Cost Accounting – The Estimating Cost System
ESTIMATING COST SYSTEMS
Purpose and Kinds
The estimating cost system is used for verifying estimates of the cost of production and for locating mistakes in the estimates. How well its purpose is realized depends on the degree of refinement with which the estimates are made and on the records kept to verify them. Three plans or grades of estimating systems are presented here, ranging in scope as follows:
(1) Verification of estimates on the total amounts of the material, labor, and indirect expense
(2) Verification of estimates on material and labor classified by departments or operations, together with the total indirect expenses not classified
(3) Verification of estimates on each class of product according to departmental material, labor and indirect’expenses
The good features of estimating cost systems are three in number. First, the clerical work is comparatively small compared with that involved in a complete system; second, the estimating system often discloses weak spots in the estimates, and indicates where complete methods should be
introduced; and third, it may be used with good success in small factories, or in larger plants where the product does not represent a wide variety of articles.
First Plan of Estimating Costs
In the simplest and most elementary estimating cost system, there are but three forms used:
(1) Schedule of Estimated Costs
(2) Inventory Sheet
(3) Analysis of Cost of Sales
Schedule of Estimated Costs (Form 52)
This form is specific in character, and provides for the total estimated cost of each kind of article manufactured, divided into the three elements, material, labor and indirect expense. The estimates that appear in this schedule are to be used in pricing the inventory and cost of sales. The figures should remain constant until the verification has shown them to be inaccurate, when they should be revised, and the revised figures used at the beginning of the new period.
The form may be provided with extra columns to show variations from period to period in the elements of cost; but such variations should not be incorporated in the other forms of the system until a new inventory is taken at the beginning of a new period.
Inventory Sheet (Form 61)
The “Inventory Sheet,” based on the schedule of estimated costs, shows the estimated cost value of all the product in the plant divided into its elements; that is, material, labor and indirect expenses. In the case of raw material, the cost appears only in the material column. The cost of articles in process is estimated as closely as possible. The errors that may exist in such an estimate will probably be cancelled by the same errors in the ending inventory, and will not be appreciable unless there is a great difference in the amount of materials in process in the two inventories.
The totals of the three elements of cost are posted from the inventory sheet to the ledger to the debit of their respective accounts at the beginning of the period, and serve to open these accounts upon the books.
Analysis of Cost of Sales (Form 65)
In order that the estimates may be verified, a record must be kept of all articles sold and the quantity of each, this information appearing on the analysis of cost of sales. The costs of the articles are entered and classified on the analysis of cost of sales in the same way as the costs on the inventory sheet. By adding the several columns, the total of each element of cost as estimated is shown for each article sold.
Verification Under First Plan
It will be noticed that the totals of each of the elements of cost are debited to their respective accounts from the inventory sheet at the beginning of the period. During the period all expenditures for material, labor and expense should be charged against the proper accounts; and in doing this great care must be exercised to keep the original classification unchanged; i. e., the items charged to the labor or indirect expense account must include only the items that were considered as labor and indirect expense charges in making the schedule of estimated costs. If there is any change in the classification, the validity of the whole plan is destroyed. Only the totals need be considered in posting to the accounts for material, labor and indirect expense.
It is clear that the debit side of the three accounts represents the estimated value of the inventory at the beginning of the period, plus the actual expenditures relating to these accounts for the period.
The totals of the material, labor and indirect expense columns on the analysis of cost of sales are credited to their respective accounts in the ledger. The balance of these accounts will be in effect a book inventory classified in the same way as before, and based partly on the estimated beginning inventory, and partly on the actual charges incurred during the period. The next step is to take an actual inventory at the end of the period based on the schedule of estimated costs.
It is obvious that the book inventory will agree with the physical inventory if the estimates are correct. Any difference shown between the two is due to inaccuracies in the estimates. If any element in the book inventory exceeds the corresponding element in the physical inventory, it shows that the estimated costs were too low as regards that element, and if the reverse, the estimated costs were too high, provided of course that there has not been any theft or waste of the stock.
The manufacturer must judge from the amount of the differences where the trouble lies, and to what extent the estimates should be revised. For instance, if the material costs are considerably underestimated, it is probable that leaks of considerable importance exist in the methods of handling and safeguarding the material, or that wastes occur in the processes. If the estimates for labor are much too low, the cause may lie in the classification of labor; that is, labor that is really direct may have been classed as indirect. The principal difference, however, is almost always found in the indirect expense account, since comparatively few manufacturers calculate all the phases of overhead cost in their estimates.
If the cause of the differences cannot be found, the estimates should be revised on the basis of the known conditions. No method of revision will give the exact figures, but if the difference between any corresponding elements in the book inventory and physical inventory be divided by the number of units of product manufactured during the period, the result will be, approximately, the amount to be added to or subtracted from the original estimates relating to that element. This rule is fairly accurate provided no changes have occurred in the methods and routine of manufacture since the original estimate was made.
When the material, labor and indirect expense accounts are credited from the analysis of cost of sales, the total of the three elements as shown by the total column on the analysis of cost of sales is debited to the Sales account. The balance of the Sales account will then be the estimated gross profit or loss. If the book inventory exceeds the physical inventory, showing that the estimates were too low, the difference should be credited to the Inventory account according to its proper classification, and charged against the Sales account. If the estimates were too high, the entry would be reversed; f. c, the Inventory account should be debited, and the Sales account be credited. The balance in the Sales account will then show the true gross profit or loss instead of the estimated figure.
Monthly statements may be prepared based on the estimated costs, the differences being adjusted at the end of the inventory period. The monthly statement, however, is likely to be misleading unless the estimates are fairly accurate.
If such a system of verifying and revising estimates is followed up, it will sooner or later bring the estimates close to the true costs. But it will often be necessary to locate and correct seeming inaccuracies in the cost estimates. To do this, the estimates will have to be made by departments or operations, and the plan of verification will have to be extended to meet the divisions in the estimates.
Second Plan of Estimating Costs
The second plan provides for the departmental classification of material and labor; but in order to avoid the clerical work necessary for distributing and determining departmental indirect expenses, that element is still treated as an unclassified whole, covering the entire factory.
The ” Schedule of Estimated Costs,” “Inventory Sheet,” and “Analysis of Cost of Sales,” are used in the same way as before, but the material and labor estimates are divided into as many sub-heads as there are departmental classifications.
To accomplish this, the following additional details should be shown on the three forms used in the first estimating method. On the inventory sheet should appear the heading “Department”; and columns should be ruled under the captions “Material” and “Labor” for the number of operations under each classification, and also a column for indirect expenses and a column for the total cost. The same captions and columns should appear on the schedule of estimated costs and analysis of cost of sales.
Besides these three forms, the system requires a purchase journal and a pay-roll form for dissecting and arranging the material and labor cost.
Purchase Journal (Form 5)
When purchases of material are made, they are classified in the purchase journal according to the sub-divisions under the head of “Material.” The purchases are credited to the accounts of the creditors and charged in total at the end of the month or period to the account appearing at the head of the column.
Pay-Roll (Form 38)
The entries on the pay-roll are classified into direct labor for each operating department, and columns are also added to show the indirect labor, supervision, etc. The totals of the direct labor columns are debited to the department labor accounts; and the totals of the other columns are charged to the proper accounts under indirect expenses. If certain items of indirect labor are made a part of the estimates for labor cost, these items must be separated from the rest and entered under the same labor classification as in the estimates. Otherwise the comparison will not show dependable results.
Verification Under Second Plan
The plan of verification is the same as in the first system, and precisely the same steps are followed in locating and adjusting discrepancies. The only different feature is the number of accounts involved. By using the department accounts, sources of errors and leaks are often located that would be concealed in the first plan.
While the system of cost-finding just described localizes costs to some extent, there are many important facts that it does not disclose. For example, it may be known that a profit is being made on the product as a whole, but it may also be suspected that certain articles or classes of product are being sold at a loss, and that this loss is being paid out of the profits on other goods. This is a condition existing so often that it may almost be said to be prevalent.
Third Plan of Estimating Costs
The third estimating system is devised to solve the problem just mentioned by making an analysis of estimates, primarily by class of product, and secondarily by operating department. As might be expected, there is considerably
more detail work than in the other two plans, although the underlying principle of verification is the same. The forms used are:
Schedule of Estimated Costs
Analysis of Cost of Sales
Summary of Material Requisitions
Schedule of Estimated Costs
The “Schedule of Estimated Costs” is the same in design as that used in the second plan, the sub-heads under “Material” and “Labor” referring to different operating departments. The estimates, however, are classified according to the nature of the article.
The “Inventory Sheet” is the same form as the one used in the second plan, but separate inventory sheets are used for each class of product, and the raw material not yet put in process is not included in any class, but is inventoried by itself. The total amount of raw material is charged to a separate account in the ledger, and this account is credited with the raw material drawn out on material requisitions.
The finished and part-finished stock are entered as before, each article on its proper sheet. The totals appearing on each inventory sheet then represent the total estimated cost of all articles belonging to that class of product.
An account is opened in the ledger with each class of product, and with the various sub-divisions of expenditures relating to it, viz.: the departmental accounts for material and labor, and one account for indirect expenses.
Analysis of Cost of Sales
This form is the same as that used in the second plan; but separate sheets are used for each class of product, and the inventory classification must be rigidly adhered to.
Purchase Journal (Form 5)
This record is to be used for the purpose of entering invoices for goods purchased, and differs from the form used in the preceding plan only to the extent that one column for raw material is used in place of several, as material requisitions are to be used in connection with this plan. All material purchased can now be charged to one account, the distribution to the respective departments being made from the material requisitions. The total purchases of material for the month, exclusive of supplies in the nature of an expense, should be posted to the debit of the Storeroom account, which account has been previously charged with the inventory of raw material at the beginning of the period.
Material Requisition (Form 20)
The material requisitioned out is credited to the Raw Material account and charged to the proper class of product in the Material account for the department drawing the material. The form should state the date, the department, and the order number, or give some similar information indicating the class of product, as well as the name, quantity and cost of the material asked for.
Summary of Material Requisitions (Form 24)
It may save time in posting if the requisition sheets are classified and summarized on a summary sheet for entry to the journal or ledger accounts. The form is generally analyzed according to departments, the different classes of product being the sub-heads. Thus, by adding the totals of the first columns under each department, the total material cost applying to the class of product represented in that department is obtained. The posting may then be made in totals for each account at the end of the month or inventory period.
Time Report (Form 26)
The time report must be designed to show the department, classification number or other indication of class of product, besides the name of the employee, date, time or quantity, rate and amount. Each employee engaged in direct production work in any way should make out such a time report for the work in hand.
Pay-Roll (Form 38)
The pay-roll is used to summarize and classify the time reports so that the proper charges may be made against the various direct labor and indirect labor accounts. A separate sheet should be prepared for each operating department, with sub-heads referring to the different classes of product operated upon in that department. The complete pay-roll is thus dissected both by department and by class of product, and the charges can be made accordingly. It may save time, however, if the pay-roll as analyzed is entered in the cash book and posted directly to the debit of the accounts affected.
Verification Under Third Plan
All direct charges to the accounts for the different classes of product being provided for as described, the indirect expenses still remain in an account by themselves. One feasible way of applying them to the different classes of product is by making a distribution on the basis of labor cost. The total indirect expenses are divided by the total labor cost for all the product, and the rate or per cent obtained. The labor cost charged to each classification of product may then be multiplied by this rate and the pro rata share of the indirect expenses determined. The amounts distributed are charged to the various products through the journal, and the total is credited to the indirect expense account, which then balances.
The totals of all the charges then represent the estimated inventory value at the beginning of the period, plus the actual expenditures for the period. The accounts are now credited with the goods sold at the estimated cost prices, and classified in the same way. This information is taken, of course, from the analysis of cost of sales. The balance represents the book inventory, and—if the estimates are correct—will agree with the ending inventory when this is taken.
Wrong estimates as to labor or material can be located according to department and class of product. It is also possible to see, to a certain extent, how errors in calculating indirect expenses have affected the costs.
The methods of discovering sources of error and of revising estimates, and the verification of figures in the ledger, are the same as in the other plans of estimating costs, and need not be repeated here.
Profit and Loss Statement (Form 68)
The results of the third plan may readily be exhibited on a monthly statement of profit and loss, which is prepared from the ledger accounts entirely on the basis of the estimated costs, and without reference to the ending inventory.
The amount and cost of sales are entered in their columns according to the class of product, and the difference extended into the next column headed “Gross Profit.” The total selling expenses are then distributed over the several classes of products on an arbitrary percentage basis. The administrative expenses are distributed in the same manner, and the totals of the selling and administrative expenses for each column should be extended to the “Total Expense” column.
The difference between the gross profit and the total expenses is then entered in the “Net Profit” column for each class of product, and represents the estimated net profit or loss on that class of product. The total of the column will, of course, represent the total estimated net profits or losses of the business.
When the actual ending inventory is taken, the adjustments may be made in the ledger by debiting or crediting the Sales account in the same manner as before explained, and the statement may then be prepared on the basis of actual costs.
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