Key Terms
Key Terms: Cost Accounting
Learn the core terms of Chapter 7 Cost Accounting, because every Manufacturing Account and Break-Even calculation rests on precise meanings and formulas. Each term comes with an explanation, a memory hook and how it is typically tested.
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Cost Concept & Types of Cost (Direct vs Indirect Cost)
- Cost is the value of resources (money, materials, effort) sacrificed to produce goods or provide a service. In Chapter 7 the focus is the production cost of a manufacturing firm.
- A direct cost can be traced straight to one unit of output (e.g. wood for a chair). An indirect cost cannot be traced to a single unit and must be apportioned (e.g. factory rent, machine depreciation).
- Memory hook: 'DIRECT = you can point at it in the product'. If you can point to the cost inside the finished item, it is direct; if it merely supports the whole factory, it is indirect (overhead).
- How it is tested: objective and structured questions ask you to classify a list of costs as direct/indirect before computing. Misclassifying one item shifts both Prime Cost and Overhead at once.
Components of Production Cost: Direct Material, Direct Labour, Direct Expense
- Direct Material Cost is the raw material that physically becomes part of the product. Formula: Opening raw material + Purchases of raw material + carriage inwards − Purchase returns − Closing raw material.
- Direct Labour Cost is the wages of workers who make the product (machine operators, craftsmen). Direct Expense is any other cost incurred specifically for producing particular units (e.g. hire of a special machine, royalty per unit).
- Memory hook: the three 'directs' are M, L and E: Material, Labour, Expense. Together they form Prime Cost.
- How it is tested: the computation part slips in opening/closing raw material, purchase returns and carriage inwards to check whether you compute material USED, not just purchases. Carriage outwards (on sales) does NOT belong here.
Prime Cost & Production Overhead
- Prime Cost = Direct Material + Direct Labour + Direct Expense. It is the total of all DIRECT production costs.
- Overhead (production overhead) is every INDIRECT factory cost: indirect materials, supervisors' wages, factory rent, machine depreciation, factory electricity, factory insurance.
- Memory hook: 'Prime first, Overhead next'. Prime Cost plus Overhead gives production cost (before WIP adjustment). Overhead is ONLY factory expenses; office and selling expenses go to the Income Statement.
- How it is tested: questions plant administrative/selling expenses (e.g. office clerk salary, advertising) in the list to trick you into putting them in overhead. Justifying why such costs go to the Income Statement is a common theory question.
Work in Progress (Opening WIP & Closing WIP)
- Work in Progress is goods that are only part-finished at period end: materials have been worked on but are not yet finished goods. Opening WIP is the part-finished balance brought from last period; Closing WIP is the part-finished balance at this period's end.
- Adjustment: Production cost = (Prime Cost + Overhead) + Opening WIP − Closing WIP. Add the opening (last period's work finished now), subtract the closing (work not yet finished).
- Memory hook: 'Opening UP, Closing DOWN' (+Opening, −Closing). It is the same pattern as stock in the Trading Account: opening added, closing subtracted.
- How it is tested: higher-order questions ask for the Manufacturing Account WITH WIP taken into account. The classic error is flipping the signs (subtract opening, add closing); this directly changes the final Production Cost.
Manufacturing Account & Production Cost
- The purpose of the Manufacturing Account is to gather and work out the total cost of producing finished goods in a period (the Production Cost). It is prepared before the Trading Account.
- It can be prepared in 'T' form (debit/credit) or statement (vertical) format. The Production Cost obtained is transferred to the Trading Account, replacing 'purchases' used by an ordinary trader.
- Memory hook: the vertical order is 'Material → Prime → Overhead → WIP → PRODUCTION COST'. Read from material used down to the bottom line; each subtotal has its own name.
- How it is tested: you may be asked for both 'T' and statement forms, to transfer Production Cost into the Trading Account, and to justify why only part of the costs (factory) enter the Statement of Production Cost while the rest (admin/selling) go to the Income Statement.
Break-Even Analysis: Fixed Cost, Variable Cost, Contribution Margin
- Break-even analysis is a method of finding the level of sales at which total revenue = total cost, i.e. no profit, no loss. The Break-Even Point (BEP) is the quantity/sales at that level.
- Fixed Cost does not change with output quantity (e.g. rent). Variable Cost changes with quantity (e.g. material per unit). Total cost = Fixed + Variable; Total revenue = selling price per unit × quantity.
- Contribution Margin per unit = Selling Price per unit − Variable Cost per unit. It is each unit's contribution toward covering fixed cost. Core formula: BEP (units) = Fixed Cost ÷ Contribution Margin per unit.
- For target profit: Quantity = (Fixed Cost + Target Profit) ÷ Contribution Margin per unit. Graph method: draw the total revenue and total cost lines; their intersection is the BEP.
- Memory hook: 'Contribution margin FIRST, then BEP'. Without contribution margin per unit the BEP formula cannot be used. Remember: at BEP, total contribution = fixed cost.
- How it is tested: questions change ONE variable (selling price up, variable cost down, or fixed cost altered) and ask for the new BEP and the effect on profit; some also require sketching and reading the BEP graph.
| Particulars | RM |
|---|---|
| Direct Material Cost | |
| Opening raw material | 10,000 |
| Add: Purchases of raw material | 50,000 |
| Raw material available for use | 60,000 |
| Less: Closing raw material | 8,000 |
| Direct material used | 52,000 |
| Direct labour cost | 30,000 |
| Direct expense | 5,000 |
| Prime Cost | 87,000 |
| Add: Production overhead | 20,000 |
| 107,000 | |
| Add: Opening Work in Progress | 4,000 |
| Less: Closing Work in Progress | 6,000 |
| Production Cost | 105,000 |
Illustrative figures only, to show the layout and Work-in-Progress adjustment.
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