Profit equals the measurement of accomplishment (sales) minus the measurement of effort (costs).
The measurement of effort is governed by three conventions, namely the matching convention, the allocation convention and the cost convention.
2.6.1 The Matching Convention
Profit is arrived at by matching the effort (or costs) with the units shipped and invoiced to the customers (sales) during the period.
Identifying the costs of the units sold is not so easy as it sounds because the volume of units manufactured in any accounting period seldom equals the volume of units sold. When production volume exceeds sales volume, or when it is smaller than sales volume, the efforts of the period are not equal to the efforts linked to sales. In these situations the inventory of work-in-progress and/or finished goods is added to, or dipped into. Consider the following examples.
Example
(a) When sales volume exceeds the volume of units produced for a period (as in the sports bag example but ignoring faulty goods):
Bags
Sales for year 12 000
Cost of sales:
(a) Costs of manufacturing 10 000
Plus:
(b) Costs attaching to bags taken from finished goods inventory 2 000 12 000 (b) When production volume exceeds the units sold (reverse the numbers of the
sports bag example, i.e. sold 10 000, made 12 000):
Bags
Sales for year 10 000
Cost of sales:
(a) Costs of manufacturing 12 000
Less:
(b) Costs attaching to bags put into finished goods inventory 2 000 10 000
Without the matching convention the effort of producing 12 000 bags would be set against the accomplishment of selling 10 000.
What is meant by ‘efforts’? Efforts are all the costs involved in producing saleable products, and the costs involved in actually selling the products which are recognised in the measurement of sales accomplishment.
Some typical costs of production:
• raw materials
• labour
• depreciation of production plant and machinery
• overheads directly related to the production cycle.
Typical costs of selling and administration:
• advertising and promotion
• packaging and distribution
• staff salaries
• non-production overhead expenditure
• research and development.
2.6.2 The Allocation Convention
The first task is to determine how much of each means of production, expressed in money terms, was consumed during the accounting period, that is, the com-pany’s total purchases of means of production (e.g. raw materials, power, wages of production workers) have to be allocated over the accounting period. (This process is known as cost determination and recognises that not all purchases made during the period are consumed by production.)
The second task is to determine how much of each means of production, again expressed in money terms, should be matched with sales revenue and how much should be added to the closing work-in-progress (inventory of unfinished goods) and to the inventory of finished goods (on the assumption that goods remain unfinished at the end of the accounting period and that the business produces more finished units than it sells).
It will be noted that the second task is similar to the procedures adopted under the matching convention.
2.6.3 The Cost Convention
It was stated above that the means of production is measured and expressed
‘in money terms’. The general rule is found in the cost convention: accountants use the historical (or acquisition) cost of different means of production, that is, the price paid for them by the business when they were acquired. It will be seen that this rule creates problems when purchase prices fluctuate during the accounting period.
We shall now have a closer look at the two tasks of the allocation convention.
2.7 Task One: Determining the Consumption of the Means of Production
Not all goods which are purchased in an accounting period are used up in that period – some are left over in inventory. Similarly, some are drawn from the inventory left over from the previous accounting period.
2.7.1 Use of Raw Materials
The figure for raw materials used, often the largest of all the costs of production, is determined by deducting the physical quantity of raw materials at the end of the year from the sum of opening inventory of raw materials and purchases during the year.
Example
XY Ltd commenced the year with 100 units of raw materials. During the year the company purchased 1200 units. At the end of the year 300 units were left in the raw material inventory. The consumption of raw materials was therefore 1000 units.
Physical units can normally be counted relatively easily and the inventories can be calculated at the beginning and at the end of the year from the purchase invoices.
Greater problems arise when we start to value the amount consumed. Assume that the 1200 units were purchased in a period of rising raw material prices at two-monthly intervals as follows:
February 200 units @ £1.00 each £200
April 200 units @ £1.50 each 300
June 200 units @ £2.00 each 400
August 200 units @ £2.50 each 500
October 200 units @ £3.00 each 600
December 200 units @ £3.50 each 700
1 200 units £2 700
The opening inventory of 100 units was valued at £1 per unit. Therefore the total costs to be allocated amount to £2800.
When approaching the issue of valuing the 1000 units consumed, the question to be asked is, ‘What is the value of the closing inventory?’ By valuing closing inventory and deducting the value from £2800 we can determine the value of purchases consumed by production during the year. The closing valuation of 300 units is not always the most obvious valuation; the valuation selected will have a direct impact on the portion remaining, namely the 1000 units consumed. Four valuation possibilities suggest themselves:
1 300 units @ £3.50 each (using the last price paid for all the closing inventory);
2 200 units @ £3.50 each (counting back using actual prices);
and
100 units @ £3.00 each;
3 300 units @ £1.00 each (using earliest prices);
4 300 units @ £2.15 (using the average cost of units £2800÷1300).
The difference in stock valuation is significant. So therefore is the difference in cost of units consumed.
Valuation method Closing stock valuation
Valuation of units consumed
Total
1 £1 050 £1 750 £2 800
2 1 000 1 800 2 800
3 300 2 500 2 800
4 645 2 155 2 800
Note the following points:
1 The range of values for consumption of raw materials spreads between £1750 and £2500.
2 These values are determined by the value that was selected for closing stock.
This shows that we cannot keep the two tasks in the allocation process separate.
Task Two (allocating costs to closing inventory of finished goods) was undertaken before Task One could be completed.
3 The valuation of closing stock affects (a) value of units consumed (which has been shown) and therefore (b) profit (which will be considered in a later section).
2.7.2 Labour
The annual (or monthly, or weekly) payroll is the usual source for the measure-ment of labour effort expended. The information comes from the pay records and is in money terms.
2.7.3 Depreciation of Fixed Assets
The cost of the depreciation of fixed assets must be included in the measure-ment of effort: the consumption, or decline in value, of fixed assets is as valid an expense as the consumption of raw materials and labour services. The ques-tion to be asked is ‘How much should be recognised as a cost of a particular accounting period?’ There is no universally acceptable answer to this ques-tion: depreciation charges are based on rule-of-thumb procedures devised by engineers and accountants which try to reflect the periodic use of plant and machinery. The periodic charge for depreciation is calculated having regard to three factors:
(a) the actual historic (sometimes called acquisition) cost, including installation charges if any;
(b) the estimated net residual amount which the business will receive for the asset on disposal. (This is not necessarily scrap value: a company may have a policy of disposing of one-third of its car fleet each year. In such a situation the company could expect a good second-hand value);
(c) the estimated useful life of the asset to the present owner.
Note that two of the three factors are nothing more than estimates.
Three methods of depreciation will be illustrated. Bear in mind there are many others. The common set of data is as follows:
Machine X
Acquisition cost £1250
Estimated net residual value £50
Estimated service life 3 years
Estimated pattern of running hours: Year 1 5000 hours Year 2 8000 hours Year 3 2000 hours
2.7.4 Method 1: Straight-line Depreciation
The straight-line depreciation method is widely used because it is simple and reasonable in respect of many kinds of fixed assets. An equal portion of the origi-nal acquisition cost less estimated residual value is allocated to each accounting period during the asset’s service life. The annual charge would be:
£1250−£50 3 = £400
The depreciation schedule covering the life of Machine X would be as follows:
End of year Year Depreciation
expense
Balance in accumulated depreciation
Book value
At acquisition £1 250
1 £400 £400 850
2 400 800 450
3 400 1 200 50
£1 200
This method has the virtue of simplicity: it is especially appropriate where the use of the asset is essentially the same each year and is coupled with an approximately equal decline in the economic usefulness of the asset each period.
2.7.5 Method 2: Reducing Balance Depreciation
This method is based on the notion that there should be relatively large amounts of depreciation expense reported in earlier years of the service life and corre-spondingly reduced amounts of depreciation expense in the later years. The basis for this method is that a fixed asset is more efficient in generating revenue in the earlier years than in the later years of life, therefore it makes sense to allocate more cost against earlier years’ revenue than later years’. Also, repair expenditure tends to be low in the early years and higher in the later years, therefore it makes sense to counterbalance the low early maintenance with high early depreciation.
The annual charge is based on the formula:
1− n
rScrap value Cost
where n = the estimated service life of the asset. This formula results in a figure of roughly 66 per cent depreciation rate per annum in this example.
The depreciation schedule covering the life of Machine X would be as follows:
End of year Year Depreciation
expense
Balance in accumulated depreciation
Book value
At acquisition £1 250
1 £825 £825 425
2 280 1 105 145
3 95 1 200 50
£1 200
2.7.6 Method 3: Consumption Method
The consumption method is based on the number of running hours of the machine: the assumption is the greater the machine hours run, the greater is the wear and tear on the machine.
The annual charge in this example would be:
Annual running hours
Total number of running hours×Net cost Year 1 5 000/15 000× £1 200 = £400 Year 2 8 000/15 000× £1 200 = £640 Year 3 2 000/15 000× £1 200 = £160
End of year Year Depreciation
expense
Balance in accumulated depreciation
Book value
At acquisition £1 250
1 £400 £400 850
2 640 1 040 210
3 160 1 200 50
£1 200
Comparison of methods
Depreciation expense
Year Straight line Reducing
balance
Consumption method
1 £400 £833 £400
2 400 278 640
3 400 93 160
£1 200 (say) £1 200
The principal features of depreciation should be clearly understood.
1 Depreciation is the allocation of the cost of assets purchased in one account-ing period over the accountaccount-ing periods in which they are used.
2 Depreciation is a cost of production like raw materials and labour costs.
3 The selection of method influences the amount of cost allocated to each accounting period; the amount of depreciation allocated in turn influences reported profit.
4 Depreciation, by itself, does not provide cash for the replacement of the assets. But the act of allocating this cost to an accounting period serves to reduce reported profit; this in turn dampens down the loss of cash from the business by lowering the tax and dividend payments and, perhaps, wage expectations in succeeding periods. Thus charging depreciation has a positive effect on the cash position of a business, but it is by a roundabout way! Businesses are therefore better placed to replace their assets if they charge depreciation than if they did not. (In many fiscal jurisdictions such as the UK depreciation per se is not allowed as a charge against profits for the purposes of calculating tax simply because businesses have a wide choice of depreciation rates and could therefore manipulate the level of taxable profit.
Fiscal authorities substitute capital allowances for depreciation; these are statutorily determined rates of depreciation for different classes of assets).