Cambridge AS & A Level9706

Materials and labour

Accounting 9706 Chapter Notes

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Materials and labour
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In this chapter

  1. 1Cost, Management, and Financial Accounting
  2. 2Classifying Direct and Indirect Costs
  3. 3Valuing Material Issues: FIFO Method
  4. 4Valuing Material Issues: AVCO Method
  5. 5Accounting for Labour Costs
  6. 6Just-In-Time (JIT) Inventory Management

1. Cost, Management, and Financial Accounting

Accounting can be split into two main branches: Financial Accounting and Management Accounting. Financial Accounting focuses on recording past events to create financial statements (like the Statement of Profit or Loss and Statement of Financial Position) for external users such as investors, banks, and tax authorities. It is heavily regulated by accounting standards. Management Accounting, on the other hand, provides information to internal managers to help them with planning, decision-making, and control. It is forward-looking, not bound by strict rules, and tailored to the specific needs of the business. Cost Accounting is a key part of management accounting that focuses on calculating, analysing, and controlling the costs of products, services, or operations.

Key term

Management Accounting: The process of preparing reports and accounts that provide accurate and timely financial and statistical information required by managers to make day-to-day and short-term decisions.

Examiner insight

Examiners expect you to clearly distinguish between the two branches of accounting by referring to their purpose, users, and time orientation.

Fun fact

Management accounting is not just for accountants! Engineers, marketing managers, and production supervisors all use management accounting information to run their departments effectively.

Worked example 13 marks

A company's accountant prepares a cash flow forecast to decide if the business can afford a new machine. Is this an example of financial accounting or management accounting? Explain your answer.

  1. 1

    This is an example of management accounting.

  2. 2

    Explanation: The information (a cash flow forecast) is forward-looking and is being used internally by managers to make a specific business decision (purchasing a new machine).

  3. 3

    Financial accounting would be concerned with recording the purchase of the machine after it has happened and reporting its value in the Statement of Financial Position.

Recap

  • Financial accounting is for external users, is historical, and follows strict rules (e.g., IFRS).
  • Management accounting is for internal managers, is forward-looking, and is flexible.
  • Cost accounting is a part of management accounting used to determine the cost of products and services.
  • The main purpose of management accounting is to aid decision-making within the business.

Quick check

  1. Is publishing the annual financial statements for shareholders a task of financial or management accounting?1 mark

2. Classifying Direct and Indirect Costs

To find the cost of a product, we must classify costs into two categories: direct and indirect. A direct cost is a cost that can be specifically and fully traced to a single product or service, which is known as a 'cost unit'. An indirect cost (also called an overhead) is a cost that is incurred for the business as a whole and cannot be traced directly to a single cost unit. For example, in a factory making wooden tables (the cost unit), the wood and the wages of the carpenter who assembles the table are direct costs. The factory rent, the supervisor's salary, and the electricity for the lights are all indirect costs because they support the production of all tables, not just one.

Prime Cost = Direct Materials + Direct Labour + Direct Expenses

Key term

Cost Unit: A unit of product or service in relation to which costs are ascertained.

Examiner insight

Examiners frequently test the classification of costs. Be precise in identifying which costs are directly attributable to the cost unit to calculate the prime cost correctly.

Common pitfall

Confusing the salary of a factory supervisor with direct labour. A supervisor oversees production in general, so their salary is an indirect cost (an overhead).

Worked example 14 marks

A company manufactures leather bags. A single bag is one cost unit. The following costs are incurred: Leather ($50), Zip ($2), Thread ($1), Wages of the stitcher ($25), Factory supervisor's salary ($5), Factory rent ($10). Classify these costs as direct or indirect and calculate the prime cost of one bag.

  1. 1

    Step 1: Classify the costs.

  2. 2

    Direct Materials: Leather ($50), Zip ($2), Thread ($1). These are physically part of the final product.

  3. 3

    Direct Labour: Wages of the stitcher ($25). This person directly works on making the bag.

  4. 4

    Indirect Costs (Overheads): Factory supervisor's salary ($5), Factory rent ($10). These costs cannot be traced to a single bag.

  5. 5

    Step 2: Calculate the Prime Cost.

  6. 6

    Prime Cost = Direct Materials + Direct Labour

  7. 7

    Prime Cost = ($50 + $2 + $1) + $25

  8. 8

    Prime Cost = $53 + $25 = $78

Recap

  • Direct costs can be traced directly to a single cost unit.
  • Indirect costs (overheads) cannot be traced to a single cost unit.
  • Direct costs include direct materials, direct labour, and direct expenses.
  • Prime cost is the sum of all direct costs.
  • Indirect costs include indirect materials, indirect labour, and indirect expenses.

Quick check

  1. Is the salary of a factory cleaner a direct or indirect cost?1 mark
  2. What is the name given to the total of all direct costs?1 mark

3. Valuing Material Issues: FIFO Method

When a business uses materials in production, it needs to assign a cost to them. If the purchase price of materials changes over time, we need a system. The First-In, First-Out (FIFO) method assumes that the first materials purchased are the first ones to be issued to production. Think of it like a queue of stock – the oldest items are used first. This means the inventory remaining at the end of a period (closing inventory) is valued at the prices of the most recent purchases.

Key term

FIFO (First-In, First-Out): An inventory valuation method which assumes that the first items of inventory purchased are the first ones to be issued or used.

Common pitfall

When an issue is larger than the first batch in stock, students forget to split the issue and take the remainder from the next batch at its different price.

Worked example 16 marks

At 1 June, inventory of grape juice was 80 litres at $0.60 per litre. The following transactions occurred in June: June 2: Received 100 litres @ $1.00 June 6: Issued 70 litres June 15: Received 200 litres @ $1.20 June 22: Issued 200 litres Calculate the cost of materials issued on June 6 and June 22, and the value of closing inventory at June 22, using the FIFO method.

  1. 1

    Step 1: Set up a stores ledger card to track movements.

  2. 2

    Opening Balance: 80 litres @ $0.60

  3. 3

    Step 2: Record the June 6 issue. We need 70 litres. We take them from the oldest batch (the opening balance).

  4. 4

    Cost of June 6 issue = 70 litres × $0.60 = $42.00

  5. 5

    Remaining inventory: 10 litres @ $0.60 and 100 litres @ $1.00.

  6. 6

    Step 3: Record the June 22 issue. We need 200 litres. We must use the remaining oldest stock first.

  7. 7

    First, take the remaining 10 litres @ $0.60 = $6.00

  8. 8

    Next, take the 100 litres @ $1.00 = $100.00

  9. 9

    We still need 90 more litres (200 - 10 - 100). Take these from the June 15 batch.

  10. 10

    Take 90 litres @ $1.20 = $108.00

  11. 11

    Total cost of June 22 issue = $6.00 + $100.00 + $108.00 = $214.00

  12. 12

    Step 4: Calculate closing inventory at June 22.

  13. 13

    The June 15 batch had 200 litres. We used 90 litres. 110 litres remain.

  14. 14

    Value of closing inventory = 110 litres × $1.20 = $132.00

Recap

  • FIFO stands for First-In, First-Out.
  • It assumes the oldest inventory is used first.
  • Issues are priced using the cost of the oldest batches of inventory.
  • Closing inventory is valued at the cost of the most recent purchases.
  • FIFO is logical as it often matches the physical flow of goods.

Quick check

  1. Under FIFO, is closing inventory valued at the oldest or most recent prices?1 mark

4. Valuing Material Issues: AVCO Method

The Average Cost (AVCO) method, also known as the weighted average cost method, provides an alternative to FIFO. Instead of tracking individual batches, AVCO smooths out price fluctuations. After each new purchase of materials is received, a new weighted average cost per unit is calculated. All materials issued to production are then valued at this new average cost, until the next purchase arrives and the average is recalculated again.

New Average Cost = Total Value of Inventory / Total Quantity of Inventory

Key term

AVCO (Average Cost): An inventory valuation method where the cost of issues and closing inventory is based on a recalculated weighted average cost after each new purchase.

Examiner insight

Examiners look for the clear calculation of a new weighted average cost after each purchase and the consistent use of that cost for all subsequent issues until the next purchase.

Common pitfall

Forgetting to recalculate the average cost after a new delivery arrives, and instead continuing to use the old average cost for subsequent issues.

Worked example 15 marks

Using the same data as the FIFO example: Opening inventory 80 litres @ $0.60. June 2: Received 100 litres @ $1.00. June 6: Issued 70 litres. Calculate the cost of the June 6 issue and the new inventory value using the AVCO method.

  1. 1

    Step 1: Calculate the inventory value before the issue.

  2. 2

    Opening inventory: 80 litres × $0.60 = $48.00

  3. 3

    June 2 purchase: 100 litres × $1.00 = $100.00

  4. 4

    Total inventory before issue: 180 litres (80 + 100) with a total value of $148.00 ($48 + $100).

  5. 5

    Step 2: Calculate the new weighted average cost per litre.

  6. 6

    New AVCO = Total Value / Total Quantity = $148.00 / 180 litres = $0.8222 per litre (rounded).

  7. 7

    Step 3: Cost the issue using the new AVCO.

  8. 8

    Cost of June 6 issue = 70 litres × $0.8222 = $57.55.

  9. 9

    Step 4: Calculate the value of the remaining inventory.

  10. 10

    Remaining quantity = 180 - 70 = 110 litres.

  11. 11

    Remaining value = $148.00 - $57.55 = $90.45. (Or 110 litres x $0.8222 = $90.44 due to rounding).

Recap

  • AVCO stands for Average Cost.
  • A new weighted average cost is calculated after every purchase.
  • All issues are priced at the current weighted average cost.
  • This method smooths out the effect of price changes on cost of sales and profit.
  • The average must be a weighted average, not a simple average of the prices.

Quick check

  1. When is the average cost recalculated under the AVCO method?1 mark

5. Accounting for Labour Costs

Labour is a major cost for many businesses. Like materials, labour costs can be direct or indirect. Direct labour costs are the wages of employees who are directly involved in making the product (e.g., a machine operator, a car assembler). Indirect labour costs are the wages of factory staff who do not directly make the product but are essential for the factory to run (e.g., supervisors, maintenance staff, cleaners). When calculating labour costs, we must also consider overtime. The extra amount paid for overtime hours, known as the overtime premium, is often treated as an indirect cost unless the overtime was worked to fulfil a specific customer's request.

Total Labour Cost = (Hours Worked × Basic Rate) + Overtime Premium

Overtime Premium = Overtime Hours × (Overtime Rate - Basic Rate)

Key term

Direct Labour: The cost of wages for employees who are directly involved in the manufacturing of a product or the provision of a service.

Common pitfall

Incorrectly calculating the overtime premium. The premium is only the 'extra' amount paid, not the full overtime rate.

Worked example 15 marks

An employee works 42 hours in a week. Their basic rate is $20 per hour for a 40-hour week. Overtime is paid at time-and-a-half (150% of basic rate). Calculate the employee's total gross pay and split it between basic pay and overtime premium.

  1. 1

    Step 1: Identify the hours worked.

  2. 2

    Total hours = 42. Basic hours = 40. Overtime hours = 2.

  3. 3

    Step 2: Calculate the basic pay for all hours worked.

  4. 4

    Basic pay = 42 hours × $20/hour = $840.

  5. 5

    Step 3: Calculate the overtime premium.

  6. 6

    Overtime rate = $20 × 1.5 = $30/hour.

  7. 7

    Overtime premium per hour = Overtime Rate - Basic Rate = $30 - $20 = $10/hour.

  8. 8

    Total overtime premium = 2 overtime hours × $10/hour = $20.

  9. 9

    Step 4: Calculate the total gross pay.

  10. 10

    Total Gross Pay = Basic Pay + Overtime Premium = $840 + $20 = $860.

  11. 11

    Note: The direct labour cost would be $840, and the overtime premium of $20 would typically be treated as an indirect cost (factory overhead).

Recap

  • Direct labour costs are for workers who physically make the product.
  • Indirect labour costs are for factory support staff like supervisors and cleaners.
  • Total pay includes basic pay for all hours plus an overtime premium for extra hours.
  • Overtime premium is the extra amount paid per hour for working overtime.
  • The overtime premium is usually treated as an indirect cost.

Quick check

  1. An employee's basic rate is $10/hr. Overtime is paid at time-and-a-half. What is the overtime premium per hour?1 mark

6. Just-In-Time (JIT) Inventory Management

Just-In-Time (JIT) is a philosophy of inventory management that aims to have zero (or minimal) inventory. Instead of holding large stocks of materials, components are delivered by suppliers 'just in time' to be used in production. Similarly, finished goods are produced 'just in time' to be dispatched to customers. The goal is to increase efficiency and reduce waste by eliminating the costs associated with holding inventory, such as storage costs, insurance, and the risk of stock becoming obsolete or damaged.

Key term

Just-In-Time (JIT): An inventory management system where materials, components, and products are ordered and received only when they are needed.

Examiner insight

When asked about JIT, examiners expect a balanced view. You must be able to discuss both the significant benefits and the considerable risks involved.

Fun fact

Toyota is famous for pioneering the JIT system in the 1970s. The system was so successful it became a core part of 'lean manufacturing' principles adopted by companies worldwide.

Worked example 14 marks

A bakery is considering switching to a JIT system for its flour and sugar supplies. Explain one major advantage and one major disadvantage the bakery should consider.

  1. 1

    Advantage: Reduced holding and wastage costs. The bakery would not need a large storeroom for flour and sugar, saving on rent and space. There would be less risk of spoilage or pest infestation, which is a significant concern for food ingredients, thus reducing waste.

  2. 2

    Disadvantage: High reliance on suppliers. If the flour supplier's delivery van breaks down or gets stuck in traffic, the bakery could run out of its main ingredient. This would halt all bread production for the day, leading to lost sales and unhappy customers.

Recap

  • JIT aims to minimize or eliminate inventory.
  • Materials arrive just as they are needed for production.
  • Finished goods are made just as they are needed for sale.
  • A key advantage is the reduction in inventory holding costs.
  • A key disadvantage is the heavy reliance on reliable suppliers and a smooth supply chain.
  • JIT requires a close relationship and excellent communication with suppliers.

Quick check

  1. List two costs associated with holding inventory that JIT helps to reduce.2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. List three examples of indirect factory costs.3 marks
  2. Define 'prime cost' and state its formula.2 marks
  3. A business has the following material transactions: Opening inventory 100 units at $10 each. Purchase 200 units at $12 each. Issue 150 units. Calculate the cost of the issue using the FIFO method.4 marks
  4. Using the same data as question 3, calculate the cost of the issue using the AVCO method.4 marks
  5. A factory worker is paid $15 per hour for a 38-hour week. Overtime is paid at time-and-a-half. In one week, the worker worked 43 hours. 3 hours of the overtime were a specific requirement for Job 123, while 2 hours were due to general factory inefficiency. Calculate the total wage and allocate it to direct and indirect labour costs.6 marks
  6. Explain two benefits and two drawbacks of a business implementing a Just-In-Time (JIT) inventory system.4 marks
  7. The following data relates to the stores ledger account for material Z: May 1: Opening balance 200kg @ $5.00/kg. May 5: Received 300kg @ $5.50/kg. May 12: Issued 400kg to production. May 18: Received 150kg @ $6.00/kg. May 25: Issued 100kg to production. The business uses the FIFO method. Calculate the total cost of materials issued in May and the value of the closing inventory at 31 May.7 marks
  8. From the following information, calculate the Prime Cost and the Factory Cost of Production. Opening inventory of raw materials: $16,500; Closing inventory of raw materials: $16,000; Purchases of raw materials: $255,300; Direct labour: $458,900; Royalties (per unit): $7,500; Factory supervisor's salary: $60,000; Depreciation of factory machinery: $45,000; Factory rent and rates: $32,500.8 marks
  9. A company is deciding how to value its inventory. In a period of consistently rising prices, explain which method, FIFO or AVCO, would result in a higher reported profit and a more realistically valued closing inventory. Justify your answer.6 marks
  10. Define the term 'cost unit'. Provide one suitable example of a cost unit for each of the following businesses: a) a hospital, b) a bus company, c) a college.4 marks

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