Notes
DEFINITION
Cost accumulation is the use of an accounting system to collect and maintain a database of the
expenses incurred by a business in the course of its operation.
The two main forms of cost accumulation are
a) a job order system where direct materials, staffing and overhead costs are collected under
assigned job number
b) A process costing system where costs are maintained and associated with a particular cost
center.
ACCOUNTING FOR MATERIALS AND INVENTORY
MATERIAL COSTING
Inventory consists of raw materials, W.I.P, consumer goods and spare parts etc.
Material costing entails the study of the inventory control systems of the items.
Stock costs
i) Purchase costs
Actual amount paid to the supplier of the stock item.
ii)Ordering costs
Costs of obtaining inventory Include
a) Clerical and admin cost associated with purchasing and receiving goods.
b) Transportation costs from supplier
iii) Holding costs
Are costs incurred as a result of keeping inventories of stores
It depends in quantities held may include:-
a) Cost of storage and stores operation e.g. rent and storage spares, salaries for staff.
b) Insurance costs – the higher the rate for inventory held the higher the premium.
c) Cost of capital – opportunity cost of capital held in the stocks
d) Risks of deterioration / deterioration cost.
iv) Stock – out costs.
Arises where stocks kept are low which may lead to the company not being able to satisfy
demand since stocks are not enough
These costs include:-
a) Lost contribution due to unrealized sales.
b) Loss of future sales due to dissatisfied customers.
c) Loss of goodwill
d) Cost of production stoppage
e) Extra cost of urgent orders.
v) Optimal stock level
Stocks held should be maintained at optimal levels to help regulate the GNL of costs due to
problem of overstocking and undertaking.
This levels will help determine when the order, how much to order, the quantity to be held. These
levels include:-
a) The re-order level
This is that point once reached and order was to be placed with the supplier. It is the quantity in
stocks that goods will be ordered to avoid stock-outs. It is determined by considering the expected
the expected demand during re-order or lead time.
This is the amount that will be consumed during the time for waiting for deliveries. It should satisfy
the highest demand.
Recorder = max .consumption × max. Reorder period.
b)Maximum Stock level
The highest quantity of stock that can be held at any particular time .Stocks may not be allowed to
go beyond this level.
Max. Stock Level = re-order level + orderquantity - (Minimum consumption × Min.re-order period)
c) Minimum stock levels
This is the lowest quantity of stocks that should be held. Stocks should not be allowed to fall below
this level. Also known as buffer level
Max. Stock = re-order + re-order - (Normal × Normal)
Level level quantity consumption lead time
Reorder level = Maximum Consumption x Maximum Re-order period
280000 x 5=1,400,000 units
Minimum Stock Level = Re-order level (Normal cons. ×Normal lead-time)
1,400,000 – (200,000 ×4) =600 units
Maximum Stock level = Reorder level + Qty. demanded – (Min stock ×Min. lead-time)
= 1,400,000 + 5,000 – (50,000 ×3)
= 1,381,000 units
STOCK VALUATION
In a period stocks are normally purchased at different price and for product costing purposes and
profit determination stock have to be appropriately valued. This is because when stocks are
transferred to the stores they loss their identity and the issue price may not be accurately determined
because they are many in the store.
There are two systems of stock valuation i.e.
a) Periodic stock take system /physical stock takes
This involves actual counting, checking and verification of stock available in the stores at the end
of the period. The stock will normally be determined after stock take to enhance accuracy,
normally close down for the stock take exercise.
b) Perpetual / Continuous system
A transaction system where stock records are maintained as per transaction each receipt or issue
of stock is recorded and stock records. Therefore readily available and this help address the
problem of overstocking/under stocking.
To enhance accuracy each stock item must have its own stock record where the transactions will be
recorded. There are several methods which can be used to maintain records for valuation purposes.
These methods have been discussed below.
1) First in first out (FIFO)
Accounting: Method of inventory valuation based on the assumption that goods are sold or used in
the same chronological order in which they are bought. Hence, the cost of goods purchased first
(first-in) is the cost of goods sold first (first-out). During periods of high inflation-rates, the FIFO
method yields higher value of the ending inventory, lower cost of goods sold, and a higher gross
profit (hence the higher taxable income) than that yielded by the last-in first-out (LIFO) method. The
'in' office basket is an illustration of FIFO method
Illustration
NyaliMbali Ltd. are retailers who sell ceramic tiles. During the months of July to September 2000,
there were price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 July Opening stock was 5,000 tiles valued at Sh 825,000.
10 July Orders placed with the company increased, so extra tiles had to be
obtained from Mombasa. Therefore 22,000 tiles were purchased at a cost Sh
140 each but in addition, there was a freight and insurance charge of Sh 5 per
tile.
31 July During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 August A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
30 August The sales for the month of August were 14,000 tiles at a selling price of Sh 230
each.
1 September A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 September 270,000 tiles were sold during September at price of Sh 240 each.
The cost accountant of NyaliMbali Ltd decided he would apply first-in-first-out basis.
Required:
(i) A stores ledger account using first-in-first-out method and showing stock values at 30
September 2000.
2) Last in first out (LIFO)
Accounting: Method of inventory valuation based on the assumption that the goods purchased most
recently (the last in) are sold or used first (the first out). The remaining items are assumed to have
been purchased at successively-earlier periods. In this method, value of the inventory at the end of
an accounting period is based on the value of items purchased earliest. During periods of high
inflation rates, the LIFO method yields lower value of the ending inventory, higher cost of goods
sold, and a lower gross profit (hence lower taxable income) than that yielded by the application of
the first-in, first-out (FIFO) method. During prolonged inflationary periods, however, LIFO method
can seriously understate the value of inventory because the cost of replacing it would be much
higher than the value shown in accounts. The 'Out' office-basket is an illustration of LIFO method.
Illustration
The following information relates to item P003 stocked by 2000 products Ltd for the month of April 2012:
The closing balance for March 2012 was a batch of 3,000 units received at a unit price of Sh 19.
Required:
a) Stores perpetual inventory record for item P003 for May 2012 under LIFO system of stores
issues.
b) Closing stock valuation.
3) Weighted Average
Under this method the price of material issued is determine by computing the average price of all
items held in stock.
The quantity for each batch are considered when calculating the average price, the average price
is calculated by dividing the total cost of stock items held by the total quantities available.
Weighted average price = Total cost of all items held in stock
Number of stocks items available in store
Illustration
NyaliMbali Ltd. are retailers who sell ceramic tiles. During the months of July to September 2000,
there were price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 July Opening stock was 5,000 tiles valued at Sh 825,000.
10 July Orders placed with the company increased, so extra tiles had to be obtained from
Mombasa. Therefore 22,000 tiles were purchased at a cost Sh 140 each but in addition
there was a freight and insurance charge of Sh 5 per tile.
31 July During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 August A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
30 August The sales for the month of August were 14,000 tiles at a selling price of Sh 230 each.
1 September A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 September270,000 tiles were sold during September at price of Sh 240 each.
The cost accountant of NyaliMbali Ltd decided he would applyweighted average method
Required:
(i) A stores ledger account using weighted average method and showing stock values at 30
September 2000.
4) Simple Average cost
The price of material issued is determined as an average prices existing in stocks. Quantities will not
be considered when calculating average price.
Issued quantities reduces quantity of earlier purchases receipt once the issued quantity is more than
the quantity in the patch, the price of the patch is removed from the existing prices.
Average price = Total of Existing Price
No of prices
Illustration
A company records the following transactions concerning the major products during the first quarter of the year 2012.
Special cases in stock valuation
1) Carriage Inwards
The cost of stock includes the purchases cost plus any other incidental cost incurred to bring
stock to their current or saleable state which includes insurance of goods in transit.
2) Returns
a) Sales Returns / Returns in words
Sales are issues to production recorded on the issue side of the stocks ledger and therefore when
returned should be recorded at the receipt side at the price issued.
b) Purchases Returns/ Return outwards
Purchases are recorded on the receipt side. The returns should be recorded on the issue column at
the price purchases.
3) Losses
Stock losses if identified after stock counts should be adjusted so that the a/c reflects the actual
quantity losses will be recorded on the issue column and valued consistently with the method in
use.
INVENTORY CONTROL PROCEDURES
Major Types of Inventory Control Systems
There are two broad of inventory control systems, the Reorder Level and the Periodic Review
systems. These systems are examined below but naturally many hybrid systems exist in practice and
many variants of the basic types will be found.
Reorder Level System.
This system is also known as the two-bin system. Its characteristics are as follows:
a) A predetermined re-order level is set for each item.
b) When the stock level falls to the re-order level, a replenishment order is issued.
c) The replenishment order quantity is invariably the EOQ.
d) The ‘two-bin’ system comes from the simplest method of operating the system whereby the
stock is segregated into two bins. Stock is initially drawn from the first bin and a
replenishment order issued when it becomes empty.
e) Most organizations operating the re-order level system maintain stock records with calculated
re-order levels which trigger off the required replenishment order.
Basic Terminology
Brief definitions of common inventory control terms are given below
a) Lead or procurement time. The period of time, expressed in days, weeks, months, etc. between
ordering (either externally or internally) and replenishment, i.e. when the goods are available for
use.
b) Demand. The amount required by sales, production, etc. Usually expressed as a rate of demand
per week, months or year. Estimates of the rate of demand during the lead time are critical
factors in inventory control systems.
c) Economic Ordering Quantity (EOQ) or Economic Batch Quantity (EBQ). This is a calculated
ordering quantity which minimizes the balance of cost between inventory holding costs and
reorder costs.
d) Physical stock. The number of items physically in stock at a given time.
e) Free stock. Physical stock plus outstanding replenishment orders minus unfulfilled requirements.
f) Buffer Stock or Minimum Stock or Safety Stock. A stock allowance to cover errors in
forecasting the lead time or the demand during the lead time.
g) Maximum Stock. A stock level selected as the maximum desirable which is used as an indicator
to show when stocks have risen too high.
h) Recorder level. The level of stock at which a further replenishment order should be placed. The
reorder level is dependent upon the lead time and the demand during the lead time.
i) Reorder Quantity. The quantity of the replenishment order. In some types of inventory control
systems this is the EOQ, but in some other systems a different value is used.
A Simple Stock Situation Illustrated.
The figure below shows a stock situation simplified by the following assumptions: regular rates of
demand, a fixed lead time, and replenishment in one batch.
Notes:
a) It will be seen from figure above that the safety stock in this illustration is needed to cope with
periods of maximum demand during the lead time.
b) The lead time as shown is 5 weeks, the safety stock 200 units, and the reorder quantity 600 units.
c) With constant rate of demand, as shown, the average stock is the safety stock plus ½ Reorder
quantity, for example, in figure above the average stock is:
200 + ½ (600) = 500 units.
Illustration
A simple manual reorder system illustrated.
The following data relate to a particular stock item.
Normal usage 110 per day
Minimum usage 50 per day
Maximum usage 140 per day
Lead time 25-30 days
EOQ (Previously calculated) 5000
Required;
Calculate various control levels
Solution
Using this data the various control levels can be calculated
Re-order Level = Maximum Usage ×Maximum Lead Time
= 140 × 3
= 4,200 units
Minimum Level = Re-order Level – Average Usage for Average Lead Time
= 4.200 – (110 × 27.5)
= 1,175 units
Maximum Level = Re-order Level + EOQ – Minimum Anticipated Usage in Lead Time
= 4,200 + 5,000 – (50 ×25)
= 7,950 units
ECONOMIC ORDER QUANTITY (EOQ)
This is that quantity that is most economical to order. It is the quantity that minimizes the total
inventory cost of holding and ordering.
It is that size of an order that gives the maximum consumption.
It is obtaining and maintaining inventory at optimal levels.
NB: purchase cost is part of inventory cost. However under EOQ purchase price is assumed to be
constant irrespective of quantity ordered.
It is also assumed that the company will not experience stock out therefore the purchase cost and
stock-out will be ignored under EOQ
To be able to calculate a basic EOQ certain assumptions are necessary.
a) That there is a known, constant stockholding cost.
b) That there is a known, constant order cost.
c) That rates of demand are known and constant.
d) That there is a known, constant price per unit, i.e. there are no price discounts.
e) That replenishment is made instantaneously, i.e. the whole batch is delivered at once.
NOTE:
a) It will be apparent that the above assumptions are somewhat sweeping and they are good reason
for treating any EOQ calculation with caution.
b) The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in lead
time and demand.
The EOQ Formula
It is possible, and more usual, to calculate the EOQ using a formula. The formula method gives an
exact answer, but do not be misled into placing undue reliance upon the precise figure. The
calculations are based on estimates of costs, demand, etc. which are, of course, subject to error. The
derivation of the EOQ formula is given below;-
Notes:
a) From a graph closer accuracy is not possible and is unnecessary anyway.
b) It will be seen from the graph that the bottom of the total cost curve is relatively flat, indicating
that the exact value of the EOQ is not too critical.
Illustration
A company had annual demand of 800,000 units the purchase per unit is 80 while the cost of
pressing are order is Sh.4,000. The annual inventory holding cost is 5% of the inventory value.
Currently the company has been purchasing 20000 units time, they place an order.
Required;
i) Calculate the total cost of current inventory policy
ii) Calculate the EOQ
iii) Calculate the cost savings if the company adopts EOQ policy
Solution
i) Total inventory cost = ordering cost + purchasing + holding cost for stocks out cost
Economic Order Quantity in the Presence of Discounts
A company may qualify for quantity discounts if it purchases stock items in bulk. This will have an
effect of rendering the effective purchase cost.
In determining whether the company should take advantage of quantity discount we compare the
total cost of using the E.O.Q without discount and the total cost after taking the advantage of
discount.
A particularly unrealistic assumption with the basic EOQ calculation is that the price per item
remains constant. Usually some form of discount can be obtained by ordering increased quantities.
Such price-discounts can be incorporated into the EOQ formula, but it becomes much more
complicated. A simpler approach is to consider the costs associated with the normal EOQ and
compare these costs with the costs at each succeeding discount point and so ascertain the best
quantity to order.
Steps
1. Compute EOQ without discounts and hence use the EOQ to compute total costs.
2. Using the discounted purchase cost and more stock to qualify for it compute the total cost (C.
3. Compare the Total Cost in step 1 or 2 and make recommendations
Financial Effects of Discounts
Price discounts for quantity purchases have three financial effects, two of which are beneficial and
one adverse.
a) Lower price item.
b) The larger order quantity means that fewer orders need to be placed so that ordering costs are
reduced.
Adverse Effects
a) Increased costs arise from the extra stockholding costs caused by the average stock level being
higher due to the larger order quantity.
Illustration
EOQ with Discounts
A company buys 400 units of an item at the cost of Sh. 5000 at unit at an ordering cost of Sh 2000 at
order. The carrying cost has been determined to be 20% of the costs of average cost. The company
then received 2% discount offer for purchases of 100 or more unit
Safety Stock and Re-Order Levels
So far it has been assumed that the demand and the lead time have been known with certainty. In
such circumstances the re-order level is the rate of demand times the lead time.
This means that regardless of the length of the lead time or of the rate of demand no buffer stock is
necessary when there are conditions of certainty.
This results in a stock profile as follows
Re-order level in conditions of certainty (no safety stock)
It will be seen from the graph above that, in conditions of certainty, the re-order level can be set so
that stock just reaches zero and is then replenished. When demand and/or lead time vary, the reorder level must be se so that, on average, some safety stock is available to absorb variations in
demand and/or lead time. In such circumstances the re-order level calculation can be conveniently
considered in two parts:
a) The normal or average rate of usage times the normal or average lead time (i.e. as the re-order
level calculation in conditions of certainty) Plus.
b) The safety stock.
Safety Stock Calculation by Cost Tabulation
The amount of safety stock is the level where the total costs associated with safety stock are at a
minimum. That is, where the safety stock holding plus the stock-out cost is lowest. (It will be noted
Time Lead Time
Reorder Level
Stock Level
that this is a similar cost situation to that previously described in the EOQ derivation). The
appropriate calculations are given below based on the following illustration.
Illustration
An electrical company uses a particular type of thermostat which costs £5. The demand averages
800 p. a. and the EOQ has been calculated at 200. Holding costs are 20% p.a. and stock out costs
have been estimated at sh.2 per item that is unavailable. Demand and lead times vary, but fortunately
the company has kept records of usage over 50 lead times as follows
ECONOMIC BATCH QUANTITY (EBQ)
This is a model for manufacturing firms which produces component for use in the production of a
finished product.
The production technology is such that the production rate of the component is higher than the usage
rate. The balance of stock at the end of each day is put in storage facilities and it assumed to the
max. Stock level at the end of the production
The components are these produced in batches. Production stop for some time then started again
hence forth.
EBQ is the quantity to be produced per production run in order to minimize total cost model policy
variables include:-
i) Economic batch quantity
ii) Length of production run
iii) Max stock level
iv) Length of the break between production runs
v) Reorder level
vi) Associated costs including
vii) Variable cost of production
viii) Holding cost of inventory items
ix) Set-up costs i.e. cost of mobilizing production resources e.g. order of Rm.
Derivation of EBQ
Let R = set up costs per set up
S = Set up cost per set up
C = variable production cost per unit
Ch= Holding cost per unit per annum
i = Holding cost as a percentage of variable production costs per units
Ch = Ci
Q = economic batch quantity
P = production rate in units per day or any other period
U = usage rate in units per day or any other period
d = Length of production run in days or any other period
B = Length of the break between production runs
Assumption of EBQ
1) The annual requirements are assumed to be constant.
2) The variable production cost are assumed to be constant
3) The holding cost are assumed to be constant
4) The usage rate in units per day and the production rate in units per day to be constant.
5) They are assumed to be no stock out hence no stock out cost
BACK FLUSH
Back-flush accounting is a costing short-cut. It relies on businesses having immaterial amounts of
work-in-progress and it is therefore particularly suitable for businesses operating just-in-time
inventory management. If the amount of work-in-progress is negligible, what is the point in
meticulously valuing it? Fretting that some products might be 25% complete and others 60%
complete, and then adding carefully calculated labour and overheads to these (immaterial) items is a
complete waste of time and effort. That type of accounting is perhaps the modern-day equivalent of
alleged ancient arguments about how many angels could dance on the point of a needle.
In back-flush accounting costs are not associated with units until they are completed or sold. Backflush accounting is sometimes called delayed costing, which is a helpful name, as costs are not
allocated to production until after events have occurred.
Standard costs are then used to work backwards to flush out manufacturing costs into production,
splitting them between stocks of finished goods (if any) and cost of sales. No costs, whether material
or conversion costs, are allocated to work-in-progress.
Basically, back flush accounting is when you wait until the manufacture of a product has been
completed, and then record all of the related issuances of inventory from stock that were required to
create the product. This approach has the advantage of avoiding all manual assignments of costs to
products during the various production stages, thereby eliminating a large number of transactions
and the associated clerical labor.
Back flush accounting is entirely automated, with a computer handling all transactions. The back
flushing formula is:
Number of units produced × unit count listed in the bill of materials for each component
= Number of raw material units removed from stock
Backflushing is a theoretically elegant solution to the complexities of assigning costs to products
and relieving inventory, but it is difficult to implement. Backflush accounting is subject to the
following problems:
- Requires an accurate production count. The number of finished goods produced is the
multiplier in the backflush equation, so an incorrect count will relieve an incorrect amount of
components and raw materials from stock.
- Requires an accurate bill of materials. The bill of materials contains a complete itemization of
the components and raw materials used to construct a product. If the items in the bill are
inaccurate, the backflush equation will relieve an incorrect amount of components and raw
materials from stock.
- Requires excellent scrap reporting. There will inevitably be unusual amounts of scrap or
rework in a production process that are not anticipated in a bill of materials. If you do not
separately delete these items from inventory, they will remain in the inventory records, since the
backflush equation does not account for them.
- Requires a fast production cycle time. Backflushing does not remove items from inventory until
after a product has been completed, so the inventory records will remain incomplete until such
time as the backflushing occurs. Thus, a very rapid production cycle time is the best way to keep
this interval as short as possible. Under a backflushing system, there is no recorded amount of
work-in-process inventory.
Back flushing is not suitable for long production processes, since it takes too long for the inventory
records to be reduced after the eventual completion of products. It is also not suitable for the
production of customized products, since this would require the creation of a unique bill of materials
for each item produced.
The cautions raised here do not mean that it is impossible to use backflush accounting. Usually, a
manufacturing planning system allows you to use backflush accounting for just certain products, so
you can run it on a compartmentalized basis. This is useful not just to pilot test the concept, but also
to use it only under those circumstances where it is most likely to succeed. Thus, backflush
accounting can be incorporated into a hybrid system in which multiple methods of production
accounting may be used.
ACCOUNTING FOR LABOUR
Labour costing
Entails analysis of labour related costs, labour remuneration, and recording of labour costs to
products
It entails an analysis of the cost of purchasing labour hours and employees services rendered to an
organisation and other cost related to labour. Categories include:-
i. Direct labour
ii. Indirect labour
Direct labour
Refers to employees engaged in the production process and are the ones who make the products.
Their cost form part of direct cost of production e.g. machine operators in a factory etc.
Indirect labour
Refers to employees not engaged in direct production, they support the process. Their costs do not
form part of labour cost of production and treated as production overhead e.g. indirect employees in
the office.
Labour related costs
It may not include actual pay but also other indirect cost related to the organization labour cost
includes:-
1) Cost of labour turnover
2) Cost of idle time
3) Cost of fraud in payroll.
WAGES ALLOCATION
Gross rate represents the total pay to an employee however the entire amount paid to direct workers
is to be part of costs for part of product cost purposes because some elements of gross rate will be
treated as labour costs. The elements have been discussed below;-
1. Basic wage
Basic wages is the amount contracted for. There are various methods by which basic wages can be
paid out.
They include
(a) Fixed rate or fixed salary per month or per annum
Here, the employees earn a fixed amount despite the amount of work done. For instance, a
production manager may be allowed a salary of Shs500,000 per month, whether the company
production is at peak or off-peak.
(b) Piece rate or piece work
Under this method, the earnings depend on the level of activity or output achieved and it is
expressed as Earnings = Output (units) x basic rate per unit
Under the piece rate system, there are three schemes of remuneration. These are straight piece
rate, straight piece rate with a guaranteed minimum pay and a differential piece rate.
i) Differential piece rate
ii) Straight piece rate with a guaranteed minimum pay
iii) Straight piece rate
i) Straight piece rate
Here, the basic rate per unit remains constant irrespective of the number of units produced.
For instance, if 200 units are produced at a basic rate of Shs1000 per units, then the earnings
will be
= Shs.1,000 per unit x 200 units
= Shs.200,000
ii) Straight piece rate with a guaranteed minimum pay
Under this scheme, although the employee is paid on the number of units produced, one is
guaranteed of some main wage since there are occasions when production does not take place
due to power failures, machine breakdowns, etc. Therefore, a standard rate is agreed upon for
the production of each unit based upon an expected time to produce one unit and the normal
rate per hour.
iii) Differential piece rate
Here, employees’ basic rate of pay per unit changed as the level of activity changes. Under
differential rate system, the workers time rate is fixed at a higher level than the usual rate of
payment if the output exceeds the expected (usually set) level. The objective of this system is
to provide an incentive to the workers while retaining the simplicity of the system. It is most
appropriate for easily measurable output to which groups of workers contribute e.g. car
assembly lines. The low piece rate is applicable where a worker is not able to achieve the
standard (normal) output and the highest piece rate is for those above standard. It does not
provide the security of a guaranteed minimum wage but has the enhanced incentive of
increased rates for higher production.
If it does not guarantee minimum wages on time basis, this may lead to high wage differential
in the company and consequently demotivation. For this reason, the differential price rate
system as well as many variations of the piece rate system contains a minimum (guaranteed)
pay.
(c) Time rate or time work
Under this method, employees earnings depend on the time spent on the job. Total wages can
be expressed as;
Total earnings = Basic rate per hour × total hours worked
Under this system there are various schemes that may be applied. They include
Flat time rate
Under flat time rate, each worker is paid for the time spent without considering the volume of
production during that period. The basic rate per hour remains constant irrespective of the number
of hours worked. For instance, assume that an employee worked for 200 hours on a specific
assignment. Assume further that the basic rate per hour is Shs100. The total earnings under flat
time rate will be
= Shs100 per hour x 200 hours
= Shs20,000
LABOUR COSTS
Measured day rate
This is where although the employee is paid on the basis of the number of hours worked, before
such payment is made, one must have completed a given piece of assignment.
Graduated time rate
Under this scheme, the rate of pay is adjusted to reflect changes in the cost of living
2. Time keeping
A labour cost control routine should ensure that payments are paid only to employees who have
spent time at the work place and that payments are at agreed rates of pay including overtime
premium and shift premium payments where relevant. Where an employee is paid a fixed sum for an
agreed length of working week, it may be decided by a check by the supervisor that the employee is
at work is all that is necessary.
Where the employee is being paid at the rate per hour for the time spent at work together with
premium rates for overtime work, it is likely that a detailed record of time spent on the premises is
required. This is done by having the employee to register his arrival and departure times.
3. Time analysis
This is usually achieved by having the employee complete a daily or weekly timesheet or by having
job cards or piecework tickets. Where time sheets are issued, the employee records the time analysis
stating how much time was spent on each job and recording idle time. This sheet will then be
authorized by the supervisor. Job cards move with a job as it passes from one employee to another.
There may be time clocks at each work center where the time spent on the job is recorded.
Where this routine is used, employees may also be required to clock idle time on an idle time card,
which will be analyzed to determine the cause of idle time. Where payments are made in return for
output units, piecework tickets may be completed which are signed by the supervisor certifying the
number of units claimed. The analysis of employee time will facilitate:
- Correct charge of direct labour cost to each job
- Correct charge of indirect labour cost to cost centers
- Control of labour costs by job and cost center
- Calculation of employee bonus
- Measurement of efficiency
4. Improvement in the differential piece rate system
An improvement of the high day rate system is the measured day work system. This system attempts
to grade workers according to their efficiency and pay them a fixed amount based on which bracket
they fall. For example, a company may have the following efficiency brackets paid at the respective rates.
Suppose a worker falls in the 96% to 100% bracket, the actual amount of wages to be paid to him is
Shs.60,000. The challenge here is that some employees may be more or less efficient than graded.
Does the company still pay them the same amount as indicated in the efficiencytable? This calls for
a consistent review of the employees’ efficiency and remuneration scheme.
Where, for instance, an employee has performed more efficiently, the company may pay an excess
amount based on the evaluation. Assuming the employee in the same bracket as aboveachieves
104% efficiency, the company may decide to pay him/her the basic amount plus an extra amount based on evaluation
Illustration
Patanisho Quarry Ltd remunerates its casual workers based on each day’s work. Workers are graded
into various efficiency bands after training and then paid a fixed sum according to efficiency bands
as follows
Additional information;
1. Workers are guaranteed of their fixed pay within their efficiency bands irrespective of the
output achieved.
2. A wage rate of Sh. 700 per week is paid for efficiency levels below 81%.
3. Any excess units of production beyond the upper efficiency band limit are paid at Sh. 5 per
unit.
4. A 100% efficiency level repressing 1,200 units per week.
5. The data for a four-week period for three workers in a given time was as follows
5. Overtime Premium
This is the compensation paid to employees in addition to normal wages for hours worked in excess
of normal working hours. The overtime is that time paid for over and above the basic hours for the
period. Overtime premium is the difference between the rate at which normal working hours are paid
and the rate at which overtime hours are paid.
The overtime premium treatment depends on the cause of overtime.
a) If it is normal to work overtime due to general increase in production overtime premium is
treated as indirect wage and charged to production. This will help ensure that units completed
during normal time units completed during overtime carry the same unit cost.
b) If overtime is as a result of customer’s request it should be charged to the customer i.e. overtime
premium will be treated as part of wages for units produced by the customers.
NB: Overtime cost by abnormal conditions e.g. shortage of materials, machine breakdown is at
premium should be expensed transferred to P& L statement
6. Shift Premium
Additional amount paid to an employee for working in a different shift i.e. working night shift
instead of day shift.
It is treated as indirect wage and transferred to over debt cost.
7. Idle time Premium
Idle time is non-predictive time paid for i.e. workers are paid but no goods have been produced e.g.
when there is machine breakdown, power failure or tea breaks. Idle time can either be avoidable or
unavoidable. It could be due to production disruptions whereby there is machine breakdown,
inefficient scheduling of jobs or shortage of raw materials or policy decisions i.e. changes in
production specifications or retraining skills.
Labour costs for paying for hours of avoidable time are costs that simply should not have occurred.
Therefore, they should be written off in the profit and loss account.
Unavoidable idle time is that which cannot be helped. It is uncontrollable or unnecessary cost to the
business e.g. tea breaks, unexpected fall in demand for a product or a strike at the suppliers affecting
vital supplies. Unavoidable idle time of direct workers may be included in the cost of products as a
production overhead. All other idle time is treated as period costs.
Idle time ratio = Idle time × 100
Total hours worked
PAY OF INDIRECT WORK
Represents pay for hours worked on other jobs. The amount should be treated as an indirect wage
for the job in consideration. It should be charged as a job or a/c for in as an O/H cost.
An incentive paid to employee to recognize the employees’ efforts during production. For individual
bonus, it will be a/c as part of direct wages since it can be identified as an effort for particular job.
For group bonus the bonus is treated as an indirect wage cost since individual efforts cannot be
identified and also amount is paid to the entire group.
Indirect workers’ pay
Pay to indirect workers e.g. cleaners, supervisors should be treated as indirect wage. However if they
happen to participate in production the pay for time at production will be treated as direct wage.
Illustration
Zawadi Ltd is a small company which manufactures a range of plastic commodities.
In order to manufacture a lunch box, the following five manual processes are required:
LABOUR TURNOVER
It is the number of employees leaving or being recruited in a period of time. It is expressed as a
percentage of the total labour force. It is expressed as;
Labour turnover = Replacement ×100
Average no. of employees in a period
Causes of labour turnover; these causes outline the reasons why an employee may leave an
organization. They include
- Illness and accidents
- Retirement and death
- Rate of payment; the employee may find that the remuneration is not commensurate tothe
amount of work done
- Poor working relationship between the management and the employee
- Lack of opportunity for career or lack of job satisfaction
Costs of labour turnover
Costs of labour turnover can be broadly categorized into replacement costs and preventive costs.
Replacement costs are costs incurred as a result of hiring a new employee. They include cost of
selection and placement (advertising and interviewing), inefficiencies in new labour, lower
productivity, cost of training, loss of output due to delay in new labour becoming available,
increased wastage and spoilage due to lack of expertise among the new staff, possibility of more
frequent accidents, cost of tools and machine breakages.
Preventive costs are costs incurred in order to prevent employees from leaving an organization.
They include cost of personnel administration in maintaining good relationships and cost of welfare,
services and pension schemes.
INCENTIVE SCHEMES
Employees do not put extra efforts if there is no reward for their efforts. Employers reward workers
in a direct proportion to work accomplished.
In these schemes, workers can earn more if they produce more out and therefore get incentives to
make them produce more.
Grouped into the following categories
1) Direct financial plans
2) Indirect financial plans
3) Plans other than financial
1) Direct financial plans
Are schemes whose compensation is in direct proportion to output efforts.
Compensation of a worker is determined either individually or in a group.
A scheme whose compensation is based on individual performance is known as individual incentive
scheme and where it is made with reference to a group working together is known as group incentive
scheme.
Individual /Premium Bonus Scheme
Are schemes based on individual efforts and thus they provide greater incentive to an individual
effort when compared to group schemes.
The higher the effort, the higher the incentive
It is easier to measure performance since work is individual based. Schemes include:-
Rowan scheme
a) David Rowan of Glasgow (U.S.A) introduced the scheme, under which time wage is guaranteed
as in the case of Halsey scheme. For the performance of a job, standard time is fixed; otherwise
operation or task is exactly in the same manner as in the case of Halsey scheme. For the hours of
his actual work, the worker gets his time wage; on this point also it doesn’t differ from the
Halsey scheme. The bonus of the worker, who is able to finish the job in less than the allowed
time, is equal to his time wage for that proportion of the time taken as the saved time bears to the
time allowed. In other words, the ratio between the bonus & the time saved is equal to the ratio
between the time taken & the time allowed
Advantages
a) Because the premium is proportionate to the time saved, if the rate has been wrongly fixed, the
effect will be less serious. So Rowan scheme is safer than the Halsey scheme, as far as the point
of view of employer is concerned.
b) The worker is in the most advantageous position when 50% of the time allowed is saved by him,
because otherwise his earning per hour will increase at a diminishing rate, if any more time is
saved by him. As a result, the chances of wastage, defectives, breakdown etc. will be less as there
is a limit to speed.
c) Fixed overhead per unit will be lower as a result of higher output.
d) Since both the employer & the employee enjoys the time saved; though proportion is not the
same as in the case of the Halsey scheme, to some extent labour cost also diminishes.
e) Better wage is earned by the employees; their improvement in efficiency is rewarded.
Disadvantages
a) The workers do not like the idea of sharing the savings by both employer & employee, since the
time is saved by the workers. The bonus hours will not exceed the 25% of the time allowed in
any case.
b) Apart from workers efficiency, saving of time depends upon standard of tools, materials &
implements & also upon the working conditions. No useful purpose will be served unless the
best of these are assured.
Purpose of Rowan Premium Bonus Scheme:
- An incentive scheme to reward direct labor for saving time during the production process
- This method rewards the production worker with a proportion of the time saved
Illustration
Mr. A is being paid sh.9 per hour. The time allowed to complete a task is 12 hours. The actual time
taken by Mr. A to complete the task is only 8 hours
Required;
Compute the gross pay of Mr. A after completing the task.
Solution
Mr. A’s gross pay
= (8 hours × sh.9) + (Time taken/Time allowed ×Time saved ×Rate per hour)
= (8 hours×sh.9) + (67% × 4 hours × sh.9)
= sh.96.12
A = Time Wages – 7875
Bonus = 7875
B. Time wages – 8640
Bonus – 3/50 x 8640 = 345.6
C = 50 × 185 = 9250
Bonus 2/60 x 9250 = 308.33
Halsey bonus scheme (50/50)
F.A. Halsey of the U.S.A. introduced this scheme.
Under this scheme, for performing a job, operation or task, a standard time is specified.
The hourly rate is fixed & the workers are guaranteed so that even if, within the standard time
specified, the job is not completed by them, guaranteed time rate may be received by them.
The worker becomes entitled to bonus, if he is in a position to complete the job in less than the
specified time; bonus being equal to his time wage for 50% of the time saved in addition to the time
wage which he is entitled for the actual time worked.
The total earning is obtained by multiplying the sum of time allowed & time taken by half the hourly
rate.
Advantages:
a) The scheme & the calculation of the remuneration are easily understandable by the worker.
b) As time wage is guaranteed, penalty is not imposed on the slow workers; whereas rewards are
provided to the slow workers for their efficiency.
c) The workers are encouraged to save as much time as possible due to the bonus, because for the
higher time saved bonus will be higher.
d) Employers are enabled to obtain more output from the workers under the scheme, & as a result of
that, per unit fixed overhead get diminished.
Disadvantages:
a) Since the employers & employees share the savings in time, this may not be liked by many
employees’ organizations & they argue that the workers should get the entire benefits as the
savings is done by them.
b) Compared to the other incentive plans, the workers are being offered less incentives under this
scheme.
c) Apart from the workers, savings in time also depends upon the tool’s standards, materials, and
machinery & working conditions. So the desired result cannot be expected unless the best of
these are assured.
d) Chances of more spoilage, wastage, defectives & breakdown of machinery are there under this
scheme, as for the purpose of maximizing the bonus, the workers will try to save as much time as
possible. As a result, greater supervision cost has to be involved.
ILLUSTRATION
Employees Adam Smith and John are each assigned a job and they each take 3, 2.5 and 2 hours
respectively to complete the job. The time rate is sh.40 per hour and the time allowed for each job is
3 hours.
Required
a) Using the Halsey plan calculate the total earnings of each employee
b) Calculate the effective hourly rate of pay
b) Effective hourly rate of pay
Adams =120= sh.40
3
Smith = 110=sh.44
2.5
Johns = 100=sh.50
2
Halsey weir (33 1/3)
Under the Halsey-Weir scheme, a worker is entitled to bonus which is equal to his time wage for
331/3% (often 30%) of the time saved; instead of 50% in case of the Halsey scheme. Thus except
the above, there is no difference between the Halsey scheme & the Halsey-Weir scheme.
Illustration
Calculate the total earnings of a worker & the effectively rate of labour wages per hour where
payment of bonus is under (a) the Halsey (50%) scheme & (b) the Rowan scheme from the below
mentioned particulars:
Basic wage rate per hour – shs.10.80, Time allowed for the job – 48 hours, Actual time taken – 36
hours.
Solution
(a) Under Halsey (50%) Scheme
Total wages = Normal time wage + 50% of (time saved×time rate)
Effective hourly rate = shs.486.00/36 = shs. 13.50
Alternatively;
Bonus as a percentage of Time rate = (Time saved/Time allowed)×100
= (12/48)×100 = 25%
Bonus = 25% of shs.10.80 = shs. 2.70
Bonus as a fraction of time rate = (Time saved/Time allowed)×Time rate
= (12/48)×10.80 = shs.2.70
Effective hourly rate for time taken = shs.10.80+shs.2.70 = shs.13.50
Total Wages = 36 hours×shs.13.50 = shs.486
Illustration
40 hours is taken by a worker to do job for which time allowed is 50 hours. $. 1.25 per hour is his
daily rate. Calculate the works cost of the job under the following methods of payment of wages:
(i) Time rate; (ii) Piece rate; (iii) Halsey plan &(iv) Rowan plan.
Additional information: (i) Material cost $.60; (ii) Factory overhead 125% of wages
Solution: Calculation of wages under different methods:
i) Time Rate: Wages for 40 hours (actual time taken) @ shs. 1.25 = 50.00
ii) Piece Rate: Wages for 50 hours (time allowed for the job) @ shs. 1.25 = 62.50
iii) Halsey Plan: Normal time wage = 40 hours @ shs.1.25 = 50.00
Bonus=50% of (Time saved× Time rate) =50% of (10×1.25) = 6.25
Shs. 56.25
iv) Rowan Plan: Normal time wage = 40 hours @ shs.1.25 = 50.00
Bonus= Time saved/Time allowed×(Time taken× Time rate)
=10/50×(40×1.25) = 10.00
Shs. 60.00
Grant bonus scheme
In these schemes, employers are rewarded on the basis of efforts applied.
In differential piece work system effort is met by use of graduated rate of payment per unit.
Higher attract higher rates per unit. The other schemes are based on time and their incentive is a
share of gains based on employer efforts. The incentive in the aggregate proportion from financial
gain of employees effort arising as a result of reduced time on production. Each job or work issued
has its own time set and if the employees work for less time he sales on standard time.
The financial adv. from time saved is shared between employee and employer based on agreed
proportion.
Incentive = Agreed proportion of time saved x Rate per hour
Time saved = Standard time – Actual time worked.
Group Bonus Scheme
Where individual schemes are not applicable group bonus schemes may be applied, these schemes
are appropriate where production is done by a group of employees working together as a team e.g.
construction of motor vehicle assembly.
It is difficult to measure individual performance and bonus will be paid to the group. It would be
shared equitably by members of the group e.g. it can be shared in proportion to their wage level or
time taken by employees on the job.
Group wages are treated as indirect wages.
Illustration
A factory issues a job to two employees, Mark and Markus, paid at the rate of sh.210/hr. and
sh220/hr. respectively. Mark is issued with 400 containers and it takes twelve minutes to produce
each. Markus is issued with 240 containers and it takes nine minutes to produce e ach
For every hour saved a bonus is paid at the rate of 60% of bonus rat3e which is sh240/hr. The
factory works 42 hours week and overtime and overtime is paid at the rate of time and one third. At
the end of the week Mark band Markus clock cards shows 54 and 50 hours respectively and the
work complete. However Mark worked 4 hours on the indirect job given that week. However, 40
and 60 containers of Mark and Markus fail to pass inspection due to faulty materials. It was agreed
to credit all output for bonus purposes.
Required;
i) Bonus due
ii) Total gross wage due
iii) Direct wages cost/containers passing inspection. Overtime is worked regularly throughout the
year as company policy due to labor shortage
CHARACTERISTICS OF AN EFFECTIVE BONUS SCHEME
i) Efficiency in production: when the volume of production is so important, the bonus incentive
scheme should reward higher producers i.e. should be based on output achieved.
ii) Effect on workers: the scheme should be designed to motivate the employees. It should be simple
and understood by those of average intelligence.
iii) Both the employer and the employees should share the gains in labour efficiency.
iv) This will motivate the employees to be more efficient since they benefit from the gains made.
v) The method of calculating the bonus should be known and acceptable to the employees
vi) The standard hours set should be achievable and realistic. When the standards are high then the
employees will not achieve them and the bonus will not be earned
Benefits associated with group bonus schemes include
- It encourages cooperation and teamwork among workers since each member in the group has an
interest in the work.
- It reduces absenteeism since an absent worker is found to reduce the group earnings and the
group may dislike him
- The approach reduces supervision time and cost, thus it is administratively much simpler.
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