CH.

9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 235

overhead which will tend to even itself out during a full year. The best way
to detect an incorrect overhead rate is to analyze the factors used in its
predetermination. Since a rate is an estimate, small errors should be ex-
C pected and the rate need not be changed for such errors.
;

CHANGING OVERHEAD RATES

Overhead rates are usually reviewed annually. This procedure helps
level out costing through the year and overhead control in with budget ties

control. Ifxates are c hanged during a fiscal or budget p eriod^iiiganingful

— comparison s will_be_jiifficu lt. Changes in production methods, prices,
efficiencies, and sales expectancy make review and, possibly, revision of

_^ overhead rates a necessity at least annually. Revisions should be based on

a complete review of all factors involved. The extent to which a company
revises its overhead rates depends on frequency of changes, on factors
which affect overhead rates, and on management's need and desire for
current costs and realistic overhead variance information.

GRAPHIC PRESENTATION OF FACTORY OVERHEAD

This chapter's discussion of estimating, accounting for, and analyzing
factory overhead is presented diagrammatically below.

ESTIMATING FACTORY OVERHEAD APPLICATION HATE

FACTORY Estimated Total Factory Overtiead
OVERHEAD

ACCOUNTING FOR CAPACITY UTILIZED

FACTORY
OVERHEAD ^- X ACTUAL ACTIVITY
(eg. Direct Labor
FACTORY OVERHEAD APPLIED

Hours, etc)

WORK IN PROCESS —
FACTORY OVERHEAD CONTROL FACTORY OVERHEAD APPLIED FACTORY OVERHEAD FINISHED GOODS
Factory Overhead Goods Completed Completed
Applied (Rate x with Factory Goods
Actual Capacity Overhead Translerred
Based on

OVER-/UN0ER- ANALYZING FACTORY OVERHEAD

APPLIED FACTORY
OVERHEAD
(Actual-Applied)

BUDGET ALLOWANCE OF
SPENDING VARIANCE FACTORY OVERHEAD IDLE CAPACITY VARIANCE
(Actual FactoryOverhead FOR CAPACITY UTILIZED: (Budget Allowance of Factory Overhead for Capacity
Minus Budget Allowance Fixed Factory O.'H , xx UtilizedMinus Factory Overhead Applied)
o( Factory Overhead tor 'Variable Fac O'H tor
Capacity Utilized) Capacity Utilized (i e .

Actual Activity) xx
I Uudg Allowance
Budget xx

FACTORY OVERHEAD VARIANCE SPENDING VARIANCE IDLE CAPACITY VARIANCE

(Favorable/Unfavorable) (Favorable/Unfavorable) (Favorable/Unfavorable)

Estimating, Accounting for, and Analyzing Factory Overhead

OOa^s-V^^
L oOLi/s^~7fc>0
v^oci^
^ 1^ rou,w.^-c-v-. UcV- o^ 8-3- +U — -
^\^<'-2-''

c 1 A • .-A- /Or r> /-.I I yi AAii j^ 44 •s^

 . ;

236 PLANNING AND CONTROL OF FACTORY OVERHEAD PART

^ DISCUSSION QUESTIONS

1 Factory overhead constitutes a much larger proportion of total manufactur-

ing costs today than in the past. This trend is expected to continue. Why?

2. Why will a department's factory overhead vary from month to month?

3. What are the steps involved in accounting for factory overhead?

4. State some of the main expenses that are considered to be factory overhead?

5. Should the wages of an apprentice or trainee be charged to a job or con-

sidered as overhead ?

6. When and why must predetermined factory overhead rates be used? Indi-
cate the impracticalities and inaccuracies of charging actual overhead to jobs
and products.
7. Are predetermined factory overhead rates required in a process cost system?
Explain.

8. What is the purpose of each of the following items in job order costing? How
do they relate to each other?
(a) Factory overhead control account
(b) Job order cost sheet
(c) Work in process —factory overhead
(d) Applied factory overhead

9. Why is the selection of a proper predetermined rate so essential to accurate

costing? Explain.

10. Name five bases used for applying factory overhead. What factors must be
considered in selecting a particular basis?

11. If a company uses a predetermined rate for application of factory overhead,

the idle capacity variance is the (a) under- or overapplied fixed cost element
of overhead; (b) under- or overapplied variable cost element of overhead;
(c) difference in budgeted costs and actual costs of fixed overhead items
(d) difference in budgeted costs and actual costs of variable overhead items;
(e) none of the above. Which of these is correct?
(AICPA adapted)

12. For each of the following statements, select the item which gives the most
adequate answer.
(a) Overapplied factory overhead will always result when a predetermined
factory overhead rate is employed and (1) production is greater than defined
capacity; (2) actual overhead costs are less than expected; (3) defined capa-
city is less than normal capacity; or (4) overhead incurred is less than over-
head applied.
(b) The difference over a period of time between actual factory overhead and
applied factory overhead will usually be minimal when the predetermined
overhead rate is based on (1) normal capacity; (2) designed capacity;
_^ (3) direct labor hours; or (4) direct machine hours.
CH. 9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 237

(c) If a predetermined factory overhead rate is not employed and the

volume of production is reduced from the level planned, the cost per unit
would be expected to (1) remain unchanged for fixed costs and increase for
variable costs; (2) increase for fixed costs and remain unchanged for variable
costs; (3) increase for fixed costs and decrease for variable costs; or (4) de-
crease for fixed costs and decrease for variable costs.

(d) A spending variance for factory overhead is the difference between

actual factory overhead cost and factory overhead cost that should have been
incurred for the actual hours worked and results from (1) price differences
for factory overhead costs; (2) quantity differences for factory overhead
costs; (3) price and quantity differences for factory overhead costs; or
(4) differences caused by production volume variation.

(e) Factory overhead should be allocated on the basis of (1) an activity basis
which relates to cost incurrence; (2) direct labor hours; (3) direct labor cost;
or (4) direct machine hours.
(AICPA adapted)

13. The factory overhead control account has a credit balance at the end of the
period. Was overhead over- or underapplied ?

14. If large underabsorbed (underapplied) factory overhead variances occur

month aftermonth, the factory overhead rate should be revised to make
unit costs more accurate. Comment.

15. Over- or underapplied overhead can be analyzed into two parts called
variances. What are these variances, why are they so titled, and how are
they computed ?

16. Production for Lemona Beverages, Inc., shows a pronounced seasonal

fluctuation. Should factory overhead variances be shown as adjustments
to the cost of goods sold on the company's monthly income statements?
If not, what alternative is possible?

17. The Valley View Manufacturing Company applies factory overhead to

production on the basis of direct labor dollars. At the end of the year factory
overhead has been overabsorbed to the extent of $60,000. Name at least
five factors which would cause this situation and explain what should be
done with the credit balance.

18. Select the answer that best completes each of the following statements:
(a) If over- or underapplied factory overhead is interpreted as an error
in allocating actual costs against the production for the year, this suggests
to an accountant that the over- or underapplied factory overhead for the
year should be (1) carried forward in the factory overhead account from
year to year; (2) eliminated by changing the predetermined factory over-
head rate in subsequent years; (3) apportioned among the work in process
inventory, the finished goods inventory, and the cost of goods sold; (4)
treated as a special gain or loss occurring during the year.

(AICPA adapted)
 :

238 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

(b) Underapplied factory overhead costs are (1) fixed factory costs not
allocated to units produced; (2) factory overhead costs not allocated to
units produced; (3) excess variable factory overhead costs; (4) costs that
cannot be controlled; (5) none of the above.
(NAA adapted)

(c) Acompany found that the differences in product costs resulting from
the application of predetermined factory overhead rates rather than actual
factory overhead rates were immaterial even though actual production
was substantially less than planned production. The most likely explana-
tion is that (1) factory overhead was composed chiefly of variable costs; (2)
several products were produced simultaneously (3) fixed factory overhead
;

was a significant cost; (4) costs of factory overhead items were substantially
larger than anticipated.
(AICPA adapted)

EXERCISES
1. Classification of Expenses. Required: (1) Classification of the following
expenses as either (a) indirect labor, (b) indirect materials or supplies, or (c)
other factory overhead.
(2) Classification of each expense as fixed, variable, or semivariable.

(a) Building repairs (j) Power

(b) Coal (k) Rent
(c) Depreciation — machinery and equipment (1) Freight-in
(d) Fuel oil (m) Inspectors' wages
(e) Insurance on machinery and equipment (n) Shop supplies
(f) Telephone and telegraph (o) Payroll taxes
(g) Workmen's compensation insurance (p) Superintendent
(h) Small tools (q) Storekeepers' salaries
(i) Repairs to machinery and equipment

2. Calculation of Estimated Labor Hours. The Millan Manufacturing Company

employs 200 men who work 8 hours a day, 5 days a week. Normal capacity for
the firm is based on the assumption that the equivalent of 46 weeks of work can
be expected from an employee.
The number of direct labor hours to be used in setting up the
Required: (1)
firm's factory overhead rate basedon normal capacity.
(2) The number of direct labor hours if the management and the workers
agree on a 10-hour, 4-day workweek.

3. Various Overhead Rates. The Montessori Company estimated its factory

overhead for the next period at $320,000. It is estimated that 80,000 units will
be produced at a materials cost of $400,000. Production will require 80,000
man-hours at an estimated wage cost of $320,000. The machines will run ap-
proximately 50,000 hours.

Required: The factory overhead rate that may be used in applying factory
overhead to production on each of the following bases
(a) Materials cost (c) Direct labor hours
(b) Direct labor cost (d) Machine hours
 : : :

CH. 9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 239

wl7)Factory Overhead Variance Analysis. Normal capacity of the Ziff Company

IS set at 80,000 direct labor hours. The expected operating level for the period
just completed was 64,000 hours. At this expected capacity, variable expenses
were estimated to be $44,800 and fixed expenses, $64,000. Actual results show
70,000 hours were worked during the period.

Required: The following information from the data given

(a) The predetermined overhead rate based on normal capacity.

(b) The predetermined overhead rate based on expected actual capacity.
(c) The amount of factory overhead charged to production if the company
used the normal overhead rate.
(d) The amount of factory overhead charged to production if the company
used the expected actual overhead rate.
(e) Would there be a favorable idle capacity variance if the normal capacity
rate were used? Illustrate by variance computations.
(f) Would there be a favorable idle capacity variance if the expected actual
rate were used? Illustrate by variance computations.

5. Factory Overhead Rates and Variances on Various Capacity Levels. The

accountant of the Cordell Manufacturing Company is asked by his management
to compute factory overhead rates based on (a) normal capacity, (b) expected
actual capacity, (c) practical capacity, and (d) average sales for the previous
three years. The accountant prepared the following summary

Expected Average Normal Practical

Actual Sales Capacity Capacity

Capacity levels 80% 85% 90%o 100%

Direct labor hours 27,200 28,900 30,600 34,000
Factory overhead:
Fixed factory overhead $102,000 $102,000 $102,000 $102,000
Variable factory overhead 136,000 144,500 153,000 170,000
Total $238,000 $246,500 $255,000 $272,000

Required: (1) Factory overhead rates for each of the four capacity levels.
(Make calculations to two decimal places only.)

(2) The amount of over- or underabsorbed factory overhead for the other
three levels if actual hours worked and actual factory overhead incurred were
identical with the estimated hours and the estimated overhead of the expected
actual capacity level.

6. Types of Factory Overhead Rates. Minelli, Inc. engages the services of a

CPA firm for the installation of a cost system. Preliminary investigation of the
manufacturing operations discloses these facts
(a) The company makes a line of light fixtures and lamps. The materials cost of
any particular item ranges from 15% to 60% of total factory cost, depending
on the kind of metal and fabric used in making it.
(b) The business is subject to wide cyclical fluctuations since the sales volume fol-
lows new housing construction.
 :

240 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

(c) About 60% of the manufacturing is normally done during the first quarter of
the year.

(d) For the whole plant, the wage rates range from $2.25 to $5.75 an hour. How-
ever, withineach of the eight individual departments, the spread between the
high and low wage rate is less than 5%.
(e) Each product requires the use of all eight of the manufacturing departments,
but not proportionately.
(f) Within the individual manufacturing departments, factory overhead ranges
from 30% to 80% of conversion cost.

Required: A
letter to the president of Minelli, Inc. explaining whether its
cost system should use:

(a) A predetermined overhead rate or an actual overhead rate — depart-

mental or plantwide.
(b) A method of factory overhead distribution based on direct labor hours,
direct labor cost, or prime cost

Include the reasons supporting each of these recommendations.

(AICPA adapted)

7. Entries for Factory Overhead. Whirl, Inc. assembles and sells electric mixers.
All parts are purchased and labor is paid on the basis of $22 per mixer assembled.
The cost of the parts per mixer totals $20. As the company handles only this one
product, the unit cost basis for applying factory overhead is used. Estimated
factory overhead for the coming period, based on a production of 40,000 mixers,
is as follows

Indirect materials $22,000

Indirect labor 24,000
Light and power 10,000
Depreciation 10,000
Miscellaneous 14,000

During the period, 39,000 mixers were assembled and actual factory over-
head was $82,300. These units were completed but not yet transferred to the
finished goods storeroom.

Required: (1) Journal entries to record the above information.

(2) The amount of over- or underapplied factory overhead.

8. Entries and Analysis of Factory Overhead. The following factory overhead

estimate for actual direct labor hours worked in the month of April applies to the
Farro Company:

Estimated factory overhead $16,750

Overhead is applied on the basis of direct labor hours. On April 30 the

following account balances appeared on the books of the company:

Factory Overhead Control $18,250

Factory Overhead Applied 17,500
 :

CH. 9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 241

Required: (1) The entry or entries to close out the two factory overhead
balances and to set up the over- or underapplied factory overhead account.
(2) The spending and idle capacity variances. Explain why they are favorable
or unfavorable.

9. Variance Analysis. Factory overhead for the Deckler Company has been
estimated as follows

Fixed factory overhead $15,000

Variable factory overhead 45,000
Estimated direct labor hours 20,000

Production for the month reached 75% of the budget, and actual factory
overhead totaled $43,000.

Required: (1) Over- or underapplied factory overhead.

(2) Spending and idle capacity variances.

10. Level of Activity; Variance Analysis. The Conley Company estimates its
normal factory overhead to be $10,000 per month. During the past four months,
overhead applied was:
January $9,000 March $ 9,500
February 8,500 April 10,500

Required: (1) The level of operations reached in each of these months.

(2) The over- or underapplied overhead each month when actual expenses
were as follows: $9,200 in January; $8,900 in February; $8,800 in March; and
$10,650 in April.

11. Rate and Variance Analysis. Annual estimated factory overhead of the
Van Den Noort Company for an expected volume of 180,000 kilograms of a
product was as follows:

Fixed factory overhead $ 72,000

Variable factory overhead 216,000

Output was 10,000 kilograms in June, and actual factory overhead was
$15,400.

Required: (1) The total factory overhead rate per unit and the variable
factory overhead rate per unit.
(2) The factory overhead variances, in total and in detail.

VllJVariance Analysis. A
company's budgeted fixed overhead costs are $50,000
per month plus a variable rate of $4 per direct labor hour. The total factory
overhead rate is $6. Actual factory overhead in January is $115,000 and 18,000
direct labor hours were reported.

Required: (1) The total amount of budgeted overhead. ^^'^ '^ U^^~f^^ iU>r~)r^

(2) The spending variance. or- ^JO^xieZt^ J^

qT^ZT'^P
(3) The idle capacity variance. .
242 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

13. Variance Analysis. The Ludwig- Wallace Products Corporation uses a job
order cost system. Factory overhead is applied on a normal capacity basis using
direct labor hours. The annual predetermined (or budgeted) factory overhead
rate is $2 per hour based on 50,000 normal capacity hours with variable factory
overhead at $70,000 and fixed factory overhead at $30,000. Four job cost sheets
show the following data for the month of August:

Job
301
 —

CH. 9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 243

shipped out, and the customers were billed in the amounts of $18,000 and
$42,000 respectively.

Required: General journal entries to summarize the transactions for June.

Over- or underapplied factory overhead is not closed out until the end of the
year.

9-2. Journal Entries for Monthly Transactions. McDonald, Inc. uses a job
order cost system and applies factory overhead on the basis of direct labor hours.
The trial balance as of July 1, 19 is: —
McDonald, Inc.
Trial Balance, July 1, 19

Cash S 20,000
Notes Receivable 10,000
Accounts Receivable 28,000
Allowance for Doubtful Accounts $ 2,800
Materials 15,000
Work in Process 10,000
Finished Goods 5,000
Prepaid Insurance on Machinery 500
Factory Overhead Control 8,500
Machinery and Equipment 75,000
—
Accumulated Depreciation Machinery and Equipment 25,000
Accounts Payable 10,000
Federal Income Tax Payable 2,000
Accrued Payroll Taxes 900
Capital Stock 100,000
Retained Earnings 31,300
Total $172,000 $172,000

Transactions for the month of July, 19 — were:

(a) Materials purchased on account, $10,000.
(b) Shop supplies purchased on account, $5,000.
(c) Materials requisitioned, $10,000, of which $7,000 was direct materials.
(d) Paid and distributed payroll: direct labor, $15,000; indirect labor, $5,000;
federalincome tax withheld, $2,000; FICA tax, $600.
(e) Employer factory payroll taxes for the month, $700.
(f) Factory overhead paid: repairs, $75; rent, $300; power and light, $400.
(g) Depreciation of machinery and equipment, $625.
(h) Expired insurance on machinery, $50.
(i) Paid marketing and administrative expenses, $1,100.
(j) Factory overhead applied to production, $9,800.
(k) Inventories at theend of the month work in process. $9,000 finished goods,
: ;

$6,000.
(1) Sales on account, $50,000.

Required: General journal entries to record the above transactions using a

factory overhead control account to record both actual and applied overhead.
This account is not closed until the end of the year.
244 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

9-3. Factory Overhead Application to Jobs. The Tucker Company has been in
business for only one month. During this month the firm had the following costs,
as shown by its books and records:

Materials used $10,000

Direct labor 15,000
Indirect materials used in plant 3,000
Indirect plant labor 4,000
Supervisors' salaries, plant 3,000
Labor fringe costs, plant 1,500
Depreciation of plant 1,000
Depreciation of factory machinery 3,000
Taxes on plant 300
Marketing and administrative expenses 3,500
Insurance on plant 200
Miscellaneous factory overhead 1,500
Power and light for plant 500
Advertising 1 ,500

During the month the company worked on four orders, three of which were
completed. Costs and other pertinent data in connection with these orders are:

Job 501 Job 502 Job 503 Job 504

Materials cost $2,000 $3,500
Direct labor hours 4,000
Machine hours 1,900
Direct labor cost $6,000

The company has not set up a predetermined rate for applying factory over-
head. It intends to wait until the end of each month to charge actual overhead
incurred during the month to jobs worked on during that month. Labor pay
rates vary considerably among the various labor skills employed in the plant.
There is also a wide variation in the proportionate use made of labor skills on
each job order.

Required: (1) The cost of each job using as the basis for charging factory
overhead: (a) direct labor cost, (b) direct labor hours, (c) machine hours.

(2) The recommended method of applying factory overhead, assuming that

costs will remain in the same proportions.

9-4. Factory Overhead Rates and Application.The Cost Department of the

Ronde Company made the following estimates for the coming year: factory
overhead, $425,000; materials cost, $850,000; production, 20,800 cases; labor
cost, $250,000; labor hours, 106,250.

Required: (1) The factory overhead rate based on (a) labor cost, (b) labor
hours, and (c) materials cost.

The amount of overhead to be charged to Lot Order 465 by each rate in

(2)
(1)above. (Lot Order 465: materials cost, $21,000; labor cost, $14,800 for
3,700 hours.)
 CH. 9 PLANNED, APPLIED, AND ACTUAL FACTORY OVERHEAD 245

(9-5) Factory Overhead Analysis. The Moser Company's factory overhead rate
IS $2 per hour. Budgeted overhead for 3,000 hours per month is $8,000 and at
7,000 hours is $12,000. Actual factory overhead for the month is $9,000, and
actual volume is 5,000 hours.

Required: (1) Variable overhead in overhead rate.

(2) Budgeted fixed overhead.
(3) Normal volume or normal capacity hours.
(4) Applied factory overhead.
(5) Over- or underabsorbed factory overhead.
(6) Idle capacity variance.
(7) Spending variance.

^^r6^^udgeted Overhead and Variance Analysis. In June the idle capacity vari-
ance of Carr Processing, Inc. was zero, and the spending variance showed
a debit of $6,000. In July the idle capacity variance was a debit of $8,000, but
the spending variance was zero. In June, actual overhead expense was $70,000
for an output of 8,000 tons. July's expense was $56,000, and output was 6,000
tons. In August output was 9,000 tons, and actual overhead expense was $71,000.

Required: (1) Factory overhead budgeted (estimated) for 9,000 tons.

(2) Factory overhead applied in August.
(3) Variances for August.

9-7. Variance Analysis. The Dennis Manufacturing Company's factory over-

head for the month of May is summarized below.

Normal capacity is used as the activity level for computing the predeter-
mined factory overhead rate.

Factory Overhead — May

(Actual Activity — 75% of normal)
Estimated Estimated
Factory Overhead Factory Overhead Actual
Expense at 100%, {Normal) at 75% of Normal Factory Overhead

Superintendence $ 415 $ 415 $ 415

Depreciation 375 375 375
Taxes 200 200 200
Rent 300 300 300
Power 100 75 95
Maintenance labor... 200 150 115
Insurance 50 50 50
Idle labor 100 75 90
Supplies 120 90 95
Indirect labor 400 300 270
Payroll taxes 100 75 95

Total $2,360 $2,105 $2,100

Required: (1) The over- or underapplied overhead.

(2) The idle capacity variance.
(3) The spending variance, in total and by individual expenses.
246 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Overhead Analysis; Statement of Cost of Goods Sold.

9-8. Inventory Valuation;
The Cost Department of the Mahle Manufacturing Company received the fol-
lowing monthly data, pertaining solely to manufacturing activities, from the
general ledger clerk:
Work in process inventory, January 1 S 32,500
Raw materials inventory, January 1 21,000
Direct labor 130,000
Raw materials purchased 106,000
Raw materials returned to suppliers 5,050
Supervision 1 8,500

Indirect labor 29,050

Heat, light, and power 8,700
Depreciation —
factory buildings 7,500
Property taxes 4,000
Insurance on factory buildings 3,000
Research and development costs (factory overhead) 14,100
Transportation-in (factory overhead) 6,500
Repairs and maintenance —
factory equipment 8,250
Depreciation —
factory equipment 7,500
Miscellaneous factory overhead 9,900
Finished goods inventory, January 1 18,000
Factory overhead applied 11 5,200

Additional data:
(a) Physical inventory taken January 3 1 shows $9,000 of raw materials on hand.

(b) The January 3 1 work in process inventory and finished goods inventory show
the following raw materials and direct labor contents:

Direct Materials Direct Labor

Work in process S 9,000 S 8,000 ( = 2,000 hrs.)

Finished goods 10,000 20,000 ( = 5,000 hrs.)

(c) Factory overhead is applied to these two ending inventories on the basis of a
factory overhead rate of $3.60 per direct labor hour.

Required: (1) The cost assigned to the ending work in process and finished
goods inventories, including factory overhead.
(2) A schedule of the total actual factory overhead for the month.
(3) An analysis of the over- or underapplied factory overhead, assuming that
the predetermined factory overhead rate was based on the following data:
Variable factory overhead $70,875
Fixed factory overhead $42,525
Direct labor hours 31 ,500

(4) A detailed cost of goods sold statement, assuming over- or underapplied

overhead is closed to the cost of goods sold account.
 CHAPTER 10

DEPARTMENTALIZATION
OF FACTORY OVERHEAD
FOR PRODUCT COSTING
AND COST CONTROL

The preceding chapter discussed the establishment and use of one

factory-wide predetermined overhead rate, the accumulation of actual
factory overhead in books and records, and the analysis of the over- or
underapplied factory overhead. These phases are now expanded through
the use of predetermined departmental factory overhead rates to improve
the charging of overhead to jobs and products, to lead to cost control via
responsibility accounting, and to provide data useful for analytical and
decision-making processes. Methods for the control of materials and labor
costs are discussed in other chapters. However, because each product
manufactured requires a certain minimum amount of materials and labor,
there is a limit to the amount of cost reduction for materials and labor
which can be realized through the use of such controls. The situation is
different for factory overhead the tighter the control over such expenses,
;

the better the possibility for reducing them. The departmentalization of

factory overhead facilitates this responsibility control which is so necessary
if unit and total costs are to stay within predetermined or budgeted ranges.
The departmentalization of overhead costs in nonmanufacturing busi-
nesses and in nonprofit organizations is also discussed in this chapter.

247
248 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

THE CONCEPT OF DEPARTMENTALIZATION

Departmentalization of factory overhead means dividing the plant into
segments called "departments" or "cost centers" to which expenses are
charged. Accountingwise, the main reasons for dividing a plant into
separate departments are: (1) more accurate costing of jobs and products
and (2) responsible control of overhead costs.
More accurate costing of jobs and products is possible because de-
partmentalization uses different departmental overhead rates for applying
factory overhead. A job or product going through a department is charged
with factory overhead for work done in that department, using the de-
partment's predetermined rate. Therefore, jobs or products are charged
with varying amounts of factory overhead depending on the type and
number of departments through which they pass rather than being charged
with a single plant-wide overhead rate.
Responsible control of overhead costs is possible because depart-
mentalization makes the incurrence of expenses the responsibihty of a
foreman or supervisor. Expenses which originate directly and completely
in a department are identified with the foreman responsible for the
supervision of the department.
Computation of predetermined overhead rates requires a series of de-
partmental allocation processes with respect to estimated expenses. These
allocations are limited to those necessary for computing overhead rates
prior to the beginning of the fiscal period. Actual overhead accumulated
during the month or year should remain with the individual department
until the end of the accounting period.
Computing complete product costs for pricing purposes involves
recognizing all manufacturing costs regardless of their direct or indirect
relationship to a given department or product. In addition to its direct
costs, each product must bear an equitable share of indirect costs such as
utilities, materials handling, inspection, storage, general factory, etc. The
selection of the best overhead allocation methods is important in deter-
mining equitable product costs.
The entire process of departmentalizing factory overhead is an extension
of methods previously discussed. Estimating or budgeting expenses and
selecting a proper basis for applying them is still necessary but, in addition,
;

departmentalizing overhead requires separate estimates or budgets for each

department. Actual expenses of a period must still be collected through use
of a factory overhead control account and a factory overhead subsidiary
ledger, but by departments, as well as by the nature of the expense, to
permit comparison with departmentally applied factory overhead. Over-
or underapplied factory overhead is computed departmentally and analyzed
separately to determine departmental spending and idle capacity variances.
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 249

PRODUCING AND SERVICE DEPARTMENTS

Departments are classified as either producing or service departments.
For example:
250 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

each activity or group of activities constituting a department. Division

of the factory into separate, interrelated, and independently governed
units is important for the proper control of factory overhead and the
accurate costing of jobs and products.
The number of producing departments used depends on the emphasis
the cost system puts on cost control and the development of overhead
rates. If the emphasison cost control, separate departments might be
is

established for the plant manager and for each superintendent, supervisor,
and foreman. When the development of departmental overhead rates
emphasizes accurate costing, fewer departments might be used. Sometimes
the number of departments needed for cost control is larger than that
needed for overhead rates. In such cases, the cost control system can be
adapted to proper overhead rates by combining departments, thus reducing
the number of rates used without sacrificing control of costs.
In certain instances, particularly when machines are
different types of
used, departments are further subdivided for cost control and overhead
rate purposes, resulting in a refinement in overhead control and in applica-
tion to the jobs or products passing through a department.

SELECTION OF SERVICE DEPARTMENTS

The and designation of service departments has considerable
selection
bearing on effective costing and control. Services available for the benefit
of producing departments and other service departments can be organized
in several ways by (1) establishing a separate service department for each
function, (2) combining several functions into one department, and (3)
placing service costs in a department called "general factory." The spe-
cific service is not identified if service costs applicable to producing and

accumulated in a general factory department.

service functions are
Determination of the kinds and number of service departments should
consider: (1) number of employees needed for each service function,

(2) costof providing the service, (3) importance of the service, and (4) as-
signment of supervisory responsibility. Establishing a separate department
for every service function is rarely done even in large companies. When
relatively few employees are involved and activities are closely related,

service functions are generally combined for the sake of economy and
expediency. Decision with respect to combining service functions is
governed by the individual circumstances existing in each company. Since
factory overhead rates for job and product costing are calculated for
producing departments only, service department expenses are transferred
to producing departments for rate-setting and variance analysis.
 :

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 251

DIRECT DEPARTMENTAL OVERHEAD IN

PRODUCING AND SERVICE DEPARTMENTS
The majority of direct departmental overhead costs can be categorized
as follows

1. Supervision, indirect labor, and overtime

2. Labor fringe benefits

3. Indirect materials and factory supplies

4. Repairs and maintenance
5. Equipment depreciation

These expense categories are generally readily identified with the

originating department, whether producing or service. In the discussion
that follows, detailed attention is given to each of the categories of direct
departmental overhead costs.

Supervision, Indirect Labor, and Overtime. These factory labor cate-

gories, in contrast to direct labor, do not alter the shape or content of a
product; they are auxiliary to its manufacture. It is important to realize
that any factory labor not classified as direct labor is automatically
classified as factory overhead.
Inasmuch as overhead is allocated to all products, a lax or incorrect
classification results in direct labor applying to only one product being
allocated as indirect labor in the form of overhead to other products,
thereby understating the one product cost and overstating the others.
Thus, decisions on whether or not to classify costs as direct labor can have
an important effect on overhead rates. Direct labor cost is often used as
the base for determining overhead rates. In such a case, a decision to
classify certain labor as "indirect" reduces the denominator and increases
the numerator of the ratio
LaboTcost ) ^^^^ ^^ compute overhead
( ptrea
rates. The following illustration points out the possible effect of incorrect
identification of $1,000 of direct labor as indirect labor:

Correctly Incorrectly
Identified Identified
as Direct Labor as Indirect Labor

Direct labor $6,000 $5,000

Factory overhead:
Indirect labor $5,000 $6,000
Other overhead 1,000 1,000
Total factory overhead $6,000 $7,000

Factory Overhead Rates = Factory Overhead ^$^00^ $W0

Direct Labor Cost $6,000 $5,000
= 100% = 140%
252 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

The premium portion of overtime paid should generally be charged as

overhead to the departments in which the overtime occurred. This method
should be followed for all labor except for special cases discussed in the
labor chapters. However, the straight-time portion of overtime paid to
direct labor employees should be charged to direct labor.

Labor Fringe Benefits. Labor fringe benefits include such costs as:
vacation and holiday pay, FICA and federal unemployment
taxes, state
taxes, workmen's compensation insurance, pension costs, hospitahzation
benefits, and group insurance. In theory, these labor fringe benefits are
additional labor costs and should —
when they pertain to direct labor
employees —
be added to the direct labor cost. In practice, such a pro-
cedure is usually impractical; therefore, these costs that pertain to direct
factory workers are generally included in factory overhead and thereby
become part of the factory overhead rate.

Indirect Materials and Factory Supplies. Distinguishing incorrectly

between direct and indirect materials (the latter being part of overhead)
has the same adverse effects on product costing as failure to make proper
distinction between direct and indirect labor. However, distinguishing
between direct and indirect materials is usually not so difficult. In a manu-
facturing operation, direct materials are those which are changed in form
through processing, machining, etc., and become an integral part of the end
product. Indirect materials, often referred to as factory supplies, are
auxiliary to the processing or machining operations and do not become an
essential part of the end product.
There are two basic methods of accounting for the cost of supplies:
(1) as a direct departmental charge or (2) as a charge to inventories.

Direct Departmental Charge. An easy, though not the most efficient,

way to account for factory supplies is to charge the expense to the depart-
ment that originated the purchase request. This procedure assumes that
(I) the department supervisor has the authority to purchase and (2) the
cost of the purchase stays within departmental budget limits.

Charge to Inventories. When closer control of supplies is required or

when more than one department uses certain supplies, it is not practical or
correct to charge only one department at the time of purchase. In such
cases, supplies purchased are charged to an inventory account at the time
of purchase and departments using the supplies are charged
; when suppHes
are issued.
When an inventory account is used, consumption may be determined
by one of two methods. First, if the supply is used only in one department,
it is possible to determine the amount to be charged to that department by
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 253

(1) taking a physical inventory at the end of each month, (2) adding pur-
chases for the month to the cost of the beginning inventory, and (3) sub-
tracting the final cost assigned to physical inventory at month-end from
this total to determine the usage for the month.
A second method of accounting for the cost of supplies through an
inventory account involves the use of materials requisitions. Requisitions
approved by authorized employees permit charging a department with the
proper cost and thereby provide better control over the use of materials
than the physical inventory method. However, additional clerical work
is required since requisitions must be prepared, priced, and summarized.

Repairs and Maintenance. With respect to repairs and maintenance

costs, it is essential (1) to estabhsh control over the total cost incurred by
the repairs and maintenance department and (2) to devise effective means
for charging maintenance costs to departments receiving the service.
As a rule, the work of repair and maintenance crews is supervised by a
maintenance superintendent. If possible and practical, all actual mainte-
nance costs should be charged to a maintenance department so that the
total cost is controlled by the maintenance superintendent and kept within
a maintenance budget. However, since maintenance is a service function,
its must be distributed to departments that receive the service.
costs
Maintenance work performed for most departments is generally of a
recurring nature, and charges are incurred evenly throughout the year.
However, certain types of maintenance work, such as breakdowns and
overhauls, occur at irregular intervals and often involve large expenditures.
In such cases, companies using departmental budgets may spread the cost
of major repairs over the year by making monthly charges to operations
based on a predetermined rate. These rates are commonly derived from
previous years' experience. Monthly provisions are charged to Mainten-
ance Expense and credited to a reserve account. Actual repair costs are
charged to the reserve account. In this manner, large maintenance costs
are charged to operations in direct proportion to the operating rate and
presumably approximate actual deterioration of the equipment.

Equipment Depreciation. Depreciation is usually a cost not controllable

by departmental foremen. However, their use of equipment influences
maintenance and depreciation costs. This is true with respect to all types
of depreciable assets — machinery and equipment, buildings, vehicles,
furniture and fixtures, etc. Some firmsshow depreciation as a noncon-
trollable cost on departmental cost statements. For eflfective costing and
controlling, depreciation is usually identified with the departments using
and the cost is charged directly to departments. The recom-
the assets;
mended method is to compute depreciation by departments based on the
 :

254 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

cost of equipment in the departments as recorded on detailed fixed asset

records. When no records are available or equipment is not specifically
used by only one department, depreciation is frequently charged to general
plant expense.

INDIRECT DEPARTMENTAL CHARGES

Expenses such as power, light, rent, and depreciation of factory, when
shared by all departments, can understandably not be charged directly to
a department, be it producing or service. These expenses do not originate
with any specific departments. They are incurred for all to use and must,
therefore, be prorated toany or all departments using them. The selection
of fair bases for such distributions requires careful study.
Selecting appropriate bases for the distribution of these general factory
costs is difficult and, in some instances, rests on an arbitrary decision.
To charge every department with its fair share of an expense, like rent, a
basis using some factor common to all departments must be found. Square
footage is such a basis, and in many cases is used for prorating rent expense.
In plants with departments occupying parts of the factory with ceilings of
unequal height, cubic measurement rather than square footage might be
used. Areas occupied by stairways, elevators, escalators, corridors, aisles,
and so forth must also be considered. Some of the general factory expenses
that require prorating, together with the bases most commonly used, are

__ DISTRIBUTION
GENERAL FACTORY EXPENSES BASIS
Factory rent Square footage
Depreciation — buildings Square footage
Building repairs Square footage
Heat Square footage
Superintendence Number of employees
Telephone and telegraph Number of employees or
number of telephones
Workmen's compensation insurance Department payroll

Light Kilowatt-hours
Freight-in Materials used
Power Horsepower-hours

After the distribution bases have been selected, a survey of the factory
must be made to secure the information needed to permit the distribution.
Information such as total square footage and its breakdown by depart-
ments, number of employees machinery
in each department, investment in
by departments, and estimates of kilowatt-hours (kwh) and horsepower-
hours (hph) to be used are items listed in the survey.
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 255

PRORATION OF SERVICE DEPARTMENTS'

OVERHEAD TO BENEFITING DEPARTMENTS
The expenses of service departments must ultimately be transferred to
producing departments to establish predetermined factory overhead rates
and to analyze variances. Effective expense control dictates that each
service department be first charged with its direct overhead. Service de-
partments may also be charged with general factory expenses as well as
with costs from other service departments. Most of the overhead items
discussed for producing departments will naturally also be found in service
departments. The number and types of service departments in a company
depend on its operations and the degree of expense control desired. Ser-
vice departments used for illustrative purposes are: (1) materials handling,
(2) inspection, (3) utilities, and (4) general plant services.

Materials Handling. Materials handling involves the operation of

cranes, trucks, fork lifts, loaders, etc. Since many departments are served
by this function, a preferred method of organization estabhshes a separate
servicedepartment for materials handling activities. All handling costs are
charged to this department, and a foreman is made responsible for their
control. Costs charged to such a service department are the same as those
charged to any department and include wages and labor fringe costs of
crane and truck operators; supplies, such as batteries, gasoline, etc.;
and repairs and maintenance of the equipment. In addition to centrahzing
handhng operations, departmentalization has
responsibility for materials
the advantage of collecting all materials handling costs in one place —
thus permitting quick measurement of results and reduction of costs
through modern materials handling techniques and equipment, changes
in routing or production, etc.

Inspection. For cost control, inspection costs are treated in the same
manner as other service department costs. However, in certain instances,
a special work order may require additional inspection or testing. This
type of inspection cost is chargeable to the order and must be so identified.
To accumulate these specific charges, separate cost centers may be estab-
lished for the purpose of charging time and materials for special inspections.

Utilities. Power and fuel are consumed

two major purposes: for
for
operating manufacturing facilities electric welding, and
such as machines ,

cranes, and for what might be termed "working condition" purposes —

lighting, cooling, and heating. In most instances, a single bilhng is re-
ceived for electric power or natural gas. It is not possible to determine
directly the consumption for each of the above purposes —
to say nothing
of the consumption by specific departments, cost centers, or functions.
 :

256 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

However, a is often desirable and also

direct departmental allocation
possible. A common method used is to install separate meters to measure
power or fuel consumed by specific types of equipment. In other instances
separate power sources (fuel, natural gas, coal, or electricity) may be used
for different facilities or equipment making it possible to determine an
individual utility cost by department.
For purposes of departmental and product costing, two methods of
accounting for costs of utiUties are recommended
1. Charge all power and fuel costs to a separate utilities department; then
allocate to benefiting departments.
2. Charge specific departments with power or fuel cost if separate meters are
provided, and charge the remaining power and fuel costs to a separate
utilities department or to general plant; this remainder is then allocated

to benefiting departments.

Allocation of utilities costs to specific departments is based on special

studies that determine each department's horsepower of machines, number
of machines, etc.

General Plant Services. Certain expenses other than those discussed

above come under the category "general plant" because they cannot be
identified directly with any specific producing or service department.
Therefore, a separate general plant cost center or department is estabhshed
to accumulate and control such expenses. Such a department is usually
the direct responsibility of the plant superintendent. Salaries of manage-
ment personnel concerned with production are charged to this
directly
department if they cannot be charged to specific departments except by
arbitrary allocations. Janitor labor and supplies may be charged to general
plant unless charged to maintenance or to a department called "building
occupancy." Unless separate service departments for plant protection and
yard operation are established, these costs are also charged to general plant
expense. Real estate and personal property taxes, liability, fire, and use
and occupancy insurance might be charged to general plant when they
cannot be traced directly to a department.

ESTABLISHING DEPARTMENTAL OVERHEAD RATES

Factory overhead is usually applied on the basis of direct labor dollars
or hours when one factory overhead rate is used for the entire plant, since
this procedure is considered most convenient and acceptable. The use of
department rates requires a distinct consideration of each producing
department's overhead which often results in the use of diff"erent bases for
applying overhead for different departments. For example, it is possible to
use a direct labor hour rate for one department and a machine hour rate
 :

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 257

for another. A further refinement might possibly lead to different bases

and rates for cost centers within the same producing department.
In estabhshing departmental overhead rates for producing departments,
all factory overhead, whether of general nature or of service departments,
must eventually find its way into the producing departments. Overhead
chargeable directly to a producing or service department can be obtained
from past records or from new or revised estimates prepared by the budget
or cost department in consultation with the department head. General
factory expenses, such as heat, power, water, rent, etc., must first be
allocated to either producing and service departments or perhaps merely
to producing departments. The method depends upon management's
decision. Service departments costs should then be distributed equitably
to either producing departments and service departments or just to pro-
ducing departments. The distribution might be based on number of em-
ployees, kwh consumption, hph consumption, floor space, asset value,
cost of materials to be requisitioned, etc. After service department ex-
penses have been distributed, producing department overhead rates can
be calculated in terms of direct labor hours, direct labor costs, machine
hours, or some other appropriate basis.
At the end of the fiscal period actual costs of producing and service
departments as well as those of general indirect nature are again assembled
in the same manner as for estimated factory overhead at the beginning of
the year. When all overhead has been assembled in the producing depart-
ments, it is then possible to compare actual with applied overhead and to
determine the over- or underapplied factory overhead.

ILLUSTRATION FOR ESTABLISHING

DEPARTMENTAL OVERHEAD RATES
The illustration uses four producing departments: Cutting, Planing,
Assembly, and Upholstery; and four service departments: Materials
Handhng, Inspection, and General Plant. The total estimated
Utilities,

factory overhead prepared in Chapter 9, page 223, has now been depart-
mentalized, but under the account classification described above and with a
slight modification of figures for ease in calculating departmental rates.
The fixed-variable cost classification has been retained. Its purpose will be
explained on pages 268 and 269.
The estabUshment of predetermined factory overhead rates for depart-
mentalized factory operations proceeds in the following manner

1 . Estimate or budget total direct factory overhead of producing and service

departments at the selected activity levels. Determine, if possible, the fixed
(F) and variable (V) nature of each expense category. (See Exhibit 1.)
 " "

258 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

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CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 259

PROCTOR PRODUCTS, INC. 1

Factory Survey Prepared at the Beginning of the Year 1
260 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

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CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 261

consumption, asset values, etc. Functions performed by each service

department must be studied carefully to determine the most equitable basis
for distributing the expenses of each.
Indirect departmental expenses are prorated in two ways: electric
power, fuel, and water are charged from where
to Utilities a distribution is
made; depreciation of building, property taxes, and fire insurance are
prorated only to producing departments on the basis of floor area as shown
in the Factory Survey (Schedule A); i.e., 25 percent of $5,000 = $1,250
charged to the Cutting Department for building depreciation. However, as
an alternative, these costs could also be allocated to service departments
as well as to producing departments.

Certain rules are followed for the transfer of service department over-
head to benefiting departments. One rule states that service department
expenses should be transferred on the basis of the use made by producing
and other service departments of the respective services. In order to use
this rule, a decision must be made with respect to the service department
which should be closed first, for service from a service department is
received not only by producing departments but also by other service de-
partments. Thus, instead of closing all service department overhead
directly to producing departments, some overhead may first be charged to
other service departments or to general factory overhead. In some com-
panies (as illustrated in Exhibit 2), service department expenses are trans-
ferred only to producing departments. This procedure avoids much
clericalwork. It can be justified if no material difference in the final costs
of a producing department resuks when the expenses of a service depart-
ment are not prorated to other service departments or to general plant.
However, this procedure fails to measure the total cost for individual
service departments.
When following the rule stating that service department expenses
should be transferred on the basis of the use made of the respective services
by all benefiting departments, both producing and service, the usual pro-
cedure is to transfer expenses of service departments in the order of the
amount of by the departments; i.e., expenses of the de-
service rendered
partment rendering the greatest amount of service are transferred first.
When service renderedby a department cannot be determined accu-
rately, it is possible to distribute first the expenses of the service department
which has the largest total overhead. This rule assumes that the department
with the largest amount of expense rendered the greatest amount of service.
Whether the amount of service or the amount of expense determines the
order of distribution, once costs for a service department are distributed,
that department is considered closed and no further distributions are
made to it.
 :

262 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Since the illustration shows no transfer of service department costs to

other service departments, the order of distribution does not matter. The
distribution is made by starting with Materials Handling. The overhead
of this department is on the basis of the estimated cost of ma-
distributed
terials requisitioned per Schedule A; i.e., 45 percent of $28,300 == $12,735
to the Cutting Department.
Inspection costs are transferred to the producing departments Assembly
and Upholstery only, on a 50-50 basis, because these two departments are
the only ones receiving this type of service in equal amounts.
Utilities costs are transferred in a threefoldmanner: 20 percent of the
costs based on kilowatt-hours, 50 percent on horsepower-hours, and 30
percent on floor area. The amount of $13,080 represents 20 percent of
$65,400, the total costs of the department. According to Schedule A, 20
percent of $13,080 = $2,616 is distributed to the Cutting Department.
The same method is followed for the other costs and departments. General
Plant is on the basis of number of employees; i.e., 20 percent
distributed
of $36,900 =
$7,380 to the Cutting Department.
The distribution of these service department costs is based on per-
centages in the Factory Survey, page 259. Some accountants proceed in a
different manner; they calculate a rate per square foot, or per kwh, or per
employee. In connection with General Plant, the method can be illus-

trated as follows

$36,900 General Plant Costs ^ ^^46 per Employee

150 Employees

Then $246 X 30 employees in the Cutting Department = $7,380.

With department costs distributed to the producing depart-

all service

ments, the departmental factory overhead rates can be calculated. In Ex-

hibit 2, three different bases are used: direct labor hours, machine
hours,

and direct labor cost.

ALGEBRAIC METHOD FOR OVERHEAD DISTRIBUTION

The proration of department expenses to other service depart-
service
ments may be incomplete if a department provides service to a depart-
ment from which it receives service. Consider a case in which Service
Department provides service to Service Department Z and, in turn, Z
Y
using
renders service to Y. The incompleteness in proration arises because,
department would be closed out before the
the rules discussed earlier, one
other and therefore before receiving any expense proration from the
other.
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 263

If greater exactness is desired, the technique illustrated below can be

followed.!

Departmental Overhead
Services Provided
Before Distribution of
Department Service Departments

Producing —A $ 6,000
Producing —B 8,000
Service —Y 3,630
Service —Z 2,000

Total departmental overhead S19,630

264 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

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 :

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 265

DEPARTMENTAL EXPENSE ANALYSIS SHEET

Department No. i--cutting For March, i9--

Explanation Date 411 412 413 421 433 451 453 Summary

Departmental Expense Analysis Sheet

Departmental Expense Analysis Sheets. Departmentalization of factory

overhead requires that each expense be charged to a department as well as
to a specific expense account. Such charges are collected on departmental
expense analysis sheets. This form, used for both producing and service
departments, is partially reproduced above.
In this form, each column represents a certain class of factory over-
head that will be charged to the department. For example, the column
coded 411 represents supervisors and foremen, 412 represents indirect
labor, and so forth. Entries to departmental expense analysis sheets are
facihtated by combining department numbers and expense codes. A
code such as 1412 indicates that Department No. 1 (Cutting) is charged
with indirect labor (Code 412). Similar combinations are used for other
departments. The chart of accounts establishes the codes.
The subsidiary ledger must also include a sheet for each indirect factory
expense not originally charged to a department so that the total of the
subsidiary overhead ledger will equal the total in the factory overhead
control account.

Steps and Procedures at End of Fiscal Period. The steps and procedures
at the end of the fiscal period are

1. Prepare a summary of the actual direct departmental factory overhead of

producing and service departments. (See Exhibit 3.)
2. Prepare a second factory survey based on the actual data experienced
during the year. (See Schedule B.)
3. Allocate actual indirect factory overhead to producing and service de-
partments based on the results of the factory survey at the end of the year.
(See Exhibit 3 and Schedule B.)
4. Distribute actual service department costs on the basis of the end-of-
the-year factory survey. (See Schedule B and Exhibit 4 on the follow-
ing pages.)
5. Compare actual total and departmental factory overhead with the total
and departmental factory overhead applied to jobs and products during
the year, and determine the total and departmental over- or underapplied
factory overhead. (See Exhibit 4.)
266 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

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CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 267

PROCTOR PRODUCTS, INC. 1

Factory Survey — December 31, 19— 1
 :

268 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

departmental factory overhead control accounts. Using the figures pro-

vided by the overhead distribution sheet (Exhibit 4), the following entry
can be made:
Factory Overhead —
Cutting Department 82,592
Factory Overhead —
Planing Department 56,712
Factory Overhead —
Assembly Department 69,730
Factory Overhead —
Upholstery Department 82,966
Factory Overhead Control 292,000

A comparison of actual and applied overhead of each producing depart-

ment as well as of the total overhead of the company results in the following
over- or underappHed factory overhead
Total Cutting Planing Assembly Upholstery
$7.000 $(1,428) $2,312 $2,710 $3,406

The $7,000 underapplied factory overhead would seem identical with that
calculated in Chapter 9. However, this $7,000 figure is the composite
sum of the variances of the four producing departments.

SPENDING AND IDLE CAPACITY VARIANCE

ANALYSIS
In the previous chapter, page 230, the $7,000 underappHed factory
overhead had been analyzed into a $750 unfavorable spending variance
and a $6,250 unfavorable idle capacity variance. The $1.50 overhead rate
used there and based on 200,000 direct labor hours is not applicable for the
departmentalized illustration. New rates with different bases have been
created. However, it should be possible to analyze each departmental
over- or underapplied figure and determine a departmental spending and
idle capacity variance. What is particularly needed is the amount of over-
head budgeted for the level of operation attained (capacity utilized) which,
in turn, requires a knowledge of the fixed and variable overhead in each
producing department. To develop the budget allowance, the estimates
shown in the summaries of the departmental factory overhead (Exhibit 1)
and the distribution of service department costs (Exhibit 2) are examined.
The summary of the departmental factory overhead indicates the fixed and
variable departmental costs at the bottom line of the estimates. The service
department costs distributed to the producing department as shown in the
distribution of service departments costs summary are considered variable
costs for the producing departments. The fixed-variable classification does
not apply after the distribution.
The spending and idle capacity variance analysis reproduced on the next
page is prepared for executive management on the basis of the actual
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 269

CALCULATION OF ESTIMATED FIXED AND VARIABLE

OVERHEAD RATES
Producirtff Departments
Cuttinj^ Planing Assembly Upholstery

Fixed departmental overhead $17.100 $17.900 $ 16,100 $18,300

Variable departmental overhead $23,400 $18,800 $ 18,900 $20,300
Variable service department costs 40,716 22,183 38,242 48,059
Total variable overhead $64,116 $40,983 $ 57,142 $68,359

Direct labor hours 40,608 48,140

Machine hours 1 8,400
Direct labor cost $122,000
Fixed overhead rate $0.42 $0.98 1 3% $0.38
Variable overhead rate 1.58 2.22 47% 1.42
Total overhead rate:
Per direct labor hour $2.0
Per machine hour ^ $3.20
Of direct labor cost 60%
Per direct labor hour $1.80

CALCULATION OF BUDGET ALLOWANCES'

Producing Departments
Cutting Planing Assembly Upholstery

Fixed overhead $ 1 7, 1 00 $17,900 $ 16,100 $18,300

Variable overhead:
42,010 direct labor hours X $1.58... 66,376
17,000 machine hours X $2.22 37,740
$11 1,700 direct labor cost X 47''; . . . 52,499
44,200 direct labor hours X $ .42
1 . . . 62,764
Total budget allowance $83,476 $55,640 $ 68,599 $81,064

*Based on capacity utilized; i.e., actual activity.

SPENDING AND IDLE CAPACITY VARIANCE ANALYSIS

Producing
Departments
270 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

annual data after the books have been closed. However, the middle- and
operating-management levels require cost control information currently
at leastonce a month. With ever greater emphasis placed upon the control
of costs by the responsible supervisory personnel, a procedure must be
found which communicates to all levels of management the control in-
formation in a manner that permits the charging and discharging of respon-
sibility of cost incurrence. This approach is discussed in the next chapter.

OVERHEAD DEPARTMENTALIZATION IN
NONMANUFACTURING BUSINESS ACTIVITIES
AND NONPROFIT INSTITUTIONS
AND ORGANIZATIONS
The responsible control of departmental expenses is equally essential in
other than manufacturing activities. The following have or should have
divided their large complex entities into administrative and supervisory
departments, sections, or service units for cost planning and control:

Nonmanufacturing segments of manu- Insurance companies

facturing concerns (e.g., marketing Educational institutions (public school
departments — see Chapter 23) systems, colleges, and universities)
Retail or department stores Service organizations (hotels, motels,
Financial institutions (banks, savings hospitals, and nursing homes)
and loan associations, and brokerage Federal, state, and municipal governments
houses) (and their agencies)
f

Retail or department stores have practiced departmentalization for

many years by grouping their organizations under the following typical
headings: administration, occupancy, sales promotion and advertising,
purchasing, selling, and delivery. These groups receive costs similar to
those in manufacturing businesses. The group "Occupancy" is almost
identical with General Factory, for expenses like building repairs, rent and
taxes, insurance on buildings and fixtures, light, heat, power, and deprecia-
tion on buildings and fixtures are collected in this group. Again, similar to
factory procedures, group costs are prorated to revenue-producing sales
departments via a charging or billing rate.

Financial institutions (banks, savings and loan associations, and broker-

age houses) should departmentalize their organizations in order to control
expenses and establish a profitability rating of individual activities. The
sizeof the institution and the types of services offered will lead to different
numbers of departments. The accumulation of departmental costs again
follows factory procedure: (1) direct expenses, such as salaries, supplies,
and depreciation of equipment are charged directly ; (2) general expenses,
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 271

such as light, heat, and air conditioning are prorated to the departments on
appropriate bases. As income and expenses are ascertained, it is possible
to create a work cost unit that permits the charging of accounts for services
rendered and the analysis of an account's profitability.
The work of insurance companies is by dividing the office into
facilitated

departments. clerks, and the work

Some departments have several hundred
is highly organized. Insurance companies were almost the first businesses
to install large-scale digital computers to (1) reduce the clerical costs con-
nected with the insurance business and (2) calculate new insurance rates
and coverage on a more expanded basis for greater profitability. This
quite detailed departmentalization might include actuarial, premium col-
lection, group insurance, policyholders' service, registrar, medical, legal,
etc. While some costs are unique to the individual group, most are iden-

tical with expenses experienced in any office department.

Educational institutions (such as public school systems, colleges, and
universities)and service organizations (such as hotels, motels, hospitals,
and nursing homes) find it increasingly necessary to budget their expenses
on a departmental basis in order to control and be able to charge an ade-
quate cost recovering fee for their services. The extended services of social
security via Medicare have made a knowledge of costs mandatory in
hospitals and nursing homes. Departmentalization will assist management
in creating a costing or charging rate for short- or long-term care, for
special services, for nurses' instruction, etc., and for professional services
(surgical, medical, X rays, laboratory examinations, filling of prescrip-
tions, etc.).

It is generally conceded that \ht federal government employs the great-

est number of people number of departments and agencies. A
in a vast
and local community governments. This dis-
similar situation exists in state
cussion uses the municipality as an example, for its varied services are
better known to the public. Common services or departments are : street
cleaning, street repairing and paving, public work projects, police and fire

departments, city hospitals, sewage disposal plants, trash and garbage col-
lection, etc. These services should be budgeted and their costs controlled
on a responsibility accounting basis. Since the costs incurred are not
revenue but service-benefit-oriented, an attempt should be made to measure
the operating efficiency of an activity based on some unit of measurement
such as: police (per capita), street paving and cleaning (per mile), trash
and garbage collection (per ton), etc. Ever-increasing costs require addi-
tional revenues; this means additional taxes. Taxpayers, however, are
looking for efficient service in return for their tax money.
The state and federal governments must be made equally aware of the
need for responsible cost control methods so that services will be rendered
 :

272 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

at a low cost with greatest efficiency. The federal government with its many
departments and agencies and a huge sum budgeted for all of these units
must particularly make certain that these activities are being administered
by cost-conscious and service-minded people. The departmentalization
process helps to assure the achievement of such a goal in any governmental
unit.

^1.
DISCUSSION QUESTIONS
For effective control of overhead, a foreman, superintendent, manager, or
department head can be held accountable for more than one cost center; but
responsibility for a single cost center should not be divided between two or
more foremen. Discuss.
2. Why will a department's factory overhead vary from month to month?

3. Even though most companies keep fixed asset records to identify equipment
and its original cost by location or department, charges for depreciation,
property taxes, and fire insurance are often accumulated in general factory
accounts and charged to departments on the basis of equipment values. Is
this the best method for controlling such costs? If not, suggest possible
improvements.
4. Justify classifying the following items as factory overhead: overtime pre-
miums, rework labor, and day-rate differentials in piece-rate payrolls. List
some of the difficulties in estimating these items in the computation of pre-
determined overhead rates.

5. State reasons for the use of departmental overhead rates instead of a single
plantwide rate.
6. The statement has been made that the entire process of departmentalizing
factory overhead is an extension of methods used when a single overhead rate
is used. Explain.
7. What are some of the factors that must be considered in deciding the kinds
and number of departments required to control costs and establish accurate
departmental overhead rates?
8. What is a producing department? a service department? Give illustrations
of each.
9. What are important reasons for using a general factory overhead category
for certain types of overhead instead of allocating it directly to production

and other service departments?

10. What are the several steps followed in establishing departmental factory
overhead rates?
11. What are some of the practices with respect to the sequence used in trans-
ferring service department overhead to producing departments? What
bases should be used to transfer the overhead of the service departments
listed below
Production control Maintenance
Purchasing Utilities
Medical Cafeteria
Payroll Accounting
Storeroom Personnel
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 273

12. What are the important factors involved in selecting the base to be used for
applying the factory overhead of a producing department?
13. Procedures followed in computing departmental factory overhead rates
determine the accounting for actual factory overhead. Explain. What are
departmental expense analysis sheets, and how are they used? Trace a
requisition for indirect materials through the departmentalization of factory
overhead process.
14. The Sanchez Chemical Company uses departmental factory overhead rates.
The rates are based on direct labor hours. Would the sum of departmental
over- or underapplied overhead amounts be any different if a plantwide or
blanket rate were used? Would the costs of goods sold and inventory values
be different ?
15. Describe how departmental over- and underapplied overhead is determined,
and explain the computations of departmental spending and idle capacity
variances.
16. Overhead control in a nonmanufacturing business can be achieved through
departmentalization. Explain.
17. Federal, state, and local governments should practice cost control via re-
sponsibihty accounting. Discuss.

EXERCISES
1. Cost Classification. Products of Mahler Company, Inc. are produced by a
series of continuous operations. The company believes that it can keep costs as
low as possible by assigning cost responsibility to specific individuals.

Required: Classification of the following items according to specific depart-

ments (cost centers):
(a) Factory wages (e) Plant manager's salary
(b) Depreciation of machinery (f) Sales manager's salary
(c) Purchasing of raw materials (g) Cost of operating power plant which
(d) Factory supplies used serves entire plant

2. Entries with Overhead Subsidiary Ledger. The general ledger of the Dole-
Johnson Company contains a factory overhead control account supported by a
subsidiary ledger showing the details by departments. The plant is departmen-
talized with one service and three producing departments.

The following table shows details with respect to these departments:

Machining Painting Assembly General
Dept. Dept. Dept. Factory

Building space (sq. ft.) 10,000 4,000 4,000 2,000

Value of machinery $30,000 $10,000 $6,000 $2,000
Horsepower rating 100 —— 10 15
Compensation insurance rate (per $100) $1.50 $1.50 $1.00 $1.00

During January, certain assets expired and some liabilities accrued as

outlined below:
(a) Depreciation on buildings, 3% per year; cost, $60,000.
(b) Depreciation on machinery based on 10-year life; machinery cost, $48,000.
 :

274 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

(c) Taxes for the year ending December 3 1 are estimated to be $ 1 ,200, of which 60%
is on buildings and 40% on machinery.

(d) Fire insurance in the amount of $100,000 is carried on buildings and machinery,
and the rate is $.60 per $100 of coverage. Sixty percent of this insurance applies
to buildings. The prepaid fire insurance account shows a balance of $300 at
January 31 before adjustment.
(e) Compensation insurance is based on the following earnings of factory employees
for the month of January Machining Department, $3,000 Painting Department,
: ;

$1,200; Assembly Department, $1,600; and General Factory, $600.

(f) Power meter reading at January 31 shows 12,500 kilowatt-hours consumed.
Rate is $.03 per kilowatt-hour.
(g) Heat and light bill for the month of January is $300.
show $180 used in the Machining Department, $230
(h) Supplies requisitions in the
Assembly Department, and $410 in the General Factory Department.

Required: Journal entries with details entered in the factory overhead sub-
sidiary ledger.

3. Overhead Distribution and Rates. The Bloomfield Products Company has four
producing departments: 11, 15, 21, and 25; and three service departments:
M, F, and T. The direct departmental overhead has been estimated for the pro-
ducing departments: No. 11— $100,000; No. 15 —
$140,000; No. 21 —
$40,000; No. 25 —
$80,000; for the service departments: M—
$30,000; F —
$50,000; T —
$60,000. Service department overhead is to be distributed to pro-
ducing and service departments in the order of T, F, and M
using the following
bases: T —
floor area; F —
number of employees; M—
value of equipment
investment. It is the company's policy that once a service department's costs
have been allocated, no costs from other service departments are to be allocated
to it.

Factory survey and production data

 .

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 275

Actual Factory Overhead

B C D X Total

Actual expenses . S10,000 S14,000 $4,000 S8,000 $3,000 $5,000 $6,000 $50,000
Z's expenses 1,500 750 1,250 500 1,000 1.000 6,000

Y's expenses 1,800 1,200 1,800 600 600 S6,000

X's expenses 2,000 1,000 1,200 400 $4,600

Total $1 5,300 $1 6,950 $8,250 $9,500 $50,000

Budgeted Factory Overhead

20,000 Hours
(Normal) 16,000 Hours

Department A $1 7,800 $15,000

Department B 20,200 17,800
Department C 10,600 9,400
Department D 10,600 9.400

Total $59,200 $51,600

Required: (1) Assuming that the actual factory overhead incurred was
charged to a single factory overhead control account, prepare entries to record
(a) the transfer of the actual factory overhead to producing departments and (b)
the applied factory overhead of Departments A and B only.
(2) Compute the spending and idle capacity variances for Departments A
and B only.

5. Overhead Distribution and Rate Calculation. The Torrence Manufacturing

Company has four producing departments and three service departments:
Maintenance, Toolroom, and Storeroom. The estimated annual overhead for
these seven departments is as follows:
 .. :

276 PLANNING AND CONTROL OF FACTORY OVERHEAD PART II

Allocation of
Fixed Overhead
of Service Departments Total 01 02 03 04
Maintenance $15,000 $5,000 $4,000 $3,000 $3,000
Toolroom 10,500 3,500 2,500 2,500 2,000
Storeroom 12,000 6,000 3,000 2,000 1,000

The variable overhead of the service departments is distributed on the basis of

charging rates based on the following plant survey and other pertinent data:

Storeroom
Maintenance Toolroom {Number of
{Area in {Number of Materials
Department Square Feet) Employees) Requisitions)

No. 01 12,000 50 30,000

No. 02 10,000 40 30,000
No. 03 9,000 30 28,000
No. 04 5,000 30 12,000
Maintenance. 5,000 10
Toolroom . . 3,000 5
Storeroom. . 1,000 5

No service department's cost is to be prorated to other service departments.

Required: (1) A
factory overhead distribution sheet on the basis of the data
and instructions stated above.
(2) Factory overhead rates for the four producing departments based on the
following predetermined labor hours, machine hours, and direct labor cost:

Department No.
01 33,000 machine hours
02 32,000 machine hours
03 39,070 labor hours
04 $59,960 labor cost

6. Overhead Analysis and Causes for Variances. The Lowell Manufacturing

Company uses predetermined departmental overhead rates. The rate for the
Fabricating Department is $4 per direct labor hour. Direct labor employees are
paid $4.50 an hour. A
total of 15,000 direct labor hours were worked in the
department during the year. Total overhead charged to the department for
supervisors' salaries, indirect labor, labor fringe benefit costs, indirect materials,
service department costs, etc. was $65,000.

Required: (1) The over- or underapplied factory overhead.

(2) An analysis of factors affecting actual and applied overhead revealed the
following situations. For each situation, indicate the effect on the amount of
over- or underapplied overhead. Discuss each item separately as though the
other factors had not occurred
(a) One hundred overtime hours were worked by direct laborers for which time-
and-a-half was paid. Overtime premium, the amount in excess of the regular
rate, is charged as overhead to the department in which the overtime is worked.
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 277

(b) A $.15 per hour wage increase was granted November 1. Direct labor hours
worked in November and December totaled 2,500.
(c) The company cafeteria incurred a $1,500 loss which was distributed to pro-
ducing departments on the basis of number of employees. Nine of the 120 em-
ployees work in the Fabricating Department. No loss was anticipated when
predetermined overhead rates were computed.

7. Algebraic Distribution of Factory Overhead. A company's two service depart-

ments serve not only the two producing departments but also one another. The
relationships between the four departments can be expressed as follows:

Service
Departments
 .

278 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

9. Overhead Distribution. Parker Manufacturing Company has two producing

departments, Fabrication and Assembly, and three service departments, General
Factory Administration, Factory Maintenance, and Factory Cafeteria. A sum-
mary of costs and other data for each department prior to allocation of service
department costs for the year ended June 30, 19 shows: — ,

Service Departments
Producing Departments
General Factory Factory Factory
Fabrication Assembly Administration Maintenance Cafeteria

Direct labor costs $1,950,000 $2,050,000 $90,000 $82,100 $87,000

Direct materials costs 3,130,000 950,000 65,000 91,000
Factory overhead costs. . . 1,650,000 1,850,000 70,000 56,100 62,000

Direct labor hours 562,500 437,500 31,000 27,000 42,000

Number of employees 280 200 12 8 20
Square footage occupied . 88,000 72,000 1,750 2,000 4,800

The costs of General Factory Administration, Factory Maintenance, and

Factory Cafeteria are allocated on the basis .of direct labor hours, square footage
occupied, and number of employees, respectively. There are no factory overhead
variances. Round all final calculations to the nearest dollar.

Required: (1) Assuming that Parker Manufacturing Company elects to dis-

tribute service department costs directly to the producing departments without
inter-service department cost allocation, compute the amount of Factory
Maintenance costs that would be allocated to Fabrication.

(2) Assuming the same policy of allocating service departments to producing

departments only, compute the amount of General Factory Administration
costs that would be allocated to Assembly.

(3) that Parker Manufacturing Company elects to distribute

Assuming
service department costs to other service departments (starting with the service
department with the greatest total costs) as well as to the producing departments
and that once a service department's costs have been allocated, no subsequent
service department costs are recirculated back to it, compute:
(a) The amount of Factory Cafeteria costs that would be allocated to Factory
Maintenance.
(b) The amount of Factory Maintenance costs that would be allocated to
Factory Cafeteria.

(AICPA adapted)

PROBLEMS
10-1. Overhead Distribution Sheet. Montag Manufacturing Company applies
factory overhead on the following bases:
Producing Depts.

Materials costs 25%

Direct labor hours $2.50
 .. :

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 279

At the end of the fiscal period the following accounts and their balances have
been taken from the books and records:
Work in Process — Materials $46,000
— Direct Labor 29,450
— Factory Overhead (Applied) 23,250
Indirect Labor 17,400
Factory Office 3.200
Building Charges (including depreciation, insurance, etc.) 4,000
Powerhouse Expenses (coal, labor, etc.) 2,800

Additional information
Producing Departments

B Powerhouse

Direct materials $33,000 $13,000

Direct labor. . . 11,780 17,670

Direct labor hours 3,500 6,000

Power used 60% 40%
Floor space occupied 750 sq. ft. 750 sq. ft. 500 sq. ft.

Indirect labor and factory office are apportioned in direct ratio to the cost of
direct labor.

Required: (1) A distribution sheet showing the distribution of factory over-

head costs to producing departments and the powerhouse.
(2) The total and departmental over- or underapplied factory overhead after
the powerhouse expenses have been allocated to the producing departments.

10-2.Overhead Rates. The Hilsinger Manufacturing Company has three pro-

ducing departments: A, B, and C. Departmental estimates for the coming year
are as follows:
Factory Direct Direct
Over- Labor Labor Machine
Producing Departments head Hours Costs Hours

A $10,000 15,000 $24,000 9,000

B 12,000 50,000 75,000 5,000
C 16,000 40,000 60,000 2,000

Total $38,000 105,000 $159,000 16,000

Cost figures for Job Order No. 2235 are:

Department Department Department
A B C
Direct materials $300 $200 —0—
Direct labor costs 200 500 $400

Direct labor hours 125 300 250

Required: (1) Plantwide overhead rates for the company using three dif-
ferent bases.
(2) Three different overhead rates for each department.
(3) cost of Job Order No. 2235 using (a) a plantwide rate based on direct
The
labor hours and (b) separate direct labor hour overhead rates for each department.
280 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

10-3. Overhead Distribution Sheet and Rate Calculation. The president of the
Luciano Products Company has been critical of the product costing methods
whereby factory overhead had always been charged to products on a factory-
wide overhead rate. The chief accountant suggested a departmentalization of
the factory for the purpose of calculating departmental factory overhead rates.
He accumulated the following estimated direct departmental overhead data on
an annual basis:
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 281

Required: A factory overhead distribution sheet with calculation of overhead

rates for the producing departments based on direct labor hours.

10-4. Overhead Distribution Sheet and Rate Calculation. Dunlap Chemical Co.,
Inc. consists of threeproducing departments: Preparation, Mixing, and Pack-
aging; and four service departments: Utilities, Maintenance, Materials Hand-
ling, and Factory Office. For the purpose of creating factory overhead rates,
the accountant prepared the cost distribution sheet shown below. It contains
(a) operational data gathered by the accountant and (b) the expenses of the
individual departments.
 .

282 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

10-5. Overhead Distribution Sheet and Rate Calculation. At the end of Septem-
ber the factory ledger trial balance of the Wellinghoff Products Company
contained the following factory overhead items and amounts for the past three
months:
Indirect Labor $30,600 Fuel $ 2,100
Factory Rent 1 ,400 Electricity 1,600
Insurance — Machinery and Factory Supplies Used 3,600
Equipment 3,200 Social Security Taxes 5,130
Compensation Insurance 1,400 Maintenance and Repairs —
Superintendent 5,000 Machinery and Equipment. 21,000
—
.

Clerical Help — Factory 3,900 Depreciation Machinery and

Equipment 12,453

No attempt had been made (a) to charge these costs directly to departments
or (b) to create departmental overhead rates. The accountant believes that de-
partmentalization is desirable for meaningful product costing and efficient
responsibility reporting. He gathered the information shown below concerning
the three producing departments, called A, B, and C, and the two service de-
partments, Maintenance and Repairs (other than machinery and equipment)
and General Factory.
 :

CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 283

Required: (1) Distribute factory overhead to the producing and service

departments based on the data given; prorate service departments as indicated.
(2) Calculate departmental overhead rates based on direct labor hours.

10-6. Cost Center Rates and Variance Analysis. The cost department of the
Venus Manufacturing Co. applies factory overhead to jobs and products on the
basis of predetermined cost center overhead rates; i.e., in each of the two pro-
ducing departments, two cost centers have been set up. For the coming year,
the following estimates and other data have been made available:

%
Estimated Annual Estimated Annual
Department 10: Factory Overhead Machine Hours

Fixed Variable Total

Cost Center 10-1 514,040 523,400 537,440 15,600

Cost Center 10-2 26,910 43,290 70,200 23,400

Estimated Annual
Department 20: Direct Labor Hours

Cost Center 20-1 S 8,320 521 ,580 529,900 26,000

Cost Center 20-2 6,240 19,760 26,000 20,800

Required: (1) The annual normal cost center overhead rates based on the
estimated machine hours in Department 10 and the direct labor hours in De-
partment 20.

(2) Application of factory overhead to the four cost centers on the basis of
these actual machine or labor hours used or worked during the month of
February
Cost Centers 10-1 10-2 20-1 20-2

Machine hours.... 1,220 2,000

Labor hours 2,250 1,650

(3) The spending and the idle capacity variances for the two producing de-
partments. Actual factory overhead in Department 10 amounted to $9,630 and
in Department 20 to $4,205.

(4) Analysis of the total idle capacity variance of Department 10 into the idle
capacity variances of the two cost centers. Use 1 /12 of the total annual estimated
hours as normal monthly hours.

10-7. Algebraic Distribution of Factory Overhead. controller of the Haynes

The
Corporation instructs from the traditional
his cost supervisor to initiate a shift
successive iteration type of cost allocation of service departments to producing
departments to a mathematical procedure using algebra to recognize more effec-
tively interdepartmental relationships. The corporation's three producing de-
partments are served by three service departments, each of which consumes part
of the services of the other two. After primary but before reciprocal distribution,
the account balances of the service departments and the interdependence of the
departments were tabulated as shown on the next page.
 : :

284 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Services Provided
Departmental Overhead
Before Distribution of General
Department Service Departments Powerhouse Personnel Factory

Mixing $125,000 J-' /O 25%

Refining 90,000 25 30 20
Finishing 105,000 20 20 20
Powerhouse .... 16,000 10 20
Personnel 29,500 10 15
General Factory. 42,000 20
$407,500 100% 100% 100%

Required: (1) The final amount of overhead of each service department

after reciprocal transfer costs have been calculated algebraically.
(2) The total factory overhead of each producing department.

10-8. Hospital Costs Allocation Methods. Providence Hospital completed its

firstyear of operation as a qualified institutional provider under the health insur-
ance (HI) program for the aged and wishes to receive maximum reimbursement
for its allowable costs from the government. The hospital compiled the following
financial, statistical, and other information

(a) The hospital's charges and allowable costs for departmental inpatient services
were as follows

Charges for Total

HI Program Total Allowable
Department Beneficiaries Charges Costs

Inpatient routine services

(room, board, nursing) $ 425,000 $1,275,000 $1,350,000
Inpatient ancillary service departments
X-ray 56,000
Operating room
Laboratory
Pharmacy
Other
Total ancillary

Total
CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 285

part of the provider's total allowable cost attributable to ancillary (non-

routine) services is to be apportioned in the ratio of the beneficiaries' share
of charges for ancillary services to the total charges for all patients for such
services.

(c) Statistical and other information:

(1) Total inpatient days for all patients 40,000

(2) Total inpatient days applicable to HI beneficiaries (1,200 aged

patients with average stay of 12.5 days) 1 5,000

(3) A intermediary acting on behalf of the government's Medicare pro-

fiscal
gram negotiated a fixed allowance rate of $45 per inpatient day subject to
retroactive adjustment as a reasonable cost basis for reimbursement of
covered services to the hospital under the HI program. Interim payments
based on an estimated 1,000 inpatient days per month were received during
the 12-month period subject to an adjustment for the provider's actual cost
experience.

Required: (1) Schedules computing the total allowable cost of inpatient

services forwhich the provider should receive payment under the HI program,
and the remaining balance due for reimbursement under (a) the Departmental
RCC Method and (b) the Combination Method (With Cost Finding).
(2) The method under which Providence Hospital should elect to be reim-
bursed for its first year under the HI program, assuming the election can be
changed for the following year with the approval of the fiscal intermediary.
Explain.
(3) Providence Hospital wishes to compare its charges to HI program bene-
ficiaries with published information on national averages for charges for hospital
services.Determine with computations (a) the average total hospital charge for
an HI inpatient and (b) the average charge per inpatient day for HI inpatients.

(AICPA adapted)

CASES
A. Deciding on Depreciation for Old and New Building. The Rossmoyne Manu-
facturing Company owned one factory building with a net depreciated cost of
$90,000. Machinery and equipment was carried at $120,000. Because of expand-
ing business, it built a new building at a cost of $150,000 and installed $210,000
of equipment therein. During the next several years it put some new equipment
into the old building and continued to operate both plants. Depreciation has
been computed on a straight-line basis.
Recently the company shut down the old plant because of lack of orders.
The sales manager proposes that the company should no longer take deprecia-
tion on the old building and machinery. He suggests that while the old plant is
useful, it is not in use and is not wearing out. He also suggests that to take de-
preciation on it increases cost, overvalues inventory, and places the company in
a poor competitive position to bid for business since its costs are high.

Required: A full discussion of this proposal.

(AICPA adapted)
286 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

8 in
II
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CH. 10 DEPARTMENTALIZATION OF FACTORY OVERHEAD 287

B. Comparing Cost System Income Determination.

for Inventory Costing and
The Hallahan Manufacturing Company engaged in manufacturing items
is

to fill specific orders received from its customers. While at any given time it may
have substantial inventories of work in process and finished goods, all such
amounts are assignable to firm sales orders which it has received.
The company's operations, including the administrative and sales functions,
are completely departmentalized. Its cost system is on a job order basis. Direct
materials and direct labor are identified with jobs by the use of materials issue
tickets and daily time cards. Overhead costs are accumulated for each factory
service, administrative, and marketing department. These overhead costs, includ-
ing administrative and marketing expenses, are then allocated to producing de-
partments and an overhead rate computed for each producing department. This
rate is used to apply overhead to jobs on the basis of direct labor hours. The
result is that all costs and expenses incurred during any month are charged to the
work in process accounts for the jobs.

Required: (1) Comparison of this system, as it affects inventory costing,

with the usual system for manufacturing businesses.
(2) Criticism of the system as it affects inventory costing and income
determination.
(3) Justifications for the use of the company's system.
(AICPA adapted)

C. Cost Accounting Records; Overhead Distribution; Ledger Accounts. The

LaVelle Manufacturing Company uses a job order cost system that has been
kept rather inadequately by the former accountant who left in the middle of
September. The company's president asks for assistance in getting the books
and records in an acceptable order. The company's cost system includes a gen-
eral ledger and a factory ledger with reciprocal control accounts. A trial balance
of the factory ledger at September 1, 19 —
showed the following:

Debits Credits

Raw Materials $30,000

Store Supplies 10,000
Work in Process 20,000
General Ledger Control $60,000
$60,000 $60,000

After reviewing the work done up to September 1, information is gathered

for the month of September from the sources indicated on page 286.

Required: On a worksheet using the same headings as those appearing on the

sources of information material on the opposite page:
(a) The direct, indirect, and total costs that should be debited to the work in
process account for the month of September.
(b) Distribution of service departments' costs to the producing departments as
per instructions.
(c) The September 30 balances of the following factory ledger accounts : General
Ledger Control; Raw Materials; Store Supplies; Work in Process.

(AICPA adapted)
 :

CHAPTER 11

RESPONSIBILITY ACCOUNTING
AND RESPONSIBILITY
REPORTING

Direct materials and direct labor are generally directly identifiable with
specific products, jobs, or processes. Factory overhead, however, consist-
ing of indirect supplies, indirect labor, and numerous factory expense items
such as power, water, utilities, repairs and maintenance, taxes, insurance,
and depreciation, creates two distinct problems

1. Its allocation to products for the purpose of inventory costing and profit
determination, and

2. Control of factory overhead with the aid of responsibility accounting.

The well-designed information system yields product costs for inventory

costing and profit determination. However, it should also provide a con-
trol mechanism encompassing and make avail-
responsibility accounting
and making decisions.
able meaningful cost data useful in setting policies
The predetermined or budgeted revenue and expense items form the foun-
dation for comparison with actual results leading to the variance analysis
or management by exception principle.
The establishment of such a system would allow and maintain the
most efficient and profitable balance between manufacturing and market-
ing. On the one hand, management needs to decide the kinds and costs of
its products; on the other hand, management must decide the kinds and

288
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 289

prices of its products. The best profit results from the proper balance of
these considerations. For these reasons, product costs must be fairly
accurate, include all relevant costs, and recognize cost differentials among
products.

CONTROL OF FACTORY OVERHEAD AND

RESPONSIBILITY ACCOUNTING
Responsibility — Defined. Webster's dictionary defines responsibility
or being responsible as "liable to respond; likely to be called upon to
answer; accountable; able to respond or answer for one's conduct and
obligations."
Kohler's A Dictionary of Accountants defines responsibility as "the
obligation prudently to exercise assigned or imputed authority attaching to
the assigned or imputed role of an individual or group participating in
organizational activities or decisions."
The N.A.(C.)A. Research Series No. 22, says: "A responsibility may
be defined as an organizational unit having a single head accountable for
activities of the unit."

Responsibility Accounting — Basic Concepts. The concepts enumerated

below are prerequisites to the initiation and maintenance of a responsibility
accounting system.

1. Responsibility accounting is based on a classification of managerial

responsibilities (departments) at every level in the organization for the
purpose of establishing a budget for each. The individual in charge or
with the authority for each responsibility classification should be made
responsible and held accountable for the expenses of his activity. This
concept introduces the need for the classification of costs into controllable
and those not controllable by a department head. Generally, variable
costs are charged to a department and are controllable by its manager;
fixed costs, though charged to a department, generally are not con-
trollable by its manager.

2. The starting point for a responsibility accounting information system

restswith the organization chart in which the spheres of jurisdiction have
been determined. Authority leads to the responsibility for certain costs
and expenses which are forecast or present in the budget established with
the knowledge and cooperation of the supervisor, department head, or
manager.

3. Each individual's budget should clearly identify the costs controllable by

him. The chart of accounts should be adapted to permit recording of
controllable or accountable expenses within the jurisdictional framework.

Personal Factors in Responsibility Accounting. A program to develop

management accounting controls must be considered a prime responsibility
290 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

of top management with the accounting department providing the tech-

nical assistance. To assure the follow-through and therewith the ultimate
success of the program, management must provide a complete clarifica-
tion of the objectives and responsibilities of all levels of the organization.
This prerequisite requires an understanding by middle and operating man-
agement of executive management's goals. The acceptance of responsibihty
for certain costs and expenses does not always follow the mere issuance of
directives and orders. Supervisory personnel, particularly at the foreman
level, need guidance and training to achieve the control and /or profit

results expected from them. Control responsibility requires a certain fun-

damental attitude or frame of mind for the task. It just does not happen
naturally. One of the most beneficial influences is executive management's
own exemplary adherence to the cost-and-profit responsibility it created.
Of equal importance is the motivation for corrective action by the
responsible individual. The issuance of reports based on the organization's
responsibility concept is not sufficient. The successful achievement of
effective management control depends upon the lines of communication
between the accounting department, the responsible supervisors, and their
superiors. Responsibility accounting requires teamwork in the truest sense
of the word.

Responsibility for Overhead Costs. As the preceding overhead chapters

indicate, many overhead items are directly chargeable to a given depart-
ment and become the direct responsibility of the departmental supervisor.
Allocated or distributed overhead causes problems in assigning cost
responsibility. To calculate a departmental factory overhead rate, these
costs must be allocated so that all costs can be charged to the job or prod-
uct. The allocation procedure, however, is not necessary for cost control;
that is, for responsibility accounting. If allocated charges are to be shown
on the report furnished to the supervisor, they should be limited to those
expenses for which he has assumed control and responsibility. The proce-
dure depends a great deal upon the methods of cost accumulation and allo-
cation employed by a firm. Certain expenses (e.g., electricity) could, when
metered for a department, be considered a direct departmental overhead.
When these expenses together with others are collected first in an account
or in a department such as General Factory or Utilities, the allocation
takes place on a preestablished basis. Differences between actual and
allocated or charged-out costs in these accounts or departments should not
be shown on the reports for the departments served rather the control or
;

responsibility phase stays with the originating department.

The '* "Sold-Hour" Rate of a Service Department, The cost

Billing" or
system provides for a normal volume distribution of service hours, use
 . :

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 291

hours, and/or maintenance hours to producing or other service depart-

ments. The distribution can be looked upon as a purchase by the recipient
center or a sale by the servicing center. The distribution to the recipient
center is based on what
termed a "billing rate," a "sold-hour rate," a
is

"charging rate," or a "transfer rate." The method is based on the idea

that these departments or centers purchase the services in the same manner
as direct materialsand direct labor. For these cost elements, quantities
and cost are controlled and differences noted. The producing or service
department foreman is responsible for the number of hours worked, or
kw-hours purchased, and the cost incurred in his department.
The determination of the rate follows the procedures discussed in the
previous factory overhead chapters

1 Costs of any service or maintenance department are estimated or bud-

geted according to their nature (supervision, supplies, electricity, etc.).

2. Costs are classified as fixed or variable. This classification often leads to

the realization that many service departmental costs are fixed over fairly
wide ranges of service volume.

3. A rate is determined by dividing total departmental cost by the number

of hours the service is expected to be needed. The establishment of the
use hours, i.e., for the power house, is as important here as it is in factory
overhead rate determination. The hours can be based either on past
experience in a representative period or on future activity or volume as
expressed in the budget. A refinement of the rate is the apportionment
of fixed costs to cost centers on a readiness-to-serve basis. As some
departments would require more service than others, the initial cost
proration is made on that basis. The cost remaining is then divided by
the budgeted hours of the recipient departments.

4. Actual service department costs incurred in the department are compared

with the predetermined or budgeted costs. This comparison is made
(1) in the service department to which the expenses are originally charged
— actual costs are compared with charged-out or sold-out amounts;
(2) in the benefiting (recipient) departments in which the charges for
service departments' services are linked with the predetermined budget
allowances. This step is the control phase of the service department's
charging-out procedure. The foreman of the service department is re-
sponsible for the actual cost against the cost or hours charged for service.
The benefiting department foreman is responsible for the number of hours
or the cost charged for service. Comparison will also lead to the calcu-
lation of variances for service and producing departments.

Maintenance Costs and Responsibility Accounting. Maintenance ex-

penses like any other indirect factory cost must find their way into the
producing departments to be included in the total departmental cost for
 :

292 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

the calculation of overhead rates for product costing purposes. Still un-
solved is The maintenance engineer
the problem of cost responsibility.
often believes that his department really incurs no cost at all, for any cost
incurrence is for the benefit and at the request of other departments. The
factory foreman, on the other hand, may argue that he has no influence upon
costs,either personnel or machinery, of the maintenance department.
However, a solution must be found not only for product costing purposes,
but also for the control of these expenses. The control is in reality twofold
the factory foreman controls the amount of maintenance work, while the
maintenance engineer or foreman controls the quantity of men and ma-
terials required to serve the various departments. As maintenance work is

done at the request of the production foreman, the problem arises as to

whether control should be exercised at the source level or the recipient level.

At the source level, service and maintenance labor is organized and

supervised. Control at this point requires the predetermination of man-
hour requirements in each of the producing and service departments for
each service or maintenance function. At the recipient level, the cost system
establishes predetermined budget allowances for this indirect cost. Budget
allowances activated against planned levels of production permit determin-
ing the man-hour budgets for each shop service or maintenance unit for
advance scheduling of its labor force. Preplanning is the heart of the con-
trol, providing an opportunity for corrective action before the hours are

worked. Maintenance supervisors and service department foremen are

apprised of the budgeted service or maintenance allowance by individual
recipient cost centers while the distribution or scheduling of the work itself

is left to their discretion.

One major problem, however, rests with the question of how much
maintenance or repair work is needed in a department. The answer thereto
may reach the executive management group for either a decision or perhaps
even the original responsibility for the type and amount of maintenance
work For at the time the factory was laid out and the machinery
required.
maintenance program should have been planned. The size of
installed, a
the maintenance department, the type or class of workers (carpenters,
plumbers, electricians, pipefitters, masons, millwrights, machinists, etc.),
and the kind of equipment and tools are greatly influenced by the early
decision. On the other hand, experience indicates that such maintenance
objectives are lacking in many companies due to management's own lack
of interest as well as alleged difficulties encountered in planning, measur-
ing, and controlling the maintenance function.
Many organizations engage the services of outside firms for part or all

of their maintenance. This practice does not negate the need for careful
planning and control of maintenance cost.
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 293

Preventive Maintenance. A plan for the cost determination and the

control responsibility of maintenance is both needed and possible. It is

suggested that management, the supervisors of producing and service

departments, and the maintenance engineering department reach an
agreement on the overall maintenance policy to be followed by the plant.
This approach constitutes a preventive maintenance program with the
objective of keeping equipment in such condition that breakdowns and
the need for emergency repairs are at aminimum. Preventive maintenance
facilitates the scheduling of maintenance work and helps to obtain better
utilization of the maintenance work force and the productive equipment.
It also reduces operating losses due to machine breakdowns, extensive
damage, or serious injuries to personnel.

A preventive maintenance program can work automatically so that

inspection, minor and lubrication are completed as
repairs, adjustments,
a matter of course. The method further provides for a check on the effec-
tiveness of the maintenance work by the foreman of the serviced or buying
unit. The maintenance foreman, in turn, is responsible for the inspection
and the upkeep of the facilities.
The discussion has intentionally dealt with factory overhead items only,
since their assignment and control occupies the attention of many execu-
tives, department heads, supervisors, and foremen. Not only are produc-
tion people made responsible for the costs of their departments, but other
departments and functions in administration and marketing require the
same kind of responsibility accounting. Besides factory overhead, the other
cost elements also need watching and controlhng by responsible managers.

Responsibility for Direct Materials and Direct Labor. Basically, the best
approach to assigning responsibility for any cost element is a study of
those individuals who are in the most favored position to keep the costs
under control. The assignment of responsibility for overhead expenses to
foremen, supervisors, and department heads allows a conceivable amount
of control. It is admitted, however, that certain expenses are often trouble-
some; e.g., maintenance expenses. In the direct materials and direct labor
areas, the assignment of responsibility for cost incurrences falls upon many
shoulders and often becomes very obscure and nearly impossible to identify.
Of course, it seems advisable to insist upon the assignment on the basis of
relative control rather than absolute control.
In the direct materials area, the variances or deviations from a predeter-
mined norm or standard will result in (1) materials price variances, (2) ma-
:

terials quantity, or mix and yield variances, and /or (3) excessive defective

work, rejects, or scrap costs. In the direct labor area, the variances or
294 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

deviations from a predetermined norm or standard will result in: (1) pay
rate variations, (2) efficiency variations, (3) and /or overtime costs.
However, these cost elements are not the only ones subject to change
for which an executive may be held responsible. In later chapters the
deviations from budgeted gross or net profit figures require explanation.
The changes in sales prices, in sales volume, and in sales mix are the
responsibility of the marketing department. Yet the gross profit figure
contains elements of costs as well, so that a further investigation is

warranted.

Variance Analysis for Responsibility Accounting. Today with the

emphasis on responsible control of financial results via the return-on-
capital-employed concept, assets, liabilities, and costs
net worth, revenue,
form a vast area in which the entire management spectrum from the top
executive to the lowest foreman holds some share of responsibility. Like
blocks in a pyramid (see page 302), the responsibility travels from the
lowest to the highest level of supervision. Each supervisory level is
responsible for costs incurred by its supervisor and his subordinates.
To be able to exercise this control, the cost and /or budget department
must issue monthly reports that compare the actual results with prede-
termined amounts or budget allowances. An analysis prepared at the end
of the annual fiscal period, as shown in the previous chapter, is not very
helpful for immediate control actions. Reports on a monthly or more
frequent basis are advisable to allow short-range comparisons of those
costs for which operating management is being held responsible.
The illustrative problem beginning on page 295 assumes that variable
expenses are controllable at the departmental level while fixed expenses
are not. These assumptions apply to almost all costs in most situations.
In some circumstances certain variable expenses may be controlled at a
higher level in the organization; e.g., employee fringe benefits may be de-
termined by negotiations between executive management and the labor
union or by government regulations. Such costs should be analyzed and
separately identified to relieve a department manager of this responsi-
bility. Conversely, a department manager may have some control over
certain fixed costs — those that involve a long-term commitment (some-
times called "committed fixed expenses") such as equipment depreciation
or lease expense and those that can be readily changed in the short run
(sometimes called "programmed fixed expenses") such as the number of
foremen in the department. These costs should be individually identified
as controllable by the manager of the department; and whether fixed or
variable, some costs may be joint with respect to two or more departments
and thus require arbitrary allocation. Accordingly, their controllability
by a single department manager is restricted.
 :

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 295

Attention must be called to the fact that in the long run all costs are
controllable. Variable costs are generally controllable over short time
periods. Some fixed costs, such as supervisory labor or equipment rental,
can also be terminated on short notice while other fixed costs, depreciation
of fixed assets or a long-term lease agreement, involve a fixed commitment
over a longer period of time. Finally, some costs possess a dual short- and
long-run controllability characteristic. For example, a five-year contract
as to the price of a raw material, representing a long-run commitment, is

not immediately controllable and the contract may be negotiable only at a

higher management level. However, waste and spoilage of the same ma-
terial is immediately controllable by the department. Generally, a depart-
ment manager should be well enough informed to be able to explain cost
variances even though the control or certain aspects of the control do not
fall within his or her scope of authority and responsibility.

Variance Analysis on a Responsibility Basis — Illustrated. The data,

steps, and methods presented below are based on the illustration in the
previous chapter. There the annual factory overhead of four producing
departments and four service departments was estimated, and product
costing rates (factory overhead rates) were calculated after the indirect
departmental expenses and service department costs had been apportioned
and distributed. At the end of the year annual actual factory overhead
was compared with applied factory overhead, and departmental spending
and idle capacity variances were determined.
At this point the analysis moves into a monthly comparison. In order
to keep the illustration compact, the four producing departments and only
one service department. Utilities, are used. Some of the data previously
presented must now be modified to serve this control responsibility phase.
For product costing purposes, four departmental factory overhead rates
have been computed and are listed below.
Cutting department S2.00 per direct labor hour
Planing department $3.20 per machine hour
Assembly department 60% of direct labor cost
Upholstery department $1.80 per direct labor hour

At the end of January the following actual data are assembled

Actual
Actual Departmental
Actual Hours Consumption Overhead Before
{Labor or Machine) for the Month Billing Out
Departments or Labor Cost kwh hph Utilities

Cutting 3,046 direct labor hours 1,180 19,000 $3,575

Planing 1,620 machine hours 700 10,800 3,125
Assembly $1 1,400 direct labor cost 1,700 7,000 2,900
Upholstery 4,100 direct labor hours 1,980 8,000 3,570
5,560 44,800
Utilities 5,860
 :

296 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Floor space data remain the same as shown on page 259 of the previous
chapter.Based on the actual production and cost data, the cost depart-
ment would apply the following amounts of factory overhead to the pro-
ducts passing through the four departments

Cutting department = 3,046 direct labor hours X $2.00 = 56,092

Planing department = 1,620 machine hours X $3.20 = $5,184
Assembly department = $11,400 direct labor cost X 60% = $6,840
Upholstery department = 4,100 direct labor hours X $1.80 = $7,380

If it is planned to determine the amount of over- or underapplied factory

overhead, service department costs would have to be added to the actual
directand indirect departmental overhead to put actual and applied figures
on a comparable basis. Such procedures were presented in Chapter 10.

Spending Variance on a Departmental Basis. In responsibility account-

ing, the emphasis rests upon the comparison of actual departmental ex-
penses with budgeted or estimated costs exclusive of service department
costs. In fact, many accountants believe that only the variable overhead
(i.e., the controllable expenses for which management holds the depart-
ment head responsible) should be compared and not the total overhead.
Naturally, the procedure varies between different organizations.
In this example, both procedures will be illustrated for the four pro-
ducing departments and for the one service department: (1) total actual
departmental overhead, both fixed and variable, is compared with bud-
geted or predetermined departmental overhead (2) only variable or con- ;

trollable actual departmental overhead is compared with its budgeted or

predetermined amount. Service department costs are excluded in both
situations.

Departments
1.
Cutting Planing Assembly Upholstery Utilities

Actual departmental
overhead S3,575 $3,125 $2,900 $3,570 $5,860

Budget allowances:
Fixed expenses (1/12
annual fixed costs;
e.g., $17,100 ^ 12 =
$1,425) $1,425 $1,492 $1,342 $1,525 $1,333
Variable expenses:
3,046 hours X S.5762* 1,755
1,620 hours X $1.0217* 1,655
$11,400 X 15.5^;* 1,767
4,100 hours X $.4217* 1,731
5,560 kwh X $.1544* 858
44,800 hph X $.0494* 2,213
1,750 sq. ft.** X $.7057* 1,235

Budget allowances... $3,180 $3,147 $3,109 $3,256 $5,639

Spending variances.. $ 395 $ (22) $(209) $ 314 $ 221

unfavorable favorable favorable unfavorable unfavorable

*VariabIe cost rate

**1,750 sq. ft. is 1 /12 of 21,000 sq. ft. and $1,235 is 1,750 sq. ft. X the annual rate of
$.7057.
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 297

or
 : : :

298 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

The analysis is as follows

U) (2) (3) (4) (5) (6)

Actual Budget Applied Total Spending Idle Capacity

Overhead Allowance Overhead Variance Variance Variance
(1-3) (1-2) (2-3)

$3,575 $3,180 $3,038* $537 $395 $142**

unfavorable unfavorable unfavorable

3,046 actual hours X $.9973

**3,384 (40,608 hours -^ 12 months) predetermined hours 3,046 actual hours =
338 idle hours X $.4211

A similar analysis can be made for the service department, Utilities,

as follows

(1) (2) (3) (4) (5) (6)

Actual Budget Utilities'' Cost Total Spending Idle Capacity

Overhead Allowance Charged Out Variance Variance Variance
(1-3) (1-2) (2-3)

$5,860 $5,639 $5,701* $159 $221 $(62)

unfavorable unfavorable favorable

*The amount of cost charged out is based on the total predetermined cost of $65,4(X)
which was to be distributed: 20% or $13,080 based on kwh; 50% or $32,700 on hph;
and 30% or $19,620 on floor area, resulting in these charging rates: $.2044 ($13,080 -^
64,000 kwh); $.0654 ($32,700 ^ 500,000 hph); and $.9343 ($19,620 ^ 21,000 sq. ft.).

The $5,701 is the result of: 5,560 actual kwh X $.2044 = $1,136
44,800 actual hph X $.0654 = 2,930
1,750 sq. ft. (one month, i.e., 1 /12 of 21,000 sq. ft.) X $.9343 = 1,635 $5,701

While the responsibility for the cost incurred is, generally speaking,
producing departments, a service department's cost
easily identifiable in the
variances need a great deal of additional investigation. With a service
department such as Utihties, the analysis is not so easy because

1. can be charged accurately to consuming departments only when

Utilities
departmental or cost center meters are used.

2. Even with meters the quantity used might differ from the quantity pro-
duced due to line losses. The pinpointing of the responsibility for these
losses is often impossible.

3. Since any utiHty can often be either purchased from outside or manu-
factured inside, it could be possible that the interchangeable use of one
source with another will give rise to variances for which the cause is also
difficult to detect.
 :

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 299

Similar difficulties regarding the placing or pinpointing of responsibility

for the cost incurrence and the resulting variance are experienced with any
service department. The maintenance department has already been cited as
an example. In many instances service department costs are largely fixed,
at least over a relevant range of activity or volume. For this reason, respon-
sibility is difficult to establish. The idle capacity variance is particularly

bothersome when calculated on a monthly basis. The spending variance is

somewhat more meaningful since actual and budgeted costs can be com-
pared with their increases and decreases.
As a rule, the manager of the service department is responsible for the
variance between the actual cost and the cost based on the number of hours
or service units charged out or sold. The manager of the producing or
services received department is responsible, with the service department
foreman, for the number of hours or service units consumed in the depart-
ment. This statement indicates that a kind of dual responsibility exists
between the charges to the services received departments and the credits to
the services rendered departments. The consuming department's cost must
be compared with the allowed or budgeted service cost to determine the
cost increase or decrease in that department, while the service department
must examine its cost on the basis of the quantity consumed or sold.

RESPONSIBILITY REPORTING
is a program engulfing all operating manage-
Responsibility accounting
ment which the accounting, cost, or budget divisions provide technical
for
assistance in the form of daily, weekly, or monthly control reports. Re-
sponsibility reporting encompasses the reporting phase of responsibility
accounting. In fact, the terms "responsibility accounting" and "responsi-
bility reporting" are generally considered synonymous in that accounting
should imply reporting and vice versa.
Reporting to the various levels of management can be divided into
responsibility-performance reporting and information reporting. A clear
distinction between the two is important; each serves different goals or
objectives. Responsibility-performance reports are accountability reports
with two purposes

1. To inform the manager and his superior how he has done in the areas for
which he is directly responsible for performance.

2. To motivate the manager and his superior to generate the direct action
necessary to improve performance.

Information reports are issued for the purpose of providing the man-
ager with information relevant to his areas of interest, although not neces-
sarily directly associated with his specific responsibility for performance.
 :

300 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Information reports serve a broader and different set of goals than per-
formance reports. In the short view, responsibility-performance reports
aremore important than information reports because of the immediate
and pressing needs to keep the business on course. However, from the
long view, information reports bearing on the progress and growth of the
business are also important.

FUNDAMENTALS OF
RESPONSIBILITY-PERFORMANCE REPORTS
Responsibility-performance reports should be based on certain funda-
mental qualities and characteristics

1. Reports should fit the organization chart; that is, the report should be
addressed to the individual responsible for the items covered by it and
who, in turn, will be able to control those costs under his jurisdiction.
Managers must be educated to use the results of the reporting system.
2. Reports should be prompt and timely. Prompt issuance of a report re-
quires that cost records be organized so that information is available when
it is needed.
3. Reports should be issued with regularity. Promptness and regularity are
closely tied in with the mechanical aids used to assemble and issue reports.
4. Reports should be easy to understand. Often they contain accounting
terminology that managers with little or no accounting training find diffi-
cult to understand, and vital information may be incorrectly communi-
cated. Therefore, accounting terms should be explained or modified to fit
the user. Top management should have some knowledge of the kind of
items chargeable to an account as well as the methods used to compute
overhead rates, make cost allocations, and analyze variances.
5. Reports should convey sufficient but not excessive detail. The amount
and nature of the detail depend largely on the management level receiving
the report. Reports to management should neither be flooded with im-
material facts nor so condensed that management lacks vital information
essential to carrying out its responsibilities.

6. Reports should give comparative figures; i.e., a comparison of actual

with budgeted figures or of predetermined standards with actual results
and the isolation of variances.
7. Reports should be analytical. Analysis of underlying papers, such as time
work orders, and materials requisitions, provides
tickets, scrap tickets,
reasons for poor performance which might have been due to power fail-
ure, machine breakdown, an inefficient operator, poor quality of materials,
or many other similar factors.
8. Reports for operating management should, if possible, be stated in physi-
cal units as well as in dollars since dollar information may give a fore-
man not trained in the language of the accountant a certain amount of
difficulty.
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 301

Reports may
tend to highlight supposed departmental efficiencies and
inefficiencies. Care should be exercised to see that such reports do not
encourage departmental activities aimed at "making a good showing"
regardless of the effect on the entire organization.

RESPONSIBILITY-REPORTING SYSTEMS —
ILLUSTRATED
The illustrations presented on pages 302 and 303 depict the pyramid
structure or the reporting procedure for responsibility accounting. The
first system is employed in a manufacturing concern while the second
system is employed in a bank.
The first step in a responsibility-reporting system is the establishment
of lines of responsibility and responsibility areas. Each block in a com-
pany's organization chart represents a segment (cost center, division,
department, etc.) that is reported upon and that receives reports on the
functions responsible to it. Any report prepared according to this concept
easily fits into one of these blocks as is illustrated in the organization
chart below.
302 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

CCHPAKY OVEMEAD

TO, Thr Pre»

vp, Narkeclnii:.

(SOOO)

-Presldetit, JUnuf«cturlog

$5,700 S3Z2

PROWCTIOfC &EPAKTMEKTS !

Hcls. Cencrol.

SI. 180

TO: Supervlsi SubsBseobly Departs

(Lender)
Budget

5L90 (10) $.lj.S0 2 St^O)

Flow of Responsibility Reporting

in a Manufacturing Concern

expenses for the three departments for which the Production Superin-
tendent is held accountable. Report B provides the Vice-President of
Manufacturing with performance figures for the five responsibility areas
within his division. Finally, the President receives a summary, Report A,
indicating overhead expenses not only for his area but also for the three
divisions (Marketing, Manufacturing, Finance) reporting to him.
The illustration^ appearing on page 303 depicts responsibility reporting
in a bank utilizing a reporting system that permits effective expense control
by accurately identifying and reporting expenses along the bank's organi-
zational lines for enabling proper assignment of responsibility and control
at each management level. In Exhibit A, expenses at each management
by area responsibility as well as by natural classification.
level are identified
ExhibitB shows a typical report for an intermediate (middle) level of
management while Exhibit C shows a report of a cost center.

REVIEWING THE REPORTING STRUCTURE

To provide all levels of management with all the facts when needed, the
reporting system should be kept geared to the requirements of all man-

agerial personnel. Each report should be so arranged that exceptions are

^William E. Ellington, Edward T. Kennedy, and Paul W. Landgren, Jr., "Computer-Based

Bank Financial Information Systems," The Arthur Andersen Chronicle, Vol. 29, No. 2, p. 28.
RESPONSIBILITY EXPENSE SYSTEM: REPORTING FLOW EXHIBIT A
DEPARTMENTAL EXPENSE
LEVEL RESPONSIBILITY REPORT ACCOUNT REPORT

1st Executive Office — J. M, Carr

2nd Operations Department — C.E. Evans

3rd Cashier's Department — W.T. Brown

4th Savings Tellers — H.B. fvlann

RESPONSIBILITY EXPENSE SYSTEM: REPORTING — 2ND LEVEL

OPERATING PERFORMANCE REPORT
304 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

highlighted and brought to the attention of the responsible supervisor

without too much searching and reading through many pages. The num-
ber of reports issued and sent to a manager also needs constant examina-
tion. Too many times a reporting system is cluttered with old, detailed, and
voluminous reports; and no one has ever considered the cost of their prep-
aration or their justification. No reporting system is ever perfect. It re-

quires continuous checking and examination in the light of changing times

and the vicissitudes of business itself.

DISCUSSION QUESTIONS

1. Overhead control reports received by a department head should include

only those items over which he has control. Explain.
2. Enumerate a few general requirements that are absolutely necessary for a
successful responsibility accounting system.
3. Responsibility accounting does not involve a drastic change in accounting
theory or principles. Discuss.
4. Enumerate some of the benefits that should result from responsibility
accounting. (NAA adapted)
5. The electric bill of the Emmons Company
increased from $5,000 to $7,500
between January and February. As a bill is received, its cost is allocated to
various departments on the basis of actual usage.
(a) What factors may have caused the increase?
(b) Is this an effective way of handling this cost ? If not, suggest a better
procedure.
6. The departmentalization of factory overhead is essential for maximum con-
trol of overhead. Explain in terms of responsibility reporting.
7. Why service department overhead be included in the overhead rates?
must
Why should actual service department overhead be accumulated in service
department accounts instead of being charged directly to production depart-
ment accounts?
8. Although service department overhead must be included in departmental
overhead rates, actual overhead of these departments need not be distributed
to departments serviced each period. Explain.
9. Usefulness of the figures is the primary reason for all accounting. Discuss.
10. On what fundamentals should the method of presenting cost data to manage-
ment be based?
11. Discuss the information which a well-designed cost report should give to the
management from the point of view of production and of control. Is there
any other information with which the cost figures should be amplified ? How
should such information be given?
12. Which of the following should not be on a monthly cost control report of a
department manager? department labor cost; (2) department supplies
(1)
cost; (3) depreciation cost on department equipment; (4) cost of materials
used in the department. (NAA adapted)
 :

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 305

13. A frequent complaint made by management is that cost reports arrive too
late to be of any value to the executives. What are the main contributing
causes of this condition, and how can it be remedied?
14. Explain responsibility accounting and the classification of revenues and
expenses under this concept. (AICPA adapted)
15. Periodic internal performance reports based upon a responsibility accounting
system should not (a) distinguish between controllable and uncontrollable
costs; (b) be related to the organization chart; (c) include allocated fixed
overhead in determining performance evaluation; (d) include variances
between actual and controllable costs. Which of the above is correct?
(AICPA adapted)
16. Select the best answer for the following statement. The concept of "man-
agement by exception" refers to management's (1) lack of a predetermined
plan; (2) consideration of only rare events; (3) consideration of items
selected at random; or (4) consideration of only those items which vary
materially from plans. (AICPA adapted)
17. Select the best answer for each of the following statements.
(a) Of most relevance in deciding how or which costs should be assigned
to a responsibility center is the degree of (1) avoidability; (2) causality;
(3) controllability; (4) variability.
(b) Of most relevance in deciding how indirect costs should be assigned to
product is the degree of (1) avoidability; (2) causability; (3) control-
lability; (4) linearity.
(c) The most desirable measure of departmental performance for evaluating
the performance of the departmental manager is departmental (1) reve-
nue less controllable departmental expenses; (2) net income; (3) contri-
bution to indirect expenses; (4) revenue less departmental expenses
(AICPA adapted)
18. The three charges below are found on the monthly report of a division
listed
which manufactures and sells products primarily to outside companies.
State which, if any, of these charges are consistent with the "responsibility
accounting" concept. Support each answer with a brief explanation.
(a) A charge for general corporation administration at 10% of division
sales.
(b) A charge for the use of the corporate computer facility. The charge is
determined by taking actual annual Computer Department costs and
allocating an amount to each user on the ratio of its use to total cor-
poration use.
(c) A charge for goods purchased from another division. (The charge is
based upon the competitive market price for the goods.)
(NAA adapted)

EXERCISES
1. Maintenance Charging Rate. A charging rate is frequently used to charge
Maintenance Department overhead to departments using its services. The charge
is determined by multiplying the number of man-hours of service provided by
the charging rate which is computed by the following formula

Total Actual Maintenance Department Overhead

Total Man-Hours Worked
 . : : :

306 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

The superintendent of the Stamping Department of a company using this system

was upset when he received a $15,000 maintenance charge for work that in-
volved approximately the same number of man-hours as work done in a previous
month when the charge was $12,000.
Required: (1) Factors which might have caused the increased charge.
(2) What improvements can be made for the distribution of this company's
Maintenance Department overhead?

2. Transfer Rates and Variance Analysis, The Haiger Company uses predeter-
mined departmental overhead rates to apply factory overhead. In computing
these rates, every attempt is made to transfer service department overhead to
producing departments on the most equitable bases. Budgeted overhead and
other data for the Maintenance Department and General Factory are

Maintenance Dept. General Factory

Monthly fixed overhead $7,500 $30,000

Variable overhead $1.00 per mainten- $20.00 per employee

ance labor hour (producing departments only)

Average hourly wage rate. . . $4.50

Normal level of activity 15,000 maintenance 1,000 producing department

hours per month employees

Required: (1) Charging or billing rates to be used to transfer estimated

maintenance and general factory overhead to producing departments together
with a description of the method used to charge actual maintenance and general
factory costs to benefiting departments.
(2) Spending and idle capacity variances for the service departments using
the following actual November results

Maintenance overhead $27,000

General factory overhead $55,000
Maintenance labor hours 16,000
Producing department employees 1,100

3. Billing Rate and Variance Analysis. The LeClerc Company operates its own
power-generating plant. Power cost is distributed to the producing departments
by charging the fixed cost according to the standby capacity provided and the
variable cost on the basis of a predetermined rate multiplied by actual consump-
tion. The rated standby capacity of the three departments A, B, and C is 50,000,
37,500, and 12,500 kwh respectively per month.
The following information relative to the producing departments and the
power plant for the months of January through May is available
Consumption in Kilowatt-Hours Power Plant
Dept. A Dept. B Dept. C Fixed Variable

January 45,000 40,000 10,000 $10,000 5 9,800

February 55,000 35,000 11,000 10,000 10,000
March 47,500 38,000 11,000 10,000 9,900
April 53,800 37,000 12,500 10,000 10,900
May 44,000 33,000 1 3,000 10,000 9,500
 : :

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 307

Predetermined variable power costs are based on $.10 per kwh.

Required: (1) Power cost chargeable to each department for each of the
five months.
(2) The over- or underdistributed variable costs of the power plant for each
of the five months.

4. Power Plant Charging Rate. During the month of November the actual ex-
penses of operating a power plant amounted to $9,300, of which $2,500 was con-
sidered a fixed cost.

Producing Service
Departments Departments
Schedule of Horsepower-Hours:

Needed at capacity production 10,000 20,000 12,000 8,000

Used during the month of November 8,000 1 3,000 7,000 6,000

Required: (1) The dollar amounts of the power plant expenses to be allocated
to each producing and service department. Fixed costs are assigned based on
the power plant's readiness to serve.
(2) Reasons for allocating the costs of one service department to other
service departments as well as to producing departments.
(AICPA adapted)

5. Service Departments Sold-Hour Rates; Variance Analysis. A company's two

service departments provide the following data

Monthly Service-Hours Actual

Service Center Budget Available Monthly Expense

Carpenter Shop $20,000 4,000 $19,300

Electricians 30,000 5,000 23,400

The two service departments serve three producing departments that show the
following budgeted and actual cost and service-hours data

Estimated Actual
Services Required Services Used
Department No. Carpenter Shop Electricians Carpenter Shop Electricians

1 1,200 hrs. 1,800 hrs. 800 hrs. 2,000 hrs.

2 1,500 hrs. 2,000 hrs. 1 ,600 hrs. 1 ,700 hrs.

3 1,300 hrs. 1,200 hrs. 900 hrs. 1,100 hrs.

Required: (1) The sold-hour rates for the two service departments.
(2) The amounts charged to the producing departments for services rendered.
(3) The spending variance for the two service departments, assuming that
60% of the budgeted expenses are fixed in both departments.
 : : : ::

308 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

6. BillingRates; Variance Analysis. The management of the Hollander Manu-

facturing Company wishes to secure greater control over service departments and
decides to create a billing rate for the Maintenance and Payroll Departments.
For the month of September the following predetermined and actual operating
and cost data have been made available:

Maintenance Department:

Predetermined data (beginning of the month)

Normal level of maintenance hours per month 3,200

Average hourly rate for maintenance worker $5.50

Other maintenance costs

Fixed Costs Variable Costs per
per Month Maintenance Labor Hour

Supervision $9,800 $.50

Tools and supplies 2,300 .75
Other miscellaneous items 700 .05

Actual data ( end of the month)

Maintenance hours worked 3,455

Maintenance workers earnings $19,610

Other costs (supervision, etc.) 16,390

Payroll Department:

Predetermined data (beginning of the month)

Average number of employees in factory and office 1,2(X)

Budgeted fixed costs for department $12,000

plus $2 for each employee in factory and office

Actual data (end of the month)

Number of employees in factory and office 1,165

Total costs in the payroll department $14,375

Required: (1) The billing rate for the two departments.

(2) A
variance analysis for the two departments for the month of September.

7.Overhead Analysis; Report to Supervisor. For the month of April, the cost
and operating data on factory overhead for Department 10 were as shown at
the top of the next page.

Required: (1) A variance analysis ofthe factory overhead for Department 10.
(2) A departmental report for the supervisor of Department 10 with explana-
tions regarding the format used.
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 309

Budgeted Actual
Factory Overhead Factory Overhead
Month of April Month of April
Variable departmental overhead:
Supplies $ 2,000
Repairs and maintenance
Indirect labor
Power and light
Heat
Total

Fixed departmental overhead:

Building expenses
Depreciation —
machinery
Taxes and insurance
Total

Total departmental overhead

Operating data:
Normal capacity hours
Factory overhead rate per hour.
Actual hours —
April
 :

310 PLANNING AND CONTROL OF FACTORY OVERHEAD PART II

11-2. Variance Analysis in Producing and Service Departments Based on Re-

sponsibility Reporting. Production in the Milstein Linoleum Company, Inc.
moves through four producing departments assisted by three service depart-
ments. Departmental overhead rates are established at the beginning of the
fiscal year to aid in costing products completed. Actual factory overhead is ac-
cumulated and monthly budget reports are sent to each department supervisor
for the purpose of responsibility accounting. On the basis of predetermined de-
partmental expenses and after the allocation of the three service departments'
costs, the following overhead rates for the four producing departments for
product costing purposes were calculated:

Producing Departments

Forming Molding

Departmental expenses:
Variable expenses $19,500
Fixed expenses 19,500

Total direct departmental expenses . . . $39,000

Distributed service departments' costs

Machine shop 6,200
Hydraulic power 1 ,400

General plant 5,400

Total departmental overhead $52,000

Factory overhead rates $4 per

direct
labor hour
CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 311

(2) The spending and idle capacity variances for the Forming and Molding
Departments before service departments' costs are allocated.
(3) The amount of departmental overhead variance for which each depart-
mental supervisor is being held responsible considering only variable costs for
all departments. Assume that the use of service department facilities was exactly
the same as the amount budgeted when the producing departments' overhead
rates were calculated.

11-3. Variance Analysis of Producing and Service Departments Overhead. Rehn

Products, Inc., decided to push for a greater amount of cost consciousness
and cost responsibility among its departmental supervisors. The allocation of
service departments' costs to the producing departments for the calculation of
factory overhead rates has been in use for some time. Now the management asks
the Cost Department, with the cooperation of the departmental supervisors,
to prepare not only departmental budgets but also to give the supervisors
monthly reports for cost control information.
The company operates with three producing departments, A, B, and C, and
two service departments, Repairs and Maintenance, and Utilities. For the year
19— ,the Cost Department had prepared the departmental factory overhead
budgets and determined the following factory overhead rates based on direct
labor hours:

Departmental Factory Overhead Budgets

Producing Departments Service Departments

Expenses
 : : :

312 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Actual cost and operating data before allocation of service departments' costs
at the end of the budget period are:

Expenses

Total actual expenses*

ABC
Producing Departments

$56,220 $52,850 $42,580

Service Departments

Repairs and
Maintenance

$55,320
Utilities

$49,240

Operating data
Direct labor hours 20,480 29,850 20,100
Kilowatt hours 39,300 46,200 35,800 18,950

*The expenses and their amounts used to arrive at these figures have been omitted.

Predetermined rates are used to allocate service departments' costs.

Required: (1) The amount of factory overhead applied for each of the three
producing departments.

(2) The amount of over- or underapplied factory overhead for each of the
three producing departments, charging them with service department costs on
the basis of actual kilowatt hours or labor hours multiplied by the billing rate.

(3) The total variance for each of the two service departments.

11-4. Billing Rate; Variance Analysis. The Croesus Corporation has three pro-
ducing departments: Assembling, Painting, Finishing and Packing; and one
service department General Factory. Overhead is applied to the product via
:

departmental overhead rates that include a share of the service department's

expenses. The following monthly predetermined and actual costs and production
data are available

Departments
Producing Service

Assembling Painting Finishing and Packing General Factory

Variable expenses per direct

labor hour $.50 $.25 $.30 $1.00

Fixed expenses $2,800 $4,000 $2,320 $6,000

Normal monthly activity

(direct labor hours) 2,000 1,600 2,400

Actual monthly results

Expenses $4,400 $4,100 $3,300 $12,600
Hours worked 2,050 1,500 2,200
 : , ., —

CH. 11 RESPONSIb.LITY ACCOUNTING AND REPORTING 313

The service department's expenses are distributed to the producing depart-

ments on the basis of direct labor hours.

Required: (1) The charging or bilhng rate of the service department.

(2) The factory overhead rate for each of the three producing departments
with the service department's expenses being prorated on the basis of the bilhng
rate calculated in (1).

(3) The spending and idle capacity variances for each of the three producing
departments.

(4) The spending variance of the service department.

11-5. Billing Rates; Estimated Factory Overhead and Variance Analysis. The
Riehle Machine Tool Co. has two producing departments, Planers and Radial
Drills, and two service departments, Maintenance and Utilities. The Cost
Department collected the following data and information:

Estimated Data for the Year 19

Producing Departments Service Departments

Planers

Factory overhead
Fixed overhead
Variable overhead

Total

Direct labor hours.

Maintenance hours
Kilowatt hours
 : —

314 PLANNING AND CONTROL OF FACTORY OVERHEAD PART III

Required: (1) The billing (or charging) rate for each of the two service de-
partments, Maintenance and Utilities.

(2) The total predetermined factory overhead for each of the two producing
departments, Planers and Radial Drills, and their departmental factory overhead
rates based on direct labor hours. Service departments' expenses are to be dis-
tributed on the basis of the billing rates calculated in (1) above.

(3) An analysis of the over- or underapplied factory overhead of each of the

two producing departments for the month of January, isolating the spending
and idle capacity variances. Service departments' expenses are to be charged on
the basis of actual hours (maintenance or kilowatt) multiplied by the billing
rate. This method treats these expenses as being wholly variable.

(4) A calculation and analysis of the over- or underdistributed factory over-

head in each of the two service departments, isolating the spending and idle
capacity variances.

11-6.Budget Allowance; Variance Analysis Based on Responsibility Reporting.

The controller of the Kowalski Corporation prepared the following forecast
income statement for the year 19 —

Forecast Income Statement — Year 19

Amount Unit

Sales (60,000 units) $600,000 $10.00

Cost of goods sold: (see Schedule I) 384,000 6.40

Gross profit $216,000 $ 3.60

Operating expenses:
Marketing expenses $80,000
Administrative expenses 70,000 150,000 2.50

Net profit $ 66,000 $ 1.10

Schedule I — Estimated cost of goods sold:

Direct materials $102,000 $ 1.70
Direct labor 162,000 2.70
Factory overhead 120,000 2.00

Total $384,000 $ 6.40

The product's manufacturing processes require two producing departments

thatmake use of the services of Department 76 —
Maintenance and Depart-
ment 95 —
Janitorial. To charge the products moving through the two depart-
ments, the cost accountant has prepared an overhead distribution sheet and
calculated factory overhead rates for product costing as reproduced at the top
of the next page.
 : .

CH. 11 RESPONSIBILITY ACCOUNTING AND REPORTING 315

Predetermined Departmental Overhead and Production Data

Producing Departments Service Departments

Data Dept. 10

Production units
Direct labor hours
Direct labor cost

Factory overhead
Variable overhead
Fixed overhead
Share of Department 76 ...
Share of Department 95
Total factory overhead

To marketing and administra-

tive expenses

Factory overhead rate $1.80

(based on direct labor hours)
 :

CHAPTER 12

MATERIALS CONTROL
PROCEDURES
AND COSTING METHODS

Effective materials management is and important in order to

essential

(1) provide the best type of service to customers, (2) produce at maximum
efficiency, and (3) manage inventories at predetermined levels to stabilize
investments in inventories. To succeed in effectively managing materials
requires the development of a highly integrated and coordinated system
involving sales forecasting, purchasing, receiving, storage, production,
shipping, and actual sales. Materials management must consider both the
theory of costing materials and inventories and the practical mechanics of
cost calculations and record keeping.
Costing materials presents some important, often complex, and some-
times highly controversial questions concerning the costing of materials
used in production and the cost of inventory remaining to be consumed in
a future period. In financial accounting, the subject is usually presented
as a problem of inventory valuation; in cost accounting, the primary prob-
lem is a determination of the cost of various materials consumed in pro-
duction and a proper charge to cost of goods sold. The discussion of
materials management in this chapter deals with

1. Procedures for materials procurement and use

2. Materials costing methods
3. Cost of materials in inventory at the end of a period
4. Costing procedures for scrap, spoiled goods, and defective work
317
 . :

318 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

PROCEDURES FOR MATERIALS PROCUREMENT

AND USE
Although production processes and materials requirements vary, the
cycle of procurement and use of materials usually involves the following
steps

1 and routing determine the design of the product,

Engineering, planning,
and the requirements at each stage of opera-
the materials specifications,
tions. Engineering and planning not only determine the maximum and
the minimum quantities to run and the bill of materials for given products
and quantities but also cooperate in developing standards where
applicable.
2. The production budget provides the master plan from which details con-
cerning materials requirements are eventually developed.
3. The purchasing requisition informs the purchasing agent concerning the
quantity and the type of materials needed.
4. The purchase order contracts for appropriate quantities to be delivered
at specified dates to assure uninterrupted operations.
5. The receiving report certifies quantities received and may report results
of inspection and testing for quality.
6. The materials requisition notifies the storeroom or warehouse to deliver
specified types and quantities of materials to a given department at a
specified time or is the authorization for the storeroom to issue materials
to departments.
7. The materials ledger cards record the receiptand the issuance of each
class of materials and provide a perpetual inventory.

Accounting procedures for materials procurement and use involve

forms and records necessary for general ledger financial accounting as well
as those necessary for costing a job, process, or department, and for main-
taining perpetual inventories and other statistical summaries. The purchase
requisition, purchase order, receiving report, materials requisition, bill of
materials, scrap report, returned materials report, materials ledger cards,
and summary of materials used are some of the forms used for materials
control under a cost system. The purchases journal, the cash payments
journal, the general journal, and the general ledger control accounts are
also used.
The discussion in this section is not based on any particular type or size
of industry, it is, rather, a general description of the accounting and con-
trolling procedures involved in the procurement and use of materials. The
flowchart on page 319 shows procedures for purchasing, receiving, re-
cording, and paying materials; i.e., the procurement phase.

Purchases of Productive Materials. The actual purchase of all materials

is usuallymade by the purchasing department headed by a general pur-
chasing agent. In small and medium-size companies, department heads
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 319

PURCHASE
REQUISITION

HX
ACCTG. DEPT.
for
account number

PURCHASING DEPT. VENDOR ACCOUNTING DEPT.

Issues purchase Returns acknowl- Uses:
order to: edgment copy Invoice
Ships materials - Purchase order
Vendor Sends invoice — Receiving and
Inspection
Accounting Dept. report(s)
for invoice
Receiving Dept. - RECEIVING DEPT. approval
Issues receiving Payment approved
Materials Ledger report to: and voucher
Clerk Purchasing Dept. prepared
Own file

File copy Balance to

TREASURER
for
payment
INSPECTION DEPT.
Makes distribution
to: MATERIALS LEDGER
Own file
CLERK
Accounting Dept. -
Posts quantity and
Materials dollar value to
materials ledger
cards

MATERIALS DEPT.
Storekeeper stores
materials in
proper location

Flowchart for Purchasing, Receiving, Recording, and Paying Materials

or foremen have authority to purchase materials as the need arises. In

any case, systematic procedures should be written up in order to fix
responsibility and to provide full information regarding the ultimate use
of materials ordered and received.
The purchasing department should: (1) receive purchase requisitions
for materials, supplies, and equipment; (2) keep informed concerning
sources of supply, prices, and shipping and delivery schedules (3) prepare ;

and place purchase orders; and (4) arrange for adequate and systematic
320 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

reports between the purchasing, the receiving, and the accounting depart-
ments. A further function of the purchasing department in many enter-
prises is and approval for payment of all invoices received
the verification
in response to purchase orders placed by the department. This procedure
is said to have the advantage of centralizing the verification and approval

of invoices in the department that originates the purchases and has com-
plete information concerning items and quantities ordered, prices, terms,
shipping instructions, and other conditions and details of the purchases.
However, invoice verification and approval by the purchasing department
may violate sound procedures and principles of internal control. This
would be particularly true if the same individual prepared an order and
later approved the invoice. Consequently, invoice audit and approval in
many instances have been made a function of the accounting department.
Shifting invoice approval and auditing to the accounting department is
accomplished by sending a copy of the purchase order to the accounting
department. The purchase order carries all necessary information regard-
ing price, discount agreement, and delivery stipulations. Furthermore,
the centralization of invoice approval in the accounting department avoids
delaying payments within the discount period.

Purchases of Supplies, Services, and Repairs.The procedure followed

in purchasing productive materials should apply to all departments and

divisions of a business. Purchase requisitions, purchase orders, and re-

ceiving reports are appropriate for accounting department supplies and
equipment, the company cafeteria, the first aid unit, the treasurer's oflftce,
the building service department, and the public relations, personnel, sales,
engineering, and all other departments. If, for example, the cost account-
ing department needs new forms printed, a requisition should be sent to
the purchasing department in the usual manner; and a purchase order
should be prepared and sent to the printer.
In the case of magazine subscriptions, trade and professional associa-
tion memberships for company officials, and similar services, the official
or department head may send in a requisition in the usual manner. A requi-
sition, an order, and an invoice for all goods and services purchased are
a necessity in controlling all purchases properly.
Repair contracts on an annual basis for typewriters, calculators,
duplicating equipment, andsome types of factory equipment may be requi-
sitionedand ordered in the usual manner. In other cases, a department
head or other employee may telephone for service and in a matter of
minutes may have a machine repaired and back in operation. In such cases,
the purchasing agent issues a so-called blanket purchase order that
amounts to approval of all repair and service costs of a specific type without
knowing the actual amount charged. When the repair bill is received, the
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 321

invoice clerk checks the amount of the bill with the department head where
the repairs took place and then approves the invoice for payment.

Purchasing Forms. The principal forms required in purchasing are the

purchase requisition and the purchase order.

The Purchase Requisition. The purchase requisition originates with a

stores or warehouse clerk who observes that the quantity on hand is at a
set ordering minimum, or with a materials ledger clerk who may be re-
sponsible for notifying the purchasing agent when to buy, or with a works
manager who foresees the need for special materials or unusual quantities,
or with a research or engineering department employee who needs ma-
terials or supplies of a special nature, or with a computer that has been
programmed to produce automatically replenishment advice to the pur-
chasing department. For standard materials, the purchasing agent may
need Httle information other than the stock number and uses judgment
concerning where to buy and the quantity to order. For other purchase
requests, it may be necessary to give meticulous descriptions, catalog
numbers, weights, standards, brand names, exact quantities to order, and
suggested prices.
A purchase requisition is illustrated below. One carbon copy remains
with the originating employee, and the original is sent to the purchasing
department for execution of the request.

PURCHASE REQUISITION
(This is not a Purchase Order.)

TO: Purchasinq Department

322 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

The Purchase Order. The purchase order, signed by the purchasing

agent or other official, is a written authorization to a vendor to supply
specified quantities of described goods at agreed terms and at a designated
time and place. As a matter of convenience, the vendor's order forms may
be used but in typical practice, the order forms are prepared by the pur-
;

chasing company, and the form is adapted to the particular needs of the
purchaser. As a matter of record and for accounting control, a purchase
order should be issued for every purchase of materials, supplies, or equip-
ment, whether the purchase is made by mail, telephone, telegraph, or from
a salesman. Where a purchase commitment is made by wire or in an inter-
view with a sales representative, the purchase order serves as confirmation
to the vendor and places the required documents in the hands of those
concerned in the purchasing company.
The purchase order gives the vendor a complete description of the
goods and services desired, the terms, the prices, and the shipping instruc-
tions. Where necessary, the description may refer to attached blueprints

and specification pages. The original and one carbon copy, the latter being
labeled "Acknowledgment Copy," are sent to the vendor. The vendor is
asked to return the carbon copy with his signature which indicates to the
purchasing agent that the order was received and will be delivered accord-
ing to the specifications enumerated in the purchase order. The acknowl-
edgment copy is a necessary form for contract procedure. Other carbon
copies are distributed as shown in the flowchart on page 319.

Receiving. The function of the receiving department is to unload and

unpack incoming materials; to check quantities received against the
shipper's packing list to identify goods received with descriptions on the
;

purchase order; to prepare a receiving report; to notify the purchasing

department of discrepancies discovered to arrange for inspection when
;

necessary ; to notify the traffic department and the purchasing department

of any damage in transit ; and to route accepted materials to the appro-
priate factory location.
The receiving report willshow purchase order number, account number
to be charged, name of the vendor, details relating to transportation, and
quantity and type of goods received. The form also provides a space for
the inspection department to note either the complete approval of the ship-
ment or the quantity rejected and reason for the rejection. If inspection
does not take place immediately after receipt of the material, the receiving
report is distributed as follows: (1) the receiving department keeps one
copy and sends another copy to the purchasing department as an advance
notice of the arrival of the material and as a means of avoiding further
follow-up by the purchasing agent (2) all other copies go to the inspection
;
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 323

department, and distribution of them is not made until inspection is com-

pleted. After inspection, one copy of the receiving report, with the inspec-
tion result noted thereon, is sent for payment to the accounting department

where it is matched with the purchase order and the vendor's invoice.
Other copies go to various departments such as materials and production
planning. The copy to the storekeeper accompanies the materials so that
he knows the quantity and the kind of materials he is receiving.

Approval and Data Processing. By the time materials reach the receiving
department via parcel post, express, truck, rail, air, or water transporta-
tion, the company usually will have received the invoice from the vendor.
This invoice is then routed to the accounting department and is filed with
the copy of the purchase order until the receiving report arrives. When
the receiving report with its inspection report is in, the receiving report
and the invoice are examined to see that materials received meet purchase
order specifications as to items, quantities, prices, price extensions, dis-
count and credit terms, shipping instructions, and other possible condi-
tions. Inasmuch as the purchase order and the receiving report contain the
account number that was originally placed on the purchase requisition, the
invoice clerks need no further assistance in this respect and speedy ap- ;

proval is assured. When found correct in all respects or has

the invoice is

been adjusted because of rejects as noted by the inspection department,

the invoice clerk approves it, attaches it to the purchase order and the
receiving report, and sends these papers to another clerk for the prepara-
tion of the voucher.
Invoice approval is an important step in materials control procedure
since it certifies that the goods have been received as ordered and that
payment can be made. The invoice
INVOICE APPROVAL
approval information is often built
into a rubber stamp, and each invoice
is stamped. The verification proce-
dure is handled by responsible in-
voice clerks, thus assuring systematic
examination and handhng of the
paper work necessary for adequate
control of materials purchases. The
preparation of the voucher is based
on the information taken from the
invoice approval stamp. invoice Approval Stamp

The voucher dataare entered first in the purchases journal and then
in the cash payments journal according to the due date for payment.
The original voucher and two carbon copies are sent to the treasurer for
324 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

issuance of the check. The treasurer mails the check with the original
voucher to the vendor, files a voucher copy, and returns one voucher
copy to the accounting department for the vendor's file. Purchase transac-
tions entered in the purchases journal aff'ect the control accounts and the
subsidiary records as shown in the chart below.

pF
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 325

purchase order the invoice clerk will make a notation of the quantity
received in place of the quantity ordered. The vendor may explain that
he is out of stock or otherwise unable to deliver specified merchandise.
In such a case an immediate ordering from other sources may be necessary.
2. Items ordered not be received but may be entered on the invoice.
may
In this situation the shortage is noted on the invoice and is deducted

from the total before payment is approved. A letter to the vendor

explaining the shortage is usually in order.
3. The seller may ship a quantity larger than called for on the purchase
order. The purchaser may keep the entire shipment and add the excess
to the invoice, if not already invoiced; or the excess may be returned or
held, pending instructions from the seller. Some companies issue a
supplementary purchase order that authorizes the invoice clerk to pay
the overshipment.
4. Materials of a wrong size or quality, defective parts, and damaged items
may be received. If the items are returned, a correction on the invoice
should be made before payment is approved. It may be advantageous
to keep damaged or defective shipments if the seller makes adequate price

concessions, or the items may be held subject to his instructions.

5. When delivered prices are quoted and purchases are made on this basis,
itmay be expedient for a purchaser to pay transportation charges. The
amount paid by the purchaser is deducted on the invoice, and the paid
freight bill is attached to the invoice as evidence of payment.

Electronic Data Processing for Materials Received and Issued. The

preceding description of invoice approval and payment was for a manual
operation performed by an accounts payable clerk or an invoice clerk. In
an electronic data processing (EDP) system, the computer to a great —
extent —
replaces the clerk. Upon receipt of the invoice (the source docu-
ment), the accounts payable clerk enters the account distribution on the
invoice. The data are then directly inputted from the invoice to the com-
puter data bank via a terminal device. The data are edited, audited, and
merged with the purchase order and the receiving order data, both of
which have been stored in the computer data bank. The common matching
criterion on all documents is the purchase order number. Quantities, dollar
values, due dates, terms, and unit prices are matched. When in agreement,
the cost data will be entered in the accounts payable computer file with a
date for later payment or a printout of a check will be transmitted for
payment.
The above procedure deals with the accounts payable phase of a pur-
chase transaction. Yet, of equal importance is the need for posting the
data in quantities and dollar values to the materials inventory file in the
EDP system. The information would then enter the EDP system from
document) or the invoice approval form,
either the invoice (the source
which would have to include all computer-necessary data. The internal
computer program would update the materials inventory file. The program
326 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

CHECK
FOR
PAYMENT

Integration of a Purchase Transaction for Materials

into the Accounts Payable Phase of an EDP System

applicable to the accounts payable phase of a purchase transaction for

materials can be depicted in the flowchart above.
A second program would also have been designed for the withdrawal
of the materials that would eliminate the manual postings to the materials
inventory file.

Cost of Acquiring Materials. A guiding principle in accounting for the

cost of materials is that all costs incurred in entering a unit of raw mate-
rials into factory production should be included. Acquisition costs such
as the vendor's invoice price and transportation charges are visible costs

of the purchased goods. Less obvious costs of materials entering factory

operations are costs of purchasing, receiving, unpacking, inspecting, in-
suring, storing, and general and cost accounting.
Controversial concepts and certain practical limitations result in varia-
tions in implementing the principles of costing for materials even with
respect to easily identified acquisition costs. Calculating a number of cost
additions and adjustments to each invoice involves clerical expenses which
may be greater than benefits derived from the increased accuracy. There-
fore, materials are commonly carried at the invoice price paid the vendor,
although all acquisition costs and price adjustments affect the materials
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 327

costs. As a result, acquisition costs are generally charged to factory over-

head when it is not practical to follow a more accurate costing procedure.

Purchase Discount. The handling of discounts on purchases is one

major problem in accounting for materials costs. Trade discounts and

quantity discounts normally are not on the accounting records but are
treated as price reductions. Cash discounts should be handled as price
adjustments but often are accounted for as other income. Income is not
produced by buying. A lower purchase cost may well widen the margin
between sales price and cost, but it takes the sale to produce income.
When the vendor quotes terms such as 2/10, n/30 or 3/10, n/30 on a $100
invoice, is he trying to sell the goods for $100 or is he determined to get
$98 or $97 as the case may be? The purchaser has two dates to make
payment on the tenth day, which allows time to receive, unpack, inspect,
:

verify, voucher, and pay for the goods; or twenty days later. For the addi-
tional twenty days an additional charge or penalty of 2 percent is assessed
if the terms are 2/10, or 3 percent if the terms are 3/10. If regarded as
interest, the extra charge is ^^^^^^ = 18 periods X 2 percent = 36 percent

per year, or ^^-^ = 18 periods X 3 percent = 54 percent per year. On

these terms the selleris pricing on essentially a cash basis, and the pur-

chaser has no reasonable choice except to buy on the cash basis.

Although the nature of a purchase discount is readily understood, for
practical reasons the gross materials unit cost of the invoice is commonly
recorded in the materials account; the cash discount is recorded as a credit
account item. Otherwise it would be necessary to compute the discount on
each item with four or more decimal place unit costs.

Freight-In. Freight or other transportation charges on incoming ship-

ments are obviously costs of materials, but differences occur in the cost
allocation of these charges. A vendor's invoice for $600 may show 25
items weighing 1 ,700 pounds shipped in five crates, with the attached freight
bill showing a payment of $48. The delivered cost is $648. But how much

of the freight belongs to each of the invoice items, and what unit price
should go on the materials ledger card ? When the purchased units are not
numerous and are large in size and unit cost, computation of actual
amounts of freight may be feasible; otherwise, some logical, systematic,
and expedient procedure is necessary.
If freight charges are debited to Materials, the total amount should be
added proportionately to each materials card affected. This might be done
by assuming that each dollar of materials cost carries an equal portion of
"'^ ^''^Sht. ^^^'d ^"J" S-0« '° «^^h dollar on the invoice.
M?.:'riai'sccs'.'l''l
The relative weight of each item on the invoice might be determined and
 — :

328 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

used as a basis for calculating the applicable freight. If invoice item No. 4
is estimated to weigh 300 pounds, then ^~ X $48 or $8.47 would be

added for freight. This procedure is also likely to result in four or more
decimal place unit costs on the materials ledger cards. In order to simplify
procedures, all freight costs on incoming materials and supplies may be
charged to Freight-In. As materials are issued for production, an applied
rate for freight-in (and other handling costs) might be added to the unit
price kept on the ledger cards. Such an amount is thus added to the Work
in Process debit, or to Factory Overhead for indirect materials, with a
credit to Freight-In. Any balance in Freight-In at the end of a period is
closed to Cost of Goods Sold or prorated to Cost of Goods Sold and
inventories.
Another often advocated method of accounting for incoming freight
costs on materials is to estimate the total for an accounting period and
include this amount in computing the factory overhead charge rate.
Freight-In would then become one of the accounts controlled by Factory
Overhead.
For materials or suppHes used in marketing and administrative depart-
ments, freight, transportation, or delivery costs should be charged to the
appropriate nonmanufacturing account.

Applied Acquisition Costs. If it is decided that materials cost should be

the net price paid the vendor plus incoming freight charges plus other ac-
quisition costs, such as those of the purchasing department, receiving de-
partment, testing, insurance, and applicable accounting functions, an
applied rate might be added to each invoice and to each item. When this
procedure is impractical, a single amount can be added to the total ma-
terials cost for a given lot, order, or department. A single rate for these

combined costs can be used, or a more accurate method of using separate

rates for each class of costs can be computed as follows
Estimated Purchasing Dept. Cost for Month or Budget Period ^ or^Rate'^De" Dollar
Estimated Number of Purchases or Estimated Amount of Purchases Purchased
Estimated Receiving
Estimated Number
Dept. Cost for Month or
:

of Items to Be Received
— Durmg
——Budget Period
:
=; —r^-
Period
= Rate per Item

Estimated Materials Department Cost for Month or Budget Period _ Rate per Item, Cubic
Estimated Number of Items, Feet of Space, Dollar Value, etc. ~ Feet, Dollar Stored, etc.

Estimated Accounting Dept. Cost for Month or Budget Period ^ ^^^^ ^^^ Transaction
Estimated Number of Transactions

This procedure results in the accounting treatment shown below:

Materials xxx
Purchasing Dept. Expenses Applied xxx
Receiving Dept. Expenses Applied xxx
Materials Dept. Expenses Applied xxx
Accounting Dept. Expenses Applied xxx
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 329

Actual expenses incurred by each of the departments for which appHed

rates are used will be debited to the applied accounts. Differences between
the expenses incurred by the departments during the period and the
expenses applied to materials cost would represent over- or underapplied
expenses and would be closed to Cost of Goods Sold or prorated to Cost
of Goods Sold and inventories.

Storage and Use of Materials. Materials, together with a copy of the

receiving report, are forwarded to storerooms from the receiving or in-
spection department. The storekeeper and his assistants are responsible
for safeguarding the materials, which means that materials and supplies
are placed in proper bins or other storage spaces, that they are kept safely
until required in production, and that all materials taken from the store-
room are properly requisitioned. It is good policy to restrict admittance
to the storeroom to employees of that department only and to have these
employees work behind locked doors, issuing materials through cage
windows somewhat as a bank teller operates.

Since the cost of storing and handling materials may be a substantial

amount, careful design and arrangement of storerooms can result in
significant cost savings. Materials can be stored according to: (1) the
materials account number; (2) the frequency of use of the item; (3) the
factory area where the item is used; or (4) the nature, size, and shape of the
item. In practice no single one of these bases is likely to be suitable, but
size and shape of materials usually dictate the basic storeroom arrange-
ment. Variations can then be introduced, such as placing most frequently
used items nearest the point of issue and locating materials used primarily
in one factory area nearest that area.

Bin Cards. Stock or bin cards are effec-

tive ready references that may be attached
to storage bins, shelves, racks, or other
containers. Bin cards usually show quan-
tities of each type of material received,
issued, and on hand. They are not a part BIN C

STORES NO 5^5
of the accounting records as such, but they
show on hand in the store-
the quantities
room at all times and should agree with
the quantities on the materials ledger
cards in the accounting department. The
design of a bin card is not limited to the
size or shape illustrated at the right.
 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

MATERIALS REQUISITION NO. 534871 h

Deliver To Finishing Department

Requested By tXULud' IEmJum^ Date October 23, 19-

Charge To job. No. 952 Approved By

QUANTITY QUANTITY
ITEM RECEIVED NUMBER DESCRIPTION ISSUED UNIT COST TOTAL COST

125 M 1013 Carbon M $12.40 $12.40

130 M 1413 Carbon M 10.60 10.60

85 2M 1482 Carbon 2M 4.50 9.00

FILLED BY PRICED BY ENTERED BY RECEIVED BY . DATE RECEIVED

McxiL

MATERIALS LEDGER COST MATERIALS FILE

CLERK DEPARTMENT DEPARTMENT COPY

Materials Requisition

Issuing and Costing Materials into Production. To control the quantity

and cost of materials, supplies, and services requires a systematic and
efficient system of purchasing, recording, and storing. Equally necessary
and important is a systematic and efficient procedure for issuing materials

and supphes.

Materials Requisition. The materials requisition (see illustration on

this page) is a written order to the storekeeper to deliver materials or sup-
plies to the place and the department designated or to give the materials
to the person presenting a properly executed requisition. It is drawn by
someone who has the authority to requisition materials for use in the de-
partment. The authorized employee may be a production control clerk, a
department head, a foreman, a group leader, an expediter, or a materials
release analyst. In a computerized system, the computer program will often
prepare the requisition in the form of a tabulating card.
The materials requisition constitutes the basic form for materials with-
drawn from the storeroom. Its preparation results in entries in the Issued

section of the materials ledger cards and in postings to the job order cost
sheets,production reports, or the various expense analysis sheets for indi-
dividual departments. All withdrawals result in debits to Work in Process
 :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 331

or to expense control accounts for factory overhead, marketing, or ad-

ministrative expenses, and in credits to Materials.

Materials Requisition Journal. With the posting to the materials ledger

cards, the job order cost sheets, the production reports, and the expense
analysis sheets completed, it is still necessary to post the materials with-
drawals to the proper ledger control accounts. This task is greatly facili-
tated by the use of a materials requisition journal, which acts as a form of
materials summary. A materials requisition journal might take the
following form

^^^^P MATERIALS REQUISITION JOURNAL

332 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Bill of Materials. The bill of materials, a kind of master requisition, is

a printed or duplicated form that lists all the materials and parts necessary
for a typical job or production run. Time is saved, and efficiency is pro-
moted through the use of a bill of materials. When a job or production
run is started, all the materials listed on the bill of materials are sent to the
factory or are issued on a prearranged time schedule. As the bill of ma-
terials is a rather cumbersome medium for posting purposes, data pro-
cessing improves the procedure by preparing simultaneously tabulating
cards for materials requisitions. While the storekeeper issues the materials
as stated on the bill of materials, the tabulating cards can be processed in
the materials ledger section and in the cost department at almost the same
time as the materials are used in the factory. A computer program will
provide the printouts of the bill of materials and process the information
internally to update the accounting records.

Materials (or Stores) Ledger Card — Perpetual Inventory Record. As

purchased materials go through the systematic verification of quantities,
prices, physical condition, and other checks, the crux of the accounting
procedure is to establish a perpetual inventory — maintaining for each
type of material a record showing quantities and prices of materials re-
ceived, issued, and on hand. Materials ledger cards or stock ledger sheets
constitute a subsidiary materials ledger controlled by the materials or
inventory accounts in the general ledger or in the factory ledger if in-

ventory accounts are kept at the factory.

Materials ledger cards commonly show the account number, descrip-
tion or type of material, location, unit measurement, and maximum and
minimum quantities to carry. These cards constitute the materials ledger,
new cards being prepared and old ones discarded as changes occur in the
types of materials carried in stock. The ledger card arrangement is basically
the familiar debit, credit, and balance ruHng columns under the descrip-
tion of Received, Issued, and Balance. A materials ledger card is illustrated
below.

Piece or Part No. Reorder Point

Description Reorder Quantity

Materials ISSUED BALANCE

RECEIVED
Ledger
Card Unit
Date
Rec. Qty. Amount Date Req. Qty Amount Quantity Amount
No. No. Cost
 :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 333

In some businesses, the approved invoice with supporting documents,

such as the purchase order and receiving report, goes to the materials
ledger clerk. These documents enable the clerk to make the necessary
entries in the Received section of the materials ledger card. Each receipt
increases the balance on hand, and the new balance is extended upon entry
of the receipt.
Unsatisfactory goods or defective units should be detected by the
inspection department before being stored or even paid for. The receiving
report should show materials actually accepted, and the ledger entries are
made after all adjustments. However, goods accepted in the storeroom
may be found unsatisfactory after part of a shipment has been used in the
factory ;and the balance may then be returned to the vendor. Since these
units were entered in the Received and Balance sections of the materials
when they were placed in the storeroom, an adjustment must
ledger card
be made. The recommended procedure is to enter the quantity and the
value of the returned shipment in red in the Received section and to reduce
the balance accordingly.
When the storekeeper issues materials, a copy of the requisition is sent
to the materials ledger clerk who then makes an entry in the Issued section
of the materials ledger card showing the date, the requisition number, the
job, lot, or department number, the quantity,and the cost of the issued
materials. The new balance is computed and entered in the Balance
column. As already explained, these manual operations will be performed
in an EDP system based on the computer program designed for any or all
materials transactions.

MATERIALS COSTING METHODS

The ultimate objective in accounting is to produce accurate and
meaningful cost figures that can be used for purposes of control and
analysis and eventually matched against revenues produced in order to
determine net operating income.
After the unit cost and total cost of incoming materials are entered in
the Received section of a materials ledger card, the next step is to cost
these materials as they move either from storeroom to factory as direct
or indirect materials or from storeroom to marketing and administrative
expense accounts as supplies. The more common methods of costing
materials issued and inventories are

1. First-in, first-out (fifo)

2. Average cost
3. Last-in, first-out (lifo)
4. Other methods — such as month-end average cost, last purchase price
or market price at date of issue, and standard cost
 . :

334 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

These methods relate to assumptions as to flow of costs. The physical

flow of units may coincide with the method of cost flow in use, though
such a condition is not a necessary requirement. This discussion deals
with raw materials inventory; however, the same costing methods are
also applicable to work and finished goods inventories.
in process
The illustrations discussed below assume a perpetual inventory system;
i.e., an entry is made each time the inventory is reduced. Such a procedure

is a desirable characteristic of most cost accounting systems. The alterna-

tive to a perpetual inventory system is the physical inventory system

whereby purchases are added to the beginning inventory, the ending
(remaining) inventory is counted and costed, and the difference is con-
sidered the cost of materials issued.

First-In, First-Out (fifo) Method of Costing. The first-in, first-out (fifo)

method of costing is used to introduce the subject of materials costing.

This illustration, as well as those for the average and lifo costing methods,
is based on the following transactions:
Feb. 1. Beginning balance: 800 units (S,? $6 per unit.
4. Received 200 units (a $7 per unit.
10. Received 200 units (S $8 per unit.
11. Issued 800 units on a fifo basis.
12. Received 400 units (a $8 per unit.
20. Issued 500 units on a fifo basis.
25. Returned 100 excess units from the factory to the storeroom to be recoded
at the latest issued price of $8.
28. Received 600 units (oi $9 per unit.

The above transactions would be calculated as follows

Fifo Costing Method — Illustrated:

Feb. 1 Beginning balance 800 units @ $6 = $4,800
4. Received 200 units @ $7 = 1,400
10. Received 200 units (a $8 = 1,600 $7,800
11. Issued 800 units (a; $6 = 4,800
Balance /200 units (o; $7 = 1,400
^200 units @ $8 = 1,600 3,000
12. Received 400 units (S, $8 = 3,200 6,200
20. Issued /200 units @ $7 = 1,400
\300 units @ $8 = 2,400 3,800

Balance 300 units (a; $8 = 2,400

25. Returned to storeroom 100 units @ $8 = 800
28. Received 600 units (a $9 = 5,400 8,600

Balance |400 units @ $8 = $3,200

\600 units @ $9 = 5,400 $8,600

The fifo method of costing issued materials follows the principle that
materials used should carry the actual experienced cost of the specific
materials units used. The method assumes that materials are issued from
 . :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 335

the oldest supply in stock and that the cost of those units when placed in
stock is the cost of those same units when issued. However, fifo costing
may be used even though physical withdrawal is in a different order.
Advantages claimed for the fifo costing method are

1. The materials used are drawn from the cost records in a logical and sys-
tematic manner.

2. The assumed movement of materials in a continuous, orderly, single-file

manner represents a condition necessary to and consistent with efficient
materials control, particularly where materials are subject to deterioration,
decay, and quality or style changes.

The fifo method is recommended whenever (1) the size and cost of raw
materials units are large, (2) materials are easily identified as belonging to
a particular purchased and (3) not more than two or three different
lot,

receipts of the materials are on a materials card at one time. Fifo costing is
definitely awkward if frequent purchases are made at different prices and if
units from several purchases are on hand at the same time. Added costing
difficulties arise when returns to vendors and returns to stores occur.

Average Costing Method. Issuing materials at an average cost assumes

that each batch taken from the storeroom is composed of uniform quan-
tities from each shipment in stock at the date of issue.
Often it is not fea-
sible to mark or label materials items piece by piece with invoice prices and
thus to identify the used unit with its acquisition cost. It may be reasoned
that units are issued more or less at random as far as the specific units
and the specific costs are concerned and that an average cost of all units in
stock at the time of issue is a satisfactory measure of materials cost. How-
ever, average costing may be used even though the physical withdrawal is

in an raw materials tend to be made up of numerous

identifiable order. If
small items low in unit cost and especially if prices are subject to frequent
change, average costing is practical and commendable. Average costing
is advantageous because:

1 It is a reaUstic costing method useful to management in analyzing operat-

ing results and appraising future production.

2. Average costs minimize the eff"ect of unusually high and unusually low
raw materials prices, thereby making possible more stable cost estimates
for future work.

3. It is a practical and less expensive perpetual inventory system.

The average costing method divides the total cost of all materials of a
by the number of units on hand to find the average price.
particular class
The cost of new invoices is added to the total in the Balance column the ;
 .

336 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

units are added to the existing quantity and the new total cost is divided
;

by the new quantity to arrive at the new average price. Materials are issued
at the established average cost until a new purchase is recorded. Although
a new average price may be computed when materials are returned to ven-
dors and when excess issues are returned to stores, for practical purposes
it seems sufficient to reduce or increase the total quantity and cost, allowing
the unit price to remain unchanged. When a new purchase is made and a
new average is computed, the discrepancy created by the returns will be
absorbed.
Using the data of the fifo illustration (page 334), the transactions can
be summarized in this manner:

Average Costing Method — Illustrated:

Average
Cost
Feb. 1 . Beginning balance 800 units @ $6 = $4,800
4. Received 200 units @ $7 =
Balance 1 ,000 units
10. Received 200 units (a> $8
Balance 1 ,200 units
1 1 Issued 800 units @ $6.50 =
Balance 400 units
12. Received 400 units @ $8
Balance 800 units
20. Issued 500 units @i $7.25 =
Balance 300 units
25. Returned to storeroom 100 units
Balance 400 units
28. Received 600 units (gj $9
Balance 1,000 units
1,400
1,600
338 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Lifo Costing Method —

Advantages and Disadvantages. The advan-
tages of the lifo costing method are:

1. Materials consumed are priced in a systematic and realistic manner.

2. Unrealized inventory gains and losses are minimized, and reported operat-
ing profits are stabilized in industries subject to sharp materials price
fluctuations.

3. Inflationary prices of recent purchases are charged to operations in

periods of rising prices, thus reducing profits, resulting in a tax saving,
and therewith providing a cash advantage through deferral of income tax
payments. The tax deferral creates additional working capital as long as
the economy continues to experience an annual inflation rate increase.

The disadvantages of the lifo costing method are:

1. The election of lifo for tax purposes is binding for all subsequent years

unless a change is authorized or required by the Internal Revenue

Service (IRS).

2. Lifo is a "cost only" method with no write-down allowed for tax purposes
to the lower of cost or market. Should the market decline below lifo cost
in subsequent years, the business would be at a tax disadvantage. When
prices drop, the only option may be to liquidate the inventory by charging
off the older (higher) costs. However, liquidation for tax purposes must
take place at the end of the year. According to IRS regulations, liquida-
tion during the fiscal year is not acceptable if the inventory returns to its
original level at the end of the year.

3. Lifo must be used in financial statements if it is elected for tax purposes.

4. The record-keeping requirements under lifo are substantially greater than

those under alternative costing and pricing methods.

5. Inventories may be depleted due to unavailability of raw materials to the

point of consuming inventories costed at older or perhaps the oldest
(lowest) prices. This situation will create a mismatching of current
revenues and costs.

The decision to adopt the lifo method has great appeal in a period of
inflation, but it should not be automatic. Long-range effects as well as

short-term benefits must be considered.

Other Materials Costing Methods. Although fifo, average cost, and

lifo are commonly used methods of costing materials units into work in
process, various other methods exist. Briefly, some of the other methods
are described on the next page.
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 339

Month-End Average Cost. To insure quick costing and early reporting

of completed jobs or products, some companies establish at the close of
each month an average cost for each kind of material on hand and use this
cost for all issues during the following month. A variation of this method,
when perpetual inventory costing procedures are not used, is mentioned
in process costing; namely, to wait until the end of a costing period to
compute costs for raw materials consumed. The cost used is obtained by
adding both quantity and dollars of purchases to opening inventory
figures, thus deriving an average cost.

Market Price at Date of Issue. Raw materials precisely standardized

and traded on commodity exchanges, such as cotton, wheat, copper, or
crude oil, are sometimes costed into production at the quoted price at date
of issue. In effect, this procedure substitutes replacement cost for ex-
perienced or consumed cost but has the virtue of charging materials into
production at a current and significant price. This method of materials
costing and that of using the last purchase price are often used, especially
for small, low-priced items.

Standard Cost. This method charges materials units issued at a pre-

determined or estimated price reflecting a normal or an expected future
price. Receipts and issues of materials are recorded in quantities only on
the materials ledger cards or in the computer data bank, thereby simplify-
ing the record keeping and reducing clerical or data processing costs.
In recording materials purchases, the difference between actual and
standard cost is recorded in a purchase price variance account. The vari-
ance account enables management to observe the extent to which actual
materials costs differ from planned objectives or predetermined estimates.
Materials are charged into production at the standard price, thereby elimi-
nating the erratic costing inherent in the actual cost methods. Standard
quantities fornormal production runs at standard prices enable manage-
ment to detect trouble areas and take corrective action immediately.
Materials pricing under standard costs is discussed in Chapters 19 and 20.

Analysis and Comparison of Costing Methods. The several methods of

materials costing represent industry's intense study and eff'ort to measure
costs. Undoubtedly, thereno one best method applicable
is to all situa-
tions; methods may vary even within the same company. The same
method need not be used for the entire inventory of a business. What-
ever the method of costing, it should be followed consistently from period
to period.
The various costing methods represent different views of the cost
concept. The best method to use is the one that most clearly reflects the
periodic net income; consumed cost must be subtracted from current
340 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

revenue produced. Perhaps no materials costing method will reflect con-

sumed materials cost with complete accuracy at all times in all situations.
The most appropriate method of costing materials will as nearly as
possible: (1) relate current costs to current sales; (2) reflect the procure-
ment, manufacturing, and sales policies of a particular company; and
(3) carry forward to the new fiscal period a previously incurred residual
cost which will be consumed in subsequent periods.
Adequate comparison of the various methods of costing is difficult and
involved. The ending inventory figures of the three previous illustrations
indicate:

Fifo costing $8,600

Average costing 8,300
Lifo costing 7,800 (or $6,200, depending upon the
timing of the costing procedure)

Certain generalizations can be made relative to the use of fifo, average

cost, and fifo. In periods of rising prices, fifo costing will result in materials
being charged out at lowest costs ; lifo will result in materials being charged
out at highest costs and average costing will result in a figure between the
;

two. In a period of falling prices, the reverse situation will develop — with
fifoshowing the highest cost of materials consumed, lifo showing the
lowest cost of materials used, and average cost showing a result between
the other two methods.

COST OF MATERIALS IN INVENTORY AT THE

END OF A PERIOD
When the cost basis is used in costing inventories for financial state-
ments and income tax returns, the sum total of the materials ledger cards
must agree with the general ledger materials control account which, in
turn, is the materials inventory figure on the balance sheet. Unless a shift
from the cost basis is made in valuing the year-end inventory, the method
used for costing materials issued is the method used for assigning dollars
to inventory.

Inventory Valuation at Cost or Market, Whichever is Lower. American

accounting tradition follows the practice of pricing year-end inventories
at cost or market, whichever is lower. This departure from any experienced
cost basis is generally defended on the grounds of conservatism. A more
logical justification for cost or market inventory valuation can be made if
the position is taken that a full stock is necessary to expedite production
and sales. If physical deterioration, obsolescence, and price decUnes occur,
or if stock when finally utilized cannot be expected to realize its stated cost
 :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 341

plus a normal profit margin, the reduction in inventory value constitutes

an additional cost of the goods produced and sold during the period when
the decline in value occurred.

AICPA Cost or Market Rules.

The American Institute of Certified
Public Accountants (AICPA) decided on a move away from the traditional
cost or market, whichever is lower principle of valuing inventories. After
defining inventory and major objective of accounting
reiterating that the
for inventories is the proper determination of income through the process
of matching appropriate costs against revenues, the AICPA states

The primary basis of accounting for inventories is cost, which has been
defined generally as the price paid or consideration given to acquire an asset.
As applied to inventories, cost means in principle the sum of the applicable
expenditures and charges directly or indirectly incurred in bringing an article
to its existing condition and location.'

In this Bulletin the AICPA takes the position that cost may properly
be determined by any of the common methods of costing already discussed
in this chapter. The position of the AICPA is clearly stated in the fol-
lowing sentence: "In keeping with the principle that accounting is pri-
marily based on cost, there is a presumption that inventories should be
stated at cost." Having advocated the basic cost principle, the Bulletin
then reverts at least part way market rule.
to the traditional cost or
The AICPA mandatory that cost be abandoned in
in effect says it is

valuing inventory when the usefulness of goods is no longer as great as its

cost. This, then, becomes a principle of cost, or residual useful cost, which-
ever is lower:

A departure from the cost basis of pricing the inventory is required when the
utilityof the goods is no longer as great as its cost. Where there is evidence
that the utility of goods, in their disposal in the ordinary course of business,
will be less than cost, whether due to physical deterioration, obsolescence,
change in price levels, or other causes, the difference should be recognized
as a loss of the current period. This is generally accomplished by stating
such goods at a lower level commonly designated as market.^

The last sentence returns to the traditional meaning of cost or market,

whichever is lower by saying that the residual useful cost is market, which
in turn is defined as replacement cost. In the AICPA's cost or market
approach to inventory valuation, it is clear that the Institute does not hold

^Accounting Research and Terminology Bulletin — Final Edition, AICPA (New York: 1961),
p. 28.
mid., p. 30.
 . . : : 3 :

342 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

that a replacement cost should be used for inventory value merely because
it is lower than the acquisition cost figure. The real test is the usefulness
of the inventory (whether it will sell for its cost). The AlCPA is more
precise in stating what figure should be used in case the inventory cost
cannot be recovered

As used in the phrase lower of cost or market, the term market means
current replacement cost (by purchase or by reproduction, as the case may
be) except that

1 Market should not exceed the net realizable value (i.e., estimated selling
price in the ordinary course of business less reasonably predictable costs
of completion and disposal); and

2. Market should not be less than net realizable value reduced by an

allowance for an approximately normal profit margin.

The position of the American Institute of Certified Public Accountants

in regard to inventory valuation may be interpreted as follows

1 In principle, inventories are to be priced at cost.

2. Where cost cannot be recovered upon sale in the ordinary course of

business, a lower figure is to be used.

3. This lower figure is normally market replacement cost, except that the
amount should not exceed the expected sales price less a deduction
for costs yet to be incurred in making the sale. On the other hand, this
lower market figure should not be less than the expected amount to be
realized in the sale of the goods, reduced by a normal profit margin.

To illustrate the preceding narrative, assume that a certain commodity

sells marketing expenses are 20 cents; the normal profit is 25 cents.
for $1 ;

The lower of cost or market as limited by the foregoing concepts is

developed in each case as illustrated at the top of page 343."*
The lower of cost or market procedure may be applied to each inventory
item, or it may be applied to major inventory groupings or to the inventory
as a whole. Application of this procedure to the individual inventory items
will result in the lowest inventory value. However, appUcation to inventory
groups or to the inventory as a whole may provide a sufficiently conserva-
tive valuation with less effort.

Adjustments for Departures from the Costing Method Used. The prob-
lem of year-end inventory valuation is primarily a question of the materials

^Ibid., p. 31.

^Adapted from Harry Simons, Intermediate Accounting, ith ed. (Cincinnati: South-Western
Publishing Co., 1972), pp. 287-288.
CH. 12 MATERIALS CONTROL PROCEDURES &. COSTING METHODS 343
 : :

344 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

I

materials ledger cards. On the balance sheet the entry on page 343 should
result in this presentation

Materials [at cost] $100,000

Less: Allowance for Inventory Price Decline 5,000
Materials [at cost or market, whichever is lower] $95,000

The price decline may be shown as a factory overhead item in the state-
ment of cost of goods sold or it may be deducted from the ending inven-
;

tory at cost, thus increasing the cost of materials used.

Whenever the task of adjusting materials ledger cards to a lower cost
or market figure is not burdensome and the data are available early in the
next year, it should be accomplished by dating the entry with the first day
of the new fiscal period and entering in the Balance section the units on
hand at the unit price determined for inventory purposes. In such a case,
the credit portion of the adjusting entry would be to the materials account.

Transfer of Materials Cost to Finished Production. The ultimate and

intended destination of all raw materials units is to finished products sold
and dehvered to customers. Cost of materials used on each job or in each
department are transferred from the materials requisition to the job order
cost sheet or to the cost of production report. When the job, order, or
process is completed, the effect of materials used is expressed in this entry

Finished Goods xxxx

Work in Process xxxx

In production devoted to filling specific orders, cost sheets should

provide sufficient information relative to cost of goods sold. Should a
considerable portion of production be for a stock of goods to fill incoming
orders, a finished goods ledger is very advantageous in maintaining ade-
quate and proper control over the inventory. The finished goods ledger,
controlled by the finished goods account in the general ledger, is similar
in form and use to materials ledger cards. The finished goods may also
be costed out on a fifo, average cost, or lifo basis as well as consideration
being given to the concept of lower of cost or market.
Some production may consist of components manufactured for use in

subsequent manufacturing operations. If the units move directly into

these operations, the transfer issimply from one departmental work in
process account to the next. However, if the components must be held
in inventory, their cost should be debited to ]Vlaterials and credited to
Work in Process.

Even with a perpetual inventory system, periodic

Physical Inventory.
physical counts are necessary to discover and eHminate discrepancies
 :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 345

between actual count and balances on the materials ledger cards due to
errors in transferring invoice data to the cards ; mistakes in costing requi-
sitions; unrecorded invoices or requisitions; or spoilage, breakage, and
theft. In some enterprises, plant operations are suspended periodically
during a seasonal low period or near the end of the fiscal year while a
physical inventory is taken. In others, an inventory crew or members of
the internal audit department make a count of one or more stock classes
every day throughout the year, presumably on a well-planned schedule
where every materials item will be inventoried at least once during the year.

Adjusting Materials Ledger Cards and Accounts to Conform with

Inventory Count. When the inventory count differs from the balance on
the materials ledger card, the ledger card is adjusted to conform to the
actual count. If the ledger card balance shows more materials units than
the inventory card, an entry is made and the Balance
in the Issued section ;

section is reduced to equal the verified count. In case the materials ledger
card balance is less than the physical count, the quantity difference may
be entered in the Received section or may be entered in red in the Issued
section with the Balance section being increased to agree with the actual
count.
In addition to the corrections on the materials ledger cards, the ma-
account must be adjusted for the increase or decrease by means of a
terials

general journal entry. If the inventory count is less than that shown on the
materials ledger card, the entry would be:
Subsidiary
Record Debit Credit
Factory Overhead Control
Inventory Adjustment to Physical Count.
Materials ,

COSTING PROCEDURES FOR SCRAP, SPOILED

GOODS, AND DEFECTIVE WORK
Generally, manufacturing operations cannot escape the occurrence of
certain losses or output reductiondue to scrap, spoilage, or defective work.
Management and the entire personnel of an organization should cooperate
to reduce such losses to a minimum. As long as they occur, however, they
require the attention of the accounting system for the purpose of report-
ing and controlling.

Scrap and Waste. In many manufacturing processes the nature of the

raw material (metal, wood, plastic, fiber, etc.) results in waste and scrap
 : : :

346 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

due to: (1) the processing of materials, (2) defective and broken parts,

(3) obsolete stock, (4) revisions or abandonment of experimental projects,

and (5) the scrapping of worn out or obsolete machinery. This scrap
should be collected and placed in storage for sale to scrap dealers. At the
time of sale, the following entry is usually made:

Cash (or Accounts Receivable) xxxx

Income from Sale of Scrap (or Factory Overhead
Control) xxxx

The amount realized from the sale of scrap and waste can be treated
in two ways with respect to the income statement:

1. The amount accumulated in Income from Sale of Scrap may be closed

directly to Income Summary and shown on the income statement under
Other Income.

2. The amount may be credited to Factory Overhead Control, thus reducing

the total factory overhead expense and thereby the cost of goods manu-
factured.

When scrap is collected from a job or department, the amount realized

from the sale of scrap is often treated as a reduction in the materials cost
charged to the individual job or product. The entry to record this method
would be

Cash (or Accounts Receivable) xxxx

Work in Process xxxx

When the quantity and value of scrap material is relatively high, it

should be stored in a designated place under the supervision of a store-
keeper. A scrap report is generally prepared in duplicate to authorize
transfer and receipt of the scrap. The
forwarded to the materials
original is

ledger clerk, and the carbon copy remains as a copy in the department
file

in which the scrap originated. The materials ledger clerk can follow two

procedures

1. Open a materials ledger card, filling in the quantity only. The dollar value
would not be needed. When the scrap is sold, any of the previous entries
and treatment of the income item might be made.

2. Record not only the quantity but also the dollar value of the scrap delivered
to the storekeeper. The value would be based on scrap prices quoted on
the market at the time of entry. The entry would be
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 347

Scrap Inventory xxxx

Income from Sale of Scrap (or Work in Process or Factory
Overhead Control) xxxx

When the scrap is sold, the entry would be:

Cash (or Accounts Receivable) xxxx

Scrap Inventory xxxx

Any difference between the price at the time the inventory is re-
corded and the price realized at the time of sale would be a plus or minus
adjustment in the income from sale of scrap account, the work in process
account, or the factory overhead control account, consistent with the
account credited in the first entry.
To reduce accounting minimum, often no entry is made
for scrap to a
until the scrap is At that time, Cash or Accounts Receiv-
actually sold.
able is debited while Income from Sale of Scrap is credited. This is an
expedient method of handling the problem and is justified where a more
accurate accounting becomes expensive and burdensome.
Proceeds from the sale of scrap are in reality a reduction in production
cost. As long as the amounts are relatively small, the accounting treatment
is not a major consideration. What is important is an effective scrap con-
trol system based on periodic reporting to responsible supervisory per-
sonnel. Timely scrap reports for each producing department call attention
to unexpected items and unusual amounts and should induce prompt
corrective action.

DEPARTMENT Fabricating
WEEKLY
FOR WEEK SCRAP
ENDING November 10, 19-- REPORT

PART NO. DESCRIPTION UNITS USED SCRAPPED % SCRAP COST REASON

115b Joints 7,200 108 1.50 $7.00
115e Fins 9,400 305 3.23 30.50

115s Guides 15,600 520 3.33 41.40

Defec tive
115k Supports 8,500 5.30 parts
42 .50

TOTAL FOR WEEK $ 104.20

SCRAP COST -YEAR TO DATE $4,533.75
PREDETERMINED SCRAP ALLOWANCE FOR THE YEAR... $5,000.00

Weekly Scrap Report

 : :

348 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Spoiled Goods. Cost accounting should provide product costs and

cost control information. In the case of spoilage, the first requirement is to
know the nature and cause of the spoiled units. The second requirement,
the accounting problem, is to record the cost of spoiled units and to ac-
cumulate spoilage costs and report them to responsible personnel for cor-
rective action.
If spoilage is normal in the manufacturing process, its cost should be
treated as factory overhead, included in the predetermined factory over-
head rate, and prorated over all production of a period. The degree of
materials and machine precision and the perfection of labor performance
necessary to eliminate spoiled units entirely would involve costs far in
excess of some normal or tolerable level of spoilage. Spoilage may happen
at any time at any stage of the productive process. Because spoilage in a
particular job or lot in process is unpredictable, it is immaterial to cost
allocation. Therefore, normal spoilage is spread over the entire production
of a period via the factory overhead rate.
If, on the other hand, spoilage is caused by an order's exacting specifi-

cations, difficult processing, or other unusual and unexpected factors, the

spoilage cost should be charged directly to that order.

Accounting for Spoiled Materials — Charged to Total Production. The

Nevada Products Company has a monthly capacity to manufacture
125,000 three-inch coil springs for use in mechanical brakes. Production
is scheduled in response to orders received. Spoilage, which is caused by a

variety of unpredictable factors, averages $.05 per spring. During Novem-

ber, 25,000 springs were produced each week with materials cost of $.40
per unit, labor cost $.50 per unit, and factory overhead was charged to
production at a rate of 150% of the direct labor cost which included the
estimated $.05 per spring for spoilage. The entry to record work put into
production each week is

Work in Process — Materials 10,000

Work in Process — Labor 12,500
Work in Process — Factory Overhead 18,750
Materials 10,000
Payroll 12,500
Factory Overhead Applied 18,750

On the last working day of the month, the entire day's production of
4,000 units is spoiled due to improper heat treatment; however, these units
can be sold for $.50 each in the secondhand market.
In order to record the loss on spoiled goods and the possible resale
value, the entry that charges all production during the period with a
proportionate share of the spoilage is
CH. 12 MATERIALS CONTROL PROCEDURES &. COSTING METHODS 349

Subsidiary
Record Debit Credit

Spoiled Goods 2,000

Factory Overhead Control 4,600
Loss on Spoiled Goods 4,600
Work in Process — Materials 1,600
Work in Process — Labor 2,000
Work in Process — Factory Overhead 3,000

It should be noted that the 25,000 units completed each week without
spoiled units occurring that week carry a unit cost of $.40 for materials, $.50
for labor, and $.75 for overhead; During the period or on the
total, $1.65.

order when spoilage does occur, the cost of materials, labor, and factory
overhead in the spoiled units reduced by the recovery or sales value of
these units ($1,600 materials plus $2,000 labor plus $3,000 factory over-
head = $6,600 cost minus $2,000 cost recovery = $4,600 spoilage loss)
is relocated or transferred from Work in Process to Factory Overhead
Control. Each of the 96,000 good units produced during the month has a
charged-in cost of $.05 for spoilage (96,000 X $.05 = $4,800), and the
"actual" spoilage during the period is $4,600. The good units produced
during the week or on the order where spoilage did occur carry a cost of
$.40 for materials, $.50 for labor, and $.75 for overhead because spoilage
is charged to all production — not to the lot or order which happens to
be in process at the time of spoilage.
In other words, the weekly $41,250 production costs ($165,000 for four
weeks) less the $6,600 credit resulting from spoiled units leaves $158,400
to be divided by the 96,000 good units manufactured during the month at
a cost of $1.65 per good unit.
The factory overhead charged to Factory Overhead Control during the
month represents the depreciation, insurance, taxes, indirect materials,
and labor, etc., actually experienced during the month, along with the
$4,600 spoilage cost which occurred. All production during the month is
charged with $.75 overhead per unit and credited to the factory overhead
applied account. Factory Overhead Applied is an adjunct account tied
to Factory Overhead Control; therefore, a closing entry is made trans-
ferring the factory overhead applied account to the factory overhead
control account. Overhead variance analysis is then in order.
For effective cost control, normal spoilage rates and amounts need to
be established for each department and for each type or class of materials.
Weekly or monthly spoilage reports similar to the scrap report illustrated
on page 347 should be reviewed by an individual who has the responsibility
and authority to initiate corrective action where needed.
This discussion has assumed spoilage to be at normal or acceptable
levels. If abnormal, avoidable spoilage occurs, the loss may be charged to
 :

350 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

a current period expense account rather than to Factory Overhead Con-

trol and should be reported as a separate item in the cost of goods sold
statement.

Accounting for Spoiled Materials — Charged to a Particular Job Order.

The Nevada Products Company has a contract to manufacture 10,000
heavy-duty coil springs for the Swenson Supply Company. This order
requires a steel wire that is harder and slightly heavier than stock normally
used, but the production process as well as labor time and overhead factors
are identical with the standard product. Materials cost for each of these
springs is $.60. This special order requires exacting specifications, and
spoilage is The $.05 per unit spoilage factor
to be charged to the order.
is now eliminated from the overhead' rate, and 140% of direct labor cost,

or $.70 per unit, is the rate used on this job. The order is put into produc-
tion the first day of December, and sampling during the first hour of pro-
duction indicates that eleven units of production are required to secure
ten good springs. Entries to record costs placed into production for
11,000 units are:

Work in Process — Materials 6,600

Work in Process — Labor 5,500
Work in Process — Factory Overhead 7,700
Materials 6,600
Payroll 5,500
Factory Overhead Applied 7,700

One thousand units did not meet specifications and are spoiled but can be
sold as seconds for $.45 per unit. The entry to record the spoilage is

Spoiled Goods 450

Work in Process — Materials 150
Work in Process — Labor 125
Work in Process — Factory Overhead 175

Sa.es recovery S 450 ^O Materia, cos. ; S|50

^ ^ [
Cost of 1,000 units $1,800 ( 5700 Factory overhead = $175

Materials cost S 6,600 „^^„ ^.^r,

. . .
^.^' ^^ X ,
$450 sales recovery = $150
Total job cost $19,800

Labor cost $ 5,500

X $450 sales recovery = $125
Total job cost $19,800

Factory overhead $ 7,700

X $450 sales recovery = $175
Total job cost $19,800
CH. 12 MATERIALS CONTROL PROCEDURES &. COSTING METHODS 351

The entry transferring the completed order to Finished Goods would be:

Finished Goods 19,350

Work in Process — Materials 6,450
Work in Process — Labor 5,375
Work in Process — Factory Overhead 7,525

The net result of this treatment is to charge the spoilage loss of $1,350
($1,800 - $450 cost recovery) to the 10,000 good units that are delivered
at the original contract price. The unit cost of completed springs is $1,935
($19,350 ^ 10,000 units).

Defective Work. In the manufacturing process, imperfections may

arise because of faults in materials, labor, or machines. If the unit can
be reprocessed in one or more stages and made into a standard salable
product, it is often profitable to rework the defective unit. Although
spoiled work cannot usually be made into a first-class finished unit without
uneconomical expenditures, defective work can be corrected to meet
specified standards with additional materials, labor, and factory overhead.
Two methods of accounting for the added cost to upgrade the defective
work are appropriate, depending upon circumstances. If defective work
is experienced on regular manufacturing, the additional costs to correct

defective units (based on previous experience) are included in the pre-

determined factory overhead and in the resulting factory overhead rate.
To assume a company has an order for 500 units of a product
illustrate,

that has direct production costs of $5 for materials and $3 for labor with
factory overhead charged to production at 200% of labor cost. Fifty units
are found to be defective and will have to be reworked. The production
costs are: $30 for materials, $60 for labor, and overhead at 200% of
direct labor cost (all of which are charged to all of the production). The
entries are:
Subsidiary
Record Debit Credit
Work in Process — Materials 2,500
Work in Process — Labor 1 ,500

Work in Process — Factory Overhead 3,000

Materials 2,500
Payroll 1,500
Factory Overhead Applied 3,000

Factory Overhead Control 210

Defective Work (Dr.) 210
Materials 30
Payroll 60
Factory Overhead Applied 120

Finished Goods 7,000

Work in Process — Materials 2,500
Work in Process — Labor 1,500
Work in Process — Factory Overhead 3,000

The unit cost of the completed units is $14.00 ($7,000 -^ 500 units).
 :

352 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Suppose, however, that the same company received a special order for
500 units with the agreement stating that any defective work is chargeable
to the contract. During production, 50 units are found to be improperly
assembled. Cost to correct these defective units is $30 for materials, $60
for labor, and 200% of the direct labor cost for factory overhead. The
entries in this case are:

Debit Credit

Work in Process — Materials 2,500

Work in Process — Labor 1,500
Work in Process — Factory Overhead 3,000
Materials 2,500
Payroll 1,500
Factory Overhead Applied 3,000

Work in Process — Materials 30

Work in Process — Labor 60
Work in Process — Factory Overhead 120
Materials 30
Payroll 60
Factory Overhead Applied 1 20

Finished Goods 7,210

Work in Process — Materials 2,530
Work in Process — Labor 1 ,560

Work in Process — Factory Overhead 3, 1 20

The unit cost in this case is $14.42 instead of $14.

Whenever the defective work cost is charged directly to the job, a

slight overcharge of factory overhead results because of the inclusion of
rework cost in the factory overhead rate. One remedy to correct this
discrepancy would be to create a new independent overhead rate or
separate costs for the special job.

SUMMARY OF MATERIALS MANAGEMENT

Materials managers are almost constantly confronted with these
problems and requirements

1. Inventories account for a large portion of the working capital require-

ments of most businesses. This fact makes materials and/or inventory
management a major problem of significant importance requiring con-
stant attention by all three management levels.

2. At present, the problem has become even more acute due to market
conditions and the inflationary costs of materials.

3. Materials management and materials control need an organization in

which individuals have been vested with responsibility for, and authority
over, the various details of procuring, maintaining, and disposing of
inventory. Such a person or persons must have the ability to obtain,
coordinate, and evaluate the necessary facts and to take and obtain action
where it is needed.
 .

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 353

^M DISCUSSION QUESTIONS
1. List the more frequently used forms incident to the procurement and use of
materials.

2. Should formal purchase requisitions and purchase orders be prepared for

the purchase of incidental supplies, services, and repairs? Why?

3. How is an invoice approved for payment?

4. In an electronic data processing system, the computer — to a great extent —

replaces the accounting clerk. Explain.

5. Does the method of inventory costing have its principal effect on the balance
sheet or on the income statement?

6. In costing materials received and placed in stock, should the cost of trans-
portation, receiving, inspecting, and storing be added to the purchase price?
State reasons.

7. An invoice for materials shows a total of $5,400 terms 3 /lO, n /30. If the
; :

purchaser elects to pay the invoice at the end of 30 days, what is the effective
interest cost resulting from failure to take the discount ?

8. During periods of rapid increase or decrease in materials prices, which cost-

ing method might result in a more desirable figure for cost of goods manu-
factured and sold?

9. Discuss the advantages and disadvantages of the lifo costing method.

10. A company maintains a perpetual inventory control system. Is it also

necessary to take an annual year-end inventory?

11 At times physical quantities of materials as determined by actual count and

inspection do not agree with the figures in materials ledger cards. What
may cause such discrepancies? What accounting steps are taken to adjust
the differences?

12. Several methods of accounting for scrap materials are discussed in this
chapter. Which method do you regard as most accurate?

13. An item of inventory purchased this period for $15 has been written down
to current replacement cost of $10. It sells for $30 with disposal costs of
its
$3 and normal profit of $12. Which of the following statements is not true?
(a) The cost of goods sold of the following year will be understated.
(b) The current year's income is understated.
(c) The ending inventory of the current year is understated.
(d) Income of the following year will be understated.
(AICPA adapted)
 :

354 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

14. What procedures would you adopt in order to deal with the following items
listed in the materials ledger cards:

(a) Scrap delivered to the storeroom

(b) Return of materials to storage in excess of production requirements
(c) Gain or loss in weight through climatic conditions while in storage
(d) Short lengths of material cut to waste during the productive operations
(e) Breakage in the storeroom

15. In charging out materials, how would you account for the cost of the follow-
ing forms of waste:
(a) Sawdust; split, broken, and short ends of boards; and shavings from
planing machines in lumber mills
(b) Off-cuts in cutting paper linings and wrappers
(c) Off-cuts and broken pieces in foil wrapping
(d) Scraps in suit and dress factories
(e) Turnings from engine lathes

16. In the control of materials costs, why is the knowledge that excessive waste
isoccurring likely to be of greater value than the income derived from sales
of scrap?

17. In some situations labor and materials costs incurred on spoiled or defective
work are treated as factory overhead. In other cases the cost of perfecting
defective work is charged directly to the job. Explain the appropriate use
of each accounting treatment.

18. Which of the following statements is true in applying the lower-of-cost-or-

market rule to work in process inventory?
(a) This category of inventory is an exception, and the rule does not apply.
(b) Costs of completing the inventory are added to costs of disposal, and
both are deducted from estimated selling price when computing realiz-
able value.
(c) Market value cannot ordinarily be determined.
(d) Equivalent production is multiplied by the selling price.
(AICPA adapted)

19. A client who wishes to include as a part of the cost of raw materials all of the
cost of acquiring and handling incoming materials wants to know
(a) The principal items that may enter into the cost of materials acquisition
and handling.
(b) The arguments favoring the inclusion of these items as a part of raw
materials in storage.
(c) The arguments against inclusion of these items as a part of the cost of
raw materials in storage.
(AICPA adapted)

20. In order to effect an approximate matching of current costs with related

sales revenue, the last-in, first-out (lifo) method of pricing inventories has
been developed.
(a) Describe the establishment of and subsequent pricing procedures when
applied to units of product with a periodic inventory system in use.
lifo is
(b) Discuss the general advantages and disadvantages claimed for the lifo
method.
(AICPA adapted)
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 355

EXERCISES

1. Materials Costing Methods. The Mellan Company began using a new raw
material during May, 19 —
with these transactions:
,

May 2. Received 100 units (a> $5.40 per unit; total cost, $540.00.
8. Received 30 units (q^ $8.00 per unit; total cost, $240.00.
15. Issued 50 units.
22. Received 120 units %
$9.00 per unit; total cost, $1,080.00.
29. Issued 100 units.

Required: With a perpetual inventory control system in use, state the cost
of materials consumed and the cost assigned to the inventory at the end of May
using: (a) first-in, first-out costing; (b) last-in, first-out costing; and (c) average
costing. Present computations using materials ledger cards.

2. Allocation of Freight. An invoice for the raw materials A, B, and C is received

from the Lawson Manufacturing Company. The invoice totals are A, $15,000;
B, $8,000; and C, $22,000. The freight charges on this shipment weighing
9,000 kilograms are $990. Shipping weights for the respective materials are
2,900, 2,400, and 3,700 kilograms.

Required: (1) The cost per kilogram to be entered on the materials ledger
cards for A, B, and C if each dollar of invoice cost is assigned an equal portion
of the freight charge.

(2) The cost per kilogram to be entered on the materials ledger cards for
each material if the freight cost is assigned on a basis of shipping weight for
each material.

3. Ledger Accounts for Materials Cost Flow. The Littner Company produces a
product from one basic raw material. During one week of operations, the
materials ledger card reflected the following transactions:

1st weekday Beginning balance: 1,400 pounds fo $4.60 per lb.

2d « Received 1,000 pounds (q^ $4.80 per lb.
"
3d Issued 800 pounds.
4th " Issued 800 pounds.
5th « Received 1,200 pounds @ $5.00 per lb.
6th " Issued 800 pounds.

Other costs for the week were direct labor, $4,800, and factory overhead,
$4,360; 1,700 units of product were completed, and 1,500 were sold. There was
no beginning inventory of finished goods, and no work is left in process over
the weekend.

Required: (1) Ledger accounts for Materials, Work in Process, Finished

Goods, and Cost of Goods Sold, using (a) fifo costing and (b) lifo costing. As-
sume a perpetual inventory system is used.
(2) The final inventory by the lifo costing method if inventory is taken at
the end of the week and if day-to-day receipts and issues are ignored.
 :

356 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

4. Correcting Perpetual Inventory Cards. The following differences were re-

ported in reconciling the physical inventories of materials with the materials
ledger cards. The physical inventory has been verified and is correct in each case.

Materials
Physical Ledger
Material Inventory Balance Differences Reported

2,000 units 2,100 units The accountant neglected to record an issue

of direct materials to production. Average
cost per unit, $2.

500 units 400 units An invoice and receiving report for 100 units
purchased at $3 per unit has not been
recorded.

1,000 gals. 1,030 gals. The shrinkage is a normal condition of

storage and issue of this material. Average
cost per gallon, $.30.

900 lbs. 930 lbs. Shortage due to theft. Average cost per
pound, $10.

Required: (1) A separate correcting entry in general journal form for each
transaction.
(2) The procedure necessary to correct or adjust the materials ledger card for
each difference.

5. Materials Costing Methods. The following information is to be used in

costing inventory on October 31

October 1 Beginning balance 800 units

. $6 each.
: @
5. Purchased 200 units $7 each. @
9. Purchased 200 units $8 each. @
16. Issued 400 units.
24. Purchased 300 units $9 each. @
27. Issued 500 units.

Required: The cost of materials used and the cost assigned to the October 31
inventory by each of these perpetual inventory costing methods: (a) first-in,
first-out (fifo); (b) last-in, first-out (lifo); (c) moving average, using a materials
ledger card; (d) most recent purchase price.

6.Physical Inventory. A
company's own power plant uses coal as the principal
fuel.The coal is delivered by rail and stored in an open field close to the power-
house from which it is fed into furnaces by conveyor belt.

Required: Method(s) to determine coal consumption during a time period

and the coal on hand at the end of the period.

7. Inventory Valuation —
AICPA Rule. The AICPA's position regarding inven-
tory valuation was under discussion in an accounting seminar. The members
 :

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 357

were asked to decide on the proper valuation for the following situations with
these pertinent factors and simplified figures:
Situation

1 2 3 4 5
Cost $100 $100 $100 $40 $100
Net realizable value* 80 80 80 80 80
Net realizable value less normal profit** 50 50 50 50 50
Market (replacement cost) 60 90 40 30 110

* Market is not to exceed this amount (upper limit of market).

**Market is not to be less than this amount (lower limit of market).

Required: The inventory value for each situation based on the AICPA rule.

8. Journal Entries to Correct Materials Accounts. The following transactions

were completed by the Patterson Company:
(a) The inventory of raw materials on the average costing basis was $4,200 and
represented a book quantity of 8,000 units. An actual count showed 7,780 units.
(b) $150 of materials issued to Job Order No. 182 should have been charged to the
Repair Department.
(c) Materials returned from the factory as excess on requisitions for Job Order No. 257
amounted to $382.
(d) Materials returned to vendor amounted to $165. Freight-out on this shipment,
to be borne by the Patterson Company, was $14, paid in cash.
(e) Finished goods returned by customers: cost, $1,500; selling price, $2,100.
(f) Summary of materials requisitions totaled $4,814.50, of which $214,50 represented
supplies used.
(g) Materials purchased and placed in stockroom, $6,150, of which $500 represented
supplies. Freight-in paid, all applicable to direct materials, amounted to $70.
(h) Supplies returned to the storeroom, $150.
(i) Scrap materials sent to the storeroom valued at selling price (debit Scrap Materials)
From direct materials $190
From supplies 10
(j) Spoiled workreceived in storeroom: original cost, $60; salable value, $20. Loss
is charged to total production,
(k) Scrap was sold for $250 cash the book value of the scrap was $200 (see transac-
;

tion (i) above).

Required: The entries or adjustments, if any, affecting the general ledger

that should be made for each of the above transactions.

9. Effect of Costing Methods on Reported Earnings. The Halikulani Corporation

reported the following earnings for two succeeding years based on the fifo
costing method 19B, a profit of $1 17,345 19C, a loss of $30,070. The manage-
: ;

ment has been discussing changing to the Hfo costing method. The controller
prepared these comparative data:

Inventory Liters fifo lifo

December 31, 19A 250,000 $112,500 $112,500

December 31, 19B 237,500 201,500 105,000
December 31, 19C 256,500 169,000 1 17,500

Required: The profit or loss for 19B and 19C if the Halikulani Corporation
had used the lifo method of costing inventories.
 : :

358 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

10. Fifo-Lifo and Cash Flow. Due to rising prices for materials, the problem of
using the most appropriate inventory costing method has become very acute.
With the wide variety of methods available for accounting of inventories, it is
important to select one that will be the most beneficial for a company. To illus-
trate, assume that two companies are almost identical except that one uses fifo
costing and the other uses lifo costing. Both companies have a beginning inven-
tory of 200 units @
$2 per unit. The ending inventory is 240 units, for which
the current cost per unit is $2.40. Sales during the fiscal period totaled 180
items @
a selling price of $3.60. The income tax rate is 50% for both companies.

Required: (1) The amount of total materials available for sale.

(2) Income statements showingafter-tax earnings for both companies.

Cost assigned to the ending inventory based on the fifo and lifo costing
(3)
methods.
(4) The cash position at the end of the fiscal year, assuming that all transac-
tions, materials purchases, sales, and income taxes were paid for in cash.

(5) A brief evaluation of the results.

(Based on a Haskins & Sells Newsletter)

11. Journal Entries to Correct Defective Work. The Spurrier Products Company
manufactures, among other items, a unique nutcracker. One order from the
San Diego Specialty Company for ,000 nutcrackers showed the following costs
1

per unit:

Materials $3.00
Labor 2.00
Factory overhead applied at rate of 125% of labor cost.

Final inspection revealed that 120 units were improperly machined. These
units were broken down, properly machined, and reassembled. Cost of correct-
ing the defective nutcrackers consists of $1.20 per unit labor plus overhead at
the normal rate, which includes an allowance for defective work.

Required: Entries to record all costs related to the completion of the order
when the
(a) Job is charged with the cost of defective work.
(b) Cost of correcting defective work is not charged to a specific order.

12. Journal Entries for Spoiled Work. Dino Fashions, Inc., in producing
Lot No. 647, which called for 500 dresses. Style No. 34, incurred costs as follows

Materials $24 per dress

Labor 20 per dress
Factory overhead 17 per dress*

Includes an allowance for spoiled work of $1.

When the lot was completed, inspection rejected 20 spoiled dresses which
were sold for $30 each.

Required: (1) Entries if the loss is to be charged to Lot No. 647.

(2) Entries if the loss is to be charged to all production of the fiscal period.
 ,

CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 359

PROBLEMS
12-1. Analyzing a Company's Future Plant Expansion Based on Its Costing
Methods. The board of directors of the Windham Corporation is considering
the possibiHty of a plant expansion. After some research and a review of the
company's materials costing methods, the president presents the controller with
the proposition of using the lifo method instead of the present fifo method be-
cause of its apparent tax advantages. A
reduction of the company's income tax
liability might provide additional capital for the planned expansion. The presi-
dent requests the controller to make a further study on the proposal. The con-
troller's analysis regarding the inventory is based on these transactions for
June, 19—:

June 1. Beginning balance: 200 units (w, $3.00 per unit.

2. Purchased 500 units (a), $3.20 per unit.

7. Issued 400 units.
11. Purchased 300 units (a), $3.30 per unit.
14. Issued 400 units.
17. Purchased 400 units $3.20 @ per unit.
21. Issued 200 units.
24. Purchased 300 units $3.40 % per unit.
26. Purchased 400 units (gj, $3.50 per unit.
29. Issued 600 units.

Sales were 1,600 units (w, $7 per unit; marketing and administrative expenses
were $2,100.

Required: (1) Comparative income statements based on the transactions

for June, 19 — , using the lifo and fifo methods and a 50% income tax rate.

(2) The cash position of the Windham Corporation at the end of June, 19
assuming that all transactions, purchases, sales, and nonmanufacturing expenses
—
were paid in cash.

12-2. Ledger Cards for Materials. Records of the Summit Company show the
following purchases and issues of materials during October:

October 1. Beginning balance: 2,800 units @ $12.00 per unit.

4. Issued 1,200 units.
6. Received 1,000 units @ $13.30 per unit.
8. Issued 1,000 units.
14. Received 400 units (aj, $14.00 per unit.
17. Issued 800 units.
20. Received 500 units (w, $14.16 per unit.
25. Issued 900 units.
27. Received 1,200 units %
$13.00 per unit.

Required: (1) A materials ledger card using fifo costing.

(2) A materials ledger card using lifo costing.
(3) A materials ledger card using average costing.
(4) Cost of materials issued during October for the three methods.
(5) Cost of ending inventories.
(6) The October 3 1 inventory if the market price of the materials on that
date is $11 per unit.
Budgeted for
the Month
CH. 12 MATERIALS CONTROL PROCEDURES & COSTING METHODS 361

12-5. Inventory Valuation. In January the materials ledger card for metal cast-
ings of a certain kind and weight showed the following data:

Received Issued

Cost Per
Units Unit

Jan. 1. Balance 100 $1.00

10. Purchase 100 .95
20. Purchase 200 .90
28. Purchase 100 .88
362 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

(3) Normally, inventory amounts include the costs of Freight-In. Under

certain circumstances, however, these costs are excluded from the determination
of inventory cost.

(a) The circumstances under which this exclusion might be practiced with
comments on the propriety of the exclusions.
(b) Without discussion, other materials-related costs that might similarly
be excluded from inventory cost.

12-7. Journal Entries for Spoiled and Defective Work; Revising an Invoice.
Masten Manufacturing, produces small motors on special orders.
Inc. In
February a U.S. Air Force contract for the production of 120 motors at cost
plus a fixed fee of $1,145 was completed. This invoice was mailed to the con-
tracting officer of the U.S. Air Force:

INVOICE

Materials Cost $11,786.25

Labor Cost 7,811.25
Factory Overhead 5,207.50

Total Cost $24,805.00

Fixed Fee 1,145.00

Total (for 120 motors) $25,950.00

The Air Force Cost Inspector objected to this billing, stating that the spoilage
of 5 motors and additional costs for 1 defective motor had been charged directly
to the Air Force job, whereas the procedure previously had been to spread such
costs over all the jobs.
The spoiled motors had been sold as scrap for $50 each (the original scrap
value assigned to them). The defective motor had required $30 of additional
materials and 5 labor hours to correct its defects. Men working on the contract
were paid $3 per hour and had worked a total of 7,200 hours, of which 2,630
hours had been spent on the Air Force contract. Masten Manufacturing, Inc.
uses a predetermined factory overhead rate of $2 per labor hour. Each motor
requires $95 of direct materials. Spoiled and defective work is discovered
during final inspection after all normal labor costs have been incurred.

Required: Assuming that the company's work in process account has tiot
been credited for any work completed during February:

(a) All journal entries that Masten Manufacturing, Inc. has made in con-
nection with this contract.

(b) The journal entries the company should have made for the spoiled and
defective work.

(c) The journal entries to correct the books and complete the contract.

(d) A revised invoice for the U.S. Air Force.

CH. 12 MATERIALS CONTROL PROCEDURES &. COSTING METHODS 363

12-8. Accounting for Spoiled Work. The Galarde Manufacturing Co. produces
a variety of products, each requiring several parts. The parts are manufactured
and placed in stock for assembly as needed. The following cost sheet for Part
No. 105 indicates the present costing method.

COST SHEET

For Part No. 105 Job Order No. 6-5574

Quantity started 2,000 Date started 2/5/-

Quantity finished Date wanted 2/28/—
Quantity spoiled Date finished 2/26/-

Materials:
2,000 pieces Material Stock No. 81 (all material issued

ibor Cost:

Dept.
364 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

(2) The journal entries to be made at the time Job Order No. 6-5574 is com-
pleted. Assume the spoilage is to be charged to total production.

(3) The information contained in a monthly spoilage report that is sent to

the department foremen.

12-9. Journal Entries for Spoiled Units. The Hayes Company manufactures
Product C at a cost per unit of $6 that consists of $1 for material, $2 for labor,
and $3 for factory overhead costs. During May, 1,000 units were spoiled that
could have been sold for $.60 each. The accountant said that the entry for these
1,000 spoiled units could be one of these four:

Entry Debit Credit

1 Spoiled Goods 600

Work in Process — Materials 100
Work in Process — Labor 200
Work in Process — Factory Overhead 300

2 Spoiled Goods 600

Factory Overhead Control 5,400
Work in Process —
Materials 1,000
Work in Process Labor— 2,000
Work in Process —
Factory Overhead 3,000

3 Spoiled Goods 600

Loss on Spoiled Goods 5,400
Work in Process — Materials 1,000
Work in Process — Labor 2,000
Work in Process — Factory Overhead 3,000

4 Spoiled Goods 600

Accounts Receivable 5,400
Work in Process — Materials 1,000
Work in Process — Labor 2,000
Work in Process — Factory Overhead 3,000

Required: The circumstances under which each of the above entries would
be appropriate.

(AICPA adapted)
 CHAPTER 13

QUANTITATIVE MODELS
FOR MATERIALS PLANNING
AND CONTROL

The planning and control of inventory from product design to final

delivery are of considerable strategic significance to management. Inven-
tories serving as a cushion between the production and consumption of
goods exist in various forms: raw materials awaiting processing; inven-
tories of partially completed products or components; finished goods at
the factory, in transit, in warehouse distribution points, and in retail outlets
available for customers and consumers. At each of these stages a sound
economic justification for the inventory should exist. Size of inventory at
production economics inherent in large production runs,
sites reflects the

or in economic ordering, handling, and shipping lots, or the need for

flexibility in the face of uncertain future demand. Each additional unit
carried in inventory generates some additional costs. Inventory invest-
ment varies with the type of industry and characteristics of a company;
on the average, inventory accounts for about one third of total assets,
and for many manufacturers the cost of materials represents about one
half of total product cost.
Any inventory planning and control method should have but one goal
that might be expressed in two ways: (1) to minimize total costs or (2) to
maximize profit within specified time and resource allocations.

PLANNING MATERIALS REQUIREMENTS

Materials planning begins with the design of a product. Whether it is a
regular product or a special contract, a series of planning stages is neces-
sary to get raw materials into production. In the preliminary stages the

365
 : : :

366 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

engineering division studies the proposal, design, blueprints, and other

available specifications and prepares a product requirement statement.
The tooling department studies the work details necessary to manufacture
the product in the particular plant. The manufacturing control division
examines the production in terms of existing and contemplated production
schedules. The materials planning and cost estimating departments study
the cumulative information and submit a cost estimate for the production
proposal. The long-range or economic planning section suggests a product
price based on considerations of present product lines, economic conditions
and expectations, company policies, and expansion plans. Executive
management must finally decide whether to proceed with, reject, or modify
the proposal.
To plan manufacturing requirements, every stock item or class of items
must be analyzed periodically to

1. Forecast demand for the next month, quarter, or year.

2. Determine acquisition lead time.
3. Plan usage during the lead time.
4. Establish quantity on hand.
5. Place units on order.
6. Determine reserve or safety stock requirements.

Using these six steps, the quantity to order in September for November
delivery, with a lead time to order and receive delivery of two months and
approximately a two weeks' supply as the desired safety stock, is as follows

Planned or forecast usage from review date

September production 2,500 units

October production 2,000 units
November production 2,500 units
Desired inventory, November 30 1,000 units

Total to be provided 8,000 units

Quantity on hand, September 1 1,600 units

On order for September delivery 2,000 units
On order for October delivery 2,000 units 5,600 units

Quantity to order for November delivery 2,400 units

Future requirements for each purchased or produced item play a

central role in materials control. If usage requirements are not accurately
planned, even the most elaborate control system will result in the wrong
level of inventory during and at the end of a future period.
Materials planning deals with two fundamental factors: (1) the
quantity to purchase and (2) the time to purchase — or simply, how
much and when to buy. Determination of how much and when to buy
involves two conflicting kinds of cost — the cost of holding or carrying
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 367

and the cost of inadequate carrying. The nature of these conflicting costs
is indicated in this comparison:

COST OF
 :

368 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

However, it is difficult, if not impossible, to determine costs of not

carrying enough inventory; yet they must be considered in deciding upon
order quantities and order points. Ordering costs are very difficult to

measure, yet they are needed in computing the economic order quantity.
For any order, the fixed costs of order placing are not relevant; only the
variable or out-of-pocket costs of procuring an order should be included.
The costs of processing an order include preparing the requisition and the
purchase order, handling the incoming shipment and preparing a receiving
report, communicating in case of quantity /quality errors or delays in
receipt of materials, and accounting for the shipment including the pay-
ment. Costs of inadequate carrying, other than ordering costs, relate to
such questions as savings in freight and quantity discounts as well as to
the question of when to order, including appropriate allowance for safety
stock (discussed later in this chapter).
Depending upon many factors, it may cost from $2 to $20 or more to
process an order and from 10 to 35 percent of the average inventory in-
vestment to hold materials. Techniques for analyzing cost behavior,
described and illustrated in Chapter 18, should facihtate the determination
of realistic carrying and ordering cost estimates. Mathematical and sta-
tistical techniques permit improved planning and control in an endeavor
to maximize profits and minimize costs.

Tabular Determination of the Economic Order Quantity. A tabular

arrangement of data relative to a materials item allows the determination
of an approximate economic order quantity, and thereby the number of
orders that need to be placed monthly, quarterly, or yearly.

Illustration:

Estimated requirements for next year 2,400 units

Cost of the item per unit $ 1 .50
Ordering cost (per order) $6.00
Inventory carrying cost (9c of average inventory value) 10%

Based on these data, various possible order sizes can be evaluated

Quantitative Data
Order size in units
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 369

$200-,

1 1 \ 1 \ r
600 800 1 ,000 1 ,200 1 ,400 1 ,600 1 ,800 2,000 2,200 2,400
440
EOQ
ORDER QUANTITY
Graphic Determination of the Economic Order Quantity

Of the order sizes calculated, 400 is the most economical ; thus, an order
should be placed every 60 days. However, the most economical order size

may not have been calculated ; there may be some unit quantity between
200 /400 or 400 /800 with a cost to order and carry that is lower than $66.

Graphic Determination of the Economic Order Quantity. The graphic

illustrationabove shows the lowest point of the total cost to order and
carry curve, about $66, and the most economic order quantity of about
440 units. The ideal order size is the point when the sum of both costs is
at a minimum; i.e., the total cost curve is at its lowest. This point occurs
when the annual carrying charges equal the ordering charges; i.e., where
these two cost lines intersect.

The Economic Order Quantity Formula. To determine the economic

order quantity by a tabular or graphic method is lengthy and may not
provide the most accurate answer. Companies using order-point calcula-
tions based upon economic order quantities usually prefer to use a formula.
With information such as quantity required, unit price, inventory carrying
cost, and cost per order, differential calculus makes it possible to compute
economic order quantity by formula. One formula variation is on page 370.
 :

370 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

r •
/-» J
Economic Order i-v
entity —
.-.
Quar*-*" = /
'
2 X Annual Required Units X Cost per Order
^^Cost per Unit of Material X Carrying Cost Percentage

/2 X RU X CO
^OQ =
^ CU X CC%

This formula for the economic order quantity, or least-cost order

quantity in units, is the square root of a fraction whose numerator is twice
the product of the annual unit demands and and whose
the cost per order
denominator is the product of the unit price and the annual carrying rate.
Using this formula and the data from page 368 results in:

EQQ-J 2X2.400^ ^ I 28,800 ^ ^R^^;^ = 438 units

^ \ $1.50X10% \ .15 V '

Given the terms EOQ, RU, CO, CU, and CC as specified, the formula
is derived as follows

RU Number of orders placed annually

EOQ
RU X CO = Annual ordering cost
EOQ
EOQ Average number of units in inventory at any point in time
2

CU X CC X EOQ = Annual carrying cost

RU X CO CU X CC X EOQ ^ Total annual cost of inventory,

EOQ 2 designated as AC^

iJhis latter equation is then solved utilizing differential calculus to determine minimum total
annual cost of inventory, AC, represented by the EOQ formula:

RU X CO CU X CC X EOQ
EOQ 2

AC = RU X CO X EOQ-. + SiXCCXEOQ
f^=-RUXCOXEOQ-. + -f-
dAC -RU X CO
CU X CC
dEOQ EOQ
^ dAC ^. -
-RU X CO CU X2 CC „
Q >
^'-
^'' =
,

^
^''dE6Q =
^^^dEOQ EOQ2 +
CU X CC ^ RU X CO
2 EOQ2
EOQ2 X CU X CC = 2 X RU X CO
EOQ2 =
2X^^XCO
C U X CC
EOQ X RU X CO
^
=V^ CU
'
X CC%
 : :

CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 371

It is also possible to express EOQ in dollars rather than in units. The

following formula is usually employed:

2 X AB where ^— Annual requirements in dollars

hOQ = -^ g ^ Ordering costs (per order)
I

I = Inventory carrying cost (% of average

inventory value)

Example. Using this formula and the following data from the earlier
illustration

A = $3,600 (or 2,400 units @ $1.50)

B = $6
I = 10% per year

2 X $3,600
-— X $6 ^.^^
EOQ
T:r^r^ =
4^
\j = $657 ^ , ,
total costs, or
•^^
/$657
438 units I
jj^

A second example is given to indicate the results when new cost data
enter the formula. Any shift in cost data by either increasing the carrying
rate or lowering the ordering cost will affect the answer. Of course, only
those cost components that vary directly with order or production quan-
tities should be used; i.e., the variable costs.

Example:
RU = 6,000 units of material No. 60,841 used per year (500 units per month)
CO = $15 ordering cost per order
CU = $2.50 cost per unit of material
CC = 20% carrying cost as a percent of inventory

The calculation is

EOQ=JI^M20X^
^ = J\ 180>0OQ = J^^5:000"=
>
600 units
\ $2.50X20%o .50

The economic order quantity for the stock item is 600 units, or ten
orders per year. Other order quantities resulting in more or less than ten
orders per year are not so economical, as proven by the tabular arrange-
ment illustrated at the top of the next page.
372 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Annual
 2

CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 373

than the minimum, quantity price discounts and /or freight savings may
be made, enabling the purchase to be made at a lower cost per unit. How-
ever, buying in larger quantities involves a larger investment in inventories.
Therefore, larger quantities should only be purchased if an added return
on the average added investment is adequate.

The EOQ Formula and Production Runs. The EOQ formula is equally
appropriate in computing the optimum size of a production run, in which
case CO represents an estimate of setup costs and CU the variable manu-
facturing cost per unit.

Illustration: Assume that stock item No. 841967 is manufactured

rather than purchased, that setup costs such as labor cost of rearrang-
ing and adjusting machines (CO) are $62, and that the variable manu-
facturing cost {CU) is $2 per unit.

-^^
——^^^
2X6,000 unitsX$62 setup
7~. — cost
^, ^(.m
$2 variable manufacturing cost, X
= \
744,000
A
— = ^1,860,000
,,o^nnnr.
= i tcA -.
1,364 units,
20% \ .4 \
the optimum size of a production run

Determining the Time to Order. The economic order formula answers

quite satisfactorily the quantity problem of inventory control. However,
the time to order question is just as important.
The problem of when to order is controlled by three factors: (1) time
needed for delivery, (2) rate of inventory usage, and (3) safety stock. Unlike
the generally accepted solution to the economic order quantity, the order
point has no generally applicable and acceptable solution. Determining the
order point would be relatively simple if lead time — the interval between
placing an order and having materials on the factory floor ready for pro-
duction — and the usage pattern for a given item were definitely predict-
able. For most stock items there is a variation in either or both of these
factors which almost always causes one of three results: (1) if lead time
or usage is below expectation during an order period, the new materials
will arrive before the existing stock is consumed, thereby adding to the cost
of carrying inventory; (2) if lead time or usage is greater than expected, a
stockout will occur with the resultant incurrence of costs associated with
not carrying enough inventory; (3) if average lead time and figures are
used to determine an order point, a stockout could be expected on every
other order.

2For further discussion of consideration of quantity discounts in EOQ computations, see:

Richard I. Levin and Charles A. Kirkpatricit, Quantitative Approaches to Management, (2d
Edition, New Yorlc McGraw-Hill Book Company, 1971), pp. 134-139.
:
374 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Forecasting materials usage requires the expenditure of time and

money. In materials management, an expense as well as an
forecasts are
aid to balancing the cost to acquire and the cost to carry inventory. Since
perfect forecasts are rarely possible, an inventory cushion or safety stock
is often the least costly device for protecting against a stockout. The basic
problem is to determine the safety stock quantity. If the safety stock is

greater than needed, carrying costs will be too high; if too small, frequent
stockouts will occur resulting in inconveniences, disruptions, and addition-
al costs. The optimum safety stock which results in mini-
is that quantity
mal total annual cost of stockouts and carrying
Carrying costs are costs.
determined in the same manner as in calculating economic ordering
quantity. The annual cost of stockouts depends upon their probability
and the actual cost of each stockout.

Example: If a safety stock of 20 units would cause a 20 percent proba-

bility of running out of stock during an order period, and if an order was
processed ten times a year, two stockouts per year on the average would
occur. If each stockout costs $50 and if the carrying costs per 20 units of
safety stock are $15, the total stockout and carrying costs would be $115.
If by increasing the safety stock to 40 units the probability of a stockout
is reduced to 10 percent or once a year, stockout cost would be $50 and
carrying cost $30, a total of $80. If increasing the safety stock to 80 units
reduces the stockout probability to 5 percent or once every two years, the
annual stockout cost would be $25 with carrying costs of $60, a total of $85.
Analysis of this type covering important stock items leads to smooth opera-
tions and effective materials management.

Order Point Formula. Order points and /or reorder points are based on
usage during the time necessary to requisition, order, and receive delivery
of materials plus an allowance for protection against stockout. The
order point is reached when inventory on hand and quantities due in
are equal to the lead time usage quantity plus the safety stock quantity.
In equation form the order point may be expressed as:

I + QD = LTQ + SSQ, when:

I = Inventory balance on hand

QD = Quantities due in from orders previously placed, materials transfers,

and returns to stock

LTQ = Lead time quantity equals average lead time in months, weeks, or days
multiplied by average month's, week's, or day's use

SSQ = Safety stock quantity

 :

CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 375

Two approaches are illustrated

1. Usage and lead time are known with certainty; and, therefore, no safety
stock is provided.
2. Based on the same figures, a safety stock is injected into the calculation.
Both examples are solved mathematically and graphically.

First Illustration: Assume the use of 175 units per week of a stock item
(35 units each Monday through Friday, or 25 units seven days a week)
and a lead time of four weeks which estabhshes an order point at 700 units
(175 units X 4 weeks). Assuming that unit cost is $.50, carrying cost 20%,
order cost $24, and annual usage 175 units per week for 52 weeks, then
the EOQ is computed at 2,090 units.

2X9,100X$24 436,800
EOQ = = ^4,368,000 = 2,090 units
$.50X20% 10

Each order provides a 12 weeks' supply (2,090 -^ 175 = 12). Figure 1

shows the control pattern of this item if usage and lead time are definitely
known. It is apparent that (1) if lead time is more than four weeks, a
stockout will result ; and (2) if usage exceeds 700 units in any four- week
period following an order point, a stockout is inevitable. Since perfect
prediction of usage and lead time is unreaUstic, a safety stock allowance
is needed.

2,500.
 :

376 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Second Illustration. Assuming the same usage of 175 units per week
shown in Figure 1, with a lead time of normally four weeks but possibly
as long as nine weeks, the reorder point would be 175 units X 4 weeks
= 700 units usage during normal lead time plus 875 safety stock (175
units X 5 weeks) = 1,575 order point. Assuming a beginning inventory
of 2,800 units and no orders outstanding, the usage, order schedule, and
inventory levels would be:
2,800 units beginning inventory
1,225 usage to order point (1,225 -4- 175 weekly usage = 7 weeks)
1,575 order point
700 usage during normal lead time (700 -^ 175 weekly usage = 4 weeks)
875 maximum inventory or safety stock at date of delivery
2,090 EOQ units received
2,965 maximum inventory
1,920 average inventory assuming normal lead time and usage (2,090 EOQ H-
2 = 1,045 plus 875 safety stock)

Figure 2 depicts materials planning under the above assumptions and

shows that a stockout would not occur unless lead time exceeds nine weeks,
assuming normal usage.
In most businesses a constant normal usage is not likely to occur be-
cause it depends upon production schedules, and production depends upon
sales. For instance, should the usage rate be as high as 210 units per week,

with lead time normally four weeks or possibly as long as nine weeks, the
safety stock would have to be 1,190 units and the order point 1,890 units,
calculated as follows:

Normal usage for normal lead time of four weeks: 700 units (175 unitsX4 weeks)
Safety stock
Normal usage for five weeks' delay . . 875
(175 units X
5 weeks)
Usage variation 315
(210 -
175 = 35 X
9 weeks) 1,190 units

Order point 1 ,890 units

Assuming a beginning inventory of 2,800 units with no orders out-

standing, the usage, order schedule, and inventory levels would be:
2,800 units beginning inventory
910 usage to order point (910 -^ 210 maximum weekly usage = 4.3 weeks)
1,890 order point
700 normal usage for normal lead time (700 -f- 175 normal weekly usage =
4 weeks
1,190 maximum inventory or safety stock at date of delivery
2,090 EOQ units received
3,280 maximum inventory
2,235 average inventory assuming normal lead time and usage (2,090 EOQ ^
2 = 1,045 plus 1,190 safety stock)

Figure 3 shows materials planning under the above assumptions that

the rate of usage and the lead time are known but variable.
3,000-

Figure 2 — Rate of
Usage Known with

Certainty and Lead

Time Known but

Variable

WEEKS

Figure 3 — Rate of
Usage and Lead Time

Known but Variable

377
 .. :

378 PLANNING AND CONTROL OF MATERIALS AND LABOR PART iV

Safety Stock Calculations by Statistical Methods. The preceding situa-

tions tend to provide a safety stock for the extreme boundaries of usage
and lead time variability. In other situations, the amount of safety stock
is often calculated by traditional rules of thumb, such as a two weeks'
supply. These approaches have given way to statistical techniques for a
reasonable degree of protection at lower costs. With any increasing
complexity of calculations, computer application is inevitable.

Statistical Method Illustrated. The tabulation of an eight months'

actual consumption of Material No. 925 together with the forecast monthly
usage form the basis for the following statistical approach:

January.
February.
March. .

April. . .

May
June
July
August. .

In Column 3, the differences of forecast requirements from actual usage

are arithmetically derived and totaled. In Column 4, the Column 3 dif-
ferences are squared and totaled. The Column 3 total is squared and di-

vided by the number of time periods (8 months) and the quotient is sub-
tracted from the Column 4 total
 : :

CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 379

Here the average difference of —2.75 increases the safety stock be-
cause the actual usage is, on the average, greater than the forecast usage.

A positive average difference would indicate that the actual usage is on

the average less than the forecast, thus reducing the safety stock figure.
Three times the standard deviation minus the average difference, ap-
proximately 32 units [3(9.74) — (—2.75)] of safety stock, would result in
about 99.5 percent protection against stockouts due to variation in usage
based upon experience of eight months.
With a usage forecast of 260 units for a needed lead time of one month
and a safety stock of 22 units, the order point is 282 units for Material
No, 925. Of course, an additional safety stock allowance may be needed
if lead time varies, again giving consideration to the degree of protection
desired by management. When the stock reaches the order point level, it

should trigger an order for the most economical order quantity.

Lead time units must be the same time period units of measure as those
used in computing the standard deviation; e.g., days, weeks, or months.
The above illustration uses months as time period units and assumes a lead
time of one month. When the lead time is not one month, proper computa-
tion of the safety stock requires that the desired number of standard devia-
tions times the standard deviation times the square root of the number of
time period units be computed ; and from this product the average differ-

ence multipHed by the number of time period units is subtracted. As-

suming the same standard deviation and average difference as computed
above, two standard deviations and a lead time of four months, the safety
stock would be computed as follows

Safety Stock = (2 X 9.74 X V^) - (-2.75 X 4)

= (19.48 X 2)+ 11

= 38.96+ 11

= 49 96 =. approximately 50 units for safety stock

Forecasting Usage. The number of units needed during the lead time,
and the lead time itself are the two variables which influence the when to
order decision. It is usually possible to estimate fairly accurately the time
required to receive materials. seldom possible to forecast exactly the
It is

materials needed even for a short future period; and when thousands of
items are involved, the task becomes prodigious even with the aid of a
computer. Some forecasting techniques are briefly mentioned in order to
indicate the scope and complexity of the task

1. Factor listing or barometric methods

2. Statistical methods
3. Forcasting surveys
 :

380 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Factor listing involves enumerating the favorable and unfavorable con-

ditions likely to influence sales of the various divisions or products of a
company and relies upon the forecaster's judgment to evaluate the degree
of the influence factor. Barometric methods result in systematized factor
listing.

Statistical methods describe historical patterns in time series. The

methods may be simple or complex, but the purpose is to reveal patterns
that have occurred in the past and project them into the future. The usual
procedure results in plotting time series data on a graph (such as total sales,
sales of specific lines or products, inventory units or dollars, man hours or
machine hours operated), thus revealing a trend, a seasonal or cyclical
pattern. A moving average may be used to smooth a series and remove
irregular fluctuations, but the intent is to describe mathematically the
growth or decline over a period of time. Regression analysis usually em-
ploys the least-squares method (see Chapter 18) to determine economic
relationships between a dependent variable and one or more independent
variables, such as sales territory, family incomes, advertising expendi-
tures, and price of product.
Forecasting surveys are used to avoid complete dependence on his-
torical data. They are commonly made to determine consumer buying
intentions, opinions, or feehngs about the business outlook, and capital
investment intentions.

General Observations. The key to good inventory planning rests pri-

marily in sufficient knowledge of the fundamental techniques to develop

enough self-confidence to permit their practical adaption to the specific
needs of the company. Basically, economic order quantity and computed
order points assume:

1. Relatively uniform average demand.

2. Gradual usage of inventory.
3. Normal distribution of demand forecast errors.
4. Constant purchase price per unit regardless of order size.

5. Available funds when the order point is reached.

6. Statistical independence of demand for all inventory items.

Circular slide rules made expressly for computing EOQ are available,
easy to use, and sufficiently accurate for all practical purposes. The formu-
la can be translated into a logarithmic chart or nomograph which makes
its use mechanical, requiring no mathematical knowledge.

Aside from all the technical and mathematical steps, it is important to

remember that the following fundamentals largely determine the success
of the inventory planning procedures
 :

CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING &. CONTROL 381

1. The order point is singularly the most significant factor affecting in-
ventory planning inasmuch as it establishes the inventory level. It deter-
mines the investment in inventories and the ability to provide satisfactory
customer service. The order point is primarily dependent on the accuracy
of the sales or usage forecast.
2. Of equal importance is the establishment of unit costs, carrying and
ordering costs, and the investment factor. They are involved in deter-
mining the economic order quantity.

MATERIALS CONTROL
Materials control is accomplished through functional organization, as-
signment of responsibility, and documentary evidence obtained at various
stages of operations from the approval of sales and production budgets to
the completion of products which are ready for sale and shipment to w^are-
house stocks or to customers.
Two levels of inventory control exist unit control and dollar control.
:

Purchasing and production managers are primarily interested in unit con-

trol; they think, order, and requisition in terms of units instead of dollars.
Executive management is primarily interested in the financial control of
inventories. These executives think in terms of an adequate return on
capital employed, meaning dollars invested in inventory must be utilized
eflftciently and effectively. Inventory control is operating successfully
when inventory increases or decreases, both in amount and time, follow a
predetermined and predictable pattern related to sales requirements and
production schedules.
The control of materials must meet two opposing needs: (1) main-
tenance of an inventory of suflRcient size and diversity for eflflcient opera-
tions and (2) maintenance of a financially favorable inventory. A basic
objective of good materials control is the abihty to place an order at the
right time with the right source to acquire the right quantity at the right
price and quahty. Effective inventory control should

1. Provide a supply of required materials and parts for efficient and un-
interrupted operations.
2. Provide ample stocks in periods of short supply (seasonal, cyclical, or
strike), and anticipate price changes.

3. Store materials with a minimum of handling time and cost and protect
them from loss by fire, theft, elements, and damage through handUng.
4. Keep inactive, surplus, and obsolete items to a minimum by systematic
reporting of product changes which affect materials and parts.
5. Assure adequate inventory for prompt delivery to customers.
6. Maintain the amount of capital invested in inventories at a level consistent
with operating requirements and management's plans.
 :

382 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Control Principles. Inventory control systems and techniques should

be based on these fundamental principles:

1. Inventory is created by (a) spending money for raw materials and parts
and (b) additional labor and overhead costs to process the materials into
finished goods.

2. Inventory is reduced through sales and scrapping.

3. Accurate sales and production schedule forecasts are essential for efficient
purchasing, handling, and investment in materials.

4. Management policies, which attempt to balance size and diversity of

inventory for efficient operations and cost of maintaining that inventory,
are the greatest factor in determining inventory investment.

5. Ordering materials is a response to forecasts; scheduling production

controls inventory.

6. Inventory records alone do not achieve inventory control.

7. Control is comparative and relative, not absolute. It is exercised through

people with varying experiences and judgment. Rules and procedures
guide these individuals in making evaluations and decisions.

Organizing for Materials Control. Effective control of the large invest-

ment raw materials, work in process, semifinished components, and
in
finished goods inventories may be achieved by various organizational
patterns. Materials control is commonly centralized in one department
called the materials management or materials control department with a
responsible executive heading the organization. Size of company, number
of purchased items in a finished product, physical size, weight, and unit
value of items, and time required to manufacture a product are factors
that influence the organization and personnel required for effective ma-
terials control. A materials management organization may include some
or all of the following sections

Planning and Scheduling Warehousing

Purchasing Packing
Receiving Traffic
Inspection Shipping
Stores Statistical Analysis
Materials Handling Value Analysis
Finished Goods New Product Planning

Materials Control Methods. Materials control methods differ primarily

in (1) frequency of review of the status of materials and (2) care and cost
expended in making the review, especially estimating future usage of an
item. In the case of critical items and high-value materials, it is necessary
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 383

to make a weekly or even daily review with experienced supervisory per-

sonnel (responsible for control). For low-value items a quarterly, semi-
annual, or annual review may be adequate. On low-cost items, large
orders of three to six months' supply and large safety stocks are appropriate
since carrying costs are usually low and risk of obsolescence is often
negligible. Control methods include: (1) order cycling, (2) min-max
method, (3) two-bin system, and (4) automatic order system.
The order cycling or cycle review method examines periodically (each
30, 60, or 90 days) the status of quantities on hand of each item or class.

Different companies use different time periods between reviews and may
use different cycles for different types of materials. High-value items
and items that would up normal operations if out of stock usually
tie

require a short review cycle. On low-cost and noncritical items a longer

review cycle is common since these materials would be ordered in larger
quantities, and a stockout would not be as costly. In the order cycling
system, at each review period orders are placed to bring quantities up to
some determined and desired level. This quantity is often expressed as a
number of days' or weeks' supply.
For low-cost items the system is called the 90-60-30-day technique, a
rather simple method. When a quantity on hand drops to 60 days' supply,
a replenishment order is placed for a 30 days' supply. The days of supply
for order point or order quantity can be adjusted to projected sales for
seasonal items.
The min-max method is based on the premise that the quantities of
most stock items are subject to definable limits. A maximum quantity for
each item is established. A minimum level provides the margin of safety
necessary to prevent stockouts during a reorder cycle. The minimum level
sets the order point, and the quantity to order will usually bring inventory

to the maximum level.

The two-bin system of inventory control separates each stock item into
two piles, bundles, or bins. The first bin contains enough stock to satisfy
usage which occurs between receipt of an order and the placing of the next
order; the second bin contains the normal amount used from order to
dehvery date plus the safety stock. When the first bin is empty and the
second bin is tapped, a requisition for a new supply is prepared. The sec-
ond bin or reserve quantity is determined originally by estimating usage
requirements and adding a safety stock adequate to cover the time required
for replenishing the materials. For example, if monthly usage of an item is
ten dozen, a one-month safety stock is desired; and if 30 days are required
to place an order and receive delivery, the second bin or segregated reserve
should contain 20-dozen units. A purchase order must be written when
the reserve stock is tapped; otherwise, a stockout is Hkely to occur. The
 . :

384 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

two-bin or "last bag" system requires little paper work and is particularly
appropriate for control of "C" items under the ABC proportional value
system, in which "C" items are not on perpetual inventory records. Re-
ordering takes place when the "last bag" is opened.
The automatic order or order point system is "automatic" in the sense
that ordering an economic order quantity is triggered when a materials
ledger card shows that the balance on hand has dropped to the order point.
The system is especially advantageous in companies employing electronic
data processing equipment. The materials control department reviews
materials items, forecasts usage and lead time, establishes safety stock re-
quirements, and determines economic order quantities. Thereafter, sub-
ject to quarterly or semiannual review, receipts and issues are machine-
recorded on the materials cards. When the quantity on hand drops to the
established order point, the materials cards are automatically machine-
sorted and are routed to order clerks who activate orders for the quantity
specified. Companies with computers go even further in their use of the
automatic order system. The computer reviews and updates order points,
recalculates economic order quantities, and even writes purchase orders.

Selective Control — The ABC Plan. Segregation of materials for selec-

tive control, called theABC plan, is an analytical approach based upon
statistical averages. The ABC plan measures the cost significance of each
materials item, "A" or high-value items would be under the tightest con-
trol and the responsibility of the most experienced personnel. 'C" items
would be under simple physical controls such as the two-bin system with
safety stocks. The plan provides impressive savings in materials costs.
The procedure for segregating materials for selective control consists of
six steps

1 Determine future use in units over the review forecast period — month,
quarter, or year,

2. Determine the price per unit for each item.

3. Multiply the projected price per unit by the projected unit requirement
to determine the total cost of that item during the period.

4. Arrange the items in terms of total cost, listing first the item with the
highest total cost.

5. Compute for each item its percentage of the total for: (a) units number—
of units of each item divided by total units of all items and (b) total cost —
total cost of each item divided by total cost of all materials,

6. Plot the percentages on a graph.

The table and graph on page 385 demonstrate ABC inventory classi-
fication.
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 385

Item
 : :

386 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

dollar value of each item, thus providing a proportional value analysis. In

most an arbitrary number of items can be selected on a percent-
situations
age basis to approximate
10% of the items to equal 70% of the dollar cost of materials used
30% of the items to equal 25% of the dollar cost of materials used
60% of the items to equal 5% of the dollar cost of materials used

The following table suggests the handling of high-, middle-, and low-value
items to achieve effective control

High-Value Items Middle-Value Items Low-Value Items

jA) m (c)

Quality of personnel . Very best

available Average Low
Records needed Very complete Simple Not essential

Order point and As guides, fre- Infrequent

quantity use quent changes review Strictly used

Number of orders
per year Generally high Two to six One or two
Replacement time ... As short as
possible Normal Can be long
Amount of safety
stock Low Moderate High
Inventory turnover. . . High Moderate Low

Physical Control of Materials in the Storeroom. The receiving or inspec-

tion department forwards materials to storerooms together with a copy of
the receiving report. The storekeeper and his assistants are responsible for
safeguarding the materials. Materials and supplies are placed in proper
bins or other storage spaces to be kept there safely until required in pro-
duction. Materials taken from the storeroom must be properly requisi-
tioned. Admittance to the storeroom should be restricted to employees of
that department. These employees often work behind locked doors, issuing
materials through cage windows.
Since the cost of storing and handling materials may be a very substan-
tial amount, careful design and arrangement of storerooms can result in
significant cost savings. Materials can be stored according to (1) materials :

account number; (2) frequency of use; (3) factory area where used; or (4)
nature, size, and shape. In practice no single one of these bases is likely to
be suitable, but size and shape of materials usually dictate the basic store-
room arrangement. Variations can then be introduced, such as placing
most frequently used items nearest the point of issue and locating materials
used primarily in one area nearest that location.
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 387

Controlling Materials in Process. The materials cost control responsi-

bility is not ended when materials are requisitioned for production. Until
goods are finished, packed, sold, and shipped, inventory control problems
and cost savings potentials exist. This is particularly true of in-process
inventories which are intimately related to production processes and sched-
ules. Generally, the objective is to maintain inventory levels based either
on maximum production or the lowest unit cost. The in-process inventory
control is often neglected. The computation of turnover rates permits
identifying such inventory problems and measuring the effectiveness of
control procedures. A computation is usually made for each manufactur-
ing department, cost center, or process by dividing the cost of units trans-
ferred to the next department by the average inventory cost of the trans-
ferring department. Turnover rates vary from one department to another;
hence the focus is upon turnover rate changes. Scheduling or production
problems are often indicated by a dechning turnover rate. For cost control
purposes the downtrend in turnover rates should suggest analysis and
induce corrective action.

Controlling Finished Goods. Accurate sales forecasting is the key to

effective management of finished goods inventories and the abihty to meet
delivery dates to customers. This must be communicated to production
control departments for the development of production schedules to meet
delivery commitments and in turn provide sales managers with the goods
to meet customers' requirements.
In order to meet customer preferences and competition, many product
fines feature a growing array of colors, sizes, and optional equipment.
This results in added inventory items, more work in process inventory and
finished subassemblies, and the need for tighter control.

Control of Obsolete and Surplus Inventory. Almost every organization

is faced with the problem of surplus and obsolete inventory at one time or
other. Whatever the many possible reasons for such conditions may be,
some action is required to reduce or efiminate these items from inventory
and free the related capital. To accomplish a reduction, management
should first make certain that the buildup will not continue due to present
ordering policies and, second, take steps to dispose of stock. Accurate
perpetual inventory records showing acquisition and issue quantities and
dates, as well as periodic review of the records are necessary to identify
obsolete and surplus items. Obsolete inventory usually results from chang-
ing a design or dropping a product. Prompt sale of the inventory for the
first reasonable offer is usually the best policy.
 .

388 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

m DISCUSSION QUESTIONS
1. An inventory planning and control system is designed to minimize the total
cost of ordering and carrying inventory. Therefore, inventory control is good
as long as the investment in inventory is declining. Discuss.
2. Is general management concerned primarily with unit control or financial
control of inventory?
3. What data is needed in order to exercise effective management of materials
costs and inventories?
4. What are some of the costs of not carrying enough inventory? How can
these costs be measured ?
5. What factors are used to determine the inventory level at which an order
should be placed ?
6. It isgenerally true that production and inventory management can be no
better than the sales forecast. Name some techniques used to forecast sales.
7. In what situation are selective control, automatic control, and bin control
of materials effective ?
8. What are the principal differences in commonly used control plans?
9. The control of materials must meet two opposing needs. What are they?
10. The principle of exception should be utilized fully for effective materials
control. Explain.
1 1 What difference does it make whether an annual requirement of 720 units

costing $50 each is ordered weekly, monthly, quarterly, twice a year, or

once a year ?
12. Several factors influence the location and arrangement of materials in a
storeroom or warehouse. What factor(s) are regarded as most important?
13. What is the key to controlling finished goods inventory in a manufacturing
company?
14. Expected annual usage of a particular raw material is 2,000,000 units, and
the economic order quantity is 10,000 units. The invoice cost of each unit
is $500, and the cost to place one purchase order is $80. For each of the
following sentences, select the correct answer based on the above data:
(a) The average inventory is (1) 1,000,000 units; (2) 5,000 units; (3) 10,000
units: (4) 7,500 units.
(b) The estimated annual order cost is (1) $16,000; (2) $100,000; (3) $32,000;
(4) $50,000.
(AICPA adapted)

15. A sales office of Helms, Inc. has developed the following probabihties for
daily sales of a perishable product.

Daily Sales
Units Probabilities

100 .2
150 .5
200 .2
250 .1

Total 1.0
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 389

The productis restocked at the start of each day. If the company de-
siresa 90% probabihty of satisfying sales demand, the initial stock balance
for each day should be (a) 250; (b) 160; (c) 200; (d) 150.
(AICPA adapted)

16. Leslie Company has developed an inventory model for Product A and needs
a solution for minimizing total annual inventory costs. Included in Product
A's inventory costs are the costs of holding, ordering and receiving, and
incurring stockouts. Select the answer that would best complete the fol-
lowing sentence: The solution for minimizing inventory costs would state
(a) at what inventory level to reorder and how many units to reorder; (b)
either at what inventory level to reorder or how many units to reorder;
(c) how many units to reorder but not at what inventory level to reorder;
(d) at what inventory level to reorder but not how many units to reorder.
(AICPA adapted)

17. Inventories usually are an important asset for both manufacturing and
merchandising firms. A
proper balance of inventory quantities is desirable
from several standpoints. Maintaining such a balance is dependent upon
a number of factors including ordering at the proper time and in the
correct lot size. Serious penalties may attend both overstocking and stockout
situations.

(a) In connection with inventory ordering and control, certain terms are
basic. Explain each of the following: (1) economic order quantity,
(2) order point, (3) lead time, and (4) safety stock.
(b) (1) What are the costs of carrying inventories? Explain.
(2) How does overstocking add to the cost of carrying inventories?
(c) (1) What are the consequences of maintaining minimal or inadequate
inventory levels?
(2) What are the difficulties of measuring precisely the costs asso-
ciated with understocking?
(d) Discuss the propriety of including carrying costs (of normal inventory,
overstocking, and understocking) in the inventory cost: (1) for external
reporting and (2) for internal decision making.
(AICPA adapted)

EXERCISES
1. Usage Forecast and Inventory Balances. On October 5, the materials analyst
of Endicott Corp. is asked to determine the number of units of Material No.
1776 to purchase for December delivery. She has reviewed production schedules
and calculates 360 units of the material will be needed for October production,
320 units in November, and 300 units for December production. The lead time
to process an order and receive delivery on this material is two months, and a
safety stock of approximately two weeks' supply is maintained based on an
average monthly usage of 320 units. The inventory card shows an October 5
balance of 180 units with 300 units on order for October delivery and 340 units
on order for November delivery.

Required: (1) A schedule showing the quantity to order for delivery during
December.
 :

390 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

(2) If the planned usage between October 5 and December 31 occurs as

scheduled and outstanding orders are received on expected delivery dates, the
number of units on hand on (a) November 1 (b) December 1 (c) December 31.
; ;

2. Use of EOQ Formula. Shields, Inc. has an annual usage of 100 units of
Item M
with a purchase price of $55 per unit. The following data are applicable
to Item M
Ordering costs $5 per order
Carrying cost percentage 1 5%
Required: The economic order quantity (EOQ).

3. Cost Saving Using EOQ

Table. The Branden Company estimates that 36,000
ring binders will be needed next year to service clients. Heretofore, binders have
been ordered as needed, a procedure which has not proved satisfactory. The
cost of binders ordered in 100-unit lots or more is $1.25 each. The Cost De-
partment estimates a cost of $5.60 to place and process an order. Further
calculations indicate that it costs about 12% of average inventory cost to carry
the inventory. The Purchasing Department believes that the practical limits for
ordering binders would be a maximum of 45 and a minimum of 10 orders a year.
Required: (1) A table indicating themost economical order quantity.
(2) The difference in the most economical order quantity if the carrying cost
is 20% of average inventory.

4. Use of EOQ Formula. From the tabular presentation made in solving

Exercise 3,management of the Branden Company concedes that order quantities
should be somewhere in the range of 1,500 to 1,800 binders, thus requiring some
20 to 24 orders per year. However, the feeling is expressed that there should be
a more direct and accurate way to determine the most economical order quantity.
Required: (1) The economic order quantity and the frequency of orders,
using the EOQ formula.
(2) Explain whether the increased accuracy through use of the formula seems
justified.

5. Determining Optimum Size of Production Run. A

customer has been ordering
5,000 special design metal columns at the rate of 1,000 per order during the past
year. The production cost is $12 a unit —
$8 for materials and labor and $4
overhead cost. It costs $1,500 to set up for one run of 1,000 columns, and in-
ventory carrying cost is 20%. Since this customer may buy at least 5,000 columns
this year, the company would like to avoid making five different production runs.

Required: The most economic production run.

6. Cost Resulting from Inability to Use EOQ. The Electro Company manu-
factures some of its product lines from raw materials to finished units, and for
other products assembles purchased parts. For one product annual purchase of
10,000 subassembled parts at $100 each is being experienced. Per order and
receiving cost is $200, and the carrying cost is 25%.
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 391

This is only one of many inventory items the firm must carry, and a capital
rationing decision has been made to spend only $10,000 at a time on these sub-
assemblies. Units must be ordered in multiples of 100.

Required: (1) Computation of the EOQ.

(2) By changing the EOQ and inventory level to the availability of capital,
the "opportunity loss" expressed as carrying cost.
(American Production and Inventory Control Society adapted)

7. ABC Plan of Control. Manitoba Industries, Inc. is considering a system of

selective control of materials using the following data:

Materials
392 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

PROBLEMS
13-1. EOQ
Formula and Safety Stock. Robney Company sells a number of
products to many restaurants in the area. One product is a special meat cutter
with a disposable blade. Blades are sold in a package of 12 blades at $20 per
package. It has been determined that the demand for the replacement blades
is at a constant rate of 2,000 packages per month. The packages cost the
Robney Company $10 each from the manufacturer and require a three-day
lead time from date of order to date of delivery. The ordering cost is $1.20 per
order, and the carrying cost is 10% per annum. The Robney Company uses
the economic order quantity formula.

Required: (1) The economic order quantity.

The number of orders needed per year.
(2)
The total cost of buying and carrying blades for the year.
(3)

(4) Assuming there is no reserve (e.g., safety stock) and that the present
inventory level is 200 packages, when should the next order be placed? (Use
360 days = 1 year.)
Discuss the problems that most firms would have in attempting to apply
(5)
the EOQ formula to their inventory problems.
(NAA adapted)

13-2. Cost Saving by Use of EOQ. The Howe Construction Company has
been buying a given item in lots of 1,200 units which is a six months' supply.
The cost per unit is $12; order cost is $8 per order; and carrying cost is 25%.

Required: The savings per year by buying in economical lot quantities.

13-3. Establishing Safety Stock. The Arrow Products Company has been
experiencing stockouts on one of its important materials, even though deliveries
are dependable within one month from the date of an order. Management asks
that a safety stock for this item be established and provides the following record
of actual and forecast usage during the past nine months.

Month Usage Forecast Month Usage Forecast

January 475 490 June 520 510
February 480 490 July 500 510
March 490 475 August 490 510
April 500 485 September 485 500
May 510 500

It is believed that a 97.5 percent protection against a stockout is adequate.

Required: (1) A schedule showing the safety stock required.

(2) The safety stock required if the normal lead time is two months.

13-4.Economic Lot Size —

EOQ Formula. The Production Control Depart-
ment of the Texas Manufacturing Company wishes to establish economic lot
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING 4 CONTROL 393

sizes in units for different items of materials. The Cost Department has deter-
mined the unit cost, ordering cost, and carrying cost and has made the data
available in this form:
394 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Materials cost of one important manufactured product is $12 per unit; sales
average 100 units per month; and one month from order date to receipt of
materials can be expected. Calculations show that variable costs of placing an
order and handling the incoming shipment total $50, and the cost of holding
units in stock is 25% of the average inventory.

Required: (1) The most economic order quantity.

(2) The order point.
(3) A graphic presentation of materials management.

13-7. Establishing Safety Stock. With the knowledge of Titan's "average"

usage of 100 units per month and the expected lead time of one month, addi-
tional information reveals that lead time has begun to vary between one and
two months, and the Marketing Department provides the following schedule of
forecast and actual sales for the past eight months:

Month Forecast

May
June
July
August
September
October
November
December

A
stockout would close the production line for this product, and failure to
make delivery on schedule would result in dissatisfied customers. 99.5% protec-
tion against a stockout seems justified.
CH. 13 QUANTITATIVE MODELS FOR MATERIALS PLANNING & CONTROL 395

air freight in five working days at an extra cost of $52 per gross. stockout A
(complete exhaustion of the inventory) of Komtronics would stop production,
and Komtron would purchase Komtronics locally at list price rather than shut
down the plant.

(e) The cost of placing an order is $10; the cost of receiving an order is $20.

(f) Space storage cost, insurance, and taxes are approximately 16.8% of the net
delivered cost of average inventory; and Komtron expects a return of at least
8% on its average inventory investment. (Ignore rate of return on investment
in order and carrying cost, for simplicity.)

Required: (1) A schedule computing the total annual cost of Komtronics

based on uniform order lot sizes of one, two, three, four, five, and six gross of
Komtronics. The schedule should show the total annual cost according to each
lot size. From the schedule, indicate the economic order quantity (economic
lot size to order).

(2) The economic order quantity by use of the EOQ formula.

(3) A schedule computing the minimum stock reorder point for Komtronics.
This is the point below which the Komtronics inventory should not fall without
reordering so as to guard against a stockout. Factors to be considered include
average lead-period usage and safety stock requirements.
(4) A schedule computing the cost of a stockout of
Komtronics. Factors to
be considered include the excess costs for local purchases and for rush orders.
Assume no komtronics are on order at the time the stockout occurs, and that
rush orders are one gross per order.
(AICPA adapted)

CASES
A. Improving Materials Control Procedures. A small company manufacturing
various commodities for stock, and to a lesser extent for special orders, is faced
with difficulties in its control of raw materials.
Under the present system materials are requested from the storekeeper by
production foremen according to their work needs. Materials requisitions signed
by a foreman and identifying the production or lot number to which they relate
are used. The purchasing agent, who is also office manager, orders regular stock
items upon notice of the materials ledger clerk that a particular item has reached
the reorder point. Incoming materials are checked in by the storekeeper who
prepares a daily report of materials received.
One of the major difficulties has been coordinating purchasing with account-
ing. In addition to the purchasing agent, the plant superintendent and some of
the foremen are free to order, especially when supplies and parts are needed
which are not regularly carried in the storeroom. As a result of purchases being
made by the superintendent and foremen, frequently no document for the order
is available when a vendor's invoice is received. When goods do not meet speci-
fications, the person upon whose request the goods were ordered proceeds to
return the goods to the vendor; and, generally, the Accounting Department is
not notified. Sometimes a remittance in payment for a vendor's bill is made for
goods which have been returned.

Required: Comments on the basic difficulties in the company's control pro-

cedures, and recommended corrective measures.
396 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

B. Inventory Control. Kutlery Knives, Inc. produces various types of kitchen

knives. The blades and handles are purchased already processed, and Kutlery
Knives, Inc. merely assembles the two parts by riveting the handles. Customers
of the business are large retail stores ordering large quantities of specific types
of knives.
While there is always a quantity of finished knives on hand, production is
scheduled to fill orders received rather than for stock.
In addition to supplies of handles, blades, and rivets, the company maintains
at all times a small inventory of supplies and parts necessary for the upkeep of
the machinery. Continuous inventory records are not maintained.
At the end of every month the foreman of the factory supervises the counting
of blades, handles, and rivets. A
listing of these items is given to the accountant
who, by comparison with the inventory at the end of the previous month and
purchases during the month, calculates the quantities of blades, handles, and
rivets used during the month.
The blades, rivets, and handles on hand are valued at the last purchase price;
and an entry is put through the books debiting Work in Process and crediting
Materials with the amount required to reduce the materials account to the value
of inventory on hand.
The management is suspicious that the workers are either being very wasteful
or are pilfering substantial quantities of blades and handles. They also feel
that too much time is lost each month taking inventory and that some better
method of determining cost of materials used can be developed.

Required: A
system of accounting for inventories and for the quantities
and costs of materials used which will satisfy the objections of management,
explaining how the new system would eliminate the weaknesses of the present
system.

(CICA adapted)

C. Economic Order Quantity ; Inventory Control. LASI Automobile Supply, Inc.

is both a retail and wholesale auto supply business, selling engine repair parts
and a line of accessories. The company also operates a paint and body shop and
installs mufflers, shock absorbers, and tail pipes.
Six months ago LASI was contacted by a national manufacturer of auto-
motive glass about the possibility of becoming an area wholesale distributor of
curved windshields. The distributorship was accepted primarily to supply area
garages, but soon windshield replacement became a feature of the body shop.
Deciding between weekly and monthly ordering of windshields, the com-
pany's CPA obtained the following information:

(a) Insurance, storage, and handling costs of the windshields are estimated at $432
per year.
(b) LASI should sell about 300 windshields per month, combining installations in
their own shop and sales to repair shops.
(c) LASI is $45 each.
Delivered price of the windshields to
(d) An agreement between the manufacturer and LASI requires an average in-
ventory of 60 units.
(e) Cost of placing an order is $15.

Required: (1) Advice on the quantity and frequency of orders.

(2) Recommended procedure for controlling the inventory to assure ordering
only those windshields needed to replace the models sold.
 CHAPTER 14

CONTROLLING AND
ACCOUNTING FOR
LABOR COSTS

Labor cost represents the human contribution to production and is an

important cost factor requiring constant measurement, control, and anal-
ysis. The economic advantage of increased production at lower unit costs,

along with rising wage rates and ever-increasing fringe benefits, have accel-
erated the trend toward greater use of automatic equipment to produce
more goods in fewer labor hours. Changes in the utiHzation of a labor
force often require changes in methods of compensating labor, followed
by changes in accounting for labor costs.
All wage payments are, in the last analysis, directly or indirectly based
on and limited by the productivity and skill of the worker. Therefore,
proper motivation, control, and accounting for this human cost factor is
one of the most influential problems in the management of an enterprise.
A cooperative and enthusiastic labor force, loyal to the company and its
policies, can contribute greatly toward efficient, low-cost operations. Labor
costing is only one element in good employer-employee relations. Ade-
quate records, easily understood and readily available, constitute an im-
portant factor in harmonious relations between management, employees,
labor unions, government agencies, and the general public.

BASIS FOR LABOR COST CONTROL

Labor cost control is based on pertinent and timely information trans-
mitted to management. Top executives are often primarily interested in
397
398 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

the ratio of labor costs to total costs and in changes in the labor cost ratio.
A plant superintendent needs to know by depart-
details of labor costs
ments, product by direct and indirect workers, and by jobs or
lines,

processes. Shop foremen need similar detailed information applicable to

their jurisdiction.
Cost control is often described as an attitude or state of mind as much
as an activity. Labor cost control begins with an adequate production
planning schedule supported by man-hour requirements and accom-
panying labor costs, determined well in advance of production runs. In
most manufacturing plants it is usually possible to establish a reasonably
accurate ratio of direct labor hours and number of employees to dollar
sales by product lines, and, by relating this ratio to the sales forecast, to
predict future labor requirements. The relationship between sales volume
and personnel needs is perhaps more direct and predictable in wholesale,
retail, financial, and service enterprises. Effective labor cost control is

achieved through (1) production planning, (2) use of labor budgets and
labor time and wage standards, (3) labor performance reports, and (4) ap-
propriate payment for labor performance including wage incentive systems.

PRODUCTIVITY AND EFFICIENCY MEASUREMENT AND

LABOR COSTS
Control of labor costs requires a standard of performance to measure
the productivity and efficiency of the work performed and to appraise the
differences between expectation and accomplishment.
Productivity may be defined as the measurement of production per-
formance using the expenditure of human effort as a yardstick. Perhaps
productivity could also be described as the efficiency with which resources
are converted into commodities and /or services that people want. Or
one could ask: "How productive (in units) and how efficient (cost-wise)
were plant operations during the past period ?"i Greater productivity can
be achieved by better processes, improved or modern equipment, or any
other factor that improves the utilization of manpower. The objective of
productivity measurement is to provide management with a concise and
accurate index for the comparison of actual results with a standard of
performance. Productivity measurement should recognize the individual
contribution of factors such as men (including management), plant and
equipment used in production, products and services utilized in produc-
tion, capital invested, and government services utilized (as indicated by

iprank W. Kolmin and Michael J. Cerullo, "Measuring Productivity and Efficiency," Man-
agement Accounting, Vol. LV, No. 5, p. 32.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 399

taxes). However, in many productivity statistics, particularly those devel-

oped by the Bureau of Labor Statistics of the U. S. Department of Labor,
the measurement takes into account only one element of input —
labor.
It ignores such essential factors as capital and land, thereby assigning the

credit or cause of changes in productive efficiency solely to the labor in-

put factor.
At measurement ratios are crude statistical
their best, productivity
devices.The most generally utilized measurement has been physical out-
put per man-hour —
a term considered more descriptive than labor
productivity.

The Importance of Measuring Productivity and Efficiency. In today's

economy the need for more and better goods at the lowest possible cost
requires greater productivity per man-hour. This does not mean that
workers will have to work harder physically, but that management and
labor should employ ingenuity and inventive ability to develop methods,
machines, and products that will reduce the number of man-hours re-
quired to make a product. This requirement leads to an answer to the
question: "What is a fair day's (or a standard day's) work?"
In many organizations time studies conducted by industrial engineers
provide the answer to the above question. A "fair day's work" is the
amount of work expected of an individual in return for his base rate or
his guaranteed hourly wage. With an incentive wage system, a worker is
paid in proportion to his output beyond the standard of performance.
Setting a standard of performance is not an easy task, for it is often ac-
companied by serious disputes between management and labor unions.
The pace or speed at which the observed person is working is noted and
referred to as rating or performance rating. The rating factor is applied to
the selected time to obtain a normal time; e.g., the time it should take a
person working at a normal pace to do the job. Allowances are added
for personal time, rest periods, and possible delays. The final result is the
standard time for the job, expressed in minutes per piece or in units to be
produced per hour,

Productivity-Efficiency Ratio. The productivity-efficiency ratio is em-

ployed in connection with the productivity and performance standard to
measure the operating achievement of a machine, an operation, an indi-
vidual, a department, or an entire organization.
Departmental ratios, such as the labor efficiency ratio discussed be-
low, assist in judging the efficiency of department heads and foremen. A
labor efficiency ratio usually expresses the difference between actual hours
worked and standard hours allowed for the work performed. For ex-
ample, if 4,000 hours at $5 an hour is standard and if 4,400 hours are used,
 :

400 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Actual labor hours

then there is an unfavorable labor efficiency •^
ratio :
4,400 ^
Standard labor hours 4,000
110%, which indicates that actual labor hours exceeded the standard
hours by 10%- If the standard cost for 4,000 hours is $20,000, then
107c X $20,000 = $2,000, the dollar amount of the labor efficiency
variance. The relationship can also be expressed as a ratio of standard
Standard labor hours 4,000
labor hours to actual labor hours: ^ 9Q c^
''^
^_
Actual labor hours 4,400
ciency compared with the standard which means that labor productivity
was 91% efficient. If 4,400 actual labor hours at the $5 standard rate per
hour cost $22,000, then 9.1% of $22,000 = $2,000 (approximate due to
rounding) which is the dollar amount of the unfavorable labor efficiency
variance.
The calculation of labor cost variances is discussed in greater detail in
Chapter 19, the first standard cost chapter. At this point it is sufficient to
indicate that, based on the above data and an assumed actual labor rate of
$5.25 per hour, the variance analysis would be

4,400 actual labor hours at $5.25 per hour $23,100

4,400 actual labor hours at $5 per hour 22,000

Labor rate variance (unfavorable) $ 1,100

4,400 actual labor hours at $5 per hour $22,000

4,000 standard labor hours at $5 per hour 20,000

Labor efficiency variance (unfavorable) $ 2,000

Base Rate (or Job Rate). The basic payment for work performed is

called the base rate or job rate. A base rate should be established for each
operation in a plant or and grouped by class of operation. The
office

estabhshment of equitable compensation for the performance of each

occupation and operation in a plant or office is not a simple task. An
equitable wage rate or salary structure requires an analysis, description,
and evaluation of each job within the plant or office. The value of all
jobs must relate to wages and salaries paid for Hke work in the com-
munity and in the industry or business as a whole. Maintaining com-
petitive wage rates and salaries facihtates the acquisition and retention of
quality personnel.

Fringe Costs (or Fringes). Base wages or salaries do not comprise the
entire labor cost picture. Besides the base rate, supplements, sometimes
called fringe costs (or fringes), form a substantial element of labor cost.
Fringe costs — such as PICA tax, unemployment taxes, holiday pay,
vacation pay, overtime premium pay, pension costs, costs of living ad-
justments, etc. — must be added to the base rate in order to arrive at the
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 401

full While these fringe costs are generally included in the fac-
labor cost.
tory overhead rate, they should not and cannot be overlooked in man-
agement's planning and control responsibilities, in decision-making an-
alyses, or as a more specific example in labor-management wage or salary
arbitration sessions. Workers' demands for a lOjii per hour increase in
pay may result in far greater expenditures by the company when related
fringe costs are considered.

LABOR PERFORMANCE REPORTS

Production schedules, performance standards, and labor budgets repre-
sent plans and expectations but effective control of labor efficiency and
;

costsdepends upon meaningful and timely performance reports sent to

foremen and supervisors who are directly responsible for departmental
production. Labor performance reports are designed to compare budgets
and standards with actual results attained, thereby pointing to variances
from planned and expected performance. The departmental direct labor
cost report below and the plant-wide labor cost report, issued weekly or
monthly (page 402), and the daily performance and idle time reports
(page 402) illustrate media used to provide foremen and plant managers
with information needed for effective cost control.
The expected direct labor cost for the week is computed from the
October labor budget for the Cooler Assembly Department on page 407.
For example, in motor assembling the Cooler Assembly Department
produced 600 units of Model No. 625 requiring 1.5 hours of budgeted
labor per unit, 800 units of Model No. 500 with 1.5 hours of budgeted
labor per unit, and 500 units of Model No. 600 with 1.3 hours of budgeted
labor per unit; a total of 2,750 budgeted labor hours @ $6 per hour for a
total of $16,500.
402 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

LABOR COST
REPORT
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 403

(2)departmental performance, and (3) idle time. Physical factors such as

hours are coupled with percentages to improve the effectiveness of these
reports.
The Daily Efficiency Report as illustrated below is designed for and
issued to shop superintendents to help maintain schedules that depend
greatly upon the utmost efficiency of shop personnel. The report shows
actual hours, standard hours, and the percent of efficiency of each group.
404 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

The report is focused on adverse change in performance from the workers'

historical pattern. For example, G. Perez is a highly efficient performer,
but the 81% efficiency rate is out of character for this worker; and man-
agement has an opportunity to take early corrective action if needed.
With daily efficiency performances in computer storage, management
can be provided with monthly or quarterly reports on chronically low
efficiency workers. The following illustration is indicative of the informa-
tion needed to increase effectiveness in manpower utilization and labor cost
control. Even with no knowledge of the situation, a reading of the illustra-
tion suggests that Asbury, Clarke, and probably Varney are not likely to
be satisfactory workers in this department if 75% of the standard rate is

considered minimal. Dettmer and Mayes appear to be new employees

and seem to be improving, while Shaw appears capable of attaining the
desired productivity level but may have difficulty in doing so.

MANPOWER PERFORMANCE REPORT

(Chronically Low Performance) November 30, 19--

Employee
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 405

as fast as prices are forced to curb their spending habits because the prices
of goods and services rise so rapidly.
While production has generally been increasing, resulting in more
available goods and services, costs have risen even faster. Whenever out-
put does not keep pace with costs, unit costs and, therefore, prices — —
go up. Wage increases, often excessive, have been a significant factor in
this wage-price spiral because labor costs form such a large part of total
costs. If prices are to be kept from rising, then wage increases should not
exceed an amount that will cause further increases in unit costs. In recent
years, employment costs —
wages, salaries, and fringes have risen —
more than output or production per man-hour, leading to higher prices
to meet higher unit labor costs. In some cases, labor costs increased when
output per man-hour actually dropped.
To offset or curtail the wage-price spiral requires (1) increased pro-
ductivity reflected in lower prices rather than higher wages, so that every-
one may wages held at a level that will not cause higher labor
benefit ; (2)

cost per unit of product and (3) governmental reduction in deficit financing.
;

ORGANIZATION FOR LABOR COST CONTROL

achieve labor cost control, other departments and functions besides
To
the accounting department are involved, such as personnel, time and
motion study, production planning, budgeting, and timekeeping. In fact,
the entire control process begins with the design of the product and con-
tinues as a cooperative activity until the product is sold.

Personnel Department. The chief function of a personnel department

is to provide an efficient labor force. In a general way, this department is

responsible for seeing that an entire organization follows good personnel

policies but very little of the real personnel work is done by employees
—
;

of the personnel department. Personnel relations are personal relations

between department heads and their subordinates, between foremen and
workers, and among all employees.
Personnel functions, dealing with the human resources of the organiza-
tion, involve recruiting and employment procedures, training programs,
job descriptions, job evaluations, and time and motion studies. Hiring
of employees may be for replacement or for expansion. Replacement
hiring starts with a labor requisition sent to the personnel department by
a department head or foreman. If the original vacancy is for one of the
better jobs, that job will usually be filled by promotion; and the replace-
ment requisition will be for the job which is finally vacant. Expansion
hiring requires authorization by executive management. Authority to
hire results from approval of the manpower requirements of a production
 . : :

406 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

schedule rather than from separate requisitions to fill individual jobs.

The personnel department, in conjunction with department heads con-
cerned, plans the expansion requirements and agrees upon promotions
and promotional transfers to be made, the number and kind of workers
to be hired, and the dates at which new recruits will report for work.
Recruitment, interviewing, testing, physical examinations, induction
procedures, and assignment to jobs are carried out by the personnel
department.
Employment must not only comply with regulations set forth
practices
at the federal level Employment Opportunity Commission;
(i.e., the Equal
the Department of Health, Education, and Welfare; and the Department
of Labor) but also with regulations of a Human Rights Commission in
several of the states.

Production Planning Department. A production planning department

is responsible for the scheduling of work, the release of job orders to the
producing departments, and the dispatching of work in the factory. The
release of orders is generally accompanied by materials requisitions and
labor time tickets that indicate the operations to be performed on the
product. and understandable listing of detailed operations is
Specific
important if work
to be performed within the time allowed and with
is

the materials provided. Delays caused by lack of materials, machine

breakdowns, or need for additional instructions give rise to complaints
by the workers and lead to additional labor costs. Production schedules
prepared several weeks in advance, utiUzing labor time standards for each
producing department, lead to cost control through the use of depart-
mental labor budgets similar to the illustration on the next page.

PROCEDURES FOR LABOR COSTING

The above-mentioned activities lay the groundwork necessary to ac-
count for and control labor costs. The accounting for wages and salaries
requires the work of the
1 Timekeeping department —
gathers and collects total and specific time
worked on a job, product, process, or in a department.
2. Payroll department —
determines the gross and net amount of earnings
of each worker, computes the total payroll, and keeps earnings records
for each employee.
3. Cost department —
charges jobs, products, processes, or departments
with the cost applicable as evidenced by the payroll distribution.

In detail, labor costing procedures involve

1. The employment history of each worker —
date hired, wage rate, initial
assignment, promotions, tardiness, sickness, and vacations.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 407

tp
LABOR BUDGET
Department Cooler Assembly For October, 19--

Prepared September 10, 19--

Model No.
or
408 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

The accounting principles, procedures, and objectives in labor costing

are relatively simple, although considerable difficulty in their application

may be experienced with large numbers of workers or where workers shift

from one type of work to another under various factory conditions.
Basically, two sets of underlying detailed records are kept, one for financial
accounting and the other for cost accounting. The procedures for labor
accounting are outlined in the parallel presentation below. The journal
entries associated with these procedures, as well as those pertaining to
labor-related costs, are discussed and illustrated in the next chapter.

FINANCIAL ACCOUNTING COST ACCOUNTING

A record is kept of thetotal time worked A record is kept of the time worked on
and the total amount earned by each each job, process, or department by
worker. each worker and the cost thereof.

The daily or weekly amount earned by The direct labor hours and cost are en-
each worker is entered on the payroll tered on the respective job sheets or
book. production reports; the indirect labor
cost is entered in the proper column of
the departmental expense analysis
sheets or standing orders.

Each payroll period the total amount of The weekly or month-end entry for labor
wages paid to workers results in the distribution is:

following entry:
Payroll xxx Work in Process xxx
Income Tax Withheld xxx Factory Overhead Control.. xxx
PICA Tax Payable xxx Indirect Labor xxx
Accounts Payable Payroll xxx
or Cash xxx

Labor Accounting Procedures

Timekeeping Department. Securing an accurate record of the time

purchased from each employee is the first step in labor costing. To do so,
it is necessary to provide by means of a:

1. Clock card unquestionable evidence of the employee's presence in the

plant from the time of entry to departure.

2. Job ticket (or time ticket) information as to the type of work performed
while the employee is in the plant.

Both forms are supervised, controlled, and collected by the time-

keeping department. As the earnings of the employee depend mainly
upon these two forms and as the timekeeper processes them in the first
step toward final payment, the timekeeping department forms a most
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 409

valuable link in harmonious labor-management relationships. In fact, to

many a worker, the timekeeper is management. Frequently it is the time-
keeper's performance of his duties that is the basis for a worker's first

opinion of the company.

Clock Card. A clock card pro-

vides space for the name and number
of the employee and usually covers
an entire payroll period. When com-
pleted, the clock card shows the time
a worker started and stopped work
each day or shift of the payroll period,
with overtime and other premium
hours clearly indicated.
The time clock (or time recorder)
is a modern mechanical instrument

for recording employee time in and

out of the office and the factory. Un-
der a typical procedure, each em-
ployee is assigned a clock number that
identifies the department and the em-
ployee. The clock number is used for
identification on the payroll and in
charging labor time to departments
and production orders. Usually time-
keepers are stationed near the clocks
during change of shifts to expedite
smooth and rapid movement in and
out of the plant and to insure proper
clock card procedures.
In small plants a time clock may
not be used. In such cases it is customary to provide a board or rack near
the entrance where each worker has a card, or in some cases a metal disk,
that carries his name and identification number. Upon entering the plant,
the worker removes his card or disk from the rack or board and places it
on a smaller rack or board in the department where he works. Time-
keepers, or in many cases the foremen, check each department, record the
names of those present on a payroll sheet, and return the cards or disks
to the entrance way to be available for the next work period. While such
a method of labor cost recording seems less exact than the clock card
procedure, reliance must be placed on the timekeeper or the foreman to
secure accurate records.
 :

410 PLANNING AND CONTROL OF MATERIALS AND LABOR PART iV

Time Ticket (or qate S/jI// — JOB TICKET

Job Ticket). In ac-
EMPLOYEE'S
counting for ma- NAME Tf/dA^U^ Jyd^Sd^ SHIFT A^
terials, the receiving TIME STAFITED TIME STOPPED CHARGE
RGE ACCOUNT
Al NUMBER

sheet and the invoice 8 00 /Z: 00 J<i/

HRS. WORKED DESCRIPTION OF WORK
are evidence that the
/~$.4o yO<^
'yi/7Ujf
goods have been re- OVERTIME HRS. OVERTIME EARN, PIECE NO. OR JOB

ceived and payment

TOTAL EARNINGS PIECES COMPLETED OPERATION NO.
therefore
In
is

accounting
in order.
for
3.8S /4
FOREMAN'S APPROVAL

ek)V
^
labor, the clock card
is evidence that time
Job Ticket
has been purchased
and is comparable to the receiving sheet. The time ticket {or job ticket)
shows the specific use that has been made of the time purchased and is
comparable to the materials requisition.
When the individual time ticket is used, a new ticket must be made out
for each job worked on during the day. As this procedure leads to many
tickets per employee, some plants use a daily time report on which the
worker lists his jobs.
The best procedure for filling in the time or job tickets depends upon
many factors peculiar to shop operations. In some factories, where little
time is consumed and the work permits ready access to the forms, the
workers prepare their own time tickets. In other factories, timekeepers,
dispatch clerks, and foremen have desks near the work stations. Employees
report to the timekeeper when changing jobs, get a new assignment from
the dispatch clerk, secure instructions at the foreman's desk, get the re-
quired tools at the tool crib, and thus shift from one job to another with
a minimum of time and effort. Under a wage incentive plan, time tickets
form the basis for calculating bonuses. When
wages are based on hours
worked, the time tickets provide a means of auditing the clock cards and
a source of data concerning efficient utiHzation of labor.
Each day, usually after the morning shift has clocked in, the time-
keeper collects all the time tickets or the daily time reports of the pre-
vious day together with the clock cards. The total time reported on the
time tickets for each employee is compared with the total hours of his
clock card. If there is any difference, an adjustment is made as follows
If the clock card shows more hours than the time tickets, the difference
is reported as idle time. If the time tickets show more hours than the
clock card, the error is corrected in consultation with the foreman and
the worker. The time tickets are sent daily to the payroll department.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 411

The degree of accuracy in reporting time varies from plant to plant,

but in most situations a report to the exact minute is neither necessary nor

practical. Many companies find it advantageous to use a decimal system,

measuring the hour in ten periods of six minutes each rather than the
regular clock interval of five-minute periods and twelve periods per hour.
Computation of time in terms of tenths of an hour is much faster than
computation of time in minutes or in twelfths of an hour. On a decimal
system, a job started at 9:23 a.m. and finished at 11:38 a.m. would be
reported as 9.4 and 1 1.6 with an elapsed time of 2.2 hours.

Payroll Department. Preparation of the company's payroll from clock

cards, time tickets, or time sheets done by the payroll department.
is

The work, procedures, and functions of this department depend upon the
size and complexity of a company. Some companies require only a simple
payroll department staffed by one or two payroll clerks who perform the
work manually; others require an elaborate payroll department with many
employees and computerized procedures. In any case, the payroll de-
partment is responsible for the important task of recording the job clas-
sification, department, and wage rate for each employee. It records hours
worked and wages earned, makes payroll deductions, determines the net
amount due each employee, maintains a permanent earnings record for
each employee, and prepares the paycheck, or provides the cashier's or
treasurer's office with the necessary records to make the payments.
The work of the payroll department follows two basic steps: (1) com-
putation of the payroll and (2) distribution of the payroll to jobs, pro-
cesses, and departments.
The computed payroll may be recorded in a payroll journal, pay-
final

or payroll sheet. The record may be a bound

roll record, payroll report,

book with sheets ruled for the special needs of a company; it may be a
loose-leaf book, cards, or sheets for filing; or it may be produced on
sheets or rolls through the use of payroll machines or computerized
methods. A record of individual employee earnings and deductions must
also be maintained. Practically all large enterprises and many smaller ones
use a computerized system for payroll preparation.

Payroll Payments. If the number of employees is not large, all workers

are usually paid on the same day, which may be weekly, semimonthly, or
monthly. Some companies stagger the payroll during the week in order
to give an even flow to the work of the payroll department. If workers
are paid in cash, it is necessary to transport the payroll cash from a bank
to the payroll office, to prepare pay envelopes for each worker, and to
arrange them alphabetically or by clock number for distribution to the
employees.
412 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

In most instances employees are paid by check. Payroll checks may be

drawn against the regular checking account, or a special payroll deposit
may be used. The special payroll bank account is especially advantageous
with large numbers of workers. If a payroll fund is deposited in the bank,
the payroll department certifies the amount required for a particular pay-
ment date, a voucher is drawn for the specified amount, and a check is

drawn against the regular deposit account and is deposited in the payroll
fund. By utilizing this procedure, only one check, drawn on the general
bank account, appears in the cash payments journal each payroll period.
The paymaster prepares checks for each employee each drawn — against
the special payroll account. When machine methods are used for payroll
accounting, the payroll journal, the checks, the check register, and the
employee's earnings record are commonly prepared in one simultaneous
operation.

Payroll Distribution. The individual job ticket or daily time report

show the use made of the time purchased from each factory employee.
The tickets for each employee must agree with his total earnings for the
week. Time tickets are sorted by jobs, departments, and types of indirect
labor to permit the distribution of the total payroll to Work in Process and
to the various indirect labor accounts or to the departmental expense
analysis sheets controlled by Factory Overhead Control. Distribution of
the payroll is speeded up when automated methods are used. If the pay-
roll department does not prepare the distribution summary, the job
tickets are sent to the cost department, which must perform this task.
Labor costs distributed to jobs, processes, or departments must agree with
the total amount recorded in the payroll account. Often the distribution
summary also shows the labor hours when they are the basis for the appli-
cation of factory overhead.

Cost Department. On the basis of the labor distribution summary

or the time tickets, the cost department records the direct labor cost
on the appropriate cost sheets or production reports, and indirect costs
on the departmental expense analysis sheets. In some factories cost ac-
counting activities are decentralized, and cost work becomes largely a
matter of organization and direction in carrying out a system for recording
payroll information and labor costs. In such a supervisory capacity, cost
clerks may be stationed in producing departments to assist in accumulating
and classifying labor costs, using the summarized time tickets to compute
production costs and services by job orders, units of output, departmental
operations, and product types. In other factories the cost department may
be highly centralized and may not direct and control any timekeeping or
payroll preparation.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 413

PERSONNEL
414 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 415

guaranteed annual wages. Because all wages are paid for work performed,

an element of incentive is present in all wage plans. In contrast with pay

by the hour, week, or month, an incentive wage plan should reward a
worker in direct proportion to his increased output. As stated earlier, a
fair day's work standard should be established so that the worker can
meet and even exceed it, thereby receiving the full benefits from the in-
centive wage plan. At one time incentive wage plans for factory workers
were widely used. Recent studies now show that about half of all large
companies use incentive wage plans for at least some of their work centers.
Union attitudes toward incentive wage plans vary. Some unions oppose
incentive plans while others —
such as those in the textile, shoe, and steel
industries — support them.
Requirements of an Incentive Wage Plan. To be successful, an incentive
wage plan must meet certain requirements: (1) applicability to situations
in which a worker can increase output, (2) provision for proportionately
more pay for output above standard, (3) setting fair standards so that
extra effort will result in bonus pay, and (4) immediate reward every pay-
day. Along with these essentials, the plan needs to be reasonably simple
and understandable to workers as well as to managers.

Purpose of an Incentive Wage Plan. The primary purpose of an in-

centive wage plan is to induce a worker to produce more, to earn a higher
wage, and at the same time to reduce unit costs. The plan seeks to insure
greater output, to increase control over labor cost by insuring more uni-
form unit costs, and to change the basis for reward from hours served to
work accomplished. Naturally, producing more in the same period of
time should result in higher pay for the worker. Because of the greater
number of units produced, it should also result in a lower cost per unit
for fixed factory overhead and labor cost combined.
For example, suppose that a factory operation takes place in a building
that is rented for $1,200 per month (or $40 per day) and that insurance,
taxes, and depreciation amount to $64 per day. Assume further that 10
workers on an 8-hour day are paid $3 per hour and that each worker pro-
duces 40 units of product per day (an individual production rate of 5
units per hour). Now suppose that the workers and the management
agree that a rate of $3.30 per hour will be paid if a worker produces 48
units per day, thereby increasing the hourly output from 5 to 6 units.
The illustration at the top of the next page, reduced to cost per hour
and cost per unit to produce the product, shows how a wage incentive
can reduce unit costs and at the same time provide the worker with a
higher income.
416 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

ORIGINAL SYSTEM, $3 PER HOUR

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 417

Types of Incentive Wage Plans. In actual practice, time wages and

output wages are not clear-cut and distinct. Incentive plans typically in-
volve wage rates based upon various combinations of output and time.
Many wage incentive systems retain the names of industrial engineers and
efficiency experts who originated the plans — the Taylor Differential
Piece Rate Plan, the Halsey Premium
Bedaux Point System, the
Plan, the
Gantt Task and Bonus Plan, and the Emerson Efficiency System. Most
of these plans —
like obsolete machinery are no longer used, but many —
adaptations are still in use.
An employee's earnings are determined by the (1) ratio of a worker's
production to standard production, (2) hourly base rate for the job clas-
sification, and (3) incentive wage plan in use. In order to demonstrate
the operation of incentive wage plans, the straight piecework plan, the
100 percent bonus plan, and the group bonus plan are discussed as repre-
sentative examples.

Straight Piecework Plan. The

straight piecework plan, one of the sim-
plest incentive wage wages above the base rate for production
plans, pays
above the standard. The production standard is computed in minutes
per piece and is then translated into money per piece. If time studies
determine that five minutes is to be the standard time required for pro-
ducing one unit, the standard rate is 12 pieces per hour. If a worker's
base pay rate is $3.72 per hour, the piece rate is $.31. A worker is generally
guaranteed a base pay rate, even if he fails to earn that amount in terms
of output. If a worker's production exceeds 12 pieces per hour, the $.31
per unit still appHes. In the table below, with standard production of 12
pieces per hour and with a guaranteed hourly rate, the labor cost per unit
of output declines until the standard is reached and then remains constant
at any level of output above standard.
 418 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

While piece rates reflect an obvious cause-effect relationship between

output and pay, the incentive is effective only when workers can control
their rates of output. Piece rates would not, of course, be effective where
output is machine-paced. As previously stated, modification of produc-
tion standards and labor rates becomes necessary when increases in out-
put are the result of the installation of new and better machines.

100 Percent Bonus Plan. The 100 percent bonus plan is a variation of
the straight piecework plan. It differs in that standards are never stated
in terms of money, but in time per unit of output. Instead of a price per
piece, a standard time is allowed to complete a job or unit; and the worker
is paid for the standard time at his hourly rate if the job or unit is com-
pleted in standard time or less. Thus if a worker produces 100 units in
an 8-hour and the standard time is 80 units per shift (or 10 units per
shift

hour), he would be paid his hourly rate for 10 hours. In other variations
of the 100 percent bonus plan, savings are shared with the foreman and /or
the company.
A production indicator must be figured for every worker each payroll
period before earnings can be computed. Production standards in units of
output per hour are set by industrial engineers. Hours of work and units
produced are reported to the payroll department where the reported hours
worked are multiplied by the hourly production standard to determine the
standard units. The worker's hourly production is then divided by the
standard quantity resulting in the production indicator, or efficiency ratio.
The efficiency ratio multiplied by the worker's base rate results in the
hourly earnings for the period. below illustrates how earnings
The table
are computed, assuming standard production to be 15 units per hour.

Worker
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 419

Group Bonus Plan. Today industry employs a great variety of incentive

wage plans, some of which depend upon superior productive perfor-
mance of a whole department or an entire factory. Factory operations
often require workers to work as groups or crews using large machines. Al-
though the work of each employee is essential to the machine operation,
it is frequently impossible to separate the work of one individual member

of a crew for incentive purposes. It is impossible for a worker on an assem-

bly line to increase his output without the cooperation of the entire group.
Group bonus plans have proven successful in such situations. Usually,
the bonus earned by the group for production in excess of a quota or stan-
dard is divided among the group members in accordance with their respec-

tive base rates. Group plans reduce the amount of clerical work necessary
to compute labor cost and payrolls and the amount of supervision neces-
sary to operate the incentive system. Group plans may also contribute to
better cooperation among workers, and good workers are likely to bring
pressure to bear upon poor workers who might jeopardize the earning of
the group bonus.
Group bonus plans, like those designed for individual incentive, are
intended to encourage production at rates above a minimum standard.
Each worker in thegroup receives his hourly rate for production up to the
standard output. Units produced in excess of the standard are regarded
as time saved by the group, and each worker is in effect paid a bonus for
time saved as well as being paid for time worked. Group plans quite often
lead to the absence o/ something, such as accidents, spoilage, waste, and
absenteeism. For example, a bonus may be paid to a crew or department
which has not had an accident for a specified period of time, or which has
a reject rate in units of output below a specified ratio.
The following table illustrates the operation of a 100 percent group
bonus plan. A crew of 10 men uses costly equipment, and each man is
paid $5 an hour for a regular 8-hour shift. Standard production is 50
units per hour, or 400 units per shift; overhead is $320 per 8-hour shift,
or $40 per hour.
420 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

General Observations Regarding Incentive Wage Plans. The installa-

tion and successful operation of incentive wage plans require not only the
combined efforts of the personnel department, labor unions, factory en-
gineers, and accountants but also the cooperation and willingness of each
worker. The discussion on wage incentives is:

. .based on the premise that monetary bonuses will, in fact, motivate workers
.

to achieve higher production rates. While this seems a reasonable assumption, the
writing of behavioral scientists and the empirical research that has been carried out
suggest that the relationship between monetary incentives and increased production
is not a simple or unambiguous one. William F. Whyte, a behavioral scientist, notes
in a study of the effect of piecework on productivity, 'It is only in a fraction of the
jobs. .that the piecework proves an incentive to tap the full productive capacities of
.

workers.'^ After describing in detail a number of case situations, he concludes, 'Man-

agement should recognize that financial incentives are both a technical engineering
and a human relations problem. '5 This suggests that management should approach
the design, evaluation, and implementation of such plans with the awareness of their
possible behavioral, as well as economic, implications.^

WAGE INCENTIVE TIME STANDARDS VIA

LEARNING CURVE THEORY
Incentive wage plans assume that monetary bonuses will motivate
workers to achieve higher productivity rates. In turn, the greater the out-
put, the lower the conversion cost per unit. Yet, the previous discussion
also stresses the fact that motivation is not always based on financial
rewards. Furthermore, an incentive wage plan, based on fixed time
standards — no matter how scientifically engineered — often does not
appear to motivate workers. A fixed time standard is best explained by
referring to the 100 percent bonus plan (page 418), in which the standard
is fixed at 80 units per day (or 10 units per hour during an 8-hour shift).

Even with such drawbacks, many current incentive wage plans still use
fixed time standards for rewarding individual performance through bonus
payments. The deficiencies existing in fixed time standards of wage in-
centives have been remedied by means of the learning curve theory.
The learning curve theory stipulates that every time the cumulative
quantity of units produced is doubled, the cumulative average time per
unit is reduced by a given percentage; that is, "the last unit will cost (in

time, hours, or dollars) a given percentage less than the last unit produced
prior to doubling the quantity. If it is assumed that this reduction is 20
percent, it means that the second unit requires 80 percent of the time re-
quired for the first unit; the fourth unit, 80 percent of the second; the
eighth unit, 80 percent of the fourth; and so on. With this theory, the

'William F. Whyte, Money and Motivation (Harper & Bros., 1955), p. 28.
^Ibid., p. 262.
^Frank, op. cit., pp. 159-160.
 7 :

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 421

following table of values for an 80 percent learning curve can be com-

puted, assuming that 10 direct labor hours are required to produce the
first unit:

Unit X Cumulative Average = Estimated Total Time Needed

Number Required Man-Hours per Unit To Perform the Task

1 10.0 10.0 hours

2 8.0 (10.0 hours X 80%) 16.0 hours
4 6.4 (8.0 hours X 80%) 25.6 hours
8 5.1 (6.4 hours X 80%) 40.8 hours
16 4.1 (5.1 hours X 80%) 65.6 hours
32 3.3 (4.1 hours X 80%) 105.6 hours
64 2.6 (3.3 hours X 80%) 166.4 hours
Computations for a Typical 80 Percent Learning Curve

The results indicate that the rate is constant at each doubling of the
accumulated number of times the task is performed. The figures in the
second column are the cumulative average times per unit. To estimate the
total time needed to perform the task the first 32 times, the calculation
would be 32 X 3.3 = 105.6 hours; for the first 64 times, 64 X 2.6 =
166.4 hours; etc.
The 80 percent learning curve is used here for illustrative purposes.
The actual percentage will, of course, depend on the particular situation.
At the extremes, the actual percentage could range from 100 percent (if no
learning occurs; i.e., 100 minutes X 100% = 100 minutes), to 50 percent.
At the latter extreme, if the average accumulated time for the first unit is

100 minutes, then the time for the second unit must equal zero (i.e., 100
minutes X 50% = 50 minutes — accumulated average time per task unit
at the 2 task units level, or a total of 100 minutes for the 2 accumulated
units). Inasmuch as the first unit required 100 minutes, this would mean
that the time for the second unit must be equal to zero

100 + = 50
,^ . . , .

z minutes, average time per task unit

Thus, the 50 percent rate is an upper limit of learning — one that can
never be reached. ^

By means of the learning curve, the time standard or unit standard

used for determining a worker's earnings has now changed to a variable
time instead of the fixed time standard. The variable time standard is

said to meet more equitably the needs of an incentive wage system. "The
improvement phenomenon, as well as its mathematical model, the learning

''James A. Broadston, "Learning Curve Wage Incentives," Management Accounting, Vol.

XLIX, No. 12, pp. 15-23.
8For further discussion of learning curves, see Leonard W. Hein, The Quantitative Approach
to Managerial Decisions (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1967), pp. 90-113.
422 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

curve, provides an insight into human capabiUties that bears directly up-
on the abihty of workers to do work and the time required for them to
learn new skills. An actual learning curve may show small irregularities;
yet it will eventually follow an underlying natural characteristic of group
or individual human activity. "^

As soon worker has passed the learning stage and begins to pro-
as a
duce the expected number of units (i.e., reaches the "standard" profi-
ciency), he will begin to draw bonus pay for doing the operation in less
than standard time. Then the worker may even slow down a little and
yet perform the operation in "standard" time or better, drawing the bonus
pay but working less hard for it.
Government procurement agencies have used the learning curve
theory as a tool for cost evaluation in negotiating prices for contracts.
When a bid on a contract is entered, the unit labor costs are usually esti-
mated. The learning curve theory permits the determination of lot costs
for various stages of production. As production progresses, the average
unit labor cost should decrease.
By comparing the budgeted costs with the experienced labor costs in
the initial stages of production, the trend of the labor costs can be deter-
mined. If, for example, an average labor cost of $20 per unit is to be
achieved, the following output and cost table with 80, 85 and 90 percent
learning curves can be predetermined i^^

^ ,
Cumulative
Learning Curve
Quantity 80% 85^7 90%

25 $61.02 $45.36 $33.22

50 48.82 38.56 30.47
100 39.06 32.78 27.43
200 31.25 27.68 24.69
400 25.00 23.53 22.22
800 20.00 20.00 20.00

Output and Cost Table for 80%, 85%, and 90% Learning Curve

The learning curve theory allows projection of the final average unit
cost at any stage of production. The learning curve also predicts man-
hours with accuracy and reliability, establishes manpower load, and al-
lows production control to take advantage of reducing time per unit by
increasing lot sizes, thereby maintaining a level work force. It further
provides a basis for standard cost variances calculations (see Chapter 19),

9Broadston, op. cit., p. 15.

lOWilliam H. Boren, "Some Applications of the Learning Curve to Government Contracts,"
NAA Bulletin, Vol. XLVI, No. 2, pp. 21-22.
 .

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 423

allows judgment of a manager's performance relative to the department's

target, and finally provides a basis for cost control by analyzing upward
swings of the learning curve.

UNION CONTRACTS
Many possible provisions relative to wages, hours, and working condi-
tions are always present when a labor contract is negotiated. The employer
and employee have a mutual interest in the terms of a contract and a mutual
responsibility for carrying out the agreement.
Inasmuch as the union serves as the employees' representative and
the agreement is signed by both union and company officials, the contract

is hkely to be printed for distribution to all interested parties. Provisions

of a typical contract involve the personnel department in the hiring,
promotion, and dismissal of employees; the payroll department in the
determination of regular wages, premium pay for overtime, holidays,
vacations, night shifts, and premium
bonus payments under incen-
rates or
tive wage plans; and the cost department, since a contract represents the
terms and price of labor to be purchased during the life of a contract. It
is important that managers of these departments become thoroughly

familiar with provisions of the contract and that all procedures in con-
nection with labor accounting be designed and executed in harmony with
its provisions. Grievances leading to stoppages and strikes can be
caused by poorly understood or poorly executed union agreements.
The accounting function is a vital link in harmonious labor-management

relations.

DISCUSSION QUESTIONS
1 Define productivity.

2. What is meant hy performance rating']

3. The subject of inflation has been receiving ever-increasing attention through-

out the nation and the world? Why?

4. All wage payments are ultimately limited by and are usually based, directly
or indirectly, on the productivity of the worker. Is this statement generally
true?

5. The basis for labor cost control is the provision of pertinent and timely
information to management. What kind of information is needed by execu-
tive management as compared with that needed by departmental managers?

6. How can labor efficiency be determined or measured ?

424 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

7. In a highly mechanized or automated plant, direct labor tends to become a

fixed cost. Discuss the validity of this statement.
8. In controlling labor cost, is the primary objective to control labor cost per
hour of work or per unit of output?
9. In what way are the creation and maintenance of an efficient labor force a
cooperative effort ?
10. In accounting for and controlling labor costs, what is the function of:
(a) thetimekeeping department, (b) the payroll department, and (c) the cost
accounting department?
11. What purpose is served by: (a) the clock card; (b) the time ticket?
12. If an employee's clock card shows more time than his time tickets, how is

the difference reconciled ?

13. Accounting for labor has a twofold aspect: financial accounting and cost
accounting. Differentiate between the two.
14. What is the purpose of determining the labor hours: (a) worked by each
employee; (b) worked on each job, or in each department?

15. What is the purpose of an incentive wage plan?

16. Do you consider it necessary to record the time spent by pieceworkers on
their various jobs or operations? Give reasons.
17. Wage incentive plans are successful in plants operating near full capacity.
(a) Discuss the desirability of using these plans during periods of curtailed
production.
(b) Would you advise the installation of an incentive wage plan in a plant
operating at 60% of capacity? Discuss.
18. In most incentive wage plans, does production above standard reduce the
labor cost per unit of output? Discuss.
19. Differentiate between wages based on the straight piecework plan, the 100
percent bonus plan, and the group bonus plan.
20. Because of faulty determination of piecework rates, workers' earnings in a
particular plant have been unduly high. Sales volume and prices are declin-
ing, and it is necessary to reduce production costs. What solution would you
suggest ?
21. State the basic concept underlying the relationship involved in the learning
curve theory.
22. Name some situations for the application of the learning curve theory.
23. It frequently stated that accurate cost accounting is of great value in
is
wage negotiations. How may cost records contribute to settlement of wage
disputes?
24. The management of the Marquette Manufacturing Company established a
key man bonus plan in which a bonus is paid to the foreman, assistant fore-
man, or any other supervisor within a specific department based on net sav-
ings made in the department. The company does not pay out the entire
bonus but pays part in cash and places the remainder in a fund. The fund
acts as a reserve against which negative variances are charged during the
year. At the end of February, the net savings in a certain department for the
month amount to $680. Of these savings, 20% are distributed to the super-
visorystaff. The department employs a foreman and an assistant. The
method of sharing the bonus is on a point scale basis with 100 points assigned
to the foreman and 60 points to his assistant. How much bonus is each
supervisor entitled to receive ?
 :

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 425

25. A factory foreman at Steblecki Corporation discharged an hourly worker

but did not notify the Payroll Department. The foreman then forged the
worker's signature on time cards and work tickets and, when giving out
the payroll checks, diverted the checks drawn for the discharged worker
to his own use. Select the statement that would be the most effective pro-
cedure for preventing this activity:
(a) Require a written authorization for each employee added to or re-
moved from the payroll.
(b) Have a paymaster with no other payroll responsibility than that of
distributing payroll checks.
(c) Have someone other than persons who prepare or distribute the payroll
obtain custody of unclaimed payroll checks.
(d) From time to time, rotate persons distributing the payroll.
(AICPA adapted)

EXERCISES
1.Production Planning and Control Reports. Ferguson Fabricators, Inc., a sup-
plierof bulk metals and alloys, recently negotiated to supply 3,000 sections of
aluminum air conditioning ductwork for an office building under construction.
The order requires fabricating, cutting, and assembly. Based on experience, the
foreman prepared the following daily budget:
Sections Hours
Department Scheduled Budgeted

Fabricating 100 50
Cutting 100 30
Assembly 100 25

Realizing the need for up-to-the-minute production information, the fore-

man obtained these results of the first day's activity:
Sections Hours
Department Produced Required

Fabricating 112 48
Cutting 81 30
Assembly 77 22

The second day's report showed

Sections Hours
Department Produced Required

Fabricating 120 49
Cutting 96 30
Assembly 96 23

Required: (1) Action to be taken by the foreman, based on the first day's
report.
(2) Action needed according to the results on the second day's report.

2. Labor Performance Variances. Ellsworth-Trevor, Inc. prepares monthly

production budgets for its largest selling product, Elsby, which is manufactured
through three departments Mixing, Processing, and Packaging. Budgeted and
:

actual amounts for April were as shown on the next page.

 :

426 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Actual
Budgeted Labor Units
Department Hours Cost Produced

Mixing 1,100 $ 4,312 740

Processing 3,320 12,700 615
Packaging 580 1,744 800

The following standards have been adopted for this product

Standard
Hours Standard Labor
Department per Unit Cost per Hour

Mixing 1.5 . $4.10

Processing 5.0 4.50
Packaging 0.5 4.00

Required: A labor cost control report for April.

3. 100 Percent Bonus Plan. Mary Mullin, employed by the Barnegat Bay Can-
ning Company, submitted the following labor data for the first week in June:
Monday 270 units 8 hours
Tuesday 210 units 8 hours
Wednesday 300 units 8 hours
Thursday 240 units 8 hours
Friday 260 units 8 hours

A schedule showing Mary's daily earnings, the effective hourly

Required:
and the labor cost per unit, assuming a 100 percent bonus plan with a base
rate,
wage of $4 per hour and a standard production rate of 30 units per hour.

4. 100 Percent Bonus Plan. Tronicircuit Corporation produces printed circuits

for the electronics industry. The firm has recently initiated a 100 percent bonus
plan with standard production set at 50 units per hour.
The company employs 10 workers on an 8-hour shift at $5 per hour. Depre-
ciation on plant equipment is $4.50 per hour, and other overhead is applied at
$3.50 per hour.
Production for the first week under the 100 percent bonus plan was:

Monday 3,800 units

Tuesday 4,500 units
Wednesday 4,600 units
Thursday 4,500 units
Friday 4,400 units

Management is interested in appraising the results of the new incentive

wage plan.
Required: A schedule showing employee earnings, unit labor cost, unit over-
head cost, and conversion cost per unit.

5. Incentive Wage Plan. Memorizon Electronics Company, a relatively small

supplier of computer-oriented parts, is currently engaged in producing a new
component for the computer sensory unit.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 427

The company has been producing 150 units per week; fixed factory overhead
was estimated to be $600 per week. The following is a schedule of the pay rates
of three workers properly classified as direct labor:

Employee Hourly Rate

Clancy, D $3.00
Luken, T 4.00
Schott, J 3 50
.

Customers have been calling in for additional units, but management does
not want to work more than 40 hours per week. In order to motivate its workers
to produce more, the company decided to institute an incentive wage plan. The
following schedule describes the plan formulated and started on a trial basis:

Employee Base Rate Incentive Premium

Clancy, D $1.75 $.50 per unit
Luken, T 2.75 $.50 per unit
Schott, J 2.25 $.50 per unit

The
first week the plan was put into operation production increased to 165
units. The shop superintendent studied the results and believed the plan too
costly; production had increased 10%, but labor costs had increased by approxi-
mately 23.2%. He requested permission to redesign the plan to make the labor
cost increases proportionate to the productivity increase.

Required: (1) The approximate dollar value of the 23.2%, labor cost increase.
An opinion, supported by figures, as to whether the shop superintendent
(2)
was correct in assuming that the incentive wage plan was too costly. Discuss
other factor(s) to be considered.

6. Piece Rates with Increased Productivity. Employees of Duwel Power Tools

are paid $4.20 per hour for an 8-hour shift. Currently, production has been 3
units per hour per worker. A
management consultant team has proposed the
following piece rate incentive plan.

(a) $1.40 per unit up to 27 units per 8-hour day

(b) $1.44 per unit from 27 through 29 units per day, for all units
(c) $1.48 per unit from 30 through 32 units per day, for all units
(d) $1.51 per unit from 33 through 36 units per day, for all units
(e) $1,535 per unit for 37 units and above, for all units

Overhead consists almost entirely of depreciation, taxes, and insurance. Con-

sequently, it is assumed that the current overhead rate of $5.50 per labor hour
will remain constant.

Required: (1) An analysis of the proposal showing unit conversion cost for
production of 24, 27, 30, 33, and 37 units.
(2) An opinion as to whether or not (a) management and (b) employees
would be receptive to such a plan.

7. Cost of Training Program to Upgrade Workers' Productivity. Pocahontas

Products, Inc. employs 40 machine operators for the same type of work. The
428 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

average output per employee is 48 good units per hour with two rejects per hour
per worker. The last efficiency report shows 50% of the operators averaged
only 40 good units an hour with three rejects, while the other 50% averaged 55
good units per hour with one reject. The piece rate is $.15 each for good units.
Repairing rejects costs $.25 each.
The job is a one-man, one-machine operation. The depreciation cost of each
machine is $1,000 a year, and the variable cost of operating one machine is $.20
an hour. Fixed factory overhead other than depreciation is $4 per machine hour.
The plant operates 2,000 hours a year, or 250 days.

Required: Assuming that product demand increases, the amount the com-
pany can afford to pay for a training program which would upgrade the 20
poorer workers to equal the average production of the better operators.

8. Learning Curves and Production Costs. A

company's new process will be
carried out in one department. The production process has an expected learn-
ing curve of 80 percent. The costs subject to the learning effect for the first
batch produced by the process were $10,000.

Required: Using the simplest form of learning function, the cumulative

average cost per batch subject to the learning effect after the 16th batch has
been produced.
(AICPA adapted)

PROBLEMS
14-1. Planning Manpower and Labor Costs. Virontrol, Inc. is a relatively new
company in the environmental control industry and is experiencing tremendous
growth in product demand. To meet customers' increasing demands, the man-
agement is considering the addition of a nighttime operation production shift
beginning October 1.
Production takes place in three departments: Assembly, Molding, and
Finishing. Standard time in the Molding Department is 10 minutes per unit
produced, while the Finishing Department averages MVi items per hour. Em-
ployees in these two departments are paid $5 per hour. Two people are needed
in the Assembly Department, each with a monthly salary of $850, to serve the
extra shift. One foreman for each 19 workers is needed in the Molding and
Finishing Departments, and 5 cleanup employees are required. Foremen are paid
$1 ,200 per month, and each member of the cleanup crew is paid $3.50 per hour.
Under normal conditions, the company schedules 20 work days per month
with standard monthly production of 120,000 units.

Required: A monthly labor budget for the extra shift, showing the time
required in each department, the labor cost for each department and service,
unit labor cost, and the number of employees required.

14-2. Labor Performance Report; Efficiency Variances. The DeLeone Company

isinterested in improving its control over labor costs. The Accounting Depart-
ment assembled the following data for September:
 ,
., :

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 429

Actual Actual
Labor Activity Hours Expenses

Productive labor time 8,000 $46,900

Setup time 200 1,254
Cleanup time 110 462
Down time 350 1,776

A predetermined standard of 7,700 hours of productive labor has been

provided. Statistical analysis has established that setup time, cleanup time, and
down time should be 3%, 1%, and 4%, respectively, of standard production
time allowed. The standard labor rate is $6 per hour.

Required: (1) Alabor performance report for September to be sent to the

plant manager. For control purposes, it should include total variances and
labor efficiency variances.

(2) An explanation and analysis for any difference between the labor effi-
ciency variance and the total labor variance.

14-3. Incentive Wage Plans. Different departments of the Winkle Chocolate

Company use different incentive wage plans. For instance, Irving Dunn of the
Mixing Department is covered by a 100 percent bonus plan, while his wife
Peggy of the Wrapping Department participates in a straight piecework arrange-
ment. Both employees receive a guaranteed base rate of $3.50 per hour.
Irving produced 15 units per hour every day of the first week in May.
Standard production under his plan is only 12 units.
Peggy, whose straight piecework plan has designated 18 units per hour as
the standard, produced 20 units per hour Monday through Thursday and 21
units per hour on Friday of the same week.

Required: The weekly gross earnings of both employees, assuming that both
work 5 days a week and 8 hours each day and that the $3.50 base rate forms
the basis applicable to both incentive wage plans.

14-4. Group Bonus Plan. Employees of Chianti Enterprises work in groups of

five,plus a group leader. Standard production for a group is 400 units for a
40-hour week. The workers are paid $4 an hour until production reaches 400
units; then a bonus of $1.20 per unit is paid, with $1 being divided equally
among the five workers and with the remainder passing to the group leader
(who is also paid a weekly salary of $150). Factory overhead is $3 per direct
labor hour and includes the group leader's earnings.

The production record of a group for one week shows

Hours

Monday
Tuesday. , .

Wednesday
Thursday. .

Friday
 . , : :

430 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Required: (1) Based upon the above data, show the week's earnings of the
group (excluding the leader), the labor cost per unit, the overhead cost per unit,
and the conversion cost per unit (carrying figures to three decimal places).

(2) Assuming Chianti Enterprises uses the group bonus plan, a schedule
showing daily earnings of the group (excluding the leader), unit labor cost, unit
overhead cost, and the conversion cost per unit.

14-5. Group Bonus Plan. Ten-man crews work as teams in a Processing De-
partment. Each crew member is paid a bonus if his group exceeds the standard
production of 200 kilograms per hour.
The amount of the bonus is computed by first determining the percentage
by which the group's production exceeds the standard one half of this percentage
;

is then applied to a wage rate of $4.80 to determine the hourly bonus rate. Each
man in the group is paid a bonus for his group's excess production in addition
to his wages at hourly rates.

Production Record for the Week

Monday..
Tuesday. .

Wednesday
Thursday.
Friday

Required: On the basis of the production record

(1) The group's bonus for each day and for the week.

(2) The week's earnings for each employee, assuming that each worker
earned $4.80 per hour and that each worked the same number of hours during
the week.

14-6. Quarterly Bonus Allotment. Aquapipes, Inc. is a manufacturer of standard

pipe fittings for water and sewage lines. A
bonus is paid to its employees based
upon the production recorded each calendar quarter. Normal production is set
at 240,000 units per quarter. A
bonus of $.10 per unit is paid for any units in
excess of the normal output for each quarter. Distribution of the bonus is made
on the following point basis

Employees Points Allowed for

Participating Each Employee

1 Works manager 250

2 Production engineers 200
5 Shop foremen 200
1 Storeskeeper 100
5 Factory office clerks 10
1 50 Factory workers 20
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 431

The employees' earnings are not penalized for any month in which the actual
output falls below the monthly average of the normal quarterly production. In
such a case, the deficiency is deducted from any excess in subsequent months
before any bonus is earned by and paid to the employees.
At the end of March, cumulative actual production amounted to 270,000
units.

Required: (1) A calculation showing the amount of bonus payable to the

employees in the different classifications.

(2) Journal entries at the end of each month on the basis of the production
figures: January, 75,000 units; February, 94,000 units; March, 101,000 units.
(3) A statement as to whether this bonus is considered a direct labor cost or
a factory overhead item and its position on the income statement.

14-7. Incentive Wage Plans. The company's union steward complained to the
Payroll Department that several union members' wages had been miscalculated
in the previous week. The schedule below indicates the wages and conditions
of the earnings of the workers involved:
Gross
Down Units Stan- Wages
Incentive Wage Total Time Pro- dard Base per
Worker Plan Hours Hours duced Units Rate Books

DODD
 :

432 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

(c) Emerson Efficiency System. A

minimum wage is paid for production up to
66%% of standard output or "efficiency." When the worker's production
exceeds 66y3% of the standard output, he is paid at a bonus rate. The bonus
rate is determined from the following table

Efficiency Bonus
Up to 662/3%
 : :

CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 433

Olympia's direct labor hour input process for payroll and job-cost deter-
mination is summarized in the following flowchart:

TIME CARDS JOB TICKETS

TIME CARDS JOB TICKETS

PAYROLL HOUR LABOR HOUR

COMPUTER COMPUTER
SUMMARY SUMMARY

Steps A
and C are performed in the Timekeeping Department; Step B in
the factory operating departments; Step D
in the Payroll Audit and Control
Department; Step E in the Data Preparation (Keypunch) Department; and
Step F in the Computer Operations Department.

Required: For each input processing Step A through F

(a) List the possible errors or discrepancies that may occur.

(b) Cite the corresponding control procedure that should be in effect for
each error or discrepancy.

NOTE : Limit the discussion of Olympia's procedures to the input process for direct
labor hours (as shown in Steps A through F in the flowchart). Do not
discuss personnel procedures for hiring, promotion, termination, and pay
rate authorization. In Step F, do not discuss equipment, computer program,
and general computer operational controls.

Organize your answer for each input-processing step as follows

Step Possible Errors or Discrepancies Control Procedures

(AICPA adapted)

B. Setting Productivity Standards. The Alton Company intends to expand its

Punch Press Department with the purchase of three new presses from Presco,
Inc. Mechanical studies indicate that for Alton's intended use, the output rate
434 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

for one press should be 1,000 pieces per hour. The Alton Company has similar
presses now in operation that average 600 pieces per hour. This average is
derived from these individual outputs:

Daily Output
Worker (in Pieces)

Alfers, L 750
Brown, J 750
Green, R 600
HoAG, H 500
Jones, R 550
Smith, G 450
Total 3,600

Average daily output 600

Alton's management also plans to institute a standard cost accounting

system in the very near future. Alton's engineers are supporting a standard
based upon 1,000 pieces per hour; the Accounting Department, a standard
based upon 750 pieces per hour; and the Punch Press Department foreman, a
standard based upon 600 pieces per hour.

Required: (1) Arguments used by each proponent to support his case.

(2) The alternative which best reconciles the needs of cost control and the
motivation of improved performance. Explain the choice made.

(NAA adapted)

C. Controlling Hiring Practices and Payroll Procedures. The Besco Corpora-

tion employs about fifty production workers and has these payroll procedures:

The factory foreman interviews applicants and on the basis of the interview
either hires or rejects them. When hired, the applicant prepares a W-4 form
(Employee's Withholding Exemption Certificate) and gives it to the foreman,
who writes the hourly rate of pay for the new employee in the corner of the W-4
form. He then gives the form to a payroll clerk as notice that the worker has
been employed. The foreman verbally advises the Payroll Department of rate
adjustments.
A supply of blank time cards is kept in a box near the entrance to the factory.
Each worker takes a time card on Monday morning, fills in his name, and notes
in pencil on the time card his daily arrival and departure times. At the end of the
week the worker drops the time card in a box near the factory door.
The completed time cards are taken from the box on Monday morning by a
payroll clerk. Two payroll clerks divide the time cards alphabetically, one taking
the A to L section of the payroll and the other taking the M
to Z section. Each
clerk is fully responsible for his section of the payroll. He computes the gross
pay, deductions, and net pay, posts the details to the employees' earnings
records, and prepares and numbers the payroll checks. Employees are auto-
matically removed from the payroll when they fail to turn in a time card.
The payroll checks are manually signed by the chief accountant and given to
the foreman. The foreman distributes the checks to the workers in the factory
and arranges for the delivery of the checks to absent workers. The payroll bank
account is reconciled by the chief accountant who also prepares the various
quarterly and annual payroll tax reports.
CH. 14 CONTROLLING AND ACCOUNTING FOR LABOR COSTS 435

Required: Suggestions for improving the Besco Corporation's system of

internal control for factory hiring practices and payroll procedures.

D. Timesaving vs. Cost Saving. Laurel, Inc., manufacturers of a large variety

of women's garments, employs one thousand female workers in its production
departments.
Some time ago the management engaged the services of a CPA firm for the
purpose of making a complete analysis of the methods of production. Its
findings and recommendations were given to a committee for the purpose of
studying them before instituting any changes in the existing production setup.
The committee is presently discussing a suggestion aimed at reduction of the
time required for a particular operation. The operation is performed on all
products and takes ten minutes or approximately 30% of total productive labor.
It is claimed that, by applying a new method, twenty seconds per item could
be saved.
One committee member, although recognizing that no investment would be
necessary, believes that the proposed timesaving method is too insignificant to
be worth considering.

Required: Comments on the committee member's attitude, explaining your

agreement or disagreement considering the fact that the pay rate is $2.50 per
hour and the standard work week is 40 hours.

E. Labor Budget and Performance Variances. The Devon Co.'s contract with
the labor union guarantees a minimum wage of $500 per month to each direct
labor employee having at least ten years of service. One hundred employees
currently qualify. All direct labor employees are paid $5 per hour.
—
The direct labor budget for the current year, 19 was based on the annual
,

usage of 400,000 hours of direct labor at $5 or a total of $2,000,000. Of this

amount, $50,000 (100 employees X $500 a month) or $600,000 for the year
was regarded as fixed. The budget for any given month was determined by the
formula $50,000 plus $3.50 X direct labor hours worked. Data on perfor-
mance for the first three months of 19— show:

January February March

Direct labor hours worked 22,000 32,000 42,000

Direct labor costs budgeted 5127,000 5162,000 $197,000

Direct labor costs incurred 51 10,000 5160,000 5210,000
Variances (F — favorable;
U— unfavorable) $ 17,000F 5 2,000F 5 13,000U

The factory manager is perplexed by the results, which show favorable

variances when production is low and unfavorable variances when production
is high. He believes control over labor costs is consistently good.

Required: (1) Explanation of causes of variances and an illustration, using

amounts and diagrams as appropriate.
(2) Explanation of this direct labor budget as a basis for controlling direct
labor cost, indicating changes that might improve control over direct labor cost
and facilitate performance evaluation of direct labor employees.
(AICPA adapted)
 CHAPTER 15

ACCOUNTING FOR
LABOR-RELATED COSTS

Fundamentally, a labor cost consists of the hourly rate, the daily or

weekly wage, or the monthly salary paid to an employee. Yet, in addition
to the basic earnings computed on hours worked or units produced, many
other cost elements enter into labor cost, such as overtime earnings; pre-
mium pay for work on holidays, Saturdays, and Sundays where overtime
is not involvedshift bonuses or differentials production incentives such
;
;

as an attendance bonus, length of service bonus, nonaccident bonus, and

Christmas or year-end bonus; paid vacations; apprenticeship or trainee
costs and training programs for the hard core unemployed; dismissal or
severance pay; and retirement pensions. In addition to these elements,
labor cost usually includes paid hohdays; unemployment compensation;
Federal Insurance Contributions Act benefits other insurance such as hfe,
;

accident, health, and workmen's compensation; hospital and surgical

benefits for employees and their dependents; and in some companies pay
for jury service, and even free lunches. The total cost to keep an employee
at work for an hour or a full day will include some or all of these fringe
benefits. For factory workers the labor and the labor-related costs may be
classified as direct labor, indirect labor, or factory overhead; for sales
personnel, as marketing expenses; and for office and administrative
personnel, as administrative expenses.

OVERTIME EARNINGS
The Fair Labor Standards Act of 1938, commonly referred to as the
Wages and Hours Law, estabhshed a minimum wage per hour with time
436
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 437

and a half for hours worked in excess of 40 in one week. Subsequently

the Act has been amended, broadening the coverage and raising the mini-
mum to a level of $2.30 an hour in 1976. Some types of organizations and
workers are exempt from the provisions of the Act and its amendments, or
have lower minimums.
A number of payroll practices are mandatory to comply with the
Wages and Hours Law. For each employee, records must show:
1. Hours worked each working day and the total hours worked during each
work week
2. Basis on which wages are paid
3. Total daily or weekly earnings at straight time
4. Total wages paid during each pay period, the date of payment, and the
work period covered by the payment
5. Regular rate of pay and total extra pay for overtime worked each week

Overtime earnings consist of two elements: (1) the regular pay due
for the employee's work and (2) the overtime premium pay, which is an
additional cost due to work done beyond the regular work day (as specified
in some labor union contracts) or 40-hour work week. For most workers,
an employer must pay as a minimum the regular rate plus one half the
rate for overtime employment. For example, if an employee is paid $4
per hour for a regular work week of 40 hours yet works 45 hours, his gross
earnings are:
Regular work week. 40 hours @ $4 = $160
Overtime 5 hours @ 4= 20
Overtime premium. 5 hours @ 2— 10
Gross earnings $190

Even though these details are not required by the Wages and Hours Law,
good payroll practice to separate regular wages and overtime premium
it is

wages.
Charging overtime premium pay to a specific job or department, or to
factory overhead depends primarily upon the reason for the overtime work.
The contract price of a particular job, taken as a rush order with the fore-
knowledge that overtime will be necessary, may include the premium wage
factor, which should be charged to the specific job. For example, if a law-
yer brings a brief to a printing plant on Friday afternoon and wants it set
in type and printed by Monday morning, all of the premium pay should be
charged to that job. In another situation, Job No. 205 may be due for de-
livery on a particular date; but delays, slow production, or inadequate
plant capacity in finishing up numerous other jobs may make it necessary
to work overtime on Job No. 205. Neither this job nor any one of the
other jobs is responsible for the overtime. When a plant is working over-
time because it has more orders than it can complete in the regular time,
438 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

the overtime premium pay should be included in the predetermined fac-

tory overhead rate as factory overhead because itcannot properly be
allocated to work that happens to be in process during overtime hours.

BONUS PAYMENTS
Bonus payments may be a fixed amount per employee or job classifica-
tion, a percentage of profits, a fraction of one month's wages, or some other
calculated amount. The amount of bonus for each employee may be a fixed
and long-established tradition of a company, or the amount may vary from
year to year. Bonus payments are production costs, marketing expenses,
or administrative expenses as the case may be but when and how should
;

they be charged to operations? If a factory worker's average weekly

earnings amount to $260 and the company intends to pay him two weeks'
pay as a bonus at the end of the year, his earnings actually amount to
$270 per week with $260 paid for each week and with the additional $10
per week paid in a lump sum of $520 ($10 X 52 weeks) at the end of the
year. In order to spread the bonus cost over production throughout the
year via the predetermined factory overhead rate, the weekly entry would
be:
Subsidiary
Record Debit Credit

Work in Process 260.00

Factory Overhead Control 10.00
Bonus Pay 10.00
Payroll 260.00
Liability for Bonus 10.00

When the bonus is paid, the liability account is debited and Cash and
the withholding accounts are credited.
In theory, this and other labor-related or fringe benefit costs are addi-
tional labor costs and for direct labor should be charged to Work in Process
the same as the employees' gross wages. In practice, such a procedure
usually is impractical; and these costs are generally included in the pre-
determined factory overhead rate.

VACATION PAY
Vacation pay presents cost problems similar to those of bonus pay-
ments. When a shop employee is entitled to a paid vacation of 2 weeks,
the total wages earned during 50 weeks of productive labor are paid over
a period of 52 weeks. For example, assume that an employee has a base
wage of $200 per week and is entitled to a paid vacation of 2 weeks. The
cost of his labor is $200, plus $8 per week. In 50 weeks at $8 per week,
 :

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 439

the deferred payment of $400 will equal the expected vacation pay. The
entry to set up the weekly labor cost including the provision for vacation
pay would be
Subsidiary
Record Debit Credit

Work in Process 200.00

Factory Overhead Control 8.00
Vacation Pay 8.00
Payroll 200.00
Liability for Vacation Pay 8.00

When the vacation is taken, the liability account is debited and Cash
and the withholding accounts are credited. Similarly, accrual should be
made for employer liability pertaining to sick leave, holidays, jury duty,
military training, or other personal activities for which the employer pays
compensation.!
Salaried employees usually receive two or more weeks of vacation.
Pay of a payment for other absences, is gene-
salaried worker, as well as
rally considered a cost of the period in which the absence occurs. The
rationale for this treatment is that the salaried employee's work either
continues to a large extent during the absence with associates performing
the duties or it is performed at the time of the employee's return.
Should it become necessary to hire temporary employees to perform
the duties of salaried personnel while on vacation or absent for some
other reason, this additional expense is rightfully charged to the depart-
mental salary accounts. In some instances, the wages of salaried per-
sonnel should be accrued as described earlier.

GUARANTEED ANNUAL WAGE PLANS

While a guaranteed annual wage plan for all industrial workers is far
from realization, a step in that direction has been taken in the labor con-
tracts that provide for the company to pay employees who are laid off.
In one industry's plan, for example, the unemployed worker is guaranteed
60 to 65 percent of his normal take-home pay, beginning the second week
of layoff and continuing for as long as 26 weeks. The company pay is a
supplement to the state unemployment insurance. In order to provide
funds from which payments can be made during unemployment periods,
a specified amount such as $.10 an hour for each worker is paid into a
fund by the company for financing layoff payments.

iJhe accrual of employer obligations for labor-related costs for personal absence is required
in accounting for government contracts to which Cost Accounting Standards Board (CASH)
regulations apply. See CASH Standard No. 408, "Accounting for Costs of Compensated
Personal Absence," Federal Register, Vol. 39, No. 183, pp. 33681-33686.
440 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

if it is assumed that layoffs will eventually occur, it is

In principle,
clear that the employee while working is earning $.10 an hour an —
amount that is not included in the payroll check at the end of the payroll
period. This amount is held in reserve by the company in order to make
payments during unemployment periods. For a factory worker whose
base pay rate is $5 an hour, the cost effect of unemployment pay for a 40-
hour week is illustrated by this entry:
Subsidiary
Record Debit Credit

Work in Process 200.00

Factory Overhead Control 4.00
Unemployment Pay 4.00
Payroll 200.00
Liability for Unemployment Pay 4.00

Another version of the above plan is one which not only guarantees
that the weekly payroll check will not fall below a minimum figure but
also sets no on how high earnings may rise during other weeks of
limit
the pay period. This plan amounts to a "floor" placed under weekly
earnings to keep them above a predetermined minimum. Employees are
paid their actual earnings each pay period; the guarantee comes into
effect only when earnings drop below the minimum.

APPRENTICESHIP AND TRAINING PROGRAMS

In many plants new workers
some preliminary training before
receive
they become economically productive. The portion of the wages paid in
excess of the average or standard paid for the productive output, plus the
cost of instruction, is an indirect labor cost to be charged to the total annual
output through inclusion in the factory overhead rates. In case of unusual
training programs due to the opening of a new plant or the activating of a
second or third shift, a case can be made for treating the training cost as
development or starting load cost and deferring a portion of the cost over
a considerable period of time.

HUMAN RESOURCE ACCOUNTING

In annual reports management often speaks in glowing terms of its
employees as the company's most valuable asset. Yet management makes
little effort to assess the value of this asset, and the company's accounting

system does little to provide any assistance. Human resource accounting

is the process of developing financial assessments of people or groups of
people within organizations and society and the monitoring of these
assessments over time. It deals with investments in people and with the
related economic results. Managers are being asked to give more serious
 441
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS

consideration to resource investment decisions and to the human

human
personnel function within
resource impact of all their decisions. Thus, the
of acquisition, develop-
an organization may serve more efficiently its role
ment, and utilization of human resource potential.

Human resource accounting attempts to evaluate investments in

human assets. Many firms invest heavily in personnel training programs

without evaluating the expected payoff or the return

on such investments.
executive development
A firm is apt to send its managers to a variety of
which are dis-
programs whose value is essentially taken on faith and
continued when profits cannot afford them.
to identify incurred
A human resource accounting system needs first

other costs.
human resource costs that are to be separated from the firm's
used should distinguish between the asset
The techniques and procedures
The resulting human
and expense components of human resource costs.
functional categories such as
resource assets would then be classified into
and Such infor-
familiarization.
recruiting, hiring, training, development,
decisions based
mation would purportedly enable management to make
amortization and would fur-
on a reahstic cost /benefit analysis and cost

investors with an improved basis to assess the value of an

ther provide
enterprise for purposes of making better investment decisions.

quantification of human resources appears to be the first

stumbhng
The
All companies have
block for the creation of human resource accounting.
equipment,
methods of measuring sales, profits, investments in plant and
investments in inventories, etc. Similarly, incurred human resource costs
determining the
such as training programs can be measured although
the possibility
time period for amortization may be difficuk. But beyond
of capitalizing certain incurred human resource costs,
how does a com-
morale,
pany set a quantitative value for such attributes as loyalty, skills,
Since seems difficuk to
decision-making ability, intelligence, etc.? it

human factors, it seems equally difficuk to assign asset

quantify these
costs can be
status to human resources except where measured incurred
The justification for measuring an asset value is based on the
identified.
benefits to
economic concept that an asset is capable of providing future
important to the future suc-
the firm. Therefore, the employee group is
should be reported as
cess of the company and, as such, has value that
assets on the balance sheet. Asset determination
for human resources is

particularly meaningful for professional sports franchises where a "super-

essentially the asset that creates gate receipts. As is the case wkh
star" is
thus, the
any other asset, the professional athlete can be sold or traded;
increasing litigation involving current player contracts.
In spke of the difficulties, a number of proposals have
been expounded
that attempt to utiUze human resource accounting.
Some proposals focus
442 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

on incurred costs only while others encompass estimated values. These

proposals, reviewed in a Management Accounting^ article, are:

1. Capitalizing salaries —
whereby a firm merely capitalizes salaries paid
its employees, assuming that what the employees are doing will be of
some future benefit to the firm and that appropriate rates of capitaliza-
tion can be determined.

2. Capitalizing the cost of'''' acquiring''' an employee — envisions capitalizing

the cost of "acquiring" an employee, a plan that would require collecting
the costs of acquiring, hiring, and training. ( A precedent for this method
exists in professional sports.)

3. Capitalizing startup costs —

involves not only capitalizing startup costs
but goes one step further by considering the synergistic components of
cost and time required for members of a firm to establish effective co-
operative working relationships.

4. Behavioral variables approach —

whose foundations are even more
tenuous than startup costs. Here, periodic measurements would be
made of the key causal and intervening variables for the corporation as
a whole. Statistical variation in leadership styles, technical proficiency
levels, etc. (causal variables), and the resulting changes in subordinate
attitudes, motivations, and behavior (intervening variables) can establish
relationships among such These changes would produce
variables.
changes in the end such as productivity, innovation, and
result variables
manpower developments; and trends in earnings can then be predicted.
These forecasts are discounted to find the present value of the human
resources.

5. Opportunity costs — suggest that investment center managers are en-

couraged to bid for any scarce employee they desire. The winning man-
ager includes his bid in his investment base. The division's benefit is

the increased profit produced by the new employee.

6. Economic value approach — compares differences in present and future

earnings of similar firms in the same industry. Ostensibly, the differences
are due to their human organization. Future earnings are forecast and
discounted to find their present value. A
portion thereof is allocated to
human resources based on their contribution.

7. Present value method — involves a determination of wage payments over

a five-year period, and then a discounting of these payments at the rate
of return of owned assets in the economy for the most recent year. This
calculation yields the present value of the future five-years' wage pay-
ments based on this year's return.

8. Stochastic rewards valuation model (designed by Eric Flamholtz) in- —

volves a stochastic process defined as a natural system that changes in
time in accordance with the law of probability. To measure an indi-
vidual's value to an organization requires:

2Roger Jauch and Michael Skigen, "Human Resources Accounting: A Critical Evaluation,"
Management Accounting, Vol. LV, No. 11, pp. 33-36.
 :

443
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS

an individual ex-
estimate of the time interval during which
is
(a) An
pected to render services to the organization, and
the individual
(b) A measure of the services expected to be derived from
during this interval.
resource's expected value is then multiplied
by a discount factor
The
present value of expected future services.
to arrive at the

resource accounting
At present, as theory and techniques for human
have become known and established, the
problem must turn to models
testing. Research is required to
and methods subjected to empirical
attitude and behavior.
demonstrate both its feasibility and its effects on
using human resource ac-
Unless empirical data from organizations
published, the attractive-
counting systems are collected, analyzed, and
^
lose its glamour.
ness of current theoretical arguments may
soon

PENSION PLANS
A pension plan is an arrangement whereby a company provides retire-
of his or her work
ment benefit payments for each employee in recognition
contribution to the company. This arrangement may be an informal
the retired employee in
pension plan calling for voluntary payments to
the descretion of the em-
amounts and under conditions more or less at
benefit payments and other
ployer or it may be a formal plan with the
or otherwise determined.
features explicitly stated or readily computed
but an established
A formal plan is usually set forth in a written document,
unwritten policy with regard to pension payments
may be sufficiently
definitive to constitute a formal plan.
A pension plan is probably the most important, as well as the most
costs. A pension plan
complicated, factor associated with labor and labor
is also important in that it influences
personnel relations, company financ-

ing, income determination, income

tax considerations, and general eco-

nomic conditions.

Pension Cost Factors. The ultimate cost of a company pension plan

depends upon several related factors
1. The number of employees
reaching retirement age each year
2. The average benefit to be paid to
each retired employee
which benefits will be paid
3. The average period over

4. Income from pension fund investments

5. Income tax allowances

6. Expense of administration
Treatment of benefits to employees who leave the
company before
7.
reaching the pension age
Conunittee on Accounting for Human
-v American Accounting Association Report of the
Resources," The Accounting Review, Supplement to
Vol XLIX, pp. 114-1/4.
444 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Pension Cost Estimate. When a pension plan is initiated, the amount

necessary to provide pensions for all the present employees who are ex-
pected to stay until retirement is the product of (1) the number of em-
ployees eventually to retire, (2) the average benefit, and (3) the average
period of payment.

Example: Assume a company has 100 employees who are each to be

paid $1,200 per year for an average of 10 years to equal an estimated
eventual cost of $1,200,000. If each employee who retires has worked an
average of 30 years, the average annual cost is $40,000 ($1,200,000 ^
30 years). The annual cost per employee would then be $400 ($40,000 -f-
100 employees). If each employee works 40 hours per week and 50 weeks
per year, the pension cost for each of the 2,000 hours worked is $.20.
While this procedure ignores administrative costs and possible earnings
from funds invested, it is indicative of a method that may be used to
convert the pension cost to an hourly basis.

Pension Cost Allocation. In the case of bonuses and paid vacations,

part of the total earnings of an employee is withheld or accrued for a period
of months and then paid in a lump sum. In the case of pension payments,
the wage is earned and the labor cost is incurred many years before the
;

payment is made. As a matter of principle, if an employee is paid a base

wage of $160 for a 40-hour week and if the retirement payments to be made
will amount to $.20 an hour for all the hours purchase from this em-
ployee, the pension cost incurred is $8 per week chargeable to factory
overhead, marketing, or administrative costs as the case may be."*

Employee Retirement Income Security Act of 1974. On September 2,

1974, the Employee Retirement Income Security Act of 1974^ (more
commonly known as the Pension Reform Act of 1974) was enacted. This
Act makes certain that promised pensions are actually paid at retirement
age and sets minimum government standards for pension vesting, partici-
pation, funding, management, and a variety of other matters. The Act
also covers a wide range of employee welfare plans in addition to pen-
sion or retirement plans and establishes both "labor'' standards (admin-
istered by the Secretary of Labor) and "tax" standards (administered by
the Secretary of the Treasury). The labor and tax standards taken to-
gether bring under a common body of legislation practically all employee
benefit plans not specifically exempted from the Act.

4For an extensive study of accounting for pension plans, refer to: AICPA Research Study
No. 8 (1965) by E. L. Hicks; AICPA APB Opinion No. 8 (1966); FASB Interpretation No. 3,
1974.
^Explanation of Pension Reform Act of 1974. (P. L. 93-^06), Commerce Clearing House, Inc.,
Pamphlet No. 4891, pp. 1-96.
 :

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 445

Virtually every private pension, profit-sharing, thrift, or savings plan

will have to be amended within the next few years in order to comply with
the Pension Reform Act of 1974. All plans will have to contend with
increased record keeping, compliance, and reporting. Many plans will be
burdened with increased costs and /or funding obligations. Plans most
Hkely to be affected are those that (1) have not provided for a substantial
degree of vesting prior to retirement, (2) have not been funding past service
costs or have operated on a "pay-as-you-go" basis, and (3) have had
restrictive criteria as to age and years of service as a condition for
participation.
The Pension Reform Act of 1974, a vast and momentous piece of legis-
lation, should be studied by every accounting student. The presentation
here enumerates only a few matters that are relevant to labor-related
costs. Among the more important changes and new requirements affecting
employers and employees are
1. New employees cannot be denied participation for more than one year
unless an employee is under twenty-five years of age or benefits are

fully vested at the end of a three-year waiting period.

2. Minimum funding standards require that an employer's minimum annual

contribution generally must include the normal cost for the year plus
level amortization of initial past service liabilities over forty years for
existing plans and over thirty years for new plans, and liabilities re-
sulting from plan amendments and experience gains and losses over
thirty years and fifteen years, respectively.

3. In case the assets of a terminated plan are not sufficient to pay the in-
sured benefits, the Pension Benefit Guaranty Corporation (PBGC)
guarantees vested benefits of terminated plans up to $750 per month
for each participant or beneficiary. To finance this insurance program,
the PBGC will collect a premium from all covered plans. The annual
premiums are $1 per participant for single-employer plans and 50 cents
per participant for multi-employer plans. For many existing plans, this
benefit coverage is retroactive to July 1, 1974; and the obligation to pay
the premiums began on the date of enactment.
4. Descriptions of the plan and annual financial, actuarial, and other in-
formation must be provided to participants and beneficiaries and to the
Secretaries of Labor and the Treasury.

Vesting. A participant of a pension plan is assured of receiving future

benefits under a plan when his rights to the benefits become vested. Vesting
is a kind of guarantee that enough money has been set aside by a company
to enable the payment of an employee's pension at retirement age and that
his benefits cannot be forefeited even in the event of dismissal or discon-
tinuance of company operations. An employee who resigns before retire-
ment age will still be entitled upon retirement to receive the benefits in
which his rights were vested before his resignation. The Pension Reform
446 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Act of 1974 sets minimum standards for vesting of employee benefits that
must be met by all plans subject to the participation standards. To protect
participants and beneficiaries against a possible loss of pension benefits
arising from plan termination, the Act created the aforementioned Pension
Benefit Guaranty Corporation (PBGC) within the Department of Labor.

Funding. The Pension Reform Act of 1974 established minimum

funding standards for certain defined benefit plans. The effect of these
standards is to impose time limitations for accumulating sufficient assets
to pay retirement benefits to participants. Generally, employers must
contribute currently the normal cost of the plan for the plan year plus a
level funding, including interest, of past service costsand certain other
costs. Each plan must and maintain a funding standard account.
establish
A plan satisfies the minimum funding deficiency at the end of the year, as
reflected in its funding standard account. An accumulated funding de-
ficiency is the excess of the total charges over the total credits to the fund-
ing standard account. The law will not permit the use of the so-called
"pay-as-you-go" method, whereby employers would make periodic
pension payments directly to retired employees.

Present Value (PV). Basic to all funding methods is the concept of

present value {PV), sometimes referred to as capitalized value. The present
value principle permits the value at any given point of time under a set
of future conditions to be expressed as the equivalent value at a different
point of time. The principle is particularly useful in dealing with financial
transactions involving a time series, such as periodic contributions, retire-
ment annuities, etc. It permits the computation of an entire series of
financial transactions over a period of time to be expressed as a single
value at any point of time.

The Role of the Actuary. Computations relating to pension plan costs,

contributions, and benefits are made by an actuary —
an expert in pension,
life insurance, and related matters involving life contingencies. An actuary
employs mathematical, statistical, financial, and other techniques to
compute costs or benefits, to equate costs with benefits, and to evaluate
and project actuarial experience under a plan. Membership in the Ameri-
can Academy of Actuaries, or one of the other recognized actuarial
organizations, identifies a person as a member of the actuarial profession.

Administrative Problems. The Pension Reform Act of 1974 mandates

sweeping changes in the structure and administration of all types of quali-
fiedemployee benefit plans. For many businesses, the new and more rigid
tax requirements for eligibility, vesting, and funding means dramatically
increased pension costs.
 CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 447

Pension costs (excluding social security costs) are now running from
5 percent to 10 percent of a company's annual payroll —a level often
equivalent to 25 percent or more of its annual profit. It may
only be a
matter of time before pension costs rise to 20 percent of a company's
annual payroll, or higher. This increase will in turn be translated into
price increases that will fuel further wage increases and lead to even higher
pension costs. In addition, the Pension Reform Act of 1974 creates a
staggering number of complicated, nontax requirements in such areas as
disclosure, reporting, investments, and insurance.

ADDITIONAL LEGISLATION AFFECTING

LABOR-RELATED COSTS
Costing labor and keeping payroll records were relatively simple prior
to the first social security act. This legislation made it necessary for many

employers to initiate or redesign payroll procedures in order to make an

accurate accounting for payroll deductions. and fed-
Later, other state
eral legislation imposed additional requirements affecting the accounting
for wages and salaries.*^

Federal Insurance Contributions Act (FICA). This legislation is ad-

ministered and operated entirely by the federal government. Originally
enacted in August of 1935 and operative January 1, 1936, the Act provided
that employers in a covered industry must withhold 1 percent of the wages
paid to each employee up to $3,000 of earnings in any one year, which
amounted maximum of $30 of FICA tax. The employer was required
to a
to contribute an equal amount. Employees in several types of work, such
as agricultural workers, domestic services, federal, state, and municipal
employees, nonprofit organizations, self-employed persons, and a variety
of others, were specifically excluded in the 1935 Act.
The Federal Insurance Contributions Act has been amended several
times since 1935, the amendments tending to bring more employees under
the Act, and to increase the benefits, the tax rate, and the wage base upon
which the tax is levied. Under the 1965 amendments to FICA, the long
debated Federal Hospital Insurance Program (Medicare) was enacted. ^

^These pages summarize the major provisions. U. S. Treasury Department Internal Revenue
Service Circular E entitled "Employer's Tax Guide" is an excellent source for a more compre-
hensive coverage of these regulations. A free copy of the current edition can be obtained by
writing to the nearest District Director, Internal Revenue Service.
''Although 6 percent for FICA tax was not the current rate at publication date, it is used in
the illustrations and in the end-of-chapter material because it facilitates calculation of the tax.
The actual rate changes from time to time. The wage base to which the tax applies, assumed
in this textbook to be on annual wages up to $15,000 paid each employee, is also subject to
change.
448 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Records Necessitated by the FICA. The Federal Insurance Contribu-

tions Act requires that employers who are subject to its provisions keep
records providing:
1. The name, address, and social security account number of each em-
ployee.
2. The total amount and the date of each remuneration payment and the
period of service covered by such payment.
3. The amount of such remuneration payment that constitutes taxable wages.
4. The amount of tax withheld or collected.

Although the legislation does not order, suggest, or recommend forms

or details for securing the required information, the employer must keep
records that will enable a government agency to ascertain whether the taxes
for which the employer is liable are correctly computed and paid. These
records must be kept for at least four years after the date the tax becomes
due or the date the tax is paid, whichever is later. Employees are not
required to keep records, but the Act recommends that each employee keep
accurate and permanent records showing the name and address of each
employer, dates for beginning and termination of employment, wages
earned, and tax withheld during employment.

Collection and Payment of the FICA Tax. All employers, except in

excluded classes of employment, are required to pay a tax on wages paid
equal to the amount paid by the employees and the employer is further
;

required to collect the FICA tax from the employees by deducting the
current percent from the wages paid each payday up to the current annual
limit or base to which the tax applies.
In general, federal income tax withheld and employee and employer
FICA taxes must be deposited with either an authorized commercial bank
depository or a Federal Reserve Bank on a quarter-monthly, monthly, or
quarterly basis, depending on the amount of taxes to be remitted. On or
before the last day of the month following each calendar quarter —
April 30, July 31, October 31, and January 31 —
the employer is required
to file a quarterly return, remitting the FICA and withheld federal income
taxes applicable to the expired quarter reduced by any deposits made. Ten
additional days are allowed for filing the quarterly report if all deposits are
made on time.

Federal Unemployment Tax Act (FUTA). Unemployment compensa-

tion insurance is another phase of social security legislation affecting labor
costs and payroll records. Unlike FICA, which is strictly a federal pro-
gram, FUTA provides for cooperation between state and federal govern-
ments in the establishment and administration of unemployment insur-
ance. When the initial legislation was enacted in August, 1935 by the
 :

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 449

federal government, provisions of FUTA forced various states to pass

adequate unemployment laws.
Under the Federal Unemployment Tax Act, an employer in covered
employment must pay an unemployment insurance tax to the federal
government. The federal annual earnings base is $4,200 of each employee's
annual wages paid with ,5 percent or $21 a year payable to the federal
government for the cost of administering the federal-state unemployment
compensation program.
While the federal legislation provides for a 3.2 percent employer payroll
tax (.5 percent to the federal government and 2,7 percent to the state),
most states provide a merit rating plan under which an employer who
stabilizes employment may pay less than 2.7 percent to the state agency
with zero as a possible payment. A few states use an earnings base of
more than $4,200 in determining the state tax.^ Most states provide for
maximum unemployment insurance rates above 2.7 percent with rates
tending toward a maximum of 4 to 5 percent.

Records Necessitated by the FUTA. Every employer subject to unem-

ployment taxes must keep records providing

1. The total amount of remuneration paid to each employee during the

calendar year.
2. The total amount of such remuneration that constitutes taxable wages.
3. The amount of contributions paid into each state unemployment compen-
sation fund, showing separately (a) payments made and not deducted from
the remuneration of his employees and (b) payments made and deducted
from the remuneration of his employees.
4. All information required to be shown on the prescribed tax return.

As with the FICA tax, the Federal Unemployment Tax Act does not
prescribe or recommend forms or procedures for securing the required
information. Each employer is expected to use accounting procedures
and to prepare accounting records that will enable the Internal Revenue
Service to determine whether the tax is correctly computed and paid.

Payment of the FUTA Tax. The federal portion of the unemployment

tax is payable quarterly. However, if the employer's tax hability (plus
any accumulated tax liabihty for previous quarters) is $100 or less for the
fiscal year, only one payment is required by January 31 of the following

year. The related tax return, due January 31, is sent to the IRS regional
service center of the employer's principal place of business.

8The $4,200 base and the rates of .5 percent (federal) and 2.7 percent (state) were current at
the time of publication and are used in the illustrations and in the end-of-chapter material.
 :

450 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

State Unemployment Reports and Payments. The various state unem-

ployment compensation laws require reports from employers to determine
their liability to make contributions, the amount of taxes to be paid, and
the amount of benefit to which each employee is entitled if he becomes
unemployed. While the reports and report forms vary from state to state,

the more important requirements are

1. Status Report. The status report determines whether an employer is

required to make contributions to the state unemployment insurance

fund.

2. Contribution Report. All employers covered by the state unemployment

compensation laws are required to file quarterly tax returns, commonly
called Contribution and Wage Reports. The report provides a sum-
mary statement of wages paid during the quarter, a computation of the
tax, names of employees, and wages paid to each during the quarter.

3. Separation Report. When it becomes necessary to lay off" workers,

printed materials prepared by the State Employment Commission are
provided informing employees how to secure new employment and how
to make an application for unemployment benefits. An employee
quitting without good cause or discharged for ample reason may be
ineligible for unemployment payments. In these cases, an employer
files a separation notice with the State Employment Commission. Since
any unemployment benefits paid to a former employee may increase the
employer's state rate, the separation notice is filed (when justified) in
order to prevent the charge-back that the State Employment Commis-
sion would otherwise make.

Workmen's Compensation Insurance. Workmen's compensation insur-

ance laws provide insurance benefits for workers or their survivors for
losses caused by accidents and occupational diseases suffered in the course
of employment. These are all state laws and in most states have been in
effect for many While the benefits, premium costs (usually less than
years.
1 percent of the payroll), and various other details vary from state to state,

the total insurance cost is borne by the employer. The employer may have
the option of insuring with an approved insurance company or through a
state insurance fund. In some cases, if the size and the financial resources
are suflRcient, the enterprise may carry its own risk.

Withholding of Federal Income Tax, State Income Tax, and City Wage
Tax. The employer is required to withhold federal income tax and state —
income and city wage tax, if applicable —
from salary and wage payments
to employees and to furnish information to the Internal Revenue Service
showing the amount of remuneration paid each employee and the amount
 451
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS

taxes from em-

of federal income tax withheld. The collection of income
obviously affect payroll ac-
ployees and the remittance of these taxes
required to
counting. Before a new employee begins work, he or she is
out a withholding exemption certificate (W-4 form).
fill

Income taxes are withheld from each wage payment in accordance

claimed
with the amount of the employee's earnings and the exemptions
statement
on the W-4 form. Employers are required to furnish a written
withheld showing
or receipt to each employee from whom taxes have been
and the amount of taxes withheld (income taxes and
the total wages earned
PICA) during a calendar year. This withholding statement (W-2 form)

must be delivered to the employee on or before January 31 of the following

the W-2 form
year. If employment is terminated before December 31,
must be furnished within 30 days from the last payment of wages. Each
employer must deposit federal income taxes withheld and file a quarterly
return in the manner described in the discussion of collection
and pay-
ment of the PICA tax on page 448.
the
A reconciliation of the quarterly returns with duplicate copies of
forms furnished employees must accompany the fourth-quarter
W-2
return each year. Therefore, payroll records must names of
show the

persons employed during the year, the periods of employment, the amounts

and dates of payment, and the taxes withheld each payroll date.
The state may also levy an income tax that must be withheld from
au-
employees' wages. The tax withheld must be remitted to the taxing
thorities along with required reports.
A city or municipality may levy a wage earnings tax on an employee
working within its boundaries even though the employee is not a resident.
Here, too, reports and payments must not only be made to the local
taxing

authority, but information must also be supplied to the employee.

The Pair Labor Standards Act, PICA tax, federal and state taxes for
unemployment compensation insurance, workmen's compensation laws,
and other governmental regulations require a multiplicity of forms for
their monthly, quarterly, and annual reports. Competent
personnel in a

company's payroll department are needed to comply with all regulations.

LABOR-RELATED DEDUCTIONS
In addition to compulsory payroll deductions, a variety of
other de-

ductions are withheld from the take-home pay with the consent of the

employee.

Insurance. Many companies provide various benefits for their em-

ployees, such as health, accident, hospital, and life insurance. It is common
452 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

for the company and the employee to share the cost, with the employee's
share being deducted from wages each payroll period or at regular in-
tervals. If the company has paid insurance premiums in advance, including
the employee's share, an asset account such as Prepaid Health and Acci-
dent Insurance will be debited at the time that the payments are made;
and the account will be credited for the employees' share of the premiums
when the payroll deductions are made. In this payroll deduction, as in all
similar cases, a subsidiary ledger showing the contributions of each
employee is necessary; and one or more general ledger accounts are
maintained.

Union Dues. Many enterprises employing union labor agree to a

union shop and to a deduction of initiation fees and regular membership
dues from the wages of each employee. To account for these deductions,
a column is provided in the payroll journal; and a general ledger account
Union Dues Collected is carried to show the HabiHty
entitled Liability for
foramounts withheld from the employees. At regular intervals, the
company prepares a report and remits the dues collected to the union
treasurer.

U.S. Savings Bonds. In order to cooperate with the federal government,

an employer and an employee frequently agree to some systematic plan of
withholding from wages each payroll period a fixed amount for the purpose
of purchasing U.S. Savings Bonds. A deduction column is provided in the
payroll journal for the detailed record with each employee, and a general
ledger account entitled Employee U. S. Savings Bond Deposits is set

up to show the liability for wages withheld for this purpose. When the
accumulated amount withheld from a given employee is sufficient to
purchase a bond, an entry is made debiting Employee U. S. Savings Bond
Deposits and crediting Cash.

Payroll Advances. For a variety of reasons, payroll advances may be

made and factory workers. The advances may be
to officers, salesmen,
in the form of cash or in the form of raw materials or finished goods. To
provide control, an advance authorization form should be executed by a
responsible official and should be sent to the payroll department. The
asset account debited for all advances, representing a receivable to the
company, might be and Wage Advances.
entitled Salary
When form of merchandise, the credit would
the advances take the
be to Materials or to Finished Goods. If the merchandise is charged to
the employee at a figure above cost, the credit may be to Sales. When the
price is above cost but substantially less than the regular sales price, an
account entitled Sales to Employees might be maintained. At the regular
 :

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 453

payroll date, the employee's earnings are entered in the payroll journal
as usual ; and the advance is deducted from wages to be paid. The amount
of the advance being deducted is credited to Salary and Wage Advances.

SUMMARY OF LABOR-RELATED COSTS

The hourly wage or monthly salary which an employer agrees to pay
is only a portion of the total wage cost involved. One recent survey shows
that by including overtime and holiday premium pay, shift differential,
production bonus, and other sundry payroll items as employee benefits,
the benefits average 37.8 percent of straight-time earnings. Some of the
labor-related costs not included in the basic wages are

FICA tax for employees' old-age and survivors' and disability

insurance and the hospital insurance program 6.0%
Federal unemployment insurance tax (FUTA) .5
State unemployment insurance (representing a typical rate with
most companies paying less than the 2.7% maximum) 2.0
State workmen's compensation insurance (rates vary with the
hazards —
a fraction of 1% to 3% and over) 1.0
Vacation pay and paid holidays (two weeks of vacation and 7 to
10 holidays in relation to 52 weeks of 40 hours) 8.0

Total fringe benefits for practically any employer 17.5%

Other labor-related costs commonly experienced:

Contributions to pension fund (probable average) 10.0%

Recreation, health services, life insurance, medical care 4.0
Contributions to unemployment pay funds 3.5
Time off for voting, jury duty, grievance meetings, etc 1.3
Services related to parking lots, income tax, legal advice, supper
money, uniforms, etc 1.5

Total other labor-related costs 20.3%

Typical total labor-related costs expressed as a percentage of

straight-time earnings 37.8%

RECORDING LABOR COSTS

Many methods of recording wage transactions exist, depending in part
upon the entries (if any) that are posted from the payroll journal itself.

Details of payroll accounting and some of the problems incident to labor

costing have been presented in the preceding pages. It is worth repeating
that the basic principle of labor costing is simple and straightforward.
 :

454 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

A record of the labor time "purchased" is made through use of the clock
card; a record of the performance received made through the use of time
is

tickets or the daily time report. The accounting entries required,

therefore, are:

1. To record wage payments due employees and the liability for all amounts
withheld from wages.
2. To charge the total labor cost to appropriate jobs, processes, and de-
partments.

Weekly, semimonthly, monthly, or as often as a payroll is met the —

total amount earned by workers is debited to Payroll with credits to Ac-
crued Payroll and to the withholding accounts. The cost of labor pur-
chased is summarized and recorded as debits to Work in Process, Factory

Overhead Control, Marketing Expense Control, and Administrative

Expense Control and as a credit to Payroll. When the payroll is paid.
Accrued Payroll is debited, thereby discharging the liability for the labor
purchased. Employer payroll taxes must also be recorded.
The accounting for labor costs and payroll liabilities is illustrated in
general journal form on pages 455 and 456 based upon these assumptions

1. The payroll period

is for the month of
January, 19B.
 ..
.

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 455

Subsidiary
Record Debit Credit

Reversing entry for wages payable

as of December 31:

Jan. 2 Accrued Payroll 26,000.00

Payroll 26,000.00

Jan. 9 Payroll 50,000.00

Accrued Payroll 37,550.00
Federal Income Tax Withheld 4,800.00
PICA Tax Payable 3,000.00
Salary and Wage Advances 2,200.00
Liability for Union Dues Collected 1,000.00
Employee U.S. Savings Bond Deposits. . 1,200.00
Prepaid Health and Accident Insurance. . 250.00

Accrued Payroll 37,550.00

Cash 37,550.00

Jan. 23 Payroll 40,000.00

Accrued Payroll 31,800.00
Federal Income Tax Withheld 3,700.00
PICA Tax Payable 2,400.00
Liability for Union Dues Collected 1,000.00
Employee U.S. Savings Bond Deposits . . . 900.00
Prepaid Health and Accident Insurance. . 200.00
Accrued Payroll 31,800.00
Cash 31,800.00

Jan. 3 1 Payroll 24,500.00

Accrued Payroll 24,500.00
Work in Process — Labor 38,500.00
Factory Overhead Control 6,429.50
FICA Tax 2,310.00
Unemployment Insurance Taxes. . . . 1,232.00
Workmen's Compens. Insurance 385.00
Pension Cost 1,540.00
Health and Accident Insurance 192.50
Estimated Unemployment Cost 770.00
Payroll 38,500.00
FICA Tax Payable 2,310.00
Federal Unemployment Tax Payable 192.50
StateUnemployment Tax Payable 1,039.50
Prepaid Workmen's Compensation Ins. . . . 385.00
Liability for Pensions 1,540.00
Prepaid Health and Accident Insurance. . . 192.50
Liability for Unemployment Pay 770.00

{continued)
 ..

456 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Subsidiary
Record Debit Credit

Jan. 31 Factory Overhead Control 21,186.00

(cont.) Labor
Indirect 18,000.00
PICA Tax 1,080.00
Unemployment Insurance Taxes. . . . 576.00
Workmen's Compensation Ins 180.00
Pension Cost 900.00
Health and Accident Insurance 90.00
Estimated Unemployment Cost 360.00
Payroll 18,000.00
PICA Tax Payable 1,080.00
Pederal Unemployment Tax Payable 90.00
State Unemployment Tax Payable 486.00
Prepaid Workmen's Compensation Ins. . . . 180.00
Liability for Pensions 900.00
Prepaid Health and Accident Insurance. . 90.00
Liability for Unemployment Pay 360.00

Marketing Expense Control 22,940.00

Sales Salaries 20,000.00
PICA Tax 1,200.00
Unemployment Insurance Taxes . . . 640.00
Pension Cost 1,000.00
Health and Accident Insurance 100.00
Payroll 20,000.00
PICA Tax Payable 1,200.00
Pederal Unemployment Tax Payable 100.00
State Unemployment Tax Payable 540.00
Liability for Pensions 1,000.00
Prepaid Health and Accident Insurance . . . 100.00

Administrative Expense Control 13,724.00

Office and Administrative Salaries ... 1 2,000.00
PICA Tax 720.00
Unemployment Insurance Taxes . . . 384.00
Pension Cost 560.00
Health and Accident Insurance 60.00
Payroll 12,000.00
PICA Tax Payable ! 720.00
Federal Unemployment Tax Payable 60.00
State Unemployment Tax Payable 324.00
Liability for Pensions. 560.00
Prepaid Health and Accident Insurance. . 60.00

The cost of the employer's payroll taxes is recorded when the month-end
labor cost distribution entry is made, with separate liability accounts for
federal and state agencies. Employees' PICA taxes are recorded as a
liability when they are withheld at the payroll date, in compliance with
the regulations.

Added assumptions:
Unemployment insurance: .5% federal; 2.7% state.
Workmen's compensation insurance: 1% of factory payroll earned.
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 457

Added assumptions {continued):

Pension cost estimated to be $4,000 per month, divided as follows: direct

factory labor, $1,540; indirect factory labor, $900; sales salaries, $1,000;
office and administrative salaries, $560.
Payroll advances, $2,200 deducted on Jan. 9 payroll.
Union dues collected, $1,000 each payroll period.
Savings bonds deductions, $1,200 on Jan. 9 and $900 on Jan. 23.
Health and accident insurance, 1% of payroll, shared equally.
Cost for estimated unemployment payments under guaranteed annual wage
plan, 2% of factory labor earned.

This illustration records the employer's payroll taxes as a liability when

the wages are earned, following the accrual concept of account. As a
practical matter, many employers do not accrue payroll taxes at the end
of each fiscal period because the legal hability does not occur until the
next period when the wages are paid. This latter practice may be con-
sidered acceptable if it is consistently applied or if the amounts are not
material.

m DISCUSSION QUESTIONS
The hourly wage of an employee is $5.50, but the labor cost of the employee
1.

is considerably more than $5.50 an hour. Explain.

2. An employee, who is paid $4 per hour for a 40-hour week with time and
a half for overtime and double time for Sundays and holidays, works 40
hours Monday through Friday, 8 hours on Saturday, and 4 hours on Sunday.
Figure the employee's regular pay, overtime pay, overtime premium, and
total earnings for the week. How should the overtime premium wages be
accounted for?

3. For many years a company has paid all employees with 1 to 10 years of
service one month's wages as a Christmas bonus and employees with more
than 10 years' service two months' wages. It is company policy to give 2-week
paid vacations to those with 1 to 10 years' service and 4-week paid vacations
to those with more than 10 years' service. What accounting procedures
should be followed with respect to the bonus and vacation pay?

4. An important function of cost accounting is accounting for labor costs and

related fringe benefits.

(a) Define direct labor and indirect labor.

(b) Discuss reasons for distinguishing between direct and indirect labor.
(c) Give three costing methods of accounting for the premium costs of over-
time direct labor. State circumstances under which each method would
be appropriate.
(d) The Northgate Company has expensed vacation pay on the cash basis
in prior years and is considering changing to the accrual basis in the
next fiscal period. What would be the effects of this change upon the
next fiscal period's annual financial statements ?
(AICPA adapted)
458 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

5. The productive efficiency of the Brighton Company depends upon superior

group leaders and foremen. The company management suggests that group
leaders, foremen, and selected workmen organize a class in personnel ad-
ministration and group leadership. The class is set up at a nearby university
with one of the regular professors in charge. The employees attend the
class at night on their own time, but the company pays the tuition charges.
How should the company account for this cost?

6. In recent years the concept of human resource accounting has been theorized
in management and accounting literature.

(a) How could this theory be defined?

(b) What are the objectives of the concept?
(c) State the theoretical proposals that have been made in favor of human
resource accounting.
(d) What are some of the more serious drawbacks of this new accounting
concept ?

7. A certain company employs approximately 100 factory workers for a

40-hour week and on the average operates 48 weeks each year. Under the
provisions of the pension plan, it is estimated that 40 of the employees will
be pensioned after an average of 25 years of employment. It is further
estimated that, on the average, pension payments will be $200 a month for
a period of 10 years. Set up a schedule estimating the pension cost per hour
of labor purchased.

8. The Spangler Company has just entered into a pension plan for the first
time as a result of union contract negotiations. The plan became effective
as of January 1, 19 — On December 31, 19
.
—
only two entries have been
,

made on the books of the company. The first entry (a debit to Retained
Earnings and a credit to Cash in the amount of $5,000) was the first of a
series of five equal annual payments required to be made to an insurance
company to cover the cost of pensions based on past services. The second
entry was a debit to Factory Overhead Control and a credit to Cash in the
amount of $3,000 to cover the current year's contribution to the insurance
company for pension costs based on the current year's factory wages. Did
the two entries reflect properly the facts relative to the pension plan ? Present
your reasoning and describe any changes which you conclude are needed.

(AICPA adapted)

9. The term "pension plan" has been referred to as a formal arrangement for
employee retirement benefits, whether established unilaterally or through
negotiation, by which commitments, specific or impUed, have been made
that can be used as the basis for estimating costs. What is the preferable
procedure for computing and accruing the costs under a pension plan?
Explain.
(AICPA adapted)

10. Choose the correct procedure in completing the following sentence.

Past service benefit costs incurred upon the adoption of a pension plan
should be charged (debited) to (a) the current period; (b) retained earnings;
(c) current and future periods benefited (d) future periods benefited.
;

(AICPA adapted)
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 459

11. The increasing amount of fringe benefits has focused the attention of ac-
countants on these costs. One of the principal costs is that of pension plans.
(a) Distinguish between "pay-as-you-go" and funded pension plans.
(b) The total cost of contributions that must be paid ultimately to provide
pensions for the present participants in a plan cannot be determined
precisely in advance; however, reasonably accurate estimates can be
made by the use of actuarial techniques. List the factors entering into
the determination of the ultimate cost of a funded pension plan.
(AICPA adapted)

12. When a funded pension plan is adopted, its total cost to the employer for
the first year may be apportioned to past-service cost and current-service
cost.
(a) Distinguish between these two costs.
(b) How should these costs be charged to accounting periods?
(c) What should be the balance sheet treatment of these costs if the em-
ployer must (by contract) accumulate in a trusted fund enough equity
to guarantee employees their benefits upon retirement?
(AICPA adapted)

13. Explain these terms as they apply to accounting for pension plans: (a)

actuarial valuation; (b) vested benefits.

14. Enumerate the social security taxes by indicating (a) whether they are
federal or state taxes and (b) whether they are paid by the employer, the
employee, or both.
15. What is meant by the merit-rating provisions of the unemployment com-
pensation laws of various states?
16. The Glencoe Company has a straight hourly wage rate system with the
hourly rates ranging from $2.75 to $4.25 depending solely on the length of
the employee's service with the company. Sometimes, unusually high or
unusually low labor cost occurs on a job or in a department depending
upon the seniority of the workers who draw the production assignment.
The company does not wish to change its wage policy but also does not
want per-unit labor cost to depend on the seniority of workers on a par-
ticular job or in a particular department. How might the company ac-
complish both of these objectives?

Unless otherwise directed, use these rates in the exercises, problems, and
cases that follow: PICA tax, 6%; federal unemployment insurance tax, .5%;
state unemployment insurance tax, 2.7%.

EXERCISES
1. Distribution of Labor Cost. The general ledger of the Alvarez Products
Company showed these balances at the end of November: direct labor, $24,000;
indirect labor, $5,500; sales salaries, $6,000; and office salaries, $4,500.
PICA
tax is applicable to 60% of the payroll in each department; unemployment
insurance rates apply to only 20%. Income taxes to be withheld are $5,350,
and there is a city payroll tax of 1% on employee gross earnings. Due to an
 :

460 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

excellent employment record, the company pays 1% state unemployment

insurance tax.

Required: (1) The entry to record payroll liability.

(2) The entry to distribute the payroll cost.

(3) The entry to record the employer's payroll taxes.

2. Payroll Taxes. It is the policy of the Tager Company to recognize employer

payroll taxes as wages are incurred employee payroll deductions, however, are
;

not recorded until after the payment of the wages to which the deductions apply.
On December 31, the accrued factory payroll of the Tager Company had a
$2,000 balance, of which $500 represented indirect labor. During January,
factory wages amounting to $15,200 were earned, of which $11,400 was direct
labor. There was no accrued payroll at the end of January.

Deductions on wages paid in January were

Advances to Employees $525
Employees' Life Insurance Premiums 325
Employees' Stock Subscriptions 400
Union Dues 185
Income Taxes 1,720
Employees' PICA Tax 6%
Required: The entries to record the payroll, payment of wages, distribution
of labor cost, and employer's payroll taxes.

3. Payroll Taxes. The following information, taken from daily time tickets,
summarizes time and piecework for the week ended April 30 for a producing
department.
Job Produc-
Clock Order Hours tion Hourly Piece
Employee No. No. Worked Pieces Rate Rate
Busam, J 90 641 40 960 $.24
Garner, M 91 ... 46 ... $5.00
Stange, B 92 638 40 ... 4.80
Wolf, T 93 ... 40 ... 5.20

The company operates on a 40-hour week and pays time and a half for
overtime. Additional information is as follows:

(a) A PICA tax deduction should be made for each employee.

(b) An advance of $20 was made to Busam on April 26.
(c) A 2% deduction is to be made from each employee's wage for the company's
employee health and hospital benefit plan.
(d) Garner works in the storeroom issuing materials; Wolf is the foreman;
all others work directly on special orders as noted.
(e) Use 10% in computing income taxes withheld. State unemployment insurance
is 2%.

Required: (1) The calculation of each employee's gross pay, deductions, and
net pay.
(2) Journal entries (a) to set up the accrued payroll and other liabilities, (b)
to pay the payroll, and (c) to distribute the payroll and to record the employer's
payroll taxes.
 :

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 461

4. Fringe Benefits. Mary Murphy works for the Colorado Land Development
Corporation at a monthly salary of $1,380. The company contributes $368 a
year into a pension fund in her behalf and grants her a two-week paid vacation
annually. The state unemployment insurance rate is 1.3%. All labor-related
costs are considered part of Mary's salary as a sales representative.

Required: (1) The entry to record Mary's employment cost in March.

(2) The entry for December.

5.Payroll Entries. Pasceri Products, Inc. operates on a six-day work week,

Monday through Saturday, with paychecks being distributed on the following
Wednesday. Examination of the firm's books indicates the following entry
made on January 2:

Accrued Payroll 5,000

Payroll 5,000

On January 31, an analysis of payroll records reveals that $27,000 of direct

labor (including $730 overtime premium) and $3,500 of indirect labor (in-
cluding $380 overtime premium) were incurred during January. Ten percent
of the employees' earnings are withheld for income taxes.

During January the following payrolls were paid

January 7 (December 29-January 3) $7,500

January 14 (January 5-10) 7,800
January 21 (January 12-17) 7,600
January 28 (January 19-24) 6,900

Required: (1) The entries to record each of the payrolls met during January.
(2) The entries to record accrued labor at the end of January, to distribute
payroll, and to record employer's taxes on wages earned in January.
(3) Ledger accounts for Accrued Payroll and Payroll.

6. Pension Costs. The Mathis Company employs 125 factory workers for a 40-
hour week and, on the average, operates 50 weeks each year. Under the pro-
visions of a pension plan, it is estimated that 70 of the employees will be pen-
sioned after an average of 25 years of employment. It is further estimated that,
on the average, pension payments will be $250 a month for a period of 10 years.
For the payroll period of March 15, factory labor totaled 5,000 hours.

Required: (1) The pension cost.

(2) The entry to record the pension cost in the March 1 5 payroll.

7. Cost Principles and Cost Determination. A company operating a machine

shop undertook to produce, as a subcontractor under a prime contract with a
government agency, certain parts on a cost-plus-a-fixed-fee basis. The hours of
operation were about evenly divided between the above contract and the regular
business of the company.
 .

462 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

Each day the work required for the regular company business was completed
first.The remainder of the day, with whatever overtime was necessary, was given
over to production under the contract. During the contract period, overtime
hours represented a substantial proportion of the total hours worked. Under
an agreement with the employees, time and a half was paid for all hours over
eight worked each day.
Job sheets recorded the actual cost of materials and direct labor, including
any overtime premium paid. Factory overhead was applied on the basis of the
labor cost so recorded, and the job sheets were adjusted each month to eliminate
any balance in the overhead variance account.

Required: (1) Objections to the cost accounting principles applied.

(2) Incorrectness of the client's statements.
(3) Procedure for making a revised cost determination.
(AICPA adapted)

PROBLEMS
15-1. Entries for Payroll and Payroll Taxes. The general ledger accounts of the
Rundo Company contained these credit balances for the period October 1
through November 30:

Federal Income Tax Withheld $8,500

FICA Tax Payable 940
Federal Unemployment Tax Payable 90
State Unemployment Tax Payable 408

For the December 1-15 payroll, which totaled $28,000, employees' FICA
deductions amounted to only $730 since some of the employees had already
earned the maximum applicable during the year. For the same period, income
taxes withheld totaled $2,372.
The company apportions employer payroll taxes as follows: 60% to Factory
Overhead, 30% to Marketing Expenses, and 10% to General Office Expenses.
The state unemployment insurance tax rate is 2%, and only $5,000 of the pay-
roll is subject to this tax since all other employees had earned more than $4,200
by December 1. The company closed for the year on December 15 and had no
more payroll expenses.

Required: (1) The entry to record the payroll for the period December 1-15.
(2) The entry to pay the payroll of December 1-15.
(3) The entry to record the employer's payroll taxes for the period Decem-
ber 1-15.
(4) The entry to record payment of all taxes due governmental agencies for
the period October 1 through December 3 1

15-2. Payroll Entries — General and Factory Airpol, Inc. manufactures

Office.
air pollution control devices. The firm maintains
factory records at each plant
location. At the St. Louis factory, a payroll journal is maintained as a book of
original entry for the factory employees, even though salaries of persoimel in
 : —

CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 463

the Shipping Department and Finished Goods Stockroom are charged to mar-
keting expenses. Payroll checks are prepared at the home office and sent to the
factory for delivery to the factory employees. Overtime premium wages are
treated as factory overhead. The liability for payroll taxes is kept on the general
office books. Factory payroll taxes are charged to factory overhead.

For the week ending May 30, the following factory payroll summary was
prepared

Factory Payroll Summary

For Week Ending May 30, 19—
Income
Payroll Tax With-
Labor (Earned Overtime holding Net
Department Hours Hours) Premium (10%) Pay
Casting 240 $1,134 54 $118.80 $ 71.28 $ 997.92
Forging 410 1,720 80 180.00 108.00 1,512.00
Machining 560 2,860 60 292.00 175.20 2,452.80
Assembly 160 640 64.00 38.40 537.60
Toolroom 84 344 32.20 21.12 295.68
Storeroom 82 322 33.60 20.16 282.24
Stockroom 40 140 14.00 8.40 117.60
Shipping 40 152 15.20 9.12 127.68

Total 1,616 $7,322 $206 $752.80 $451.68 $6,323.52

Sales Office $1,600 $160.00 $ 96.00 $1,344.00

General Office $ 750 $ 50 $ 80.00 $ 48.00 $ 672.00

A recapitulation of the time tickets for direct labor showed:

Recapitulation of Time Tickets

For Week Ending May 30, 19

Job
Total
Weekh
 CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 465

(2) The labor cost entry on November 30, treating the employer's payroll
taxes and vacation pay as factory overhead. The state unemployment tax rate
is 2%.
(3) Ledger accounts for Payroll and Accrued Payroll and the entry to record
accrued wages at the end of November.

15-5. Overtime Premium. The Jernigan Clothing Company produces several

lines of women's fashions and has had exceptional success in selling its products
to leading department stores across the nation. Jernigan employs 20 produc-
tion workers, paying $4 per hour for a 5-day, 40-hour work week; 20% of wages
are withheld for income taxes, and state unemployment insurance is 1.4%.
Currently, production reports indicate that the workers average 320 dresses
per day. Since customer demand is considerably greater than that, the firm's
management decided to work overtime for the first week in May to increase
daily output to 440 dresses.
By May 23 production had met customer orders, and no additional over-
time was needed. On the following day, May 24, however, an accident caused
five employees to halt work for one hour while repairs were made. The five-man
crew was forced to work one hour overtime that evening to maintain regular
production schedules.
On May 27 a salesman called in a rush order for 280 dresses which needed
to be ready for delivery by the following Monday. It was decided to work the
entire work force on Sunday, May 29, at 200% wages to fill this order.

Required: (1) Entries to record the payroll liability and labor cost for the
first week in May.
(2) The entry to record labor cost for May 24.
(3) The entry to record the labor cost for the rush order.

15-6. Pension Plans. The DiMario Corporation adopted a pension plan for its
employees on January 1, 19E. A trial balance of the records of the plan at De-
cember 31, 19F, follows:
Debit Credit
Cash $ 400
Investments (at cost) 3,400
Bone, Equity $1,590
Cohan, Equity 1,060
Dohler, Equity 850
Income from Investments — Received in 19F 300
$3,800 $3,800

The following data pertain to the corporation's employees for 19F:

Date Date Salary Paid

Employed Terminated in 19F
Bone
Cohan
Dohler
Dec.
Feb.
8,

1,
19A
19C — $17,900
14,100

Kolman
Jones
Dec. 8,
Sept. 15,
Sept. 21,
19C
19D
19F
—
April 9,

Dec. 22, 19F

19F 3,500
8,000
3,000
Lehman May 6, 19F 5,500
Total $52,000
 ) :

466 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

The provisions of the plan include the following:

(a) The corporation shall contribute 10%

net income before deducting
of its

income taxes and the contribution, but not excess of 15% of the total
in
salaries paid to the participants in the plan who are in the employ of the
corporation at year end. The employees make no contributions to the plan.
(b) An employee shall be eligible to participate in the plan on January 1 following
the completion of one full year of employment.
(c) The corporation's contribution shall be allocated to the participants' equities
on the following point system:
( For each full year of employment
1
—
2 points.
(2) For each $100 of salary paid in the current year — I point.
(d) A participant shall have a vested interest of 10% of his total equity for each
full year of employment. Forfeitures shall be distributed to the remaining
participants in proportion to their equities in the plan at the beginning of the
year. Terminated employees shall receive their vested interests at year end.
(e) Income from the plan's investments shall be allocated to the equities of the
remaining participants in proportion to their equities at the beginning of the
year.

The DiMario Corporation's net income in 19F before income taxes and con-
tribution to the plan was $73,250.

Required: (1) A schedule computing the corporation's contribution to the

plan for 19F.
(2) A
schedule computing the vested interests of the participants termi-
nating their employment during 19F.
(3) A schedule showing the allocation of the corporation's 19F contribution
to each participant.
(4) A schedule showing the allocation of the plan's 19F income on invest-
ments and forfeitures by terminated participants.

(AICPA adapted)

15-7. Pension Plans. The Hercules Tire Company is planning a pension

system for some of its employees and wishes to provide funds for meeting the
payments under the pension plan.
The company does not contemplate making any pension payments under
the plan until January, 1982. Payments in 1982 and thereafter to the present
group of covered employees are expected to be as follows
January 1
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 467

Amount of $1 Present Value of Amount of Annuity Present Value of

at Compound $1 at Compound of $1 at End of Annuity of $1 at
Periods Interest Interest Each Period End of Each Period

1
 B

468 PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

(b) balance sheet as ofDecember 31, 19C, for Deferred Past Service Costs and
Due to Pension Trustee; (c) notes for both of these financial statements. [If the
amount cannot be calculated, use 5a-x.y.]
(NAA adapted)

CASES
A. Payroll Taxes. In January, 19C, the financial statements of the Grabill
Company for the year ended December 31, 19B, were examined. The company
filed the necessary payroll tax returns for the first three quarters of 19B and had
prepared drafts of the returns scheduled to be filed by January 31, 19C.
The following information was available from the general ledger, copies
and drafts of payroll tax returns, and other sources:

General Ledger:
Balance as of
Account December 31, 19 Composition of Balance

Wages (various expense accounts). . . $121,800.00 12 monthly entries from the payroll
summaries

Payroll Taxes Expense 8,458.00 PICA (6% of

S102,000), $6,120;
state unemployment tax (2.7%
of $59,000), $1,593; federal unem-
ployment tax (.5% of $59,000),
$295; amounts withheld from em-
ployees for PICA tax in October
and November and paid to depos-
itary, $450

Employees' Payroll Taxes Withheld 3,122.50 December income tax, $1,530; Octo-
ber through December PICA tax,
$1,592.50

Employer's Payroll Taxes Payable 956.50 December PICA tax, $462.50; Octo-
ber through December state un-
employment tax, $199; 19B fed-
eral unemployment tax, $295

Additional information:
(a) In August 19B, six laborers were hired to tear down an old warehouse building
located on the site where a new warehouse would soon be constructed. The
laborers' 19B wages totaling $1,000 were charged to the land and buildings
account. Payroll taxes were not withheld.

(b) Included in a 19B wages expense account is one month's salary of $1,400 paid
to the president on December 30, 19B, for his 19A vacation allowance.
(c) Agross factory payroll of $1,200 through December 31, 19B, and the related
FICA taxes (employer and employee) were accrued on the general ledger at the
year end for a portion of the week ending January 4, 19C. Each of the em-
ployees included in this payroll earned between $4,000 and $6,000 as a Grabill
employee in 19B.

(d) In December, 19B, a contractor was paid $2,300 for making repairs to machinery
usuallymade by company employees and the amount was charged to Wages
Expense. No payroll taxes were withheld.
CH. 15 ACCOUNTING FOR LABOR-RELATED COSTS 469

(e) Copies of 19B tax returns:

First Three Quarters
Totals
for Year
 ~ :

PLANNING AND CONTROL OF MATERIALS AND LABOR PART IV

470

Casey & Lewis Printers, Inc.

Basic Noncontributory Pension Plan

Actuarial Report as of June 30, 19A

I. C urrent Year's Funding and Pension Cost

Normal cost (before adjustment for
actuarial gains) computed under the
^4 1 «50
j J4,iou
entry-age-normal method

Actuarial gains:
Investment gains (losses):
Excess of expected dividend income
over actual dividend income $ (350)
Gain on sale of investments 4,050
Gains in actuarial assumptions for:
Mortality 3,400
Employer turnover • • • 5,050
Reduction in pension cost from closing
°fP'='"'
Net actuarial gains
-^^ —20150
tt^t^t^
14,000

Normal cost (funded currently) $ 14,000

Past service costs:
Funding 14,245
^^ ^^^
Amortization
Total funded ^ 28,245

Total pension cost for financial-statement ^^^

'
purposes

II, Fund Assets:

Cash $ 4,200
Dividends receivable 1,5/j
Investment in common stocks, at cost
1^2,750 $168,475
(market value, $177,800)

Liabilities:
III.
—Actuarial —
46
Number of employees „
Number of employees retired
Yearly earnings of employees ci^^ nnn
3.14!),UUU
Actuarial liability

IV. Actuarial Assumptions

Interest
5%
..,,., 1951 Group
'^^'-t^^'^y
Annuity Tables
Retirement ^
 CHAPTER 16

PLANNING AND BUDGETING

OF PROFITS, SALES,
COSTS, AND EXPENSES

Cost accounting is a "tool of management," and as such serves as a

means for planning and control. General or financial accounting is pri-
marily concerned with the preparation and issuance of monthly and annual
financial statements. Cost accounting, however, provides management
with total and detailed costs of products, thereby enabling executives to
formulate intelligent production plans and sales policies. Detailed state-
ments furnished to management at short intervals compare and analyze
actual costs of materials, labor, factory overhead, marketing, and ad-
ministrative expenses with estimates and standards prepared in advance
of production. This permits responsible management levels to exercise
effective control over the operations of divisions and departments. A
standard cost system combined with budgets constitutes the most logical
foundation for the achievement of these multiple tasks and goals.

PROFIT PLANNING
Sound and intelligent planning of profits, sales, and costs and expenses
is both more important and more difficult than ever before in this age of

rapid technological change and heightened recognition of the need to

consider social and political parameters. Modern profit planning encour-
ages desirable action and recognizes the divisional and departmental
autonomy and responsibihty of managers, motivating them to strive for
471
472 PLANNING OF PROFITS, COSTS, AND SALES PART V

attainment of their personal objectives in congruence with the organiza-

tion's objectives. Profit planning is directed to the final objectives of the
organization and generally includes all of its important elements. Bud-
geting,employed as a tool of both planning and control, offers manage-
ment one of its best means for placing an organization on a definite course
and keeping it there. A budget is simply a plan expressed in financial and
other quantitative terms. The terms "budgeting" and "profit planning"
can be viewed as synonymous.
Profit planning is a well thought-out operational plan with its financial
implications expressed as both long- and short-range profit plans or bud-
gets in the form of financial statements, including balance sheets, income
statements, and cash and working capital projections. Profit planning is

especially effective in enabling middle management to help plan profit and

control costs. It is management's primary tool to accomplish its objectives.

Long-Range Profit Planning. In recent years business has become

aware of a need to introduce long-range profit planning or forecasts. These
long-range plans are not stated in precise terms, nor are they expected to
be completely coordinated future plans. They deal rather with specific
areas such as future sales, long-term capital expenditures, extensive re-
search and development activities, and financial requirements. Long-
range profit planning intends to find the most probable course of events or
range of probabilities. It deals with the futurity of present decisions. To
find the best short-range plans and make the wisest decisions, manage-
ment must look to the future. Long-range planning does not ehminate
risk, for risk-taking is the essence of economic activity. The end result of
successful long-range profit planning is a capacity to take a greater risk,
for this is the only way to improve entrepreneurial performance. Long-
range planning has been defined as "the continuous process of making
present decisions systematically and, with the best possible knowledge of
their futurity, organizing systematically the efforts needed to carry out
these decisions and measuring the results of these decisions against the
expectations through organized, systematic feedback." i Long- and short-
range planning should be merged into integrated strategic planning.
Market trends and economic factors, growth of population, personal
consumption expenditures, and indices of industrial production form the
background for long-range planning. Quantitative sales estimates for a
three- to five-year forecast are developed, followed by a dollar evaluation
of the combined plans. The financial section might culminate in a pro-
spective income statement showing by years anticipated sales, variable
costs, contribution margin, fixed factory overhead, fixed marketing and

iPeter F. Drucker, "Long-Range Planning," Management Science, VoL 5, No. 3, p. 240.

 :

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 473

administrative expenses, and net operating income. balance sheet by A

years can be prepared to indicate anticipated cash balances, inventory
levels, accounts receivable balances, liabilities, etc. This financial long-
range plan might also be supported by a cash flow statement.

Setting Profit Objectives. A management's long-range plans can only

be achieved through successful long-run profit performance where the
basic requirements are growth and a reasonably high and stable level of

profit.

In setting profit objectives, management needs to consider the following

factors

1. Profit or loss resulting from a given volume of sales

2. Sales volume required to recover all consumed costs, to produce a profit

adequate to pay dividends on preferred and common stock, and to retain
sufficient earnings in the business for future needs

3. Break-even point
4. Sales volume that the present operating capacity can produce
5. Operating capacity necessary to attain the profit objectives
6. Return on capital employed

Most companies operate with some kind of profit expectancy which

motivates their planning. Fundamentally, three different procedures can
be followed to set the profit objectives.

1. The a priori method in which the profit objectives take precedence over
the planning process. At the outset, management specifies a given rate
of return to be achieved in the long run which it seeks to realize by
means of planning directed toward that end.

2. The a posteriori method in which the determination of profit objectives

is subordinated to the planning, and the objectives emerge as the product
of the planning itself.

3. The pragmatic method which management uses a profit standard that

in
has been tested empirically and sanctioned by experience. By using a
target rate of profit derived from experience, expectations, or compari-
sons, management establishes a more or less definite profit level which is
considered satisfactory for the company; and this constitutes a relative
profit standard. The rate of return on capital (total assets) employed,
introduced in Chapter 2, is generally considered the most important
statistic in long-range profit planning and setting profit objectives. The

» usual practice is to compute rates of return for each individual year cov-
ered in the long-range plan in order to show whether planned increases
in total net income will keep pace with increases in assets and to measure
the effectiveness with which management is likely to use the assets. This
comparative analysis is prepared at both corporate as well as divisional
p
 2

474 PLANNING OF PROFITS, COSTS, AND SALES PART V

and/or operating levels. Though return on capital employed is the basic

measure of profit performance (discussed in detail in Chapter 27), com-
panies typically use several other measures such as the ratio of net in-
come to sales, the ratio of sales to shareholders' capital, and earnings
per common share.

Heightened public expectations with regard to social responsibilities

compel companies to consider the social consequences when formulating
plans to achieve profit objectives. Increasingly, important actions must be
evaluated in a context that includes social as well as economic impacts.
Potential social impacts specifically pertain to ". . . environmental pollu-
tion, the consumption of nonrenewable resources, and other ecological
factors; the rights of individuals and groups; the maintenance of public
service; public safety; health and education; and many other such social
concerns."^ Such social factors are likely necessary considerations in the
framework of corporate thinking,

Short-Range Plans or Budgets. Long-range plans with their future

expectancy of profits and growth must, however, be placed on a shorter
range for both planning and more importantly control of the contem-
plated course of action. The short-range budget may cover periods of
three, six, or twelve months depending upon the nature of the business.
One year, however, is the usual planning period. For efllicient planning,
the annual budget should be expanded into an eighteen-month budget,
allowing for a three-month period at the end of the old year, twelve months
for the regular budget period and an additional three months into the
third year. These overlapping months are needed in order to allow transi-
tion from year to year and to make adjustments based on prior months'
experience. The budget period should be divided into months. It should:

1. Be long enough to complete production of the various products.

2. Cover at least one entire seasonal cycle for a business of a seasonal nature.
3. Be long enough to allow for the financing of production well in advance
of actual needs.
4. Coincide with the financial accounting period to compare actual results
with budget estimates.

Some organizations use a continuous budget by which a month or

quarter in the future added as the month or quarter just ended is
is

dropped, and the budget for the entire period is revised and updated as

2"Long-Range Profit Planning," Research Report No. 42 (New York: National Association
of Accountants, 1964), pp. 60-65.
3Robert K. Elliott, "Social Accounting and Corporate Decision-Making," Management
Controls, Vol. XXI, No. 1, p. 2.
 4

CH. 16 BUDGETING: PROFITS, SALES, COSTS, &. EXPENSES 475

needed. This procedure forces management to think continuously about

its short-range plans.

Advantages of Profit Planning. Profit planning or budgeting has the

advantages of:

1. Providing a disciplined approach to the solution of problems.

2. Obliging management to make an early study of its problems and in-

an organization the habit of careful study before making
stilling into
decisions.

3. Developing throughout the organization an atmosphere of profit-

mindedness, encouraging an attitude of cost-consciousness and maximum
resource utilization.

4. Enlisting the aid and coordinating the operating plans of the diverse
organizational segments of the entire management organization so that
the final decisions and contingency plans represent the total organization
in the form of an integrated, comprehensive plan.

5. Aff'ording the opportunity of appraising systematically every facet of the

organization as well as examining and restating periodically its basic
policiesand guiding principles.

6. Coordinating and correlating all efforts, for no management activity

reveals weaknesses in organization so quickly as the orderly procedure
necessary for systematic budgeting.

7. Aiding in directing capital and effort into the most profitable channels.

8. Encouraging a high standard of performance by stimulating competition,

providing a sense of purpose, and serving as an incentive to perform
more eff"ectively.

9. Providing yardsticks or standards for measuring performance and

gauging the managerial judgment and ability of the individual executive.

Limitations of Profit Planning. While the advantages of profit planning

or budgeting are unquestionably impressive and far-reaching, certain
limitations and pitfalls need to be mentioned:

1. Planning, budgeting, or forecasting is not an exact science; a certain

amount of judgment is present in any budgetary plan. revision or A
modification of estimates should be made when variations from the esti-
mates warrant a change of plans.

2. A planning program needs the cooperation and participation of

profit
all members of management. Basic for success is executive management's

"^Adapted from Peter A. Noll and Edward A. Radetsky, "Values of Profit Planning," NAA
Bulletin, Vol. XLV, No. 6, p. 36.
 :

476 PLANNING OF PROFITS, COSTS, AND SALES PART V

absolute adherence to and enthusiasm for the budget plan. Too often a
budgetary plan has failed because executive management has paid only
lip service to its execution.

3. Profit planning does not eliminate nor take over the role of administra-
tion. Executives should not feel "hemmed-in."
Rather, the budgetary
plan is designed to provide detailed information that allows the execu-
tives to operate with strength and vision toward achievement of the or-
ganization's objectives.

4. Installation takes time. Often, a management becomes impatient and

loses interest because it expects too much too soon. The budget plan
must first be sold to the responsible people; and they, in turn, must then

be guided, trained, and educated in the fundamental steps, methods, and

purposes of a budgetary system.

PREREQUISITES OF A BUDGET PLAN

A company's organization chart and its chart of accounts form the two
basic frameworks on which to build a coordinated, cooperative, and effi-

cient system of managerial planning and budgetary control. The organi-

zation chart defines the functional responsibilities of each executive whose
activities justify a budget. Final responsibility for the budget rests with
top management. However, each executive is responsible for the prepara-
tion and execution of his departmental budget. If a budgetary control
system is to be successful, it is necessary to have the full cooperation of

each company official, and each official must understand the budget
system and his role in making the system successful.

THE BUDGET COMMITTEE

The budget committee is composed of executives in charge of major
functions of the business and includes the sales manager, the production
manager, the chief engineer, the treasurer, and the controller.

The principal functions of the budget committee are to

1. Decide on general policies.

2. Request, receive, and review individual budget estimates.
3. Suggest revisions.
4. Approve budgets and later revisions.
5. Receive and analyze budget reports.
6. Recommend action designed to improve efficiency where necessary.

In performing these functions, the budget committee becomes a man-

agement committee. It is a powerful force in knitting together the various
activities of the business and enforcing real control over operations.
CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 477

DETAILS OF THE TOTAL PERIODIC BUDGET

The budget committee's initial function is to request, receive, and
review individual budget estimates. A complete set of budgets generally
consists of:

1. Sales estimates by:

a. Territory and product, or
b. Territory, customer group, and product
2. Estimates of inventory, production, and purchase requirements
3. Estimates of materials, labor, and factory overhead combined into a
cost of goods sold schedule
4. Detailed expense budgets for marketing and administrative expenses
5. A budget of major repairs, replacements, and improvements of plant and
machinery, and research and development expenditures
6. A cash budget showing cash receipts and disbursements
7. A forecast income statement
8. A forecast balance sheet showing the estimated financial position of the
company at the end of the budget period

SALES BUDGET
The most important single element in a budgetary control system is a
sound and accurate sales forecast. This forecast must consider past sales
and be based on market and sales analyses. The task of preparing the sales
budget is usually approached from two different angles: (1) judging and
evaluating external influences and (2) considering internal influences.
These two influences are brought together in an intelligent and workable
sales budget. External influences are the general trend of industrial ac-
tivity, governmental policies, cychcal phases of the nation's economy, pur-
chasing power of the population, population shift, and changes in buying
habits and modes of living. Internal influences are sales trends, factory
capacities, new products, plant expansion, seasonal products, sales force
estimates,and establishment of quotas for salesmen and sales territories.

Last but not least, the profit desired by the company plays a significant
part.

Forecasting Sales. The preparation of sales estimates is usually the

responsibility of the marketing manager assisted by individual salesmen
and market research personnel. Because of the many dissimilarities in the
marketing of products, actual methods used to forecast sales vary widely
in various companies. One method of forecasting sales still used by many
companies is the preparation of sales estimates by individual salesmen.
Each salesman suppHes his district manager with estimates of what he
thinks he can sell in his territory during the coming period. These esti-
mates are consolidated and perhaps adjusted by the district marketing
478 PLANNING OF PROFITS, COSTS, AND SALES PART V

manager before he forwards them to the general marketing manager

where further adjustments are made. These adjustments make allowances
for expected economic conditions and competitive conditions of which
salesmen are unaware, as well as allowances for expected canceled orders
and sales returns that ordinarily would be disregarded by salesmen who
base their estimates on the orders they expect to procure.
In many firms the method described above has been either supple-
mented or superseded by the establishment of market research or market
analysis divisions which assist the marketing manager and the salesmen in
arriving at more accurate estimates.
In larger organizations the forecasting procedure starts with known
factors; namely, (1) the company's sales of past years broken down by
product groups and profit margins, (2) industry or trade sales volume and
perhaps profits, and (3) unusual factors influencing sales in the past. The
company's past sales figures often require a restudy or reclassification due
to changes in products, profit margins, competition, sales areas, distribu-
tion methods, or changes within the industry. Industry or trade volume
of sales and profits are secured from trade associations, trade publications,
and various business magazines. For some industries the U, S. Department
of Commerce publishes information that is useful as background data.
Unusual factors influencing past sales are inventory conditions, public
economic sentiment, competition, and customer reactions. Charting a
company's physical volume in units of various products for a three- to
five-year period and comparing it with the industry's volume will disclose
the company's sales trend and permit pinpointing factors that affected past
sales.

With such known facts assembled, the sales forecast turns toward
prediction of the future. Although the feeling frequently exists that this
is the crystal-ball area, a good sound basis for determining future sales
can be established by considering:
1. General business conditions.
2. The industry's prospects and the company's potential share of the total
industry market.
3. The plans of other and particularly competitive companies.

Seasonal Variations. When the annual sales forecast has finally been ap-
proved, it must be placed on an operating period basis. Experience will
show that each product manufactured has its own seasonal sales pattern.
Records are examined to determine the trend a product has followed during
past years. Consideration should be given to the causes of the fluctuations.
They might be due to customs or habits based on local or national traits,
climate, holidays, or even influences caused by companies in the firm's own
industry. All this information is used in preparing a monthly sales budget.
 —

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 479

The seasonal or operating sales budget is of great help in judging the

records of individual salesmen. Averaging sales over a budget period is not
sufficient to assure success of a sales program. Too many times low sales in
one month have been excused with the optimistic statement that sales in
the following month will make up the difference. When this does not hap-
pen, the sales budget and the entire budget plan suffer.

Sales Budget on a Territory and Customer Basis. A sales budget should

not only be placed on a monthly basis for each product but should also
be prepared by territories or districts and classified as to types of cus-
tomers. (See illustration below.) The customer classification will show
sales to jobbers, wholesalers, retailers, institutions, governmental agencies,
schools and colleges, foreign businesses, etc. Such a breakdown indicates
the contribution each class of trade makes to total sales and profits. An
analysis of this type will often reveal that certain classes of customers or
trades are not given sufficient attention by sales managers and salesmen.
A customer budget can thus become a strong means for analyzing possible
new trade outlets. It also assists in locating reasons for a drop in sales to
various customer classes so that such a decrease can be investigated
quickly and remedial steps taken.

Product X
Sales Budget
(By Territory and By Customer Group)
For Year Ending December, 19

Customer January February

Territory Group
North

East

South

West

Total
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480 PLANNING OF PROFITS, COSTS, AND SALES PART V

experiences are available, coordination of the sales budget with the pro-
duction budget is not too difficult.

However, production planning must realize that the best possible level
of production keeps men and machinery operating all year with a sufficient
but economic inventory on hand. If, for example, the sales budget should
indicate that in certain months factory employment would fall seriously
below a desirable level, it would be necessary to attempt to increase sales
volume or increase inventories. Should estimated sales be higher than
available capacity, the possibility of increasing plant capacity through
purchase or rental of new machinery and factory space must be considered.
If factory capacity is available, an efficient rate of production should be
established to avoid serious fluctuations in employment. To hire and lay
off" workers is always expensive. StabiUzation of employment is desirable
and should become a definite company policy. An even flow of production
will make for better labor relations.
When scheduling production, beginning and ending inventories of
finished stock on handend of each month are important. It is neces-
at the
sary to have inventories on hand which permit fulfillment of the month's
sales requirements. At the same time, the investment in inventories should
be held to a level consistent with sound financial policy.

PRODUCTION BUDGET
A production budget is stated in physical units and frequently is merely
the sales budget adjusted for any inventory changes (as shown below).
Seasonal fluctuations of sales are usually leveled out in production plan-
ning in order to stabiHze employment without causing a shortage of
finished products, inefficient service to customers, or large inventories.
The production budget, like other budgets, will be detailed by months
or quarters along with a tentative annual budget. Uncertainty of estimated

Product X
Production Budget
For Year Ending December, 19

Year,
January February December 19—
Units required to meet sales budget .... 8,000 9,000 7,000 120,000
Add desired ending inventory 6,400 7,400 4,400 4,400
Total units required 14,400 16,400 11,400 124,400
Less estimated beginning inventory 4,400 6,400 1,400 4,400
Planned production 10,000 10,000 I S 10,000 120,000
CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 481

sales makes this desirable in many concerns. The detailed budget should be
broken down by work stations for comparison with actual production. The
nature of the breakdown will be determined by plant layout, type of pro-
duction, and other factors.
For a company that does not manufacture a standard product but pro-
duces only on orders, plans cannot be too detailed. The problem here is to
be prepared for production when orders are received. However, if there are
standardized parts, production can often be budgeted in a manner similar
special-order
to that used by a company producing a standard product. In
work, the routing and scheduhng of work through the factory is of prime
importance to prevent delays and to utilize production facilities fully.
Coordination of the production budget with the sales budget is of
extreme importance, otherwise production may become unbalanced. The
sales department may emphasize volume and overlook balance.
Sales per-

sonnel mayconcentrate on selling what they think are the most profitable
lines and overlook products that the company has facilities to produce
and which cannot be used for other products. Such a condition may result
in idle capacity with resultant losses greater than if sales effort
had been
concentrated otherwise.
No division of a manufacturing business has made so much progress in

scientific management as the production department. When competition

becomes keen and pressure for price cutting increases, management looks
for reduced production costs. With labor resisting decreases or
pressing
devices
for increases in wages, reduction must take the form of labor-saving
and careful planning, routing, and scheduling. Constant effort is always
directed toward devising new ways and short cuts that will lead to more
efficient production and cost savings. Any gains production
in efficiency

will be reflected in earnings.

The production budget deals with the scheduUng of operations, the de-
termination of volume, and the establishment of maximum and minimum
quantities of raw materials and finished goods inventories. Its summaries
and details provide the basis for preparing the budgets of materials, labor,
and factory overhead. These three elements of cost constitute the cost of
goods sold section of the income statement, and their totals are estimated
in the manufacturing budget.

MANUFACTURING BUDGET
With the forecasted sales volume translated into physical units in the

production budget, the future costs of materials, labor, and factory over-
head essential to the sales and production program can be computed.
These costs, often based on standard costs, are usually summarized in a
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482 PLANNING OF PROFITS, COSTS, AND SALES PART V

manufacturing budget which, in effect, is made up of three budgets:

materials, labor,and factory overhead. The costs are further classified into
fixed and variable costs and budgeted accordingly: variable costs as a
constant dollar amount per unit; fixed costs only in total. A fundamental
axiom of the relationship of fixed and variable costs to the product must
never be forgotten: fixed costs are fixed in total, but variable per unit;
variable costs are variable in total, but fixed per unit. Example

Lopez Company
Manufacturing Budget Estimates
For Year Ending December 31, 19—

Production 20,000 Units 25,000 Units

Direct materials cost, $5 per unit $100,000 $125,000

Direct labor cost, $3 per unit 60,000 75,000
Variable factory overhead, $1 per unit 20,000 25,000
Fixed factory overhead 40,000 40,000
Fixed factory overhead per unit ($2) ($1.60)

The factory overhead is budgeted in greater detail by responsibility

centers or departments with the strong probability that flexible budgets
would be prepared for each center. The budget information thus developed
becomes part of the master budget to be used as a standard or target
against which the performance of the individual department is judged and
evaluated. Detailed budgets are also prepared for direct materials and
direct labor.

Direct Materials Budget. A materials budget indicating the quantity

and cost of materials required to produce the predetermined units of
finished goods is usually the first cost budget prepared. A materials budget

1. Permits the purchasing department to set up a purchasing schedule that

assures delivery of materials when needed.
2. Leads to the determination of minimum and maximum quantities of
raw materials and finished parts that must be on hand.
3. Establishes a means by which the treasurer can gauge the financial re-
quirements of the purchasing department.

The materials budget usually deals with direct materials only. Supplies
and indirect materials are generally included in the factory overhead
budget; however, the necessary factors discussed below are also applicable
to supplies and indirect materials.

Purchase Requirements. The production planning department deter-

mines the quantity and type of materials required for the various products
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CH. 16 BUDGETING: PROFITS, SALES, COSTS, &. EXPENSES 483

manufactured by a company. Most companies have standard parts lists

and bills of materials which detail all materials requirements. The require-
ments are given to the purchasing department which sets up a buying
schedule making certain that sufficient materials are always available with-
out overstocking or creating a shortage. (See schedule below.) In preparing
the schedules, the purchasing department must consider: (1) changes in
possible delivery promises by the supplier and (2) changes in the rate of
materials consumption because of unforeseen circumstances.

Raw Material A
Production, Inventory, and Purchase Requirements Schedule
For Year Ending December 31, 19

Raw Material A January February ! December Total

Beginning inventory. , . 80,000 80,000 ;

' 80,000 80,000
Purchases 45,000 45,000 50,000 600,000
Materials available. ... 1 25,000 1 25,000 130,000 680,000
Ending inventory 80,000 80,000 ;
80,000 80,000
Materials used 45,000 45,000 50,000 600,000

Minimum and Maximum Quantities. The materials ledger cards of

many companies carry a section in which the minimum and maximum
quantities to be stored are shown. These figures indicate to the stock
record clerk quantities that should not be exceeded and below which
stocks should not drop. When either condition develops, the clerk will
inform the purchasing department — or in some companies the produc-
tion planning department. Coordination of materials records with pur-
chasing department data acts as a check on both overstocking materials
and the danger of a possible shortage.

Data for Cash Budget. The completed direct materials budget broken
down by types and quantities is priced to arrive at the dollar value of
materials needed for the year. Funds needed for monthly purchases are
included in the cash budget (see Chapter 17). An increase or decrease in
expenditures for materials must be known to the treasurer so that necessary
funds will be available at the proper time.

Direct Labor Budget. The labor budget must tie in with the general
program by the production planning department. It is generally
laid out
preferable to prepare a separate direct labor budget and to include indirect
labor in the factory overhead budget. Direct labor is based on specifica-
tions drawn up by product engineers. Indirect labor is included in the
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484 PLANNING OF PROFITS, COSTS, AND SALES PART V

factory overhead budget and consists of those employees who work in

producing departments as helpers as well as the large contingent of indirect
workers engaged in maintenance work, in hauling, or of those who work
as crane operators, materials clerks, receiving clerks, and so forth.
The labor budget for direct and indirect labor guides the personnel
department in determining the number and types of workers needed. If the
labor force has been with the firm for several years and if the production
schedule does not call for additional workers, the task of the personnel
department is rather easy. It is the increase or decrease of the labor force
that requires the personnel department to make plans in advance to assure
availabihty of workers. Frequently the personnel department must provide
a training program which must be so timed that the production department
can rely on receiving workers at the proper time. When workers are to be
laid off, the personnel department must prepare a list of the workers
affected, giving due recognition to skill and seniority rights. In many
companies this schedule is prepared in collaboration with union repre-
sentatives to protect employees from any injustice or hardship.
The hours or number of men must be translated into
the dollar values.
EstabUshed labor rates as agreed upon in union contracts are generally
used. Should conditions indicate that labor rates might change, the new
rates should be used so that the financial budget reflects the most recent
figures available.

Factory Overhead Budget. The factory overhead budget is prepared on

the basis of the chart of accounts, which properly classifies expense ac-
counts and details the various cost centers. As discussed previously,
expenses can be grouped in several ways

1. Natural expense classification, such as indirect materials and supplies,

indirect labor, freight, light, power, etc.

2. Departmental or functional classification, which divides or determines

the expense in terms of the department or cost center that incurred or
originated the expense

3. Division of expenses according to variability, i.e., variable and fixed

The natural expense classification alone is not too useful for budget
purposes. Expenses are usually incurred by various departments. It is by
dealing with individual departments that the value and importance of
budgetary control for expenses becomes significant. The departmental
expense classification falls into two main categories: producing depart-
ments and service departments.
Preparation of any expense budget should be guided by the underlying
principle that every expense is chargeable to a department supervised by