Edexcel A-Level Accounting: Introduction to costing (YAC11)

This guide teaches topic 1.4, Introduction to costing, from the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018. It covers learning outcomes 1.4.1 to 1.4.13. This is Unit 1 (The Accounting System and Costing) content, so it is International AS material that also counts towards the full International A Level. All money amounts are in dollars.

Course hub: Edexcel A-Level Accounting. Printable checklist: YAC11 topic checklist. For quick recall use the costing revision notes, then test yourself with the costing practice questions. To find your gaps first, try a free 10-minute diagnostic.

What this topic covers

Outcome	You must be able to
1.4.1	Describe FIFO, LIFO and net realisable value (NRV)
1.4.2	Value inventory with FIFO and LIFO, perpetual and periodic
1.4.3	Explain the effect of the method on profit and inventory value
1.4.4	Measure labour productivity
1.4.5	Describe day work, piecework, individual and group bonuses
1.4.6	Calculate employee earnings and employer cost
1.4.7	Classify overheads: fixed, semi-fixed, semi-variable, variable
1.4.8	Allocate, apportion and absorb overheads
1.4.9	Re-apportion service departments, including continuous allotment
1.4.10	Calculate machine hour and labour hour rates
1.4.11	Explain over and under absorption
1.4.12	Describe job costing
1.4.13	Cost batches and customer orders

Prudence and consistency, which sit behind inventory valuation, are explained in the Principles and Double Entry Bookkeeping guide.

Valuation of inventory (1.4.1 to 1.4.3)

• FIFO (first in, first out) assumes the oldest units are issued first. Closing inventory is valued at the most recent prices.
• LIFO (last in, first out) assumes the newest units are issued first. Closing inventory is valued at the oldest prices. LIFO is not permitted under the international standard on inventories (IAS 2), so a business reporting under international standards cannot use it in its published financial statements.
• NRV is the estimated selling price less the costs to complete and sell the item. Inventory is valued at the lower of cost and NRV, which applies prudence.

Perpetual means the record is updated after every receipt and issue, so each issue is priced from the units on hand that day. Periodic means one valuation at the end of the period, from total purchases and total issues. FIFO gives the same closing value either way. LIFO usually does not, because periodic LIFO can charge an issue with units bought after it happened.

Worked example: Pellam Lighting

1 May   Opening inventory   60 lanterns at 8
4 May   Purchased          100 lanterns at 9
10 May  Issued             120 lanterns
18 May  Purchased           80 lanterns at 10
25 May  Issued              70 lanterns

Units left: 60 + 100 - 120 + 80 - 70 = 50. Goods available cost 480 + 900 + 800 = 2,180.

FIFO. The 50 units left are the latest bought: 50 x 10 = 500.

LIFO perpetual.

10 May issue 120: 100 at 9 + 20 at 8     left: 40 at 8
18 May receipt                           left: 40 at 8, 80 at 10
25 May issue 70: 70 at 10                left: 40 at 8, 10 at 10
Closing inventory = 320 + 100 = 420

LIFO periodic. The 190 units issued come from the month’s latest purchases: 80 at 10, 100 at 9, then 10 at 8. The 50 left are all at 8 = 400.

Effect on profit (1.4.3)

All 190 units were sold at 15 each, so revenue = 2,850. Cost of sales = goods available less closing inventory.

Method	Closing inventory	Cost of sales	Gross profit
FIFO	500	1,680	1,170
LIFO perpetual	420	1,760	1,090
LIFO periodic	400	1,780	1,070

Prices rose during May. FIFO charges older, cheaper costs to cost of sales, so it reports the highest gross profit and the highest inventory in the statement of financial position. LIFO matches recent costs against revenue, so both are lower. Falling prices reverse the order. The difference reverses later, because closing inventory becomes next period’s opening inventory.

Applying NRV

Suppose 12 of the 50 lanterns (FIFO cost 10 each) are damaged. Each can be sold for 8 after a repair costing 1.20. NRV = 8.00 - 1.20 = 6.80, below cost. Write-down = 12 x (10.00 - 6.80) = 38.40. Closing inventory = 500.00 - 38.40 = 461.60, and gross profit falls by 38.40.

Labour costs (1.4.4 to 1.4.6)

Labour productivity is output per labour hour. A team making 3,360 units in 480 hours produces 7 units an hour. Next month it makes 3,600 units in 450 hours: 8 an hour, a rise of (8 - 7) / 7 x 100 = 14.3%.

Methods of remuneration

• Day work (time rate): hours x hourly rate. Predictable, but no reward for extra output.
• Piecework: units x rate per unit. Rewards speed, but quality may suffer and pay falls when machines break down. A scheme may add a guaranteed minimum wage.
• Individual bonus schemes pay the time rate plus a bonus for time saved against time allowed:
  • Halsey: bonus = 50% x time saved x hourly rate
  • Rowan: bonus = (time taken / time allowed) x time saved x hourly rate
• Group bonus schemes pay a team when its output beats a target. They suit work where individual output cannot be measured, but fast workers share the reward with slower ones.

Worked example: one worker, four methods

A worker earns 14 an hour, works 40 hours and makes 500 units. Time allowed is 6 minutes per unit; piecework pays 1.20 per unit. The employer pays social security contributions of 10% of gross pay.

Time allowed = 500 x 6 / 60 = 50 hours    Time saved = 50 - 40 = 10 hours
Day work:  40 x 14                             = 560.00
Piecework: 500 x 1.20                          = 600.00
Halsey:    560 + (0.5 x 10 x 14)   = 560 + 70  = 630.00
Rowan:     560 + (40/50 x 10 x 14) = 560 + 112 = 672.00

Employee earnings are the gross pay. Employer cost is gross pay plus the employer’s own contributions (x 1.10 here):

Method	Employee gross earnings	Employer cost
Day work	560.00	616.00
Piecework	600.00	660.00
Halsey	630.00	693.00
Rowan	672.00	739.20

Group bonus. A team of four has a target of 2,000 units a week and earns 0.30 per unit above it. Output is 2,400, so the pool is 400 x 0.30 = 120. Shared by hours (40, 40, 35, 35 = 150 hours), each hour earns 0.80: bonuses of 32, 32, 28 and 28.

Overhead costs (1.4.7 to 1.4.11)

Type	Behaviour	Example	1,000 units	2,000 units
Fixed	Same total at any output	Rent 5,000	5,000	5,000
Variable	In proportion to output	Materials 3 per unit	3,000	6,000
Semi-variable	Fixed part plus variable part	Telephone 600 + 0.50 per unit	1,100	1,600
Semi-fixed (stepped)	Fixed, then jumps at a level	Supervisor 2,400 per 1,500 units	2,400	4,800

• Allocation: a cost belonging wholly to one cost centre is charged to it in full.
• Apportionment: a shared cost is split on a fair basis, such as floor area for rent, carrying amount for depreciation, employees for supervision.
• Absorption: each production department’s overhead is charged to output using an overhead absorption rate (OAR).

Worked example: Brackley Moulding

Production departments: Machining (Mach) and Finishing (Fin). Service departments: Stores and Maintenance (Maint).

Basis	Mach	Fin	Stores	Maint	Total
Floor area (m²)	600	400	150	50	1,200
Machinery carrying amount	80,000	30,000	5,000	5,000	120,000
Employees	22	26	6	6	60

Overhead	Mach	Fin	Stores	Maint	Total
Indirect materials (allocated)	3,200	2,850	1,275	1,475	8,800
Rent (floor area)	18,000	12,000	4,500	1,500	36,000
Depreciation (carrying amount)	10,000	3,750	625	625	15,000
Supervision (employees)	8,800	10,400	2,400	2,400	24,000
Total	40,000	29,000	8,800	6,000	83,800

Rent to Machining = 600 / 1,200 x 36,000 = 18,000.

Continuous allotment (1.4.9)

Service departments make no products, so their costs pass to production departments before an OAR is set. Stores serves Machining 50%, Finishing 30%, Maintenance 20%. Maintenance serves Machining 60%, Finishing 25%, Stores 15%. Each serves the other, so use continuous allotment: keep re-apportioning until the balance is negligible, then split the last amount between production departments only.

                       Mach       Fin    Stores    Maint
Stores 8,800.00     4,400.00  2,640.00     -     1,760.00
Maint 7,760.00      4,656.00  1,940.00  1,164.00     -
Stores 1,164.00       582.00    349.20     -       232.80
Maint 232.80          139.68     58.20     34.92     -
Stores 34.92           17.46     10.48     -         6.98
Maint 6.98              4.19      1.75      1.04     -
Stores 1.04 (50:30)     0.65      0.39     -         -
Received            9,799.98  5,000.02

To the nearest dollar, Machining = 40,000 + 9,800 = 49,800 and Finishing = 29,000 + 5,000 = 34,000. Check: 49,800 + 34,000 = 83,800, so nothing is lost.

Machine hour and labour hour rates (1.4.10)

Use machine hours where work is machine-led, labour hours where it is manual.

Machining: 49,800 / 8,300 budgeted machine hours = 6.00 per machine hour
Finishing: 34,000 / 4,250 budgeted labour hours  = 8.00 per labour hour

Over and under absorption (1.4.11)

Absorbed overhead = budgeted OAR x actual hours. It rarely equals actual overhead.

	Machining	Finishing
Actual hours	8,450 machine	4,120 labour
Absorbed	8,450 x 6 = 50,700	4,120 x 8 = 32,960
Actual overhead	50,320	33,610
Result	Over absorbed 380	Under absorbed 650

Over absorption means too much was charged to production, so it is added to profit in the statement of profit or loss. Under absorption is an extra expense. Net: 650 - 380 = 270 under absorbed, reducing profit by 270.

Job costing (1.4.12 and 1.4.13)

• Each job is done to a customer’s own specification and is separately identifiable.
• Costs are collected on a job cost sheet: direct materials, direct labour, direct expenses and absorbed overheads.
• Jobs differ in size and length, so each is priced separately, often as cost plus a mark-up.
• Batch costing applies job costing to a group of identical items: cost per unit = batch cost / units in the batch.

Customer order: Job 214

Using Brackley’s rates: direct materials 1,840; 30 labour hours in Machining at 15; 45 labour hours in Finishing at 13; 64 machine hours in Machining. Administration is 20% of production cost; the price is total cost plus a 25% mark-up.

Direct materials                           1,840.00
Direct labour  (30 x 15) + (45 x 13)       1,035.00
Prime cost                                 2,875.00
Machining overhead  64 x 6.00                384.00
Finishing overhead  45 x 8.00                360.00
Production cost                            3,619.00
Administration 20%                           723.80
Total cost                                 4,342.80
Mark-up 25%                                1,085.70
Price quoted                               5,428.50

Batch of 250 trays

Direct materials                           2,150.00
Direct labour  (40 x 15) + (60 x 13)       1,380.00
Machining overhead  90 x 6.00                540.00
Finishing overhead  60 x 8.00                480.00
Batch production cost                      4,550.00
Cost per tray  4,550 / 250                    18.20

Common errors

• Pricing periodic LIFO issues in date order instead of from the period’s latest purchases.
• Comparing NRV with selling price, not cost, or forgetting completion and selling costs.
• Adding the employee’s tax to employer cost.
• Using total time instead of time saved in a Halsey or Rowan bonus.
• Calling a cost with fixed and variable parts “semi-fixed”; it is semi-variable.
• Absorbing on budgeted hours instead of actual hours.

Where next

For paper technique, see Edexcel IAL Accounting exam preparation.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018 (first teaching September 2015), Pearson Education Limited. Unit 1: The Accounting System and Costing, topic 1.4 Introduction to costing.