POINT - The cost or raw materials consumed/used is the same as Direct Materials.
2. Calculate the Cost of Production
Factory overheads are then added to Prime Costs to arrive at Cost of Production. Factory overheads, also referred to as indirect costs or manufacturing overheads are costs that do not vary directly with a unit of production and thus cannot be traced to a specific unit of output. However, these are necessary costs which are incurred in the day to day running of the production facility. Factory overheads include expenses such as depreciation on factory equipment, factory heat and light, factory supervisor's salary and factory insurance.
KEY POINT - Prime Costs plus factory overheads equals Cost of Production.
3. Calculate Cost of Completed Goods
After calculating the Cost of Production, opening stock of work in progress is added to cost of production. This total represents the cost of processing for the period in question. Closing stock of work in progress is then deducted from the Cost of Processing to arrive at the Cost of Completed Goods.
KEY POINT - Cost of production plus opening work in progress, minus closing work in progress equals Cost of Completed Goods.
Below is the schedule used to calculate the Cost of Goods Manufactured:
Summary of key points:
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The author holds a Bsc (Hons) Degree in Applied Accounting from Oxford Brookes University, England and enjoys a successful career as an Accounting Supervisor and a private tutor.