Integrated Cost Accounting

1 Introduction

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Transactions of a business need recording, both for the financial accounts and for the management accounts. Some businesses keep completely separate sets of records, but this clearly involves duplication which is why it is common to have one set of records for both purposes - this is known as integrated cost accounting. In this chapter we will work through an example in order to show how the records are maintained.

The alternative, where the cost accounts and the financial accounts are kept in two separate ledgers that are regularly reconciled with each other, is called an interlocking (or non-integrated) system. In BA2 you need to know the integrated system. The double entry itself is taught in BA3; here you only need the rules set out in this chapter.

2 Labour

Before we work through a full example, it is important to appreciate that labour can be either a direct cost or an indirect cost (or overhead).

All costs of indirect workers (i.e. those not directly involved in making products, such as maintenance staff and supervisors) are indirect costs.

For workers directly involved in making products:

• Direct costs are their basic pay, and any overtime premium (i.e. the extra that is paid over and above their basic pay) paid for a specific job at the customer’s request.

• Indirect costs are general overtime premiums, bonus payments, idle time, and sick pay.

3 The accounting entries

To explain the accounting entries, we will work through an example step-by-step.

First, we record the actual costs by entering them on the debit (left-hand) side of accounts for each of materials, direct labour, and overheads. At the same time we enter the amounts on the credit (right-hand) side of cash (in respect of costs paid in cash) or on the credit side of payables (in respect of anything bought on credit).

We also record the sales revenue by entering it on the credit side of a sales account, and at the same time entering it on the debit side of cash (if the sales were for cash) or on the debit side of receivables (if the sales were made on credit).

Next, we will transfer any indirect labour from the labour account to the overheads account.

Next, we put all the production costs together in order to get the total cost of production, by transferring each of them to a Cost of Sales account. In each case, we credit the cost account and debit the Cost of Sales account.

Now, we transfer the total standard cost of the goods sold to the Statement of Profit or Loss account - we credit the Cost of Sales account and debit the SOPL account, with the standard cost of the goods sold.

You will notice that the total on the debit side of the cost of sales account does not equal the total on the credit side.

The reason is that we have debited with what was actually spent, but credited with the standard cost.

If you look back, then for direct labour and overheads, the amount actually spent is the same as the standard costs for the production. However, in respect of materials, the total actually spent of $77,000 was not equal to the standard cost of materials of $75,000 (1,000 units at $75 per unit).

As a result we have variances, and we need to analyse into the price variance and the usage variance.

When we have done this, we transfer the variances from the cost of sales account to the SOPL account.

We have now almost finished!

To complete the exercise we will transfer the figure on the sales account to the SOPL account. The balancing figure on the SOPL account will be the profit for the month and we can then re-write the figures in the account in the form of a statement to present to management (the operating statement).

4 The manufacturing control accounts

Example 1 to Example 6 moved the costs straight to a cost of sales account, because everything produced in January was sold. In practice some units are still being made at the end of a period, and some finished units are still in the warehouse. A full integrated system therefore moves costs through a series of control accounts, each holding the total of one stage of production:

The entries:

Production overheads are charged to work-in-progress at the predetermined absorption rate, not at the amount actually spent. So the production overhead control account will rarely balance: the difference is the over- or under-absorbed overhead, calculated exactly as in chapter 5 (section 4), and it is transferred to the statement of profit or loss. Under-absorbed overhead is an extra expense (debit SOPL); over-absorbed overhead reduces the expense (credit SOPL).

When standard costing is used, work-in-progress, finished goods and cost of sales are kept at standard cost, and each variance is taken to the statement of profit or loss as it is calculated – adverse variances debited, favourable variances credited – exactly as in Example 5.

5 Job and batch costing

The examples so far assumed that a business makes large numbers of identical units. Many businesses do not. They work to each customer’s order, or they make products in batches. Their costing, and their accounts, are organised around each job or batch.

Job costing

Job costing is used where work is done to a customer’s own specification and each order is different – for example a builder, a printer, a garage carrying out repairs, a firm making machinery to order, or a firm of accountants. Each job is given a number and its own job cost card (job account), and its costs are collected on it as they are incurred:

• direct materials – from the materials requisitions issued to the job

• direct labour – from the hours booked to the job on time sheets, at the labour rate

• direct expenses – costs incurred for that job only, such as hiring special equipment

• production overheads – absorbed at the predetermined rate (for example per direct labour hour)

Non-production overheads (administration, selling) are often added as a percentage of production cost, and a profit is then added to arrive at the price quoted to the customer (chapter 7).

In the integrated accounts, the work-in-progress control account is the total of all the individual job accounts. Materials, labour, direct expenses and absorbed overheads are debited to work-in-progress (and to the job card). When a job is finished, its cost is credited to work-in-progress and debited to finished goods – or straight to cost of sales when the job is handed to the customer at once. Jobs not finished at the end of the period make up the closing work-in-progress.

Batch costing

Batch costing is used where a number of identical units are made together as one batch – for example 500 shirts in one style and size, 2,000 loaves of bread, or a batch of tablets. The batch is costed exactly like a job, with its own batch cost card and its own costs, including any cost of setting up the machines for the batch. The cost of one unit is then:

Cost per unit = total cost of the batch ÷ number of units in the batch

In the accounts, each batch is treated as a job: its costs are debited to work-in-progress, and the cost of a completed batch is transferred to finished goods.

6 Cost statements in manufacturing, service and not-for-profit organisations

Management needs regular cost statements whatever kind of organisation it runs. The layout changes with the organisation, but the aim is the same: to show what the output cost, in total and per unit, so that it can be compared with budgets, previous periods and similar organisations.

Manufacturing organisations

A manufacturer’s cost statement (sometimes called a manufacturing account) builds up the cost of production in stages:

Service organisations

A service business has no physical product and usually little or no inventory, so there is no work-in-progress or finished goods to account for: the costs of the period are the costs of the service provided. Most of its costs are often labour and overheads rather than materials. The main difficulty is choosing a cost unit – a measure of the service provided – so that a cost per unit can be calculated and compared (see the four features of services in chapter 12). Often it is a composite cost unit made up of two measures:

Not-for-profit organisations

Charities, public hospitals, state schools and government departments do not aim to make a profit. Their aim is to provide as much service as possible, of a good quality, with the money they have. Their cost statements therefore compare actual costs with the budget, and measure the cost per unit of service – cost per patient treated, per pupil taught, per meal delivered – alongside non-financial measures of how well the service is delivered.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.