Functional Activity Cost

An Analysis Made of the Internal Accounting Configuration

By Dr. Emanuel F. Schwarz

(July 12, 1999) - This article will emphasize the abolishment of the phrase Work in Process and the reconstruction of the Functional Activity Costs.

It is necessary to recognize that the phrase "Work in Process" should only refer to the amount that is the difference between the total amount that we have debited an account, and the total amount that we have credited this same account.

Such a difference expressed in dollar amount is correctly identified as Work in Process - the amount of work that was left over at the moment of closing the activities for this day.

This day may refer to any day during the month--or just the last day of our accounting period. Regarding this amount, pay attention to and recognize the different detailed values that this Work in Process consists of.

Through this analysis the following conclusions may be established:

1. Work in Process possesses plain raw material that is still not processed--the amount our Direct Production Department took out of the Raw Material inventory (the raw material they needed). For instance, the quantity that they would need for a week's planned production at the end of each day. During this week there will always be some raw material on hand that has not been processed.

2. At the end of the day, some raw material is processed a quarter, some is processed half, some is processed three-quarters, and naturally some raw material will be totally processed.

3. Each processing of the raw material needs to have some direct labor activity cost included. So at the end of each day, we have to calculate how much direct labor was used to process this raw material.

4. Next it would be necessary to measure the value of the use of the machine for this process. We may calculate that one hour of use of certain machine costs us so many dollars (referring not only to the depreciation per hour, but also the use of the machine for one hour). With regards to the Work in Process, we would need to include such machine value referring to the raw material that was partially or completely processed.

5. Naturally we have to consider the hourly value of the Departmental Operating Cost of this specific Direct Production Department. In this operating cost we need to include the salary of the supervisor and other personnel. Then the cost of the Indirect Labor and the calculated rent for this Direct Production Department. Finally, all other costs related to the operation of this department.

6. In this Departmental Operating Cost we also have to include the reallocated values of the different Indirect Production and Service Departments. This has to be realized in order to follow the ABC procedures.

Out of this presentation, it is possible to understand that the question of establishing the value of the work in process is highly difficult.

Today's Cost Accounting books use a very generalized presentation, telling students that the supervisor will have to establish the percentage of work in process. These are very simplified statements that in practical life are worthless.

It is also necessary to recognize that the Work in Process information does not belong to any inventory and should not be identified as a Work in Process Inventory.

No company has ever prepared an inventory control procedure with this Work in Process value.

To teach our students that we have a Work in Process Inventory falsifies the truth. In my next article, I will show you how these Production Cost accounts have to be manipulated.

Finally, the value of the Work in Process in an industry that produces a larger daily quantity of products, is very insignificant. This value will refer to just a few hours production of the last day of the period, compared to the total hours of production during the rest of the month.

In my June 7 article of this year, Exhibit 5-1 showed the basic structure of the Class 5 accounts. These accounts belong to the different Functional Activities that your company may have. The first and most important Group of the Functional Activities is referring to the Production Cost of Finished Products.

Within Each Group Identify Main and Sub Accounts.

The Sub Accounts will refer to the final product identified by the product's name within our production activity. This could be a different name than what is used in sales activity.

Record each Job-Order as part of the information that we have to register on the Sub-Account.

To this Sub Account we also have to charge the Raw material, the Direct Labor and the Departmental Operating Cost.

The amounts that must be debited to a specific Sub Account in Class 5 will be the basic information regarding the production cost of this Job-Order. Use the same Sub Account the next time a product must be produced. This time the Job-Order will be a different one.

These Sub Accounts will give management all the detailed information they need regarding all Job-Orders that were produced during a specific accounting period (a year).

Class 5 will only be debited the same as Class 3, Departmental Operating Costs.

Class 6 will have the same code structure for its Groups, Main and Sub Accounts and will also refer to the same Job-Orders. Class 6 will be credit with the production cost of products transferred to Inventory of Finished Goods. Observe that from credit Class 6, Class 7 must be debited. This action remains within the Internal Accounting.

It should be clear that the value difference between Class 5 Sub-Account and Class 6 Sub Account will be really the amount that we identify as Work in Process.

An Important Observation.

Work in Process is only the amount of difference between Class 5 and Class 6. Not the total amount that we have recorded in Class 5 with all the details referring to the production cost of a specific Job-Order.

Returning to Exhibit 5-1 of my June 7 article, you see the whole basic structure of our Class 5 - Functional Activities.

An important functional activity is the control of costs referring to the Maintenance and Repair within our company. In today's General Accounting, in my opinion, there are not accounts that would give management such important information.

In regards to a specific repair account of a machine (or vehicle) identified with a Job-Order we will charge both direct cost and all indirect cost. The direct cost would be the parts that this Job-Order needs. From Inventory of Repair Parts (in Class 2) we credit the amount of these parts and debit this amount to the specific repair account in Class 5. The same type of transaction has to realize the indirect cost of this repair. From credit Class 4 of the Repair Department account, we transfer the indirect cost of this repair by Job-Order to the debit of the same Job-Order account in Class 5, Group 3 etc.

If the repair is terminated during the same accounting period as it was started (a month), the total repair amount will be credited Class 6 and transferred to Class 7: Repair of a Machine.

If the repair during the first month was not finished, Class 6 will be credited with this partial amount and Class 7 debited with this same amount. The Month End Transactions will be discussed in a later Solution.

The same procedure can also accomplish the production cost of some internal production that the company must realize. For example: the company produces its own tools or machines. A department was created for this purpose. This department will be identified as Indirect Production Department in Class 3 group 3. Charge the direct and indirect cost to the production cost account in Class 5.. This type of production will also have some Job-Order identification. This will be the same procedure discussed regarding repair.

The monthly cost of this specific production that was transferred to inventory, will be credited a Class 6 account and transferred to Class 7: Inventory of this product.

Again, this remains within the Chart of Accounts for the Internal Accounting. These inventory accounts in class 7, are used as "Contra" accounts for the inventory accounts in the Assets of our company.

The Functional Activity accounts within the Group 7 - Constructions-Projects, will also be used for larger construction projects realized by our company. We would open a specific Group of accounts for this construction project. We will also open special Main and Sub Accounts to control our production costs. In the case that managers need more detailed information, we would open some Sub-sub Accounts.

These larger construction projects may extend during several years, but accounting wise we will treat them monthly as any other production process we discussed here and have within our Other Assets specific contra accounts toward this total project.