Cost of Goods Sold


 DEFINITIONS

Cost

Cost is forgoing (exchange price, sacrifice), measured in monetary terms, incurred or potentially to be incurred to achieve specific objective.

Expense

The expired cost is called expense OR the decrease in net assets as a result of the use of economic services in the creation of revenue.

Use of Cost Data

1.      Planning Profit by means of budgets.

2.      Controlling costs via responsibility accounting.

3.      Measuring annual or periodic profit, inventory costing.

4.      Assisting in pricing policy.

5.      Furnishing cost data for analytical processes for decision making.

Definition of Management Accounting

According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources.


Classification of Cost

  1. Natural Classification

A). Manufacturing Costs

Ø  Direct Materials

Ø  Direct Labour

Ø  Factory Overheads

                 B). Commercial Expenses

Ø Marketing

Ø Administration

  1. With respect to Accounting Period

                 A). Capital Expenditures

                 B). Revenue Expenditures

  1. By their Tendency to vary with Volume or Activity

           A). Variable Costs

           B). Semi-Variable Costs

           C). Fixed Costs

4. Costs for Planning and Control

           A). Budgeted Costs

           B). Standard Costs

5. Costs for Analytical Processes 

Ø  Opportunity Cost

Ø  Differential Cost

Ø  Sunk Cost

Ø  Out-of-Pocket Costs

Ø  Imputed Costs

Ø  Relevant and Irrelevant Costs.

      6. With respect to Stock Valuation & Profit Measurement

Ø  Period Cost

Ø  Product Cost

Elements of Cost

Ø  Material

Ø  Labour

Ø  Factory Overheads

Direct Material

The material that forms an integral part of finished product and that can be easily identified with the product.

Examples:

  • Lumber to make furniture
  • Steel to make automobile bodies
  • Crude Oil to make gasoline 

Direct Labour

The labour (working hands involved in production) that applies directly to the material comprising finished product.

Factory Overheads

FOH are also called "manufacturing overheads", "manufacturing expenses", or "factory burden". FOH may be defined as the cost of indirect materials, indirect labour and all other manufacturing costs that can not conveniently be charged to specific jobs, units or products.

Costs in their tendency to vary with Volume or Activity

A.    Variable Costs

B.     Fixed Costs

C.    Semi-Variable Costs

A.    Variable Costs

Following are the characteristics of variable costs:

Ø  Vary in direct proportion to the volume of production

Ø  Comparatively constant per unit within a relevant range

Ø  Control of their incurrence and consumption by their responsible department head.

Examples of Variable Costs:

Ø  Direct Materials

Ø  Direct Labour

Ø  Supplies

Ø  Fuel

Ø  Power

Ø  Small tools

Ø  Receiving costs

Ø  Communication Costs

Ø  Over time premiums

B. Fixed Costs

Following are the characteristics of fixed costs:

Ø  Fixed in total within relevant range.

Ø  Vary per unit with increased production.

Ø  Control of incurrence in most cases rests with executive management.

Examples:    

Ø  Salaries of Production Executives

Ø  Depreciation

Ø  Factory Rent

Ø  Maintenance of Factory Building

Ø  Insurance- Property

Ø  Wages of security Guards

C. Semi-Variable Costs

Semi-variable costs contain both fixed and variable elements.

Examples:

Ø  Supervision

Ø  Inspection

Ø  Maintenance & Repairs of machinery

Ø  Health and Accident Insurance

Ø  Payroll Taxes

Ø  Heat, Light and Power

Prime Cost = Direct Material + Direct Labour

Conversion Cost = Direct Labour + Factory Overheads

Manufacturing Cost = Direct Material + Direct Labour + Factory Overheads

                                                             OR

                                    = Prime Cost + Factory Overheads

                                                            OR

                                    = Direct Materials + Conversion Cost

Cost of Goods Sold Section comprises of:

Ø  Direct Materials

Ø  Direct Labour

Ø  Factory Overheads

Ø  Work in Process

Ø  Finished Goods

Opportunity Cost

An opportunity measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up.

OR

Opportunity Cost is the measurable value of an opportunity bypassed by rejecting an alternative use of resources.

Example

A company has an opportunity to obtain a contract for the production of a special component. This component will require 100 hours of processing on machine X. Machine X is working at full capacity on the production of Product A; and the only way in which the contract can be fulfilled is reducing the output of Product A. This will mean a loss of revenue of Rs.200. The contract will result in additional variable cost of Rs.1,000.

If the company takes on the contract, it will sacrifice revenue of Rs.200 from the lost output of product A. This represents an opportunity cost, and should be included as a part of the cost when negotiating the contract. The contract price should at least cover the additional cost of Rs.1,000 plus Rs.200 opportunity cost to ensure that the company will be better off in the short term by accepting the contract.

Differential Cost                  

Differential cost is the difference in the cost of alternative choices. Differential cost is often referred to as marginal or incremental cost.

Example

Variable production cost is the typical example of differential cost. If, however, the selection of other alternative requires additional fixed cost, then this cost will also be considered as differential cost.

Sunk Costs

These costs are the cost of resources already acquired where the total will be unaffected by the choice between various alternatives. These are the costs that have been created by a decision made in the past and can not be changed by any decision that will be made in future.

Example

Written-down Value (Depreciation) of an asset previously purchased is sunk costs.

For example, if a machine was purchased 4 years ago for Rs.100,000 with an expected life of 5 years with no salvage value and then written down value will be Rs.20,000 p.a. if straight line depreciation is used. The written down value will have to be write off, no matter what possible alternative future action might be chosen. If the machine was scrapped, the Rs.20,000 would be written off; if the machine was used for production, Rs.20,000 still  have to be written off. This cost can not be changed by any future decision and is therefore classified as a sunk cost. It is irrelevant for decision making.

Imputed Costs

Imputed costs are hypothetical costs representing the cost or value of resource measured by its use value. These costs do not involve actual cash outlay.

Examples

Interest on invested capital, rental-value of company-owned properties.

Out-of-Pocket Costs

While imputed costs do not lead to cash outlays, out-of-pocket costs do, either immediately or at some future date. These costs are often identified as variable or direct costs, because these costs are relevant to any decision when the total product costs are not pertinent.

Relevant and Irrelevant Costs

Relevant Costs are those costs that will bee changed by a decision, whereas irrelevant costs are those costs that will not be affected by the decision.

Example

A company purchased raw materials a few years ago for Rs.100. There appears no possibility of selling these materials or using them in future production apart from in connection with an inquiry from a former customer. This customer is prepared to purchase a product that will require the use of all these materials, but he is not prepared to pay more than Rs.250. The additional costs of converting these materials into the required product are Rs.200. Should the company accept the order for Rs.250?

It appears that cost of the order is Rs.300, consisting of Rs.100 material cost and Rs.200 conversion cost, but it is incorrect because the Rs.100 material cost will remain the same whether order is accepted or rejected. The material cost is, therefore, irrelevant for the decision; but if the order is accepted, the conversion cost will change by Rs.200, and this conversion cost is a relevant cost. If we compare the revenue of Rs.250 with the relevant cost for the order of Rs.200, it means that the order should be accepted, assuming of course that no higher-priced orders can be obtained elsewhere. The following calculations show that this is correct decision to accept the order:


                                                                                Don't Accept Order                       Accept Order

                                                                                       Rs.                                           Rs.

Materials                                                                       100                                            100

Conversion cost                                                            ----                                            200

Revenue                                                                        ----                                           (250)                               

Net Cost                                                                       100                                              50

 

The net cost of the company is Rs.50 less, or alternatively the company is Rs.50 better off as a result of accepting the order. This agrees with the Rs.50 advantage which was suggested by the relevant cost method.

Period Costs

Period costs are charged against the income of the current period. In direct costing, fixed FOH as well as selling and administrative expenses are treated as period costs.

Product Costs

Costs that apply to the production of goods are called period costs. Variable manufacturing costs (Direct Materials, Direct Labour and Variable FOH) are typical product costs in Direct Costing and are charged against the income when the units to which they relate are sold.


Questions on Cost of Goods Sold

Question 1

From the following information, calculate the amount of Raw Material used.

Opening inventory Raw Material --------------------------------------------- Rs.35,000

Raw Materials Purchased ------------------------------------------------------      90,000

Freight Inward -------------------------------------------------------------------        5,000

Raw Materials Returned to Supplier ------------------------------------------      10,000

Raw Materials Ending Inventory ----------------------------------------------      20,000


Question 2

The accounting department of Shellay Company provided the following data:

Direct Material put into process -----------------------------------------------Rs.50,000

Direct Labour incurred ----------------------------------------------------------    80,000

Factory Overheads ---------------------------------------------------------------    40,000

Required:

  1. Prime Cost
  2. Conversion Cost
  3. Manufacturing Cost

Question 3

The accounting department of Sapphire Company provided the following data:

Direct Material put into process -----------------------------------------------Rs.80,000

Direct Labour incurred ----------------------------------------------------------    90,000

Factory Overheads ---------------------------------------------------------------    25,000

Inventories:                                                                               Opening          Ending

Raw Materials                                                                                10,000           20,000

Work-in-Process                                                                             15,000          10,000

Finished Goods                                                                               20,000          35,000

Required:

  1. Purchases
  2. Prime Cost
  3. Conversion Cost
  4. Manufacturing Cost
  5. Cost of Goods Manufactured
  6. Cost of Goods Sold

Question 4

On October 1st, the Florida Company had the following inventories:

Materials                          Rs. 24,000

Work in Process                     12,000

Finished Goods                      36,000

During the month, materials costing Rs.56,000 was purchased. Direct Labour was Rs.40,000 and  actual FOH for the month were Rs.48,000.

Inventories on October 31st were as follows:

Materials                          Rs. 20,000

Work in Process                       8,000

Finished Goods                      40,000

Required:

  1. Prime Cost
  2. Conversion Cost
  3. Cost of Goods Manufactured
  4. Cost of Goods Sold

 

Question 5

The following information was taken from the books of Spider Manufacturing Corporation for the year ended December 31st 2004. 

                                                                                                                 Units              Rs.

Sales during the year---------------------------------------------------  8,000             ?

Opening Inventories:

        Work in process                                                                              ----              ----

        Finished Goods --------------------------------------------------  1,800        14,850

Closing Inventories:

         Work in process ---------------------------------------------------  100               ?

         Finished Goods  -------------------------------------------------  2,000               ?

Manufacturing Costs:

Direct Materials Cost ---------------------------------------------------------------  30.000

Direct Labour ------------------------------------------------------------------------  20,000

Factory Overheads ------------------------------------------------------------------  16,000

The foreman has submitted the following estimate of  Work in process ending Inventory:

Direct Materials-----------------Rs.2,700

Direct Labour-----------------------1,000

FOH----------------------------------    ?

The Company's past experience shows that FOH cost tends to fluctuate closely in proportion to Direct Labour Cost.

Required:

  1. Calculate the number of units manufactured during the year.
  2. Complete the Forman's estimate of cost of work in process.
  3. Calculate the Cost of each unit manufactured during the year.
  4. Prepare Cost of goods sold statement.
  5. Calculate Sales figure by assuming that sales price consists of a markup of 25% of its total production cost.    

Question 6

From the following data, compute the sales price per unit.                               

Estimated Annual Sales      16,000 units

Estimated Cost                                                                           Total                  Per Unit

Materials                                                                                    Rs.96,000               Rs.6.00

Direct Labour                                                                                  14,400                    0.90

Factory Overheads                                                                           24,000                   1.50

Administrative Expenses                                                                 28,800                   1.80

                                                                                                  Rs.163,200            Rs.10.20

Question 7

You are given the following data of KKJ Manufacturing Company.

Prime Cost ----------------------------------------------- 70% of cost of goods manufactured

Gross Profit --------------------------------------------- 20% of net sales

Factory Overheads ------------------------------------- 40% of conversion cost

Cost of goods to be sold ------------------------------- Rs.300,000

Direct Materials Purchased --------------------------- Rs.135,000

Opening WIP ------------------------------------------- Rs.84,000

Opening Direct Material Inventory ------------------ Rs.15,000

Opening Finished Goods ------------------------------ Rs.60,000

Sales ------------------------------------------------------ Rs.307,500

Direct Labour ------------------------------------------- Rs.42,000

Required:

                Calculate Closing Inventories of:

·         Direct Materials

·         WIP

·         Finished Goods

Question 8

Following information relates to Ciza Chemical industries for the month of December:

Materials purchased during December -------------------------------------- Rs.110,000

Cost of goods sold ------------------------------------------------------------- Rs.345,000

FOH was 50% of Direct Labour Cost.

Inventories were as follows:

                                                               Beginning                          Ending

Finished Goods -------------------------  Rs.102,000----------------Rs.105,000

Work in Process ------------------------  Rs.  40,000----------------Rs.  36,000

Materials---------------------------------- Rs.  20,000----------------Rs.  26,000

Required: Prepare a cost of goods sold for the month of December.  

                                                     

Question 10

The proprietor of Decent Industries has a limited knowledge of accounting. At the end of the accounting year he prepared the following income statement:


Decent Industries

Income Statement

For the Year Ended December 31, 2005

 

                                                                                          Rs.                                Rs.

 

Sales                                                                                                                   675,000

Less Operating expenses:

   Direct Labour                                                              137,500

   Indirect Labour                                                             18,000

   Selling & Administrative Expenses                              48,000

   Raw Materials Purchased                                            248,500

   Electricity Bill                                                               22,500

   Insurance Expense                                                          6,000

   Depreciation Expense of Factory Equipment               33,000

   Depreciation of Head Office Equipment                        4,500

   Rent of Premises                                                           75,000

   Advertising                                                                    81,500                       674,500

Net Profit                                                                                                                   500

The proprietor is concerned as to the accuracy of the above statement and has requested you to check over the statement and make necessary corrections.

During analysis, you have determined the following additional information:

  1. 80% of the electricity bill, 75% of the insurance expense, and 70% of rent of premises apply to factory operations and the remaining amounts apply to the selling and administrative activities.
  2. Beginning and ending inventories were:

                                                                                     January 1st            December 31st

          Finished Goods                                                        Rs.50,000               Rs.60,000   

          Work in Process                                                            42,500                    30,000

          Raw Materials                                                                 7,500                    18,000

  1. FOH are applied @ Rs.5 per machine hour. Machine hours during the year totaled 26,400. Under/over applied FOH are to be closed to the cost of goods sold.   

Required:

  1. Prepare cost of goods manufactured and sold statement indicating cost of goods sold at normal and at actual.
  2. Prepare revised income statement.
  3. Explain the reason for difference between net profit as per proprietor's income statement and your revised income statement.