Cost Accounting-II

B.Com Sixth Semester

Module -1
JOB COSTING
Job costing (or job order costing) is a method of cost ascertainment used in job order
industries. Special features of such industries are as follows:
(a) Production is against customer's orders and not for stocks.
(b)Each job has its own characteristics and requires special attention.
(c) The flow of production from one department to another is not uniform. It is the nature of
job which determines the department through which it is to be processed.
Job costing is applied to such industries as printing work, motor car repair, machine tools,
general engineering, interior decoration, etc.
Objectives of Job Costing
The following are the main objectives of job costing:
1. Cost of each job/order is ascertained separately. This helps in finding out the profit or
loss on each individual job.
2. It enables management to detect those jobs which are more profitable and those which
are unprofitable.
3. It provides a basis for determining the cost of similar jobs undertaken in future. It thus
helps in future production planning.
4. It helps management in controlling costs by comparing the actual costs with the
estimated costs.

Job Costing Procedure

The following steps are taken in job costing:
1. Job number. When an order has been accepted, an individual job number must be
assigned to each such job so that separate jobs are identifiable at all stages of production.
Assignment of job numbers also facilitates reference for costing purposes in the ledger and is
1
conveniently short for use on various forms and documents.
2. Production order. The Production Control Department then makes out a Production
Order thereby authorising to start work on the job. Several copies of production order are
prepared, the copies often being in different colors to distinguish them more easily. These
copies are passed on to the following:
(i) All departmental foremen concerned with the job;
(ii) Storekeeper for issuance of materials; and
(iii)Tool room for an advance notification of tools required.
Proforma of a Production Order is given in Fig. 7.1. The columns provided in the
production order differ widely, depending largely upon the nature of production. Sometimes
orders are accompanied by the blue prints and contain a bill of materials and detailed
instructions as to which tools and machinery are to be used.
3. Job cost sheet. The unique accounting document under job costing is the job cost sheet.
Receipt of production order is the signal for the cost accountant to prepare a job cost sheet on
which he will record the cost of materials used and the labour and machine time taken. Each
concern has to design a job cost sheet to suit its needs. A simple proforma of job cost sheet is
given in Fig. 7.2.

Production Order
Name of the Customer ..................…………….. Job No……………………………….
Date of Commencement………………………... Date…………………………………
Date of Completion.......................……………... Bill of Material No …………………
Special Instruction ……………………………… Drawing attached Yes/No .
Quantity Description Machines to be used Tools
required

(Sign)……..
Production authorised by :
Head of Production Control Deptt.

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 Job cost sheets are not prepared for specified periods but they are made out for each job
regardless of the time taken for its completion. However, material, labour and overhead costs
are posted periodically to the relevant cost sheet. The material, labour and overhead to be
absorbed into jobs are collected and recorded in the following way:
(a) Direct materials. The method of recording receipts and issues of materials on materials
requisitions or bill of materials was explained in detail in chapter on Materials. It may be
recalled that material requisitions or bill of materials show the quantities of materials issued
to jobs from store. When copies of these documents reach the cost office, they are priced and
entered in the stores ledger account in the "Issues" column.
Job Cost Sheet
Customer................. Job No................................................
Date of commencement........…… Date of Completion.................
Material Cost Labour Cost Factory Overhead (Absorbed)
Date Materia Amount Date Hours Rate Ami. Deptt. Hours Rate Ami.
l Req. Rs. Rs. Rs. Rs. Rs.
No.

Total Total Total

Profit/Loss Cost Summary
Rs. Rs.
Price Quoted ……… Materials
Less: Cost ……… Labour
Prime Cost
Profit or Loss ……… Factory overhead
Works Cost
Adm. overhead
Cost of Production
Selling and distribution overhead
Total Cost

Each requisition shows the job number to which the material is to be charged. Summaries of
material requisitions are prepared at regular intervals on Materials Abstract These
summaries facilitate debiting the job with total cost of materials rather than charging with
many small items.
(b) Direct wages. As explained earlier in a chapter on Labour, the wages payable to

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workers are calculated on clock cards, job cards, time sheets, etc. The summaries of job
cards are made on Wages Abstract or Wages Analysis Sheets, which shows the direct
wages chargeable to each job. The total of wages chargeable to various jobs is debited to
work-in-progress control account.
(c) Direct expenses. Direct expenses which can be identified with specific jobs are
directly charged to these jobs, the total being debited to work-in-progress control account.
(d) Overheads. Indirect materials, indirect wages and indirect expenses which cannot be
identified with specific jobs are apportioned to cost centers in the manner described earlier
in chapter on Overheads. Absorption of overhead by the jobs passing through the cost
centers is based upon percentage of direct wages or direct material cost, direct labour hours
or machine hours, etc. These methods of absorption have also been discussed in detail in the
chapter on Overheads.
The direct materials, wages and expenses and the overheads absorbed are totalled to give
the total cost.
Completion of jobs. When jobs are completed, the cost is transferred to cost of sales
account. The total cost of jobs completed during each period is set against the sales to
determine the profit or loss for the period.

Problems and Solutions

Problem 1. The following direct costs were incurred on Job No. 239 of X YL Co. Ltd.
Materials Rs. 6,010
Wages: Deptt. A- 60 hours @ Rs. 30 per hr.
B - 40 hours @ Rs. 20 per hr.
C - 20 hours @ Rs. 50 per hr.
Overhead for these three departments were estimated as follows:
Variable overheads: Deptt. A- Rs. 15,000 for 1,500 labour hours
B -Rs. 4,000 for 200 labour hours
C- Rs. 12,000 for 300 labour hours
Fixed overheads: Estimated at Rs. 40,000 for 2,000 normal working hours.
You are required to calculate the cost of Job No. 239 and calculate the price to give profit of
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25% on selling price.

Solution
Job Cost Sheet
Job No. 239
Rs. Rs.
Direct materials 6,010
A A- A- 60 hrs. x Rs. 30 1,800
B - 40 hrs. x Rs. 20 800
C - 20 hrs. x Rs. 50 1,000 3,600
* Variable Overheads
Deptt. A - 60 hrs. @Rs. 10 600
B - 40 hrs. @Rs. 20 800
C - 20 hrs. @ Rs. 40 800 2,200
* Fixed Overheads : 120 hrs. @ Rs. 20 per Total Cost 2.400
14,210
Profit (25% of sales or 33-1/3% of total cost cost) 4,737
Selling Price 18.947

*Working Notes. Overhead rates per hour are calculated as under:

Variable overhead : Deptt. A Rs. 15,000 ÷ 1,500 hrs. =Rs. 10 per hour
B Rs. 4,000 ÷ 200 hrs. = Rs. 20 per hour
C Rs. 12,000 ÷ 300 hrs. = Rs. 40 per hour
Fixed overhead : Rs. 40,000 ÷ 2000 hrs. = Rs. 20 per hour
Total hours worked on the job = 60 + 40 + 20 = 120 hours.

Problem 2. A factory uses job costing. The following data are obtained from its books for the year
ended 31st December, 2002.

Rs. Rs.
Direct materials 90,000 Selling and dist. overheads 52,500
Direct wages 75,000 Administration overheads 42,00,0
Factory overheads 45,000 Profit 60,900
(a) Prepare a Cost Sheet indicating the Prime cost, Works cost, Production cost, Cost of
sales and the Sales value.
(b) In 2003, the factory received an order for a number of jobs. It is estimated that direct
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 materials required will be Rs. 1,20,000 and direct labour will cost Rs. 75,000. What should be
the price for these jobs if factory intends to earn the same rate of profit on sales assuming that the
selling and distribution overheads have gone up by 15% ? The factory recovers factory overheads as
a percentage of direct wages and administration and selling and distribution overheads as a
percentage of works cost, based on cost rates prevailing in the previous year.

Solution
Cost Sheet for the year ended 31st Dec, 2002
Rs.
Direct materials 90,000
Direct wages 75,000
Prime Cost 1,65,000
Factory overheads 45,000
Works Cost 2,10,000
Administration overheads 42,000
Cost of Production 2,52,000
Selling and distribution overheads 52,500
Cost of Sales 3,04,500
Profit 60,900
Sales Value 3,65,400

Calculation of Rates:
1. Percentage of factory overheads to direct wages =
45,000 x 100 = 60%
75,000
2. Percentage of administration overheads to works cost = 42,000 x 100 = 20%
2,10,000
3. Selling and distribution overheads Rs. 52,500 Add: 15%
increase Rs. 7,875
Total Rs. 60,375
Selling and dist. overhead % to works cost = 60,735 x 100 = 28.75%
2,10,000

4. % of profit to sales = 60,900 x 100= 16.67% ( 1of sales or 1 of total cost)

3,65,400 6 5

Job Cost Sheet

(Statement showing Estimated Cost and Price of Jobs in 2003)
Rs.
Direct materials 1,20,000
Direct wages 75,000
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 Prime Cost 1,95,000
Factory overheads (60% of direct labour) 45,000
Works Cost 2,40,000
Administration overheads (20% of works cost) 48,000
Cost of Production 2,88,000
Selling and distribution overheads (28.75% of wo 69,000
Total Cost 3,57,000
Profit (1/5 of cost) 71,400
Selling Price 4,28,400

Problem 3. Job No. 718 was commenced on 10th October, 2002 and completed on 1 st November,
2002. Materials used were Rs. 600 and labour charged directly to the job was Rs. 400. Other
informations were as follows:

Machine No. 215 used for 40 hours; the machine hour rate is Rs. 3.50
Machine No. 169 used for 30 hours; the machine hour rate is Rs. 4
Six welders worked on the job for 5 days of 8 hours each; the direct labour hour rate for welders
is 20 paise.
Other expenditures of the concern not apportioned for calculating the machine hour or the direct
hour rates amounted to Rs. 20,000, total direct wages for the period being Rs. 20,000.
Ascertain the works cost of Job No. 718.

Solution
Job Cost Sheet
Job No. 718
Date started 10-10-2002 Date finished 1-11 -2002
Particulars Rs. Rs.
Materials 600
Labour - 400
Prime Cost 1.000
Factory overhead :
Machine No. 215 (40 hrs. @ Rs. 3.50 140
Machine No. 169 (30 hrs. @ Rs. 4 120
Welders (6 x 5 x 8 x 0.20) 48
Other expenses (100% of direct 400 708

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 Works Cost 1,708
*Note : Other expenses are charged at 100% of direct wages as calculated below :

Other expenses X 100 20,000 X 100 = 100%

Direct wages 20,000

Problem 4. Nahar Electricals Ltd., engaged in job work, has completed all jobs in hand on
30th Dec, 2002, except Job No. 1448. The cost sheet on 30th Dec, showed direct materials
and direct labour costs of Rs. 40,000 and Rs. 30,000 respectively as haying been incurred on
Job No. 1448.
The costs incurred by the business on 31st Dec, 2002, the last day of accounting year, were as
follows :
Rs.
Direct materials (Job 1448) 2,000
Direct labour (Job 1448) 8,000
Indirect labour 2,000
Miscellaneous factory overhead 3,000
It is the practice of business to make the jobs absorb factory overheads on the basis
of 120% of direct labour cost.
Calculate the cost of work-in-progress of Job No. 1448 on 31 st Dec, 2002.

Cost of Work-in-Progress of Job No. 1448

as on 31st Dec, 2002

Direct materials (40,000 + 2,000) Rs.

Direct labour (30,000 + 8,000) 42,000
38,000
Prime Cost 80,000
Add: Factory overhead (38,000 x 120%) 45,600
Works Cost 1,25,60
0

Problem 5. The following information for the year ended December 31,2002 is obtained from
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 the books and records of a factory.
Completed Jobs Work-in-Progress
Rs. Rs.
Raw materials supplied from stores 90,000 30,000
Wages 1,00,000 40,000
Chargeable expenses 10,000 4,000
Materials transferred to work-in-progress 2,000 2,000
Materials returned to stores 1,000 —
Factory overhead is 80% of wages and office overhead is 25% of factory cost.

The price of the executed contracts during 2002 was Rs. 4,10,000. Prepare (i)
Consolidated Completed Jobs Account showing the profit made or loss incurred, and also (ii)
Consolidated Work-in-Progress Account.
Solution

Consolidated Completed Jobs Account

Rs. Rs.
To Materials 90,000 By Sales 4,10,000
Less: Transfer 2,000
Less: Return 1,000 87,000
To Wages 1,00,000
To Chargeable expenses 10,000
Prime Cost 1,97,000
To Factory Overhead
(80% of wages) 80,000
Factory cost 2,77,000
To office overheads
(25% of factors cost) 69,250
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 To Net Profit 63,750
4,10,000 4,10,000

Consolidated Work-in-Progress Account

Rs. Rs,

2002 To Materials 30,000 32.000 By Balance c/d 1.35,000

Add: Transfer 2,000 40.000
To Wages 4.000
To Chargeable Expenses 76.000
Prime Cost
To Factory Overhead
(80% of wages) 32,000
Factory Cost 1.08.000

To Office Overhead (25% of 27.000

factory cost) 1.35,000 1,35.000

2003 To Balance b/d 1.35,000

Problem 6. From the records of a manufacturing company, the following budgeted details
are available:
Rs. Rs.
Direct materials 1,99,000
Direct wages:
Machine shop (12,000 hours) 63,000
Assembly shop (10,000 hours) 48,000 1,11,000
Works overhead :
Machine shop 88,200
Assembly shop 51,800 1,40,000
Administrative overhead 90,000
Selling overhead 81,000
Distribution overhead 62,100

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Assuming that the company follows absorption method of costing, you are required to :
(a) Prepare a Schedule of Overhead Rates from the figures available stating the
basis of overhead recovery rates used under the given circumstances.
(b) Work out a Cost Estimate for the following job based on overhead so
computed.
Direct material: 25 kg @ Rs. 16.80/kg
15kg@Rs.20.00/kg
Direct labour (on the basis of hourly rate Machine shop 30 hours
for Machine shop & Assembly shop) Assembly shop 42 hours

Solution
(a) Cost Sheet for the period

Rs.
Direct materials 1,99,000

Direct wages : Machine shop 63,000

Assembly shop 48,000 1,11,000
Prime Cost 3,10,000
Works overhead : Machine shop 88,200
Assembly shop 51.800
1,40,000
Works Cost 4,500,00
Administration overhead 90,000
Cost of 5,40,000
Selling overhead Production 81,000
Distribution overhead 62,100
6,83,000
Total Cost

Schedule of Overhead Rates

(i) Work overhead. Hourly rate = (Overhead amt. -H Hours)
Machine shop = 8,200 4- 12,000) = Rs. 7.35 per hour Assembly
shop = (51,800 - 10,000) = Rs. 5.18 per hour

(ii) Administrative overhead as a % of works cost = 90,000 x 100 = 20%

4,50,000

(iii) Selling and distribution overhead as % of works cost =

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 81,000 + 62,100 x 100 = 31.80%
4,50,000

Labour hour rates are calculated as under :

Machine shop = Rs. 63,000 ÷ 12,000 hrs. =Rs. 5.25
Assembly shop = Rs. 48,000 ÷ 10,000 hrs. =Rs.4.80

(b) Cost Estimate for Job

Rs. Rs.
Direct Materials
(i) 25kg@Rs. 16.80 per kg 420
(ii) 15 kg @ Rs. 20 per kg 300 720.00
Direct Labour
Machine shop (30 hrs. @ Rs. 5.25) 157.50
Assembly shop (42 hrs. @ Rs. 4.80) 201.60 359.10
Prime Cost 1079.10
Works Overhead
Machine shop (30 hrs. @ Rs. 7.35) 220.50
Assembly shop (42 hrs. @ Rs. 5.18) 217.56 438.06
Works Cost 1517.1
Administration overhead (20% of 6
works cost)
Cost of Production 1820.59
Selling and distribution cost (31.8% 482.46
of works cost)
Total Cost 2302.05

Problem 7. X Co. Ltd. has absorbed overhead by means of a blanket rate based on direct
labour hours. As from 1 st January, 2003, it decides to adopt separate rates for the three main
activities — Store-keeping and material handling, machining and assembly. The estimates of
costs and absorption rates for selling and distribution cost remain unchanged. Overhead
absorption rates are :
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Prior to 1st January, 2003
Production overhead — Re. 0.50 per direct labour hour
Selling and distribution overhead — 25% of production cost
From 1st January, 2003
Production overhead :
Store-keeping and material handling — 10% of direct material cost
Machining—Re. 0.75 per machine hour
Assembly—Re. 0.30 per labour hour
Selling and distribution overhead —25% of production cost
Direct costs of Job No. 401 have been Rs.
Direct material cost 90
Direct wages:
Machining 200 hours @ Re. 0.60 120
Assembly 100 hours @ Re. 0.40 40
250
Contract price of the job is Rs. 525 and it requires 180 machine hours to complete. Show the
job cost sheet for Job No. 401 :
(a) as it would appear if the job had been completed prior to 1st January, 2003;
(b) as it would appear if the job were completed in January, 2003.

Solution
Job Cost Sheet
Job No. 401
Finished before 1-1-2003
Particulars Rs .
Direct materials 90
Direct wages:
Machining 200 hours @ Re. 0.60 120
Assembly 100 hours @ Re. 0.40 40
Prime Cost 250
Production overhead :
300 hours® Re. 0.50 150
Production Cost 400
Selling and distribution overhead 25% of Rs. 100
Total Cost 500
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 Profit 25
Selling Price 525

Job Cost Sheet

Job No.401
Finished in 2003
Particulars Rs. Rs.

Direct materials 90
Direct wages:
Machining 200 hours @ Re. 0.60 120
Assembly 100 hours @ Re. 0.40 40 160
Prime Cost 250
Production overhead :
Store-keeping and handling 10%of Rs. 90 9
Machining 180 hours @ Re. 0.75 135
Assembly 100 hours @ Re. 0.30 30 174
Production Cost 424
Selling and distribution overhead (25% of Rs. 424) 106
Total Cost 530
Loss 5
Selling Price 525

(B) BATCH COSTING

Batch costing is a form of specific order costing. Job costing refers to costing of jobs
that are ext against specific orders whereas in batch costing items are manufactured for
stock. A finished pr may require different components for assembly and may be
manufactured in economical batch When orders are received from different customers, there
are common products among orders production orders may be issued for batches, consisting
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of a predetermined quantity of each type product. Batch costing method is adopted in such
cases to calculate the cost of each such batch per unit is ascertained by dividing the total cost
of a batch by number of items produced in that ID In order to do that a Batch Cost Sheet is
prepared. The preparation of Batch Cost Sheet is similar that of Job Cost Sheet.

ILLUSTRATION 1. Batch No. A- l00 incurred the following costs:

Direct Materials Rs. 10,000
Department : A 800 labour hours @ Rs. 5per hour
B 1400 labour hours @ Rs. 6per hour

Factory overheads are absorbed on labour hours basis and the rates are Rs. 7 per hour
for Department A and Rs. 4 per hour for Department B. The firm uses a cost plus system for
selling prices and expects a 25% gross profit (sales value minus factory cost). Administrative
overheads are absorbed at 10% of selling price. Assuming that 1000 units were produced in
Batch A-100, Calculate the selling price per unit.

SOLUTION
COST SHEET OF BATCH NO. A-100
Rs. Rs.
Materials 10,000
Labour :
Department A : 800 x Rs. 5 4000
Department B : 1,400 x Rs. 5 8,400 12,400
Factory Overheads
Department A : 800 x Rs. 7 5,600
Department B : 1,400 x Rs. 4 5,600 11,200
Factory Cost 33,600
Administration overheads (10% of selling 4,480
price)
Cost of production 38,080
Profit (15% of Selling price) 6720
Selling price 44,800

Working Note : Calculation of Selling Price Rs.

Selling Price (33,600 x 100) = 44,800
75
Less : Factory Cost = 33,600
11,200
15
Less: Administration Overheads 4,480
Profit 6,720

ILLUSTRATION 2. A company manufactures small assemblies to order and has the

following budgeted overheads for the year, based on normal activity levels.
Department Budgeted Overheads Overhead Absorption Base
Rs.
Blanking 7,500 1,500 labour hours
Machining 22,500 2,500 machine hours
Welding 9,000 1,800 labour hours
Assembling 5,000 1,000 labour hours
Selling and Administrative Overheads are 20% of Factory Cost.
An order for 250 assemblies type X 128 made as Batch 5931 incurred the following costs:
Materials Rs. 5,702
Labour 128 hours Blanking Shop at Rs. 4.50/hour
452 hours Machining Shop at Rs. 50/hour
90 hours Welding Shop at Rs. 45/hour
175 hours Assembly Shop at Rs. 36/hour
Rs. 525 was paid for the hire of special X-ray equipment for testing the welds. The time
booking in the machine shop was 643 machine hours.
Calculate the total cost of the batch, the unit cost and profit per assembly if the selling
price was Rs. 100/assembly.

SOLUTION
The first step is to calculate the overhead absorption rates for the production departments.
Blanking = Rs. 7,500 = Rs. 5 per labour hour
1500

Machining = Rs. 22,500= Rs. 9 per machine hour

2,500

Welding = Rs. 9,000 = Rs. 5 per labour hour

800

Assembling = Rs. 5,000 = Rs. 5 per labour hour

1 000

TOTAL COST—BATCH NO. 5931

Direct Material
Direct Labour 128xRs.4.50 = 576 5,702
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 452xRs.5.00 = 2,260
90xRs.4.50 = 405
175xRs.3.60 630

Hire of special X-ray equipment

Prime Cost

Factory Overhead : 3,871

Blanking 128 x Rs.5 = 640 525
Machining 643x Rs.9 = 5,787
Welding 90x Rs.5= 450 10,098
Assembling 175xRs.5 = 875

Factory Cost

Selling & Administration Overheads (20% of Factor Cost ) 7,752

Total Cost

Total cost per Unit = Rs. 21,420 = Rs.85.68 17,850

250 3,570

Profit per unit Rs.14.32 21,420

Selling Price Rs.100.00

Production is usually done in batches and each batch can have any number of units of
component in it. The optimum quantity for a batch is that quantity for which the setting up
and carrying costs are minimum, such an optimum quantity is known as Economic Batch
Quantity or Economic lot size.
Determination of the economic lot size is important in industries where batch costing
is employed. The need for determining economic lot size arises as : (i) every time a
component/product is to be made, setting up of the tool is involved. Because of this some
loss in production time will be there. Therefore, maximum number of units are produced
once the machine is set in order to reduce the cost per unit. (ii) Such large production at one
run will lead to accumulation of inventory and the costs related thereto. (iii) Thus there is a
quantity for which reduced cost of production is just offset by costs of carrying the quantity
inventory. The determination of most economical batch quantity requires consideration of
many related factors of costs and economies. The factors that influence the decision in this

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respect are (i) Set up cost, (ii) Manufacturing cost, (iii) Interest on capital, (iv) Storage cost,
and (v) Rate of consumption.
2US
T he formula to be used for calculation of economic lot size is Q =
C
Where Q = Qty. or units of products in the economic batch.
S = Set-up cost per batch
C = Carrying cost per unit of production p.a.
U = Annual units of production.

ILLUSTRATION 3.
Compute the economic batch quantity for a company using batch costing with the following
information.

Annual demand for the component 24,000

Set- up cost per batch Rs. 120
Carrying cost per unit of production Rs. 0.36

Solution
2UC 2 x 24,000 xRs.120
Economic Batch Quantity = = = 4,000units
C Re .0.36

SECTION- A

1. Stale two special features of job costing.

2.Name any three industries in which job costing is used:
3. What is production order ?
4. Job costing can be used only in small companies. Do you agree ?
5. Job is a small contract. Do .you agree ?

6. What is a job cost sheet ?

SECTION-B

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 1. Write a note on job costing and the industries which adopt job costing.
2. What are the main features of job costing ? Give a proforma cost sheet under
such a system
3. Explain job costing. What are its advantages ?
4. What is a job cost sheet ? What kind of data generally appear on job cost sheet ?
5. What are the main features of job costing ? Describe briefly the procedure of
recording costs under job order costing.
6. What is a job order number ? Explain how costs are booked against job order
numbers.
7. What do you understand by job order cost accounting ? Discuss the conditions
suitable for the introduction of the job order cost accounting.
8. “Job costing is more accurate than process costing”. Comment.

SECTION-C

1. The following information is extracted from a job ledger in respect of Job No. 443 :
Materials - Rs. 3,500
Wages - 80 hours @ Rs. 2.50 per hour
Variable overhead incurred for all jobs Rs. 5,000 for 4,000 labour hours
Find the profit if the job is billed for Rs. 4,000.
[ Ans. Profit Rs. 200] [ Hint. Variable overhead for 80 hours @ Rs 1.25]

2. The following information is extracted from the job ledger in respect of Job 907
Materials Rs. 3.400
Wages: Deptt. A : 80 hours at Rs. 2.50 per hour
B : 60 hours at Rs. 4 per hour
Variable overheads : Deptt. A : Rs. 5,000 for 4.000 hours
B : Rs. 6,000 for 3,000 hours
Fixed overhead : Rs. 7.500 for 10.000 hours of normal working time of the
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 Factory.
Calculate the cost of Job No. 907 and estimate the percentage of profit if the price
quoted is. Rs. 4,750. [ Ans. Profit Rs. 585. % of profit on sales 12.32]

3. From the following particulars, prepare the Cost Sheet for Job No. 86 and find out the
value of the job :
Rs.
Materials 6,000
Productive wages 4,600
Direct expenses 500
Provide 60% on productive wages for works on cost and 12 54% on works cost for
office on cost. Profit to be realized on the selling price is 20%.
[ Ans. Cost of job Rs. 15,592.50; Profit Rs. 3898.13]

4. The estimated material cost of a job is Rs. 5,000 and direct labour cost is likely to be Rs.
1,000. In machine shop it will require machining by Machine No. 8 for 20 hours and by
Machine No. 11 for 6 hours. Machine hour rates for Machine No. 8 and Machine No. 11 are
respectively Rs. 10 and 15. Considering only machine shop cost, the direct wages, in all other
shops last year amounted to Rs. 80.000 as against Rs. 48,000 factory overhead. Last year
factory cost of all jobs amounted to Rs. 2,50,000 as against Rs. 37,500 office expenses.
Prepare a quotation which guarantees 20% profit on selling price.
[ Ans. Price quotation Rs. 9,905]
[ Hint. 1. Factory overheads are charged at 60% of wages. These are in
addition to machining cost.
2. Office overheads are charged at 15% of factory cost.]
5. From the following particulars relating to four jobs of a manufacturer, ascertain the
total cost of each job :
Job No. 141 Job No. 142 Job No. 143 Job No. 144
Rs. Rs. Rs. Rs.
20
 Direct materials 800 1,000 1,200 1,400
Direct wages 400 500 600 700
Direct expenses' 80 100 120 140
Works on cost is 45% of prime cost and office on cost is 15%on works cost.
[ Ans. Job No. 141 Rs. 2,134.40 ; No. 142 Rs. 2.668 ; No. 143 Rs. 3,201.60 ; No. 144 Rs.
3,735.20]

6. The cost estimator of R.K. Ltd. has produced the following data :
Direct materials : 34 units @ Rs. 2 per unit.
Direct labour : Deptt. A - 12 hours @ Rs. 2 per hour
Deptt. B - 20 hours @ Rs. 1.80 per hour
The following additional information is extracted from the company's budget:
Deptt. A : Variable overhead Rs. 18.000
Hours to be worked - 18.000
Deptt. B : Variable overhead Rs. 18,000
Hours to be worked - 10,000
Fixed overhead for the company Rs. 1,00,000
Total hours to be worked 50,000
Profit is taken at 20% of the selling price.
You are required to prepare a job cost sheet.
| Ans. Price to be quoted Rs. 300]

7. From the following information, prepare Job No. 1314 and Job No. 1425
accounts hi the Job Cost Ledger:
Job No. 1314 Job No. 1425
Rs. Rs.
Direct materials 2.400 1.200
Materials received from stores 16.800 14.400
Direct wages 9.600 5.000
Other direct expenses 1.000 500
21
The production overheads are to be taken at 100% of wages and administration overheads at
20% of the production cost. The contract price of Job No. 1314, which is completed, is fixed
at Rs. 55.000. Job No. 1425 is under progress.
Ans. Job No. 1314 profit Rs. 7,720 ; Job No. 1425 W.l.P. Rs. 31,320]
8. Prepare Work-in-Progress Account and Completed Jobs Account from the following
information.
Completed Jobs Incomplete Jobs
Rs. Rs.
Materials consumed ' 48,000 . 3.000
Direct labour 36.000 4,000
Materials transferred from completed
jobs to incomplete jobs 4,000 4,000
Works expenses are charged at 60% of direct labour and office expenses are recovered at
10% of works cost.
[Ans. Completed jobs Rs. 1, 11,760 ; Incomplete jobs Rs. 14.740]

9. The following expenses were incurred on Job No. 3664.

(1) Materials: Rs. 9,720
(2) Wages paid:
Deptt. A 40 hours at Rs. 8 per hour
Deptt. B 50 hours at Rs. 9 per hour
Deptt. C 60 hours at Rs. 5 per hour
(3) Works overhead expenses of these departments were estimated as under:
Deptt. A Rs. 9,000 for 6,000 working hours
Deptt. B Rs. 10.000 for 5,000 working hours
Deptt C Rs. 12,000 for 3,000 working hours
(4) Office expenses were Rs. 75.000 when total direct wages paid in all three
departments came to Rs. 2,50,000
It is the practice to recover office overhead as percentage of direct wages.
You are required to calculate the cost of Job No. 3664 and its price to be quoted which would

22
include 20% profit on selling price.
[ Ans. Total cost Rs. 11,511 ; Profit Rs. 2,877.75 ; Price Rs. 14.388.75]

10. The following expenses were incurred for a job during the year ended 31 st December, 2002 :
Rs.
Direct materials 3,000
Direct wages 4,000
Chargeable expenses 1,000
Factory overheads 2,000
Selling and distribution overheads 2,000
Administration overheads 3,000

Selling price for the above job was Rs. 18.000. You are required to prepare a statement
showing the profit earned for the year 2002 from the job and an estimated price of a job which
is to be executed in the year 2003. Materials, wages and chargeable expenses will be required
of Rs. 5.000. Rs. 7,000 and Rs. 2,000 respectively for the job. The various overheads should be
recovered on the following basis while calculating the estimated price :
(a) Factory overheads as a percentage of direct wages.
(b) Administration and selling and distribution overhead as a percentage of factory cost.
[ Ans. Profit Rs. 3.000 ;~Factory overhead 50% on direct wages, Adm. overhead 30% on
factory cost. Selling and dist. overhead 20% on factory cost. Profit 20% on total cost :
Estimated selling price of job Rs. 31,500]

23
24
 Module -2
CONTRACT COSTING
Contract costing, also known as terminal costing, is a variant of job costing.
In this method of costing, each contract is a cost unit and an account is opened for
each contract in the books of contractor to ascertain profit/loss thereon.
Contract costing is employed in business undertakings engaged in
building construction, road construction, bridge construction and other civil
engineering works, ship-buildings, etc.

Contract Costing and Job Costing - Distinction

Main points of distinction between contract and job costing are as follows :
1. Contract is generally big while job is small. It is well said, "a job is a small
contract and a contract is a big job."
2. The number of jobs undertaken at a time are usually large as compared to
number of contracts because contracts are generally much bigger in size.
3. In contract costing most of the costs are chargeable direct to contract
accounts. Under job costing, direct allocation to such an extent is not
possible.
4. Allocation and apportionment of overhead costs is simpler in contract costing
as compared to job costing.
5. Jobs are usually carried out in factory premises while contract work is done at
site.

Features of Contract Costing

Contract costing usually shows the following features :
1. Contracts are generally of large size and, therefore, a contractor usually
carries out a small number of contracts in the course of one year.
2. A contract generally takes more than one year to complete.
3. Work on contracts is carried out at the site of contracts and not in factory
premises.

25
4. Each contract undertaken is treated a cost unit.
5. A separate contract account is prepared for each contract in the books of
contractor to ascertain profit or loss on each contract.
6. Most of the materials are specially purchased for each contract. These will,
therefore, be charged direct from the supplier's invoices. Any materials
drawn from the store are charged to contract on the basis of material
requisition notes.
7. Nearly all labour will be direct.
8. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.
9. Specialist sub-contractors may be employed for say, electrical fittings,
welding work, glass work, etc.
10. Plant and equipment may be purchased for the contractor may be hired for
the duration of the contract.
11. Payments by the customer (contractee) are made at various stages of
completion of the contract based on architect's certificate for the completed
stage. An amount, known as retention money, is withheld by the contractee
as per agreed terms.
12. Penalties may be incurred by the contractor for failing to complete the work
within the agreed period.
Contract Costing Procedure
The basic procedure for costing of contracts is as follows :
1. Contract account. Each contract is allotted a distinct number and a separate
account is opened for each contract.
2. Direct costs. Most of the costs of a contract can be allocated direct to the
contract. All such direct costs are debited to the contract account. Direct
costs for contracts include : (i) Materials, (ii) Labour and supervision, (Hi)
Direct expenses, (iv) Depreciation of plant and machinery, (v) Sub-contract
costs, etc.

26
 3. Indirect costs. Contract account is also debited with overheads which
tend to be small in relation to direct costs. Such costs are often absorbed on
some arbitrary basis as a percentage on prime cost, or materials; or wages,
etc. Overheads are normally restricted to head office and storage costs.
4. Transfer of materials or plant. When materials, plant or other items are
transferred from the contract, the contract account is credited by that
amount.
5. Contract price. The contract account is also credited with the contract
price. However, when a contract is not complete at the end of the financial
year, the contract account is credited with the value of > work-in-progress as
on that date.
6. Profit or loss on contract. The balance of contract account represents
profit or loss which is transferred to Profit and Loss Account. However, when
contract is not completed within the financial year, only a part of the
profit arrived is taken into account and the remaining profit is kept as reserve
to meet any .contingent loss on the incomplete portion of the contract. This is
discussed in detail later in this chapter.
Special Points in Contract Costing
Some of the important points in contract costing are now discussed :
Cost of Materials
Materials include (i) materials specifically purchased for the contract; (ii)
materials issued from store against material requisition notes. The cost of both
these types of materials is debited to the contract account.

Materials returned to store. Whenever materials are issued in excess of

requirements, as for instance, cement, sand, pipes, bricks, etc., these are later
returned to the store accompanied by a Material Return Note which gives the
details of the material returned. Such returned materials are credited to contract
account.

27
Materials at site. At the end of each accounting period, value of materials lying
unused at site is credited to contract account and is carried forward for charging
against the next period.

Cost of Labour
All wages of workers engaged on a particular contract are charged direct to the
contract irrespective of the type of work they perform. When several contracts are
running at different locations, payroll is normally sectionalised so as to have
separate payroll for each contract. Difficulties in costing may be encountered
when some workers may have to move from one site to another when a number of
small contracts are undertaken. In such situations it becomes necessary to provide
time sheets from which allocations can be made. In order to control labour
utilisation and prevent fraud in the payment of wages, surprise visits by head office
personnel will be necessary.

Plant Depreciation
There are two different methods of dealing with depreciation of plant in contract
account:
(a) Contract account is debited with the cost of the plant installed. When the
contract is completed or the plant is no longer required, the paint is revalued and
contract account is credited with this revalued or depreciated figure. In case plant
is sold on the completion of the contract, the contract account is credited with its
sale proceeds. The net effect of the above debit and credit will be that the contract
account will stand debited with the amount of depreciation which is the difference
between the value of plant debited and value of plant credited. The method is
generally used on long contracts which extend over more than one year because
depreciated value of the plant is credited to the contract account and brought down
as an opening balance in the next period.

28
(b) Alternatively, contract account is simply debited with the amount of
depreciation. It is usual to use this method when plant is sent to contract only for a
short period. For example, mobile crane or bulldozer used in a contract may be
charged on this basis.
However, when a plant is hired for a contract, a charge for the hire of the
plant is debited to the contract as a direct expense.

Sub-contract Costs
Work of specialized character, for which facilities are not internally available,
is offered to a sub-contractor. For example, steel work, glass work, painting, etc.,
is usually carried out by the sub-contractors who are accountable to the main
contractor. The cost of such work is charged to the contract account.

Payment based on Architect's Certificate

In case the contract is small, full payment is usually made on the completion of the
contract. But in case of large contracts, it may take more than one year to complete. In
such a case, if no payment is received until the completion of the contract, the
financial resources of the contractor could surely become strained. Therefore, a
system of progress payments is agreed by parties. In this system, part payments of
the contract amount are paid from time to time on the basis of certificate issued by
the architects (acting for the contractee), certifying the value of the work
satisfactorily completed. Such payments received by the contractor are usually
credited to the personal account of the contractee. It should be noted that such
payments are not entered in the Contract Account.

Work-in-progress — Work Certified and Uncertified

When the contract is not completed till the end of the accounting year, the
architect is required to value the work-in-progress. Such work-in-progress is
classified into work certified and work uncertified.

29
Work Certified. This is that part of the work-in-progress which has been approved
by the contractee's architect or engineer for payment. Work certified is valued at
contract price (i.e., selling price), and includes an element of profit.

Work Uncertified. This is that part of the work-in-progress which is not approved
by the architect or engineer. This is valued at cost and thus does not include an
element of profit.
Both work certified and uncertified appear on the credit side of the contract
account and also tin the assets side of the balance sheet.

Retention Money and Cash Ratio

It is usual practice not to pay the full amount of work certified. The contractee may
pay a fixed percentage, say 80% or 90% of the work certified, depending upon the
terms of the contract. This is known as Cash Ratio. The balance amount not paid is
known as Retention Money. For example, if cash ratio is 75%, the retention money
will be remaining 25%. This retention money is a type of security for any defective
work which may be found iri the contract later on. This also works as a deterrent for
the contractor to leave the contract incomplete, if he finds the contract unprofitable.
The retention money may also be adjusted against penalties that become due if the
contract is not completed within the stipulated time as per the terms of the
agreement.

Extra Work
Sometimes the contractor is required to do some extra work like additions or
alterations in the work originally done as per agreement. The contractor will charge
extra money for such extra work. The cost of such extra work is debited to the
contract account and extra price realised is credited to the contract account.

30
Profit on Uncompleted Contracts
Contracts which are started and finished during the same financial year create no
accounting problems. But in case of those contracts which take more than one year
to complete, a problem arises whether profit on such contracts should be worked out
only on the completion of the contract or at the end of each financial year on the
partly completed work. If profit is computed only on the completion of the contract,
profit will be high in the year of completion of the contract, whereas in other years of
working on contract, profit will be nil. This would result not only in distorted profit
pattern but also higher tax liability because income tax at higher rates may have to
be paid. Therefore, when contracts extend beyond a year, it becomes necessary to
take into account the profit earned (or loss incurred) on the work performed during
each year. This helps in avoiding distortion of the year-to-year profit trend of the
business.
There are two aspects of profit computation :
a) Computation of notional profit or estimated profit.
b) Computation of the portion of such profit to be transferred to
Profit and Loss Account.

Notional Profit
Notional profit is the difference between the value of work-in-progress
certified and the cost of work-in-progress certified. It is computed as follows
(Figures are assumed):

Rs
Value of work certified 20,00,000
Add: Cost of work not yet certified 1,50,000
21,50,000
Less:. Cost of work to date 19,00,000

Notional Profit 2,50,000

31
 If in any year, cost of work done exceeds the value of work certified and
uncertified, the result will be a notional loss.

Estimated Profit
Estimated profit represents the excess of the contract price over the
estimated total cost of, the. contract. It is computed as follows (Figures are
assumed):
Rs.
Contract Price 30,00,000
Less: Total cost already incurred 21,00,000
9,00,000
Less: Estimated additional costs to complete the contract 3,50,000
Estimated Profit 5,50,000

Portion of Notional Profit or Estimated Profit to be Transferred to Profit and

Loss Account
The portion of the notional or estimated profit to be transferred to P & L
Account depends upon the stage of completion of the contract i.e., ratio of
work-in-progress certified to total contract work. For this purpose work-in-
progress uncertified is not considered. Prudence requires that the total notional
profit should not be transferred to P & L Account but a portion of it should be
withheld as a reserve to meet any unforeseen future expenses or contingencies.
Rules. There are no hard and fast rules in this regard. However, the following
general rules may be followed in this account.
1. When work certified is less than 1/4 of the contract price, no profit is transferred
to Profit and Loss Account. This is based on the principle that no profit should be
taken into account unless the contract t reasonably advanced.
2. When work-in-progress certified is 1/4 or more but less than 1/2 of the contract
price, then generally 1/3 of the profit is transferred to Profit and Loss Account.

32
The balance amount is treated as reserve. Thus, profit to be transferred to Profit
and Loss Account is computed by the following formula :
Transfer to P & L A/c = Notional profit x 1
3
Alternatively, a more common practice is to further reduce this amount by the
cash ratio.
Transfer to P & L A/c = Notional profit x 1 x Cash received
3 Work certified
3. When work certified is ½ or more but less than 9/10 of the contract price (i.e.,
50% to 90%) then the

Transfer to P & L A/c = Notional profit x 2

3
Here also a more common practice is to further reduce this amount by cash ratio.
This is shown below :

Transfer to P & L A/c = Notional profit x 2 x Cash received

3 Work certified

4. When contract is near completion then the estimated profit should be calculated
on the whole contract. The proportion of estimated profit to be transferred to Profit
and Loss Account is computed by any one of the following formulas:
(a) Estimated profit x work certified
Contract price

(b) Estimated profit x Work certified x Cash received

Contract price Work certified

5. Loss on Uncompleted Contracts. In the event of a loss on uncompleted

contracts, this should be transferred in full to the Profit and Loss Account,
whatever be the stage of completion of the contract.

33
Escalation Clause
This clause is often provided in contracts to cover any likely changes in the
price or utilisation of materials and labour. Thus, a contractor is entitled to suitably
enchance the contract price if the cost rises beyond a given percentage. The object
of this clause is to safeguard the interest of the contractor against unfavourable
changes in cost. The escalation clause is of particular importance where prices of
material and labour are anticipated to increase or where quantity of material and/or
labour time cannot be accurately estimated.
Just as an escalation clause safeguards the interest of the contractor by upward
revision of the contract price, a de-escalation clause may be inserted to look after
the interest of the contractee by providing for downward revision of the contract
price in the event of cost going down beyond an agreed level.

Cost-plus Contracts
Cost-plus contract is a contract in which the contract price is ascertained by
adding a specified amount or percentage of profit to the costs allowed in the contract.
This type of contract terms are agreed upon in those cases where it is not possible to
compute the cost in advance with a reasonable degree of accuracy due to unstable
conditions of market prices, labour rates, etc. The contractee undertakes to reimburse
the actual cost of contract plus a stipulated profit. The profit to be added to cost may
be either a fixed amount or a specified percentage of cost. The items of cost to be
included for the purpose of determining contract price are broadly agreed upon in
advance. The accounts of the contractor are usually subject to audit by the
contractee.
Cost-plus contracts are usually entered into for executing special type of work,
like construction of dam, powerhouse, newly-designed ship, etc., where cost
estimation is difficult. Government often prefers to give contracts on 'cost-plus'
terms.
Cost-plus contracts offer the following advantages:

34
To the Contractor:
1. There is no risk of loss on such contracts.
2. It protects him from the risk of fluctuations in market prices of material,
labour, etc.
3. It simplifies the work of preparing tenders and quotations.

To the Contractee:
The contractee can ensure a fair price of the contract by being entitled to
audit the accounts of the contractor.
The disadvantages of cost-plus contracts are :

To the Contractor:
1. The contractor is deprived of the advantages which would have accrued
due to favourable market prices.
2. The contractor has to suffer for his own efficiency. This is because profit is
usually based as a percentage of cost and efficient working resulting lower
cost also leads to lower profits.

To the Contractee:
1. The contractee has to pay more for the inefficiency of the contractor as a
contractor has no incentive to reduce costs.
2. The price a contractee has to pay is unknown until after the completion of
work.

Problems and Solutions

Problem 1. The following expenditure was incurred on a contract of Rs. 12,00,000
for the year ending 31-12-2002.
Rs.
Materials 2,40,000

35
 Wages 33,000
Plant 40,000
Overheads 17,200

Cash received on account of the contract to 31st Dec, 2002 was Rs.
4,80,000, being 80% of the work certified. The value of materials in hand was Rs.
20,000. The plant had undergone 20% depreciation.
Prepare Contract Account.

Solution
Contract Account for the year ending 31st December, 2002
Particulars Rs. Particulars Rs.
To Materials 2,40,000 By Materials in hand 20,000
To Wages 3,28,000 By Plant in hand
To Plant 40,000 (40,000 less 20%) 32,000
To Overheads 17,200 By Work-in-Progress
Work certified (,80,000 x 100) 6,00,000
80

To Notional Profit c/d 26,800

6,52,00 6,52,000
To Profit & Loss A/c 0 14,293 By Notional Profit b/d 26,800
(26,800 x 2 x 80)
3 100
To Reserve 12,507
26,800 26,800
*Note. Profit transferred to Profit and Loss Account is computed by the following
method: Notional Profit x 2/3 x Cash ratio.

36
Problem 2. Thekedar accepted a contract for the construction of a building for
Rs. 10,00,000, the contractee agreeing to pay 90% of work certified by the
architect. During the first year, the amounts spent were:
Rs. Rs.
Material 1,20,000 Machinery 30,000
Labour 1,50,000 Other expenses 90,000
At the end of the year, the machinery was valued at Rs. 20,000 and materials
at site were of the value of Rs. 5,000. Work certified during the year totalled Rs.
4,00,000. In addition work-in-progress not certified at the end of the year had cost
Rs. 15,000. Prepare Contract Account in the books of Thekedar. Also show the
various figures of profit that can be reasonably transferred to the Profit and Loss
Account.
Solution
Contract Account for the year ending
Particulars Rs. Particulars Rs.

To Materials 1,20,000 By Work-in-Progress:

To Labour 1,50,000. Certified 4,00,000
To Machinery 30,000 Uncertified 15,000
To Other expenses 90,000 By Machinery at site 20,000
To Notional Profit c/d 50,000 By Materials at site 5,000
4,40,000 4,40,000
To P & L A/c 15,000* By Motional Profit c/d 50,000
To Reserve
35,000 50,000
50,000

Working Notes : Transfer to P & L A/c = 50,000 x 1 x 90%= Rs. 15,000

3

Other figure s that may alternatively be transferred to P & L A/c may be

computed as follows.

37
 1. National profit x 1 = 50,000 x 1 = Rs. 16,667
3 3

2. National profit x Work certified x Cash ratio = 50,000 x 4,00,000 x90%

Contract price 10,00,000

= Rs. 18,000
3. National profit x Work certified = 50,000 x 4,00,000 = 20,000
Contract price 10,00,000

Problem 3. The BBA Construction Company undertakes large contracts. The

following particulars relate to Contract No.125 carried out during the year ended on
31st March, 2003.
Rs RS.
st
Work certified by architect 1,43,000 Wages accrued on 31 1,800
Mar, 2003
Cost of work not certified 3,400 Direct expenditure 2,400
Plant installed at site 11,300 Materials on hand on 31st 1,400
Mar, 2003
Value of plant on 31st Mar, 8,200 Materials returned to 400
2003 store
Materials sent to site 64,500 Direct expenditure 200
accured on 31st Mar,
2003
Labour 54,800 Contract price 2,00,000
Establishment charges 3,250 Cash received from 1,30,000
contractee

Prepare a contract account for the period ending 31st March, 2003 and find out the
profit. It was decided to transfer2/3 of the profit on cash basis to Profit and Loss
Account .

38
 Contract No. 125 Account for the year ending 31st March, 2003
Particulars Rs. Particulars Rs.
To Materials sent to site 64.500 By Materials returned 400
To Labour 54.800 By Materials in hand 1.400
To Establishment charges 3,250 By Work-in-Progress :
To Direct expenses 2,400 Certified 1.43.000
To Wages accrued 1,800 Uncertified 3.400
To Direct expenses accrued 200 By Plant at site 8.200
To Plant at site 11.300
To Notional Profit c/d 18.150
1,56.40
1,56,400 1,56,400
To P & L A/c 11,000 By Notional Profit b/d 18.150

18.150 x 2 x 1,30,000
3 1,43,000 7,150
T o Reserve 18,150 18.150

Problem 4 The Indian Construction Co. Ltd. has undertaken the construction of
a bridge over the Rivet-Yamuna for a Corporation. The value of the contract is Rs.
15,00,000 subject to a retention of 20% until one year after certified completion of
the contract, and final approval of the Corporation's engineer. The following are
the details as shown in the books on 30th June, 2003.
Rs. Rs.
Labour on site 4,05,000 Materials on hand on June 30th, 2003 6,300
Materials direct to site 4,20,000 Wages accrued on June 30th, 2003 7,800
Materials from stores 81,200 Direct expenses accrued on June 30th, 2003,1,600
Hire and use of plant 12,100 Works not yet certified at cost 16,500
Direct expenses 23,000 Amount certified by the Corporation's
General overhead allocated engineer 11,00,000
to the contract 37,100 Cash received on account 8,80,000

Prepare (a) Contract Account, (b) Contractee's Account, and (c) show how it
would appear in the Balance Sheet.

39
Solution
Contract Account for the year ending 30th June, 2003
Particulars Rs. Particulars Rs.

To Materials direct to site 4.20.000 By Materials on hand 6.300

To Materials from stores 81.200 By Work-in-Progress :
OTo
Materials
Labour from stores
on site 4.05,000 Certified 11.00,000
To Hire and use of plant 12,100 Uncertified 16.500
To General overhead 37.100
To Wages accrued 7.800
To Direct expenses 23.000
To Direct expenses accrued 1,600
To Notional Profit c/d 1,35,000
11,22,800 11.22.800
To P & L A/c 72.000 By Notional Profit c/d 1.35.000
(1,35,000 x 2 x 8,80,000)
3 11,00,000
To Reserve 63.000 1.35.000
1.35.000

Contractee's Account

To Balance c/d 8,80,000 By Cash 8,80,000

By Balance b/d 8,80,000
Balance Sheet as on 30th June, 2003
•Rs.
Liabilities Rs. Assets
Wages accrued 7,800 Work certified Work 11,00,000
Direct expenses accrued 1,600 uncertified 16,500
11,16,500
Less: Cash received 8,80,000
2,36,500
Less: Reserve 63,000 1,73,500

40
 Problem 5. Modern Contractors have undertaken the following two contracts on
I st January, 2002.
Contract A Contract B
Rs. Rs.
Materials sent to sites 85,349 73,267
Labour engaged on sites 74,375 68,523
Plants installed at sites at cost 15,000 12,500
Direct expenditure 3,167 2,859
Establishment charges 4,126 3,852
Materials returned to store 549 632
Work certified 1,95,000 1,45,000
Cost of work not certified 4,500 3,000
Materials in hand 31st Dec., 2002 1,883 1,736
Wages accrued 31st Dec, 2002 2,400 2,100
Direct expenditure accrued 31st Dec, 2002 240 180
Value on plant 31 st Dec, 2002 11,000 9,500
The contract prices have been agreed at Rs. 2,50,000 for contract A and Rs. 2,00,000 for
contract B. Cash has been received from the contractees as follows: Contract A Rs.
1,80,000 and Contract B Rs. 1,40,000. Prepare Contract Accounts, Contractees
Accounts and show how the work-in-progress shall appear in the Balance Sheet of the
contractor.
Solution
Contract 'A' Account for the year ending 31st Dec, 2002
Particulars Rs. Particulars Rs,
To Materials sent to site 85.349 By Materials (returned to stores) 549
To Labour 74.375 By Materials in hand 1.883
To Plant 15.000 By Plant in hand 11.000
To Direct expenditure 3,167 By Work-in-Progress :
To Establishment charges 4.126 Work certified 1.95.000
To Wages accrued 2.400 Work uncertified 4.500 1,99,500
To Direct expenses accrued 240
Notional Profit c/d 28.275
2,12,932
To Profit & Loss A/c 17,400 By Notional Profit b/d 28.275
| Balance c/d (Reserve) 10.875
28,275 28,275

41
*Note. Proportion of profit transferred to Profit and Loss Account has been calculated
by the following formula:

National profit x 2 x Cash received = 28,275 x 2 x 1,80,000 = Rs.17,400

3 work certified 3 1, 95,000

A Contractee's Account

Rs. Rs.

Dec. 31 2002 To Balance c/d 1,80,000 Dec. 31,2002 By Cash 1,80,000

1,80,000 1,80,000
Jan. 1,2003 By Balance b/d 1,80,000

Contract 'B' Account for the year ending 31st Dec, 2002
Particulars Rs. Particulars Rs.
To Materials 73,267 By Materials returned to store 632

To Labour 68,523 By Materials in hand 1,736

To Plant 12,500 By Plant in hand 9,500
To Direct expenditure 2,859 By Work-in-Progress:
To Establishment charges 3,852 Work certified 1,45,000'
To Wages accrued 2,100 Work uncertified 3,000 1,48,000
To Direct expenditure 180
accrued By Loss transfer to P & L A/c 3,413
1,63,281 1,63,281

B Contractee's Account
Rs. Rs,
Dec. To Balance c/d 1.40.000 Dec. 31,2002 By Cash 1.40,000
1.40.000
1.40.000
Jan. 1.2003 By Balance 1.40.000
b/d

42
 Balance Sheet as on Dec. 31,2002
Liabilities Rs. Assets Rs.

Wages accrued (2,400 + 2,100) 4,500 Plant less Depreciation 20,500

(27,800 – 7,000)
Direct expenses accrued 420 Materials in hand 3.619
(240 + 180)
Work-in-Progress:
Profit on contract A 17,400 Contract A
Less : Loss on contract B 3,413
17,400 13,987 Work certified 1,95,000
Work uncertified 4,500
1,99,500
Less : Profit in reserve 10,875
1,88.625
Less : Cash received 1.80.000 8.625
Contract B
Work certified 1.45.000
Work uncertified 3.000.
1.48,000
Less : Cash received 1,40.000 8,000

Problem 6. T.K.. Construction Ltd. is engaged on two contracts A and B during the year. The
following
particulars are obtained at the year end (Dec. 31):
Contract A Contract B
Date of commencement April I September I
Contract price 6,00,000 5,00,000
Materials issued 1,60,000 60,000
Materials returned 4,000 2,000
Materials on site (Dec. 31st) 22,000 8,000
Direct labour 1,50,000 42,000
Direct expenses 66,000 35,000
Establishment expenses 25,000 7,000
Plant installed at cost 80,000 70,000
43
 Value of plant (Dec. 31st) 65,000 64,000
Cost of contact not yet certified 23,000 10,000
Value of contract certified 4,20,000 1,35,000
Cash received from contractees 3,78,000 1,25,000
Architect's fees 2,000 1,000

During the period, materials amounting to Rs. 9,000 have been transferred from
contract A to contract B. You are required to show : (a) Contract Accounts, (b) Contractees'
Accounts, and (c) Extracts from Balance
Sheet as on December 31st, clearly showing the calculation of work-in-progress.

Solution
Contract 'A' Account for the year ending 31 st Dec

Particulars Rs. Particulars Rs.

To Materials used 1,60,000 By Materials returned 4,000

To Direct labour 1,50,000 By Materials transferred to B 9,000

To Direct expenses 66,000 By Stock of materials 22,000
To Establishment expenses 25,000 By Work-in-Progress:
To Depreciation en plant 15,000 Work certified 4,20,000
To Architect's fees 2,000 Work uncertified 23,000 4,43,000
To Balance c/d (Notional 60,000
Profit)

4,78,000 4,78,000
To Profit and Loss A/c 36,000 By Balance b/d 60,000
(60,000 x 2 x 3,78,000)
3 4,20,000
To WIPA/c (Reserve) 24,000
60,000 60,000

44
 Contract 'B' Account for the year ending 31st Dec
Particulars Rs. Particulars Rs.
To Materials used 60,000 By Materials returned 2,000
To Materials from 9,000 By Stock Materials 8,000
To DirectALabour
Contract 42,000 By Work-in-Progress:
To Direct Expenses 35,000 Work certified 1,35,000
To Establishment 7,000 Work uncertified 10,000 1,45,000
To Depreciation on plant
Expenses 6,000
To
Architect's fees 1,000 By P& L A/c (Loss on 5,000
contract)
1,60,000 1,60,000

A Contractee's Account
Rs.
To Balance c/d 3,78,000 3 1st Dec. By Cash 3,78,000
1st Jan. By Balance b/d
3,78,000
B Contractee's Account
'Rs. Rs
To Balance c/d 1,25,000 31st Dec. By Cash 1,25,000
1st Jan. By Balance b/d 1,25,000
Balance Sheet (Extracts) as on 31st December
Liabilities Rs. Assets Rs.
Profit on Contract A 36,000 Plant 1,50,000
Less : Loss on Contract B 5,000 31,000 Less: Depreciation 21,000 1,29,000

Stock of materials,
Contract A 22,000
Contract B 8,000 30,000
Work-in-Progress:
Contract A
Work certified 4,20,000
Work uncertified 23,000
4,43,000
Less: Reserve 24,000
4,19,000
Less: Cash received 3,78,000 41,000
Work-in-Progress:
Contract B
Work certified 1,35,000

45
 Work uncertified 10,000
1,45,000
Less: Cash received 1,25,000 20,000

Problem 7. A firm of contractors undertook three contracts on 1 st April, 2002, 1 st October,

2002 and 1st Jan., 2003. On 31st March, 2003, when their accounts were made up, the position
was as follows :
Rs. Rs. Rs.
Contract price 4,00,000 1,35,000 1,50,000
Materials 72,000 29,000 1 0,000
Wages 1,10,000 56,200 7,000
General expenses 4,000 1,400 500
Plant 20,000 8,000 6,000
Materials on hand 4,000 2,000 1,000
Wages outstanding 3,400 1,800 800
Work certified 2,00,000 80,000 18,000
Cash received 1,50,000 60,000 13,500
Work uncertified 6,000 4,000 1,050
General expenses outstanding 600 200 100
The plants were installed on the respective dates of the contract and depreciation is
taken at 10% p.a. Prepare contract accounts.
Solution
Contract Accounts
Contrac Contrac Contrac Contra Contra Contra
t t t ct ct ct
I II 111 1 II III
Rs. Rs. Rs. Rs. Rs. Rs.
To Material 72,000 29,000 10.000 By Work-in-progress
To Wages 1,10.000 56.000 7.000 Certified 2.00.00 80.000 18.000
To General 4.000 1,400 500 Uncertified 6.000
0 4.000 1.050
To Plant
expenses 20,000 8.000 6.000 By Plant* 18.000 7.600 5.850
To Wages 3.400 1,800 800 By Material 4.000 2.000 1.000
To General
outstanding By P & L A/c (loss) - 3,000 -
outstanding
expenses 600 200 100
To P& I .A/c* 9,000 - -
To Reserve 9.000 - 1.500
2,28.00 25.900 46
 2,28,00 96,600 25,900 22,800 96,600 25,900
0 0

Working Notes:
1. On Contract I, notional profit is Rs. 18,000. Transfer to P& L A/c is calculated as
follows:
National profit x 1 x Cash ratio = 18,000 x 2 x 1,50,000 = RS . 9,000
3 3 2,00,000

2. Depreciation is calculated from the respective dates of installation of plant.

3. On Contract II, loss is transferred to P & L A/c.
4. On Contract III, work certified is less than 1/4 of the contract price. Thus
national profit is kept as reserve.

Problem 8. Compute a conservative estimate of profit on a contract (which has been

80% complete) from the following particulars. Illustrate at least four methods of
computing the profit transferable to P&LA/c.
Rs.
Total expenditure 85,000
Estimated further expenditure to complete
the contract (including contingencies) 17,000
Contract price 1,53,000
Work certified 1,00,000
Work not certified 8,500
Cash received 81,600
Solution
Calculation of Notional Profit Calculation of Estimated Profit
Rs. Rs.
Work certified 1.00.000 Contract price 53.000
Uncertified 8,500 Less: Expenditure incurred 85.000
1.08.500 Estimated further expenditure 17.000 1.02.000
Less: Expenditure incurred 85,000 ______

47
Notional profit 23,500 Estimated profit 51.000

48
 Methods of Computing the Profit to be transferred to P & L A/c
1. National Profit x 2 x Cash ratio = 23,500 x 2 x 81,600 = Rs. 12,784 (approx.)
3 3
2. National Profit x work certified =23,500 x 1,00,000 = Rs. 15,359 (approx.)
Contract price 1,53,000
.
3. Estimated Profit work certified x Cash ratio = 51,000 x 1,00,000 x 81,600 = Rs.
27,200
Contract price 1,53,000 1,00,000

4. Estimated Profit x Total cost of date x Cash ratio = 51,000 x 85,000 x 81,600 = Rs.
34,680
Estimated total cost 1,02,000 1,00,000

Problem 9. An expenditure of Rs. 3,88,000 has been incurred on a contract upto the end of
31st December, 2002. The value of work certified is Rs. 4,40,000. The cost of. work
uncertified is Rs. 12,000. It is estimated that contract will be completed by 31 st March, 2003
and an additional expenditure of Rs. 80,000 will have to be incurred to complete the
contract. The total estimated expenditure on the contract is to include a provision of 2.5 per
cent for contingencies. The contract price is Rs. 5,60,000 and Rs. 4,00,000 has been
realised in cash upto 31 st December, 2002. Calculate the proportion of profit to be taken to
Profit and Loss Account as on 31 st December, 2002 under different methods.

Solution
Calculation of Notional Profit Estimated Profit on Full
Contract
Rs. Rs.
Value of work certified 4,40,000 Contract price 5,60,000
Add: Cost of work not certified 12,000 Less : Cost to date 3,88,000
4,52,000 Further cost 80,000
Contingencies 12,000*
less: Cost to date 3,88,000 4,80,000
Notional Profit 64,000 Estimated profit 80.000

*(3,88,000 + 80,000) x 2.5 = RS. 12,000 for contingencies

97.5
49
Profit to be transferred to Profit and Loss Account
Method (i) 2 x Notional profit = 2 x 64,000 = Rs. 42,667
3 3

Method (ii) 2 x Notional profit x Cash received = 2 x 64,000 x 4, 00,000= Rs. 38,788
3 Work certified 3 4,40,000

Method (iii) Estimated profit x work certified = 80,000 x 4,40,000 = Rs. 62,857
Contract price 5,60,000

Method (iv) Estimated profit x Work certified x Cash received

Contract price Work certified

= 80,000 x 4,40,000 x 4,00000 = Rs.57,143

5,60,000 4,40,000

Problem 10. The following information relates to a building contract for Rs.
10,00,000.
Year 2001 Year 2002
Rs. Rs.
Materials issued 3,00,000 84,000
Direct wages 2,30,000 1,05,000
Direct expenses 22,000 10,000
indirect expenses 6,000 1,400
Work certified 7,50,000 10,00,000
Work uncertified 8,000 ---
Materials at site 5,000 7,000
Plant issued 14,000 2,000
Cash received from contractee 6,00,000
10,00,000

50
 The value of plant at the end of 2001 and 2002 was Rs. 7,000 and Rs. 5,000,
respectively. Prepare : (i) Contract Account, (ii) Contractee's Account for two years
2001 and 2002 taking into consideration such profit for transfer to Profit and Loss
Account as you think proper.

Solution
Contract Account for two years 2001 and 2002

Year 2001 Rs. Rs.

To Materials 3,00,000 By Work-in-progress :
To Direct wages 2,30,000 Work certified 7,50,000
To Direct expenses 22,000 Work uncertified, 8,000 7,58,000
To Indirect expenses 6,000 By Materials at site 5,000
To Depreciation on
(14,000-7,000) 7,000
To Balance c/d (Profit) 1,98,000
7,63,000

To P& L A/c 1,05,600 By Balance b/d 1,98,000

(1,98,000 x 2 x 6,00,000 )
3 7,50,000
To Work-in-progress
(Reserve)
A/c 92,400
1,98,000
Year 2002
To Work-in-progress: By Contractee A/c 10,00,000
Certified' 7,50,000 By Materials at site 7,000
Uncertified 8,000
7,58,000
Less : Profit in reserve 92,400 6,65,600
To Materials at site b/d 5,000
To Materials issued 84,000
To Direct wages 1,05,000
To Direct expenses 10,000
To Indirect expenses 1,400
To Depreciation on 4,000
^ (14,000 + 2,000- -5,000)
To P & L A/c 1,32,000
10,07,000 10,07,000

51
 Contractee' s Account

Particulars Rs. Particulars V fo.

2001
To Balance c/d 6.00.000 By Cash 6.00.000
6,00.000 6.00.000
2002
To Contract A/c 10,00,000 By Balance b/d 6.00.000
By Cash (balance) 4.00.000
10,00.000 10.00.000

Problem 11. Y Co. undertook a contract for Rs. 15,00,000 on an arrangement

that 80% of the value of work done as certified by the architects of the contractee,
should be paid immediately and the remaining 20c be retained until the contract is
completed. In 2001, the amounts expended were : Materials Rs. 1,80,00; Wages
Rs. 1,70,000; Carriage Rs. 6,000; Cartage Rs. 1,000; Sundry expenses Rs. 3,000. The
work was certified for Rs. 3,75,000 and 80% of this was paid as agreed.'
In 2002, the amounts expended were : Materials Rs. 2,20,000, Wages Rs.
2,30,000, Carriage Rs. 23,000. Cartage Rs. 2,000 and Sundry expenses Rs. 4,000.
Three-fourths of the contract was certified as done by 31 st December, 2002 and
80% of this received accordingly. The value of unused and work-in-progress was
ascertained at Rs. 20,000.
In 2003, the amounts expended were : Materials Rs. 1,26,000; Wages Rs.
1,70,000; Cartage Rs. 6,000. Sundry expenses Rs. 3,000, and on 30th June the
whole contract was completed.
Show how the Contract Account as also the Contractee's Account would
appear for each of these years in the books of the contractor, assuming that balance
due to him was received on completion of the contract

52
 Solution Contract Account
Particulars Rs. Particulars Rs.
2001
To Materials 1,80,000 By Work-in-progress:
To Wages 1,70,000 Certified 3,75,000
To Carriage 6,000
To Cartage 1,000
To Sundry expenses 3,000
To Notional Profit c/d 15,000
3,75,000 3,75,000
To P & L A/c 4,000 By Notional Profit b/d 15,000

(l5,000 x 1 x 80%) 11,000

3
To Reserve 15,000 15,000

2002
To Work-in-progress : Certified 3,75,000 By Work-in-progress: 11,25,000
Less: Reserve 11,000 Certified 20,000
3,64,000 Uncertified
To Materials 2,20,000
To Wages 2,30,000
To Carriage 23,000
To Cartage 2,000
To Sundry expenses 4,000
To Notional Profit c/d 3,02,000
11,45,000 11,45,000

53
 Particulars Rs. Particulars Rs.
2002
To P & L A/c 1,61,067 By Notional Profit b/d 3,02,000
(3,02,000 x 2 x 80%)
3
To Reserve 1,40,993
3,02,000 3,02,000
2003
To Work-in- 11,25,000 By Contractee 15,00,000
Progress: Certified
Uncertified 20,000
11,45,000
less: Reserve 1,40,993
10,04,007
To Materials 1,26,000
To Vages 1,70,000
To
Cartage 6,000
To Sundry 3,000
To Profit & Loss 1,90,993
A/c 15,00,000
15,00,000 15,00,000

Contractee's A/c
2001 Rs. Rs.
To Balance c/d 3,00,000 By Cash 3,00,000
2002
To Balance c/d 9,00,000 By Balance b/d 3,00,000
By Cash 6,00,000
9,00,000 9,00,000
: 03
To Contract A/c 15,00,000 By Balance b/d 9,00,000
By Cash 6,00,000
15,00,000 15,00,000

Problem 12. Elite Ltd. was engaged on one contract during the year 2002.
The contract price was 2.00,000. The trial balance extracted from the books on
31 st December, 2002 stood as follows:

54
 Rs: Rs.
Share capital — 40,000
Sundry creditors — 4,000
Building 17,000 —
Cash at bank 4,500 __
Contract account:
Materials 37,500 __
Plant 10,000 —
Wages 52,500 —
Cash received from contractee 80,000
(80% of certified work)
Expenses 2,500
1,24,000 1,24,000

Of the plant and materials charged to the contract, plant costing Rs. 1,500 and
materials costing Rs 1 were destroyed by an accident.

On 3 1-12-2002, plant costing Rs. 2,000 was returned to stores and material at site
was valued at Rs.1500.Cost of uncertified work was Rs. 1,000. Charge 10%
depreciation on plant. Prepare Contract Account for the year 2002 and Balance Sheet
as on 3 1 -12-2002.

55
Solution
Contract Account for the year ending 31st Dec, 2002
Particulars Rs. Particulars Rs
To Materials 37,500 By Plant returned to store

To Wages 52,500 (2,000 less 10% Depreciation) 1,800

To Expenses 2,500 By Plant at site 5,850
To Plant installed 10,000 By Plant destroyed 1,500
To Notional profit c/d 10,350 By Materials lost 1,200
By Materials at site 1,500
By Work-in- 1,00,000
Progress: 1,000
1,12,850 Certified 1,12,850
To P & L A/c 5,250 By Notional profit b/d 5,250

(10,350 x 2 x 80)
3 100
To Reserve 4,830
10,350 10,350

Balance Sheet as on 31st Dec, 2002

Liabilities Rs. Assets Rs.

Share Capital 40,00 Building 17,000
Sundry Creditors 0 Bank 4,500
Profit and Loss A/c Less: 5,520 4,000 Plant in store 1,800
Plant destroyed 1,500 Plant at site 5,850
4,020 Materials at site 1,500
Less: Materials lost 1,200 2,820 Certified 1,00,000
Uncertified 1,000
Less: Cash received 1,01,000
Less: Reserve 21,000 16,170
4,830
46,820 46,820

56
 Problem 13. The following is the Trial Balance of KK Construction Company
engaged on the execution of Contract No. 303, for the year ended 31 st
December, 2002.
Dr. Rs. Cr. Rs.
Contractee's account (amount received) — 3,00,000
Buildings' 1,60,000 -
Creditors — 72,000
Bank balance 35,000 —
Capital account — 5,00,000
Materials 2,00,000 —
Wages 1,80,000 —
Expenses 47,000 —
Plant 2,50,000 —
8,72,000 8,72,000

The work on Contract No. 303 was commenced on 1 st January, 2002.

Materials costing Rs. 1,70,000 were sent to the site of the contract but those of
Rs. 6,000 were destroyed in an accident. Wages of Rs. 1,80,000 were paid
during the year. Plant costing Rs. 50.000 was used on the contract all through
the year. Plant with a cost of Rs. 2 lakhs was used from 1 st January to 30th
September and was then returned to the stores. Materials of the cost of Rs.
4.000 were at site on 31 st December, 2002.
The contract was for Rs. 6,00,000 and the contractee pay 75% of the work
certified. Work certified was 80° o of the total contract work at the end of 2002.
Uncertified work was estimated at Rs. 15,000 on 31 st December, 2002.
Expenses are charged to the contract at 25% of wages. Plant is to be depreciated
at 10% for the entire year.
Prepare Contract No. 303 Account for the year 2002 and make out the Balance
Sheet as on 31 st December, 2002 in the books of Bhika Construction
Company.
57
Solution
Contract No. 303 Account for the year ending 31-12-2002

Particulars Rs. Particulars Rs.

To Materials 1,70,000 By Work certified 4,80,000
To Wages 1,80,000 By Work uncertified 15,000
To Expenses 45,000 ByP&LA/c
To Depreciation on plant (Loss by accident) 6,000
(5,000+15,000) 20,000 By Materials at site 4.000
To Notional profit c/d 90,000
5,05.000
To P & L A/c (90,000 x 2/3 x 37,500 By Notional profit b/d 90,000
To Balance 5/8*)
(Reserve) 52,50
90.000

Balance Sheet as on 31st Dec, 2002

Liabilities Rs. Assets Rs.

Capital 5.00.000 Building 1.60.000
P & L A/c 37.500 Plant in stores 1.80.000
Less : Loss 6.000 Materials in store 30.000
31.500 Work-in-
Progress : .
Less : Unabsorbed 2.000 Certified 4.80.000
(47,000 - 45,000) 29.500 Uncertified 15.000
4,95.000

Less .' Depreciation on 5.000 24.500 Less: Reserve 52,500

plant* 4.42,50
Creditors 72,000 Less..;: Cash 3.00.000
0 1.42.500
Materials at site 4.000
Plant at site 45.000
Bank 35,000
5.96.500 5.46.500

58
 * Notes:
1. The cash ratio for computing the amount to be transferred to P & L Account has been
taken as 5/8 i.e.,

3,00,000 Cash received It may also be taken as 75% as given in the question
4,80,000 Work certified

2. Depreciation on plant of Rs. 2,00,000 has been charged to contract only for 9
months. For remaining three months it has been charged to profit in the balance
sheet.

Problem 14. The following figures are extracted from the books of a contractor, for the
year ending 31st Dec, 2002
Rs. Rs.
Work-in-progress on 31st Dec, 2001 17,00,000
Less: Advances from contractee’s 11,00,000 6,00,000
Materials supplied to contracts direct 1,20,000
Materials issued from store 2,10,000
Wages 1,70,000
Working expenses 30,000
Materials returned to store 11,000
Contracts finished 4,50,000
Work certified 3,00,000
Profit taken to Profit and Loss Account upon contracts completed 2,30,000
Administrative expenses (out of which Rs.5,000 is chargeable to Profit and Loss Account) 25,000
Plant issued
50,000
Materials returned from contract to suppliers 9,000
Advances from contractees 8,00,000
Plant at site 40,000
Prepare the Contract Ledger Control Account in general ledger and total contractees'
account. Show also how the work-in-progress would appear in the Balance Sheet as on 31 st
December, 2002.

59
Solution
Contract Ledger Control Account

Particulars Rs. Particulars Rs.

To Work-in-progress b/d 17,00,000 By Contractees' A/c 4,50,000
To Materials issued 2,10,000 (Contracts finished)
To Materials supplied direct 1,20,000 By Materials returned to store 11,000
To Wages 1,70,000 By Materials returned to 9,000
To Works expenses 30,000 By Plant at site 40,000
To Plant issued 50,000 By Work-in-progress:
To Administration expenses 20,000 Certified 3,00,000
To Profit 2,30,000 Uncertified (Balancing 17,20,000
25,30,000 25,30,000
Total Contractees' Account

Particulars Rs. Particulars Rs.

To Contract Ledger Control A/c 4,50,000 By Balance b/d 11,00,000
To Balance c/d 14,50,000 By Bank 8,00,000
19,00,000 19,00,000

Balance Sheet as on 31-12-2002

Liabilities Rs. Assets Rs.

Work-in-progress:

Certified 3,00,000
Uncertified 17,20,000
20,20,000
Less: Cash received 14,50,000 5,70,000

60
SECTION-A
Short Answer Questions
1. Name any three industries in which contract costing is used.
2. Give three features of contract costing.
3. State two points of difference between job costing and contract costing.
4. What is escalation clause in contracts?
5. What do you mean by cost-plus contracts?
6. 'Job is a small contract and contract is a big job'. Do you agree?
7. How will you treat profit on a contract which is 50% complete?
8. How loss on incomplete contract is treated?
9. Write a note on cash ratio in contracts.
10. What do you mean by work certified and work uncertified in contract costing ?
11. What is notional profit in contract costing?
12. What is sub-contract cost? How is it treated?
13. What do you mean by retention money?

SECTION-B

1. Distinguish between job costing and contract costing. State the special
features of contract costing.

2. What is contract costing ? Explain briefly the principles involved in

taking profit on incomplete contract

3. Explain how the profits are determined in the case of uncompleted

contracts.

4. What is cost-plus contract? Discuss this from the point of view of (a) the
manufacturer, (b) the buyer .

5. What is the relevance of escalation clause provided in contracts ?

61
 6. Discuss the methods of ascertaining profit on the following contracts :

(a) When contract is completed.

(b) When contract is not completed.
(c) When the contract is
nearing completion.

7. The Builders Association is an organization of persons engaged in the construction

industry. You are retained as cost accountant by the Association to answer the following
questions :
(a) What are the problems of costing for a construction industry? How would you
deal with them?
(b) Discuss in your answer the apportionment of the cost of plant and machinery and
ascertainment of profit on contracts which are not completed at end of the accounting year.

SECTION-C

1.M/s X and Co. obtained a contract for building a factory for Rs. 10,00,000. The building
operation started on 1 April, 2002 and at the end of March, 2003, they received from the
party a sum of Rs. 3.9 lakhs, being 75% of the amount due on the surveyor's certificate. The
following additional information is given from the books of the company :
Rs Rs.
Stores issued to contract 2,00,000 Direct expenses 25,000
Stores on hand 31 March, 2003 10,000 Overhead allocated to contract 12,000
Wages paid 1,80,000 Work uncertified at cost 12.000
Plant purchased for the contract 2,00,000 Plant to be depreciated at 10%
Prepare Contract Account showing the profit or loss on the contract as on 31 March. 2003.
[Ans. Tr. to P & L A/c Rs. 52,500; Reserve Rs. 52,500 ]

2. The following information relates to two contracts of KP Contractors in 2002

62
 Contract A Contract B
Rs. Rs.
Materials sent to site 1,70,698 1,46.534
Labour 1,48,750 1,37,046
Plant 30,000 25,000
Direct expenses 6,334 5,718
Establishment charges 8,252 7,704
Materials returned to store 1,098 1,264
Work certified 3,90,000 2,90.000
Work uncertified 9,000 6,000
Material at site (31-12-2002) 3,766 3,472
Wages accrued 4,800 4,200
Direct expenses accrued (31-12-2002) 480 360
Value of plant (31 -12-2002) 22,000 19,000
Contract price 5,00,000 4,00,000
Cash received 80% of work certified.
Prepare : (i) Contract Accounts (ii) Contractee's Accounts.
[Ans. A - Tr. to P & L A/c Rs. 30,160; Reserve Rs. 26,390; B - Loss Rs. 6,826 ]
3. Modi Constructions Ltd. has taken two contracts on 1st Oct., 2001. The position of the contracts on 30th
Sept., 2002 is as follows :

Contract 1 Contract II
Rs. Rs.
Contract price 27,00,000 60,00,000
Materials 5,80,000 10,80,000
Wages paid 11,24,000 16,50,000
Other expenses 28,000 60,000
Plant at site 1,60,000 3,00,000
Unused materials at site 40;000 60,000
Wages payable 36,000 54,000
Other expenses due 4,000 9,000
Work certified 16,00,000 30,00,000
Cash received 12,00,000 22,50,000
Work uncertified 80,000 90,000
63
The plant at site is to be depreciated at 10%. Prepare the Contract Account in respect of each work showing the
notional profit and also profit to be transferred to Profit and Loss Account.
[ Ans. 1 - Loss Rs. 68.000; 11 - Tr. to P & L A/c Rs. 1,33,500, Reserve Rs. 1,33,500 ]

4. The following particulars relate to two houses which a firm of builders had in course of construction
under contract;
House A House B
Rs. Rs.
Work-in-progress on 1 Jan, excluding Rs. 800 estimated
profit which was
taken to profit and loss account in 2002) 14,000
Materials purchased 23,000 16,600
Wages 20,000 14,000
Electrical services and fittings 1,400 300
Road making charges 8,000 -
Contract price (including road making) 60,000 40,000
Cash received to 31 Dec, 2003 60,000 24,000
Percentage of cash received to work certified 100% 66-1/3%
Value of materials on hand on 31 Dec, 2003 400 540
Completed work not certified - 2,500
Value of plant used on sites 12,000 6,000
Period of plant remained on site during the year 10 months 8 months
The total establishment expenses incurred during the year 2003 amounted to Rs. 12,240. These are to
be charged to the contracts in proportion to wages. Depreciation of plant is to be taken into
account at the rate of 10% per annum.
Prepare the two Contract Accounts (in columnar form) showing the profit or loss on each house for
the year 2003 and the sums which you consider appropriately transferable to the Profit & Loss
Account.
[ Ans. A - Loss Rs. 15,000; B - Tr. to P & L A/c Rs. 1,200; Reserve Rs. 1,500 ] [ Hint. In House
A, work-in-progress will be taken as Rs. 14,000 + 800 = Rs. 14,800 ]
5. Gupta Construction Ltd. took a contract in 2002 for road construction. The contract price was
Rs. 10,00,000 and its estimated cost of completion would be Rs. 9,20,000. At the end of 2002, the
company has received Rs. 3,60,000, representing 90% of the work certified. Work not yet
certified has cost Rs. 10,000.
64
Expenditure incurred on the contract during 2002 was as follows : Materials Rs. 50,000; Labour Rs.
3,00,000; Plant Rs. 20,000.
Materials costing Rs. 5,000 were damaged and had to be disposed of for Rs. 1,000. Plant is
considered as having depreciated by 25 per cent.
Prepare Contract Account for 2002 in the books of Gupta Construction Ltd. Also show all possible
figures that can be reasonably credited to Profit and Loss Account in respect of the contract.
[Ans. Notional profit Rs. 60,000, Estimated profit Rs. 80,000 ]

6. The following information related to a building contract for Rs. 10,00.000 and for which
80% of the value of work-in-progress as certified by the architect is being paid by the
contractee.

I Year II Year III Year

Rs. Rs. Rs.
Material issued 1,20,000 1,45,000 84.000
Direct wages 1,10,000 1,55,000 1,10.000
Direct expenses 5,000 17,000 6,000
Indirect expenses 2.000 2,600 500
Work certified 2.35,000 7,50.000 10.00,000
Uncertified work 3.000 8,000 -
Plant issued 14.000 - -
Material on site 2,000 . 5,000 8,000
The value of the plant at the end of I, II and III year was Rs. 11,200, Rs. 7.000 and Rs. 3,000
respectively. Prepare Contract Account, for these three years taking into account such profit as
you think proper on incomplete contract.
[ Ans. 1 yr. Reserve Rs. 200, II yr. Profit Rs. 1,06,347; Reserve Rs. 93,053; III yr. Profit Rs.
1,33.553 ]

9.India Construction Limited engaged in contract work has the following Trial
Balance on 31st December. 2002 :
Dr. Cr.
Rs. Rs.
Share capital — Shares of Rs. 10 each - 35,180
Profit and Loss A/c as on 1st Jan., 2002 - 2,500
65
 Provision for depreciation on plant and tools - 6,300
Contractee's A/c — Contract No. 707 - 1,28,000
Creditors - 8,120
Land and building (at cost) 7,400 -
Plant and tools (at cost) 5,200 -
Bank balance 4,500 -
Contract No. 707 :
Materials issued 60.000 -
Direct labour 83.000 -
Expenses 4,000
Plant and tools at site (at cost) 16,000 -
1,80,100 1,80.100
Contract No. 707, having a contract price of Rs. 2,40.000 was begun in 1st January, 2002 and
contractee pays 80% of the work completed and certified. The cost of work done since
certification is estimated to be Rs. 1,600. After the
above Trial Balance was extracted on 31st Dec, 2002. plant costing Rs. 3,200 was returned to the
stores and materials at site on that date were valued at Rs. 3,000. Provision is to be made for sub-
contract costs amounting to Rs. 600
incurred on Contract No. 707 and for depreciation of all Plant and Tools @ 12.5% on cost. Prepare
Contract No. 707Account showing the computation of profit, if any, for which credit, may properly
be taken in 2002 and prepare the
Balance Sheet of the construction company on 31 st December, 2002.

[Ans. Tr. to P & L A/c Rs. 8,000, Reserve Rs. 7,000, B/S Total Rs. 69,700 ]

7. Alcon Construction Company Ltd. commenced its business construction on 1-1-2002. The
trial balance as on 31-12-2002 shows the following balances :
Dr. Cr.
Rs. Rs.
Paid-up share capital 1.00,000
Cash received on account of contract
(80% of work certified) 1,20,000

66
 Land and Buildings 30,000
Machinery at cost (75% at site) 40,000
Bank 4.000
Materials at site 40,000
Direct labour 55.000
Expenses at site 2,000
Lorries and vehicles 30,000
Furniture 1.000
Office equipment 10,000
Postage and Telegrams 500
Office expenses 2,000
Rates and Taxes 3,000
Fuel and Power 2,500
2,20.000 2,20,000
The contract price is Rs. 3,00,000 and work certified is Rs. 1,50,000. The work completed since
certification is estimated at Rs. 1,000 (at cost). Machinery costing Rs. 2,000 was returned to stores at
the end of the year. Stock of
material at site on 31-12-2002 was of the value of Rs. 5,000. Wages outstanding were Rs. 200.
Depreciation on machinery at 10%. You are required to calculate the profit from the contract and
show how the work-in-progress
will appear in the Balance Sheet as on 31-12-2002.

[Ans. Tr. to P & L A/c Rs. 28,427. Reserve Rs. 24.873]

[ Hint. Office expenses, postage and telegrams, rent and rates, fuel and power and depreciation on
machinery costing Rs. 10,000 are not charged to Contract Account. These are charged to P & L A/c
of the company.]
9. .A firm of building contractors began to trade on 1st January, 2002. During the year, the company
was engaged on only-one contract. The contract price was Rs. 5,00.000.
Of the plant and materials charged to the contract, the plant which cost Rs. 5,000 and material
which cost Rs. 4,000 ere lost in an accident.
On 31st December. 2002, the plant which cost Rs. 5.000 was returned to the stores; the cost of
work done but uncertified was Rs. 2.000 and the materials costing Rs. 4,000 were in hand on site.

67
 Charge 10% depreciation of the plant and compile the Contract Account and the Balance Sheet
from the following
Trial Balance on 31st December. 2002.
Rs. Rs.
Share capital 1,20.000
Creditors 10.000
Cash received on contract 2,00.000
(80% of work certified)
Land, buildings, etc. 43.000
Bank balance 25.000
Charged to Contract :
Materials . 90.000
Plant 25,000
Wages 1,40,000
Expenses 7,000
3.30.000 3,30,000
[ Ans. Tr. to P & L A/c Rs. 11.200; Reserve Rs. 9.800; B/S total Rs. 1,32,200 ]
10. M/s Sewers Ltd. undertook a contract for erecting a sewerage treatment plant for
municipality for a total value of Rs. 24 lakhs. It was expected that the contract would be
completed by 31 st January, 1997. You arc required to prepare a contract account for the year
ending 31st January. 1996 from the following particulars :
(i) Wages Rs. 6.00.000.
(ii) Special plant Rs. 2,00.000.
(iii) Materials Rs. 3.00.000.
(iv) Overheads Rs. 1.20,000.
(v) Depreciation @ 10% to be provided on plant.
(vi) Materials lying at the site on 31st January. 1996 Rs. 40,000.
(vii) Work certified was to the extent of Rs. 16.00,000 and 80% of same was received in
cash.
(viii) 5 per cent of the value of material issued and 6 per cent of wages may be
taken to have been incurred for the portion of work completed but not yet certified.
(ix) Overheads are charged as percentage of direct wages.
(x) Ignore depreciation on plant for use on uncertified portion of the work. (xi) Ascertain the
68
 amount to be transferred to Profit and Loss Account on the basis of realised profit.
[ Ans. Transfer to P & L A/c Rs. 3,51,040, Reserve Rs. 3,07,160 ]
[ Hint. Work uncertified is calculated as under
Rs.
Material (5% of Rs. 3,00,000) 15.000
Labour (6% of Rs. 6,00,000) 36,000
Overhead ( 20% of Rs. 36,000) 7.200
Cost of work not certified 58,200

11. Modern Construction Company with a paid up share capital of Rs. 50 lakhs undertook a
contract to construct LIG houses. The contract work commenced on 1-1-2002 and the
contract price was Rs. 50 lakhs. Cash received on account of contract on 31-12-2002 was
Rs. 18 lakhs (90% of the work certified). Work completed but not certified, was
estimated at Rs. 1,00,000. As on 31-12-2002, material at site was estimated at Rs. 30.000
and machinery at site costing Rs. 2,00,000 was returned to stores. Plant and machinery
at site is to be depreciated at 5% . Wages outstanding on 31-12-2002 were Rs. 5,000. The
following were ledger balances (Dr.) as per Trial Balance as on 31-12-2002 :
Rs.
Land and buildings 15.00.000
Plant and machinery at cost (60% at site) 25,00.000
Lorries and other vehicles 8,00,000
Furniture 50.000
Office equipment 10.000
Materials sent to site 14,00,000
Fuel & Power 1,25,000
Site expenses 5,000
Postage & Telegrams 4,000
Office expenses 8,000
Rates & Taxes 15,000
Cash at bank 1.33,000
Wages 2,50,000

Prepare the Contract Account to ascertain the profit from the contract and show the WIP in the

69
Balance Sheet.
[ Ans. Notional profit Rs. 2,43,000 ; Tr. to P & L A/c 2,43.000 x 1/3 x 90%= Rs. 72.900;
Reserve Rs. 1,70.100 ; Balance Sheet total Rs. 50,77,990
WIP in B/S =20,00,000 +1,00.000 - 18.00.000 - 1,70.100 = Rs. 1.29.900 ]
[Hint. Fuel and power, office expenses, rates and taxes and postage and telegrams have been
charged to the contract.]

70
Module-3

Process Costing

In many industries, for manufacturing a product, the raw material has to pass through
several distinct stages of manufacture in a pre-determined sequence. Each such stage of
manufacture is called a 'process'. The goods produced are identical and all factory
processes are standardised. Method of cost ascertainment in such industries is known as
process costing in which costs are compiled for each process by preparing a separate
account of each process.

Characteristics of Process Costing Process Costing is used in :

1. The production is continuous and the final Textiles mills
Sugar industry
product is the result of a sequence of processes.
Chemical industry
2. Costs are accumulated by processes. Oil refining
Cement industry
3. The products are standardised and Paper industry
Food processing
homogeneous. Steel industry
4. The cost per unit produced is the average cost Paint industry.
Soap industry
which is calculated by dividing the total process Bakery
cost by the number of units produced.
5. The finished product of each but last process becomes
the input for the next process in sequence and that of
the last process is transferred to the finished goods
stock.
6. The sequence of operations or processes is specific
and pre-determined.
7. Some loss of materials in processes (due to chemical action, evaporation, etc.) is

71
 unavoidable.
8. Processing of a raw materials may give rise to the production of several products.
These several products produced from the same raw material may be termed as joint
products or by-products.

Process Costing and Job Costing - A Comparison

A comparison of process and job costing methods will help in the better
understanding of process costing system.

Process Costing Job costing

1. Costs are compiled process-wise and Costs are separately ascertained for each
cost per unit is the average cost, i.e. job, which is cost unit.
the total cost of the process divided by
the number of units produced.
2. Production is of standardised products Production is of non-standard items with
and cost units are identical. specifications and instructions from the
customers.
3. Production is for stocks. Production is against orders from
customers.
4. Costs are computed at the end of a Costs are calculated when a job is
specific period. completed.
5. The cost of one process is transferred Cost of a job is not transferred to
to the next process in the sequence. another job but to finished stock
account.
6. On account of continuous nature of There may or may not be work-in-
production, work-in-progress in the progress in the beginning and end of the
beginning and end of the accounting accounting period.
period is a regular feature.

7. Cost control is comparatively easier. Cost control is comparatively more

This is because factory processes and difficult because each cost unit or job
products are standardised. needs individual attention.

Process Costing Procedure

The essential stages in process costing procedure are :
1. The factory is divided into a number of processes and an account is

72
 maintained for each process.
2. Each process account is debited with material cost, labour cost, direct expenses
and overheads allocated or apportioned to the process.
3. The output of a process is transferred to the next process in the sequence. In other
words, finished output of one process becomes input of the next process.
4. The finished output of the last process (i.e. the final product) is transferred to the
Finished Goods Account.

73
Process A A/c Process B A/c Process C A/c Finished Goods
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Input Output Input Output Input Output
Tr. Tr. Tr.

Fig.9.1 Process costing procedure

Illustration 1

Prepare process accounts and calculate total cost of production from the data given
below :
Process X Process Y Process Z
Rs. Rs. Rs.
Materials 2,250 750 300
Labour 1,200 3,000 900
Direct expenses:
Fuel 300 200 400
Carriage 200 300 100
Works overheads 1,890 2,580 1 .875
The indirect expenses Rs. 1,275 should be apportioned on the basis of wages.

Solution:
Process X Account
Rs. Rs.
To Materials 2,250 By Transfer to Process Y 6,140
To Labour 1,200
To Direct expenses:
Fuel 300
Carriage 200
To Works overhead 1,890
To Indirect expenses 300
6,140
6,140 6,140

74
 Process Y Account
Rs. Rs.
To Tr. from Process X 6,140 By Tr. to Process Z 13,720
To Materials 750
To Labour 3,000
To Direct expenses:
Fuel 200
Carriage 300
To Works overhead 2,580
To Indirect expenses 750
13,720 13,720

Process Z Account
Rs. Rs.
To Tr. from Process Y 13,720 By Transfer to Finished Goods 17,52
To Material 300 0
To Labour 900
To Direct expenses:
Fuel 400
Carriage 100
To Works overhead 1,875
To Indirect expenses 225
17,520 17,52
0 Z in
Note : Indirect expenses of Rs. 1,275 have been apportioned to processes X, Y, and
the ratio of 1200:- 3000: 900 i.e., 4 : 10:3 respectively.

Accounting Adjustments in Process Costing

In process costing, the following four types adjustments need to be made in accounts.
1. Process losses — normal and abnormal
2. Valuation of work in progress — equivalent production
3. Joint products and by-products
4. Inter-process profits.

PROCESS LOSSES AND WASTAGES

In industries which employ process testing, a certain amount of loss occurs at
various stages of production. Such a loss may arise due to chemical reaction,
evaporation, inefficiency, etc. It is, therefore, necessary to keep accurate records of both
input and output. Where loss occurs at a late stage in manufacture, it is apparent that
75
financial loss is greater. This is because more and more costs are incurred in processes
as products move towards completion stage.
Process losses may by classified into (a) normal, and (b) abnormal.
Normal Process Loss
That amount of loss which cannot be avoided because of the nature of material or
process is normal process loss. Such a loss is quite expected under normal conditions. It
is caused by factors like chemical change, evaporation, withdrawals for tests or
sampling, unavoidable spoiled quantities, etc.

Abnormal Process Loss

This type of loss consists of loss due to carelessness, machine break-down, accident, use
of defective materials, etc. Thus it arises due to abnormal factors and represents a loss
which is over and above the normal loss.
Accounting procedure for normal and abnormal loss differs.
Accounting Treatment of Normal Loss
It is a fundamental costing principle that the cost of normal losses should be borne by
the good production. Normal loss is generally determined as a percentage of input.
Sometimes such a loss is due to loss of weight, say, due to evaporation or chemical
action. Since such wastage is not physically present, obviously it cannot have any value.
However, when normal loss is physically present in the form of scrap, it may have some
value, i.e. it may be sold at some price. Whenever scrapped material has any value, it is
credited to the Process Account. This is illustrated below :

Illustration 2
The following information is given in respect of process A.
Materials 1,000 kg. @ Rs. 6 per kg.
Labour Rs. 5,000
Direct expenses Rs. 1,000
Indirect expenses allocated to Process A Rs. 1,000. Normal wastage 10% of input
Prepare Process A Account when:
(a)Scrap value of normal loss is nil.

76
 (b)Scrap arising out of normal has a sale value of Re. 1 per unit.

Solution
(a) When scrap value of normal loss is nil.
Process A Account
Particulars kg Rs Particulars kg Rs
To Materials 1,000 6,000 By Normal loss 100 13,000
To Labour 5,000 By Transfer to Process B 900
To Direct exp. 1,000
To Indirect exp. 1,000 1,000
13,000 1,000 13,000
Cost per unit = Rs. 13,000 + 900 units = Rs. 14.44
The normal loss is absorbed by good production and as a result the cost per unit of
good production inflates. When there is no loss, the cost per unit produced is Rs. 13 (i.e.
13,000 +1,000 units). But when there is a normal loss, the cost per unit is higher at Rs.
14.44
(b) When scrap of normal loss has a sale value of Re. 1 per unit

Process A Account
Particulars kg Rs Particulars kg Rs
To Material 1,000 6,000 By Normal loss 100 100
To Labour 5,000 900 12,900
To Direct exp. 1,000 By Transfer to Process B
To Indirect exp. 1,000

1,000 13,000 1,000 13,000

Cost per unit = Rs. 12,900 4- 900 units = Rs. 14.33
Whenever any value is realised from the sale of normal wastage, it reduces the cost to that
extent.

Accounting Treatment of Abnormal Process Loss

It has been stated earlier that abnormal loss is due to carelessness, accidents, machine
break-down and other abnormal reasons. Unlike normal loss, abnormal loss is not
absorbed by good-production, rather it is transferred to Costing Profit and Loss Account.
This is because if the cost of abnormal loss were to fall upon the good production, the
cost thereof will fluctuate and the information provided would be misleading. In order to
77
overcome this and also to disclose the cost of abnormal loss, the following procedure
may be adopted:

(a) Allow for normal loss in the manner described earlier.

(b) After considering normal loss, find out the cost per unit in that process. This is
done by the following formula:

Cost per unit = Total cost - Value of normal loss

Units introduced - Normal loss units
(c) Multiply the cost per unit (calculated as above) by the number of units of
abnormal loss. This gives the total value of abnormal loss.

(d) Credit the relevant Process Account with the quantity and value of abnormal loss.
(e) The balance figure in the Process Account is the cost of good units produced in
the process. This can also be found by multiplying cost per unit with the number
of good units produced.

(f) Open 'Abnormal Loss Account' and debit it with the quantity and value of
abnormal loss shown in the Process Account. Sale proceeds from abnormal loss
are credited to Abnormal Loss Account. Any balance left in this account is net
loss and transferred to Costing Profit and Loss Account.

Illustration 3
Fifty units are introduced into a process at a cost of rupee one each. The total
additional expenditure incurred in the Process is Rs. 30. Of the units introduced, 10% are
normally spoiled in the course of manufacture, these possess a scrap value of Re. 0.25
each. Owing to an accident, only 40 units are produced. You are required to prepare (i)
Process Account, and (ii) Abnormal Loss Account.

Solution

Process Account
Particulars Units Rs. Particulars Units Rs.
To Materials To 50 50.00 By Normal loss @ Re. 1.25
Expenses 30.00 0.25 each By Abnormal 5 8.75
loss *
5 70.0
0
78
 By Transfer to next 40
50 80.00 process (B/F) 50 80.00
*Cost of abnormal loss is calculated as follows :

Total cost - Value of normal loss Rs. 80 - 1.25 = 78.75

Input - Normal loss (in units) Units 5 0-5 = 45

Cost per unit = Input – Normal loss (in units) = Rs. 1.75
Cost of abnormal loss = Abnormal loss units x Cost per unit
= 5 x Rs. 1.75 = Rs. 8.75

Abnormal Loss Account

Particulars Units Rs. Particulars Units Rs.
To Process A/c 5 8.75 By Sales @ Re. 0.25 5 1.25
each By Profit and
Loss A/c (Balanced
figure) 7.50
5 8.75 5 8.75

Abnormal Gain or Effectiveness

The normal process loss represents the loss that would be expected under normal
conditions. It is an estimated figure. The actual loss may be greater or less than the
normal loss. If the actual loss is greater than normal loss, it is known as abnormal loss.
But if actual loss is less than normal loss, a gain is obtained which is termed as abnormal
gain or effectiveness. The value of abnormal gain is calculated in a manner similar to
abnormal loss. It is shown on the debit side of the Process Account and credit side of the
Abnormal Gain Account. Like abnormal loss, it is ultimately transferred to Costing
Profit and Loss Account. This is illustrated below.

Example
Using the figures of illustration 3. except that actual output is 47 units, show how the
process account will be prepared. Also prepare Abnormal Gain Account.

Solution
When normal output is 45 units and actual output is 47 units, there is an abnormal
gain of 2 units. This is shown in the following account.

79
 Process Account
Particulars Units Rs. Particulars Units Rs.
To Material 50 By Normal loss 1.25
To Expenses 50 30 5
To Abnormal gain* 3.50 By Transfer to next 82.2
2 process 47 5
52 83.50 52 83.50
*The value of abnormal gain is calculated as follows :
Rs.80-.1.25 x 2 units = Rs. 3.50
50-5 units
It should be noted that the method of valuation of abnormal gain is the same as
that of abnormal loss.
Abnormal Gain Account
Particulars Units Rs. Particulars Units Rs.
To Normal loss A/c 2 0.50 By Process A/c 2 3.50
(Shortfall in the sate of 3.00
normal loss)
To Profit & Loss A/c (B.F)
2 3.50 2 3.50
Illustration 4
A product passes through three processes A, B and C. The normal wastage of each
process is as follows: Process A - 3 per cent, Process B - 5 per cent, and Process C - 8 per
cent. Wastage of Process A was sold at 25 P. per unit, that of Process B at 50 P. per unit
and that of Process C at Re. 1 per unit.
10,000 units were issued to Process A on 1-4-2004 at a cost of Re. 1 per unit. The
other costs were as follows:
Process A Process B Process C
Sundry materials Rs. 1,000 Rs. 1,500 Rs. 500
Labour 5,000 8,000 6,500
Direct expenses 1,050 1,188 2,009
Actual output 9,500 units 9,100 units 8,100 units

Prepare the Process Accounts, assuming that there were no opening or closing
80
stocks. Also give the Abnormal Wastage and Abnormal Gain Accounts.

Solution

Process A Account
Particulars Units Rs. Particulars Units Rs.
To Units introduced 10,000 10,000 By Normal wastage 300 75
To Sundry materials 1,000 (3% of 10,000)
To Labour 5,000 By Abnormal wastage 200 350*
To Direct expenses 1,050 By Process B (transfer) 9,500 16,625

10,000 17,050 10,000 17,050

• Value of abnormal wastage = Rs. 17050 – Rs.75 x 200 units = Rs. 350
10,000 -300 units

Process B Account
Particulars Units Rs. Particulars Units Rs.
To Process A (Tr.) 9,500 16,625 By Normal wastage 475 238
To Sundry materials 1,500 (5% or 9,500) By
To Labour 8,000 Process C (transfer)
To Direct expenses 1,188 9,100 27,300
To Abnormal gain 75 225*
9,575 27,538 9,575 27,538
Rs. 27,313-Rs.238
* Abnormal gain = 9,500 -475 units x 75 units = Rs. 225
Process C Account
Particulars Units Rs. Particulars Units Rs.
To Process B (transfer) 9,100 27,300 By Normal wastage 728 728
To Sundry materials 500 (8%
By
of 9,100)
Abnormal wastage
To Labour 6,500 272 1156
To Direct expenses 2,009 By Finished goods
(transfer) 8,100 34,425

9,100 36,309 9,100 36,309

• Abnormal gain = Rs. 36,309 – Rs.728 x 272 units = Rs. 225
9,100 -728 units
Abnormal Wastage Account
Particulars Units Rs Particulars Units Rs

81
To Process A 200 350 By Sales of scrap in 200 50
To Process B 1,156 Process A @ Re. 0.25 272
272 Process C @ Re. 1 272
1,184
By Profit and Loss A/c
(B/F)
472 1,506 472 1,506

Abnormal Gain Account

Particulars Units Rs. Particulars Units Rs.
To Normal wastage A/c 75 By Process B 75 225
(shortfall in the sale of
normal wastage @ Re. 0.50 38
per unit)
To Profit & Loss A/c (B.F)
187
75 225 75 225

When the output of a process is partly sold and partly transferred to the next
process
Sometimes the output of a process may be partly sold and partly transferred to the
next process for further processing. For example, in textile mill, part of the output of a
spinning process may be sold and the remaining output is passed on to the weaving
process for further processing. A part of the output so sold will contain an element of
profit or loss which will be revealed in the Process Account. But when a part of the
output is sent to warehouse for sale, it is at cost and does not contain an element of profit
or loss.

Illustration 5
XYZ Ltd. manufactures and sells three chemicals produced by consecutive processes
known as X, Y and Z. In each process 2% of the total weight put in is lost and 10% is
scrap, which from processes X and Y realised Rs. 100 a tonne and from Z Rs. 200 a
tonne. The products of the three processes are dealt with as follows :
X Y Z
- Sent to warehouse for sale 25% 50% 100%
Passed on the next process 75% 50% —
The following particulars relate to the month of May:
82
 Materials used (tonnes) 1,000 140 1,348
Cost per tonne of materials (Rs.) 120 200 80
Mfg. expenses (Rs.) 30,800 25,760 18,100

Prepare an account for each process, showing the cost per tonne of each products.

Solution : Process X Account

Particulars Tonnes Rs. Particulars Tonnes Rs.

To Materials (@ Rs. 1,000 1,20,000 By Loss in weight 20 —
(120) (2% of 1,000)
To Mfg. expenses. 30,800 By Scrap 100 10,000
(10% of 1000)
By Warehouse (25% 220 35,200
By Process Y (transfer) 660 1,05,600
1,000 1,50,800 1,000 1,50,800
Working Notes : 1. Rs. 1,50,800-Rs. 10,000 x 220 tonnes Rs. 35,200
Transfer to warehouse = 1,000 – 20 – 100 tonnes

Similar calculation has been made in Process Y.

2. As the question is silent about the nature of loss, it is presumed that both weight
loss and scrap are normal.

Process Y Account
Particulars Tonnes Rs. Particulars Tonnes -Rs.
To Process X 660 1,05,60 By Loss in weight (2% of 16 —
(transfer) 0 800)
To Materials 140 28,000 By Scrap 80 8,000
To Mfg. expenses — 25,760 By Warehouse 352 75,680
By Process Z (transfer) 352 75,680
800 1,59,36 800 1,59,36

Process Z Account
Particulars Tonnes Rs. Particulars Tonne Rs.
To Process Y 352 75,680 By Loss in Weight (2% of s34 34,000
(transfer) 1,348 1,07,84 1,700) 170 1,67,62
To Materials 0 By Scrap 1,496 0
To Mfg. expenses 18,100 By Warehouse (transfer)
1,700 2,01,62 1,700 2,01,620
0
Illustration 6 -
Chemicals Ltd. processes a patent material used in buildings. The material is produced
83
in three consecutive grades — soft, medium and hard.
Process I Process II Process III
Raw materials used 1,000 tonnes — —
Cost per tonne Rs. 200 — —
Manufacturing wages and expenses. Rs. 87,500 Rs. 39,500 Rs. 10,710
Weight lost (% of input of the process) 5% 10%- 20%
Scrap (sale price Rs. 50 per tonne) 50 tonnes 30 tonnes 51 tonnes
Sale price per tonne Rs. 350 Rs. 500 Rs. 800
Management expenses were Rs. 17,500 and selling expenses Rs. 10,000. Two third of
the output of Process I and one half of the output of Process II are passed on to the next
process and the balances are sold. The entire output of Process III is sold. Prepare the
three process accounts and a statement of profit. Make approximations, where necessary.

Solution:

Process I Account
Particulars Tonnes Rs. Particulars Tonnes Rs.
To Raw materials 1,000 2,00,0 By Weight lost 50 2,500
To Mfg. wages and 00 By Scrap 50 1,05,0
expenses 87,500 By Sales 300 00
To Profit (B. F.) 10,000 By Process II 600 1,90,0
1,000 2,97,50 1,000 2,97,500
0
*Cost of 600 tonnes transferred to Process II is calculated below:

Cost per tonne =Total cost - Scrap value = 2,85,000

Units Produced 900
Cost of 600 tonnes = 2,85,000 x 600 = Rs. 1,90,000
900

Similar procedure has been followed in other processes.

Process II Account
Particulars Tonnes Rs. Particulars Tonnes Rs.
To Process I 600 1,90,0 By Weight loss 60
transfer 00 By Scrap 30 1,500
39,500 By Sales 255
To Mfg. wages and By Process III 25
expenses (transfer) 5
84
To Profit (B/F) — 13,500 1,27,500
1,14,000
*
600 2,43,00 600 2,43,000
0
*Cost of 255 tonnes, transferred to Process III =- Rs.2,28,000x255tonnes = Rs.1,14,000
510 tonnes

Process III Account

Particulars Tonnes Rs. Particulars Tonnes Rs.
To Process II 255 1,14,0 By Weight loss 51 2,550
(transfer) To By Scrap By 51 1,22,40
Manufacturing 00 Sales 153 0
wages and 10,710
expenses To 240
Profit (B.F.) 255 1,24,95 255 1,24,950
Notes : 0

1.Profit in each process is a balancing figure.

2.It is assumed that weight loss and scrap are normal.

Statement of Profit/Loss
Rs.
Profit as per Process I 10,000
Profit as per Process II 13,500
Profit as per Process III 240
Total profit 23,740
Less: Management expenses 17,500
Selling expenses 10,000 27,500
Net Loss 3,760

WORK-IN-PROGRESS
(Equivalent Production)
Process costing mainly deals with continuous type of production. At the end of the
accounting period, there may be some work-in-progress, i.e. semi-finished goods may be
in the pipeline. The valuation of such work-in-progress is done in terms of equivalent or
effective production.

Equivalent Production

85
 Equivalent production represents the production of a process in terms of completed
units. Work-in-progress at the end of an accounting period are converted into equivalent
completed units. This is done by the following formula :

Equivalent units = No. of units of work in progress x Degree of completion in %

For example, if there are 5D units in work-in-progress and these are estimated to be
50% complete, then their equivalent production is 50 units x 50% = 25 units.
In each process, an estimate is made of the degree of completion of work-in-progress
in terms of percentage. Such an estimate must be accurate because any error in such
estimation will lead to erroneous valuation of work-in-progress stock which enters into
final accounts.

Evaluation of Equivalent Production

After work-in-progress has been converted into equivalent completed units, the
following steps are taken to evaluate it.

(i) Find out the total cost (net) for each element of cost i.e. material, labour and
overhead. Scrap value of normal loss is deducted from the material cost.
(ii) Ascertain the cost per unit of equivalent production separately for each element of
cost. This is done by dividing the total cost of each element by the respective
number of equivalent units.
(iii) At this rate of cost per unit, ascertain the value of finished production and work-in-
progress.
For the purpose of computation of equivalent production and its evaluation; the
following three statements are generally prepared.
(a) Statement of Equivalent Production.
(b) Statement of Cost (per unit)
(c) Statement of Evaluation.
These three statements may also be combined in one comprehensive statement called
"Statement of Production, Cost and Evaluation."
For clear understanding, illustrations on equivalent production are classified into the
86
following two categories:
(a) When there is no opening stock i.e. when there is only closing stock of work-in-
progress. In such a situation there may or may not be process losses.
(b)When there is opening as well as closing stock—Here also there may or may
not be process losses.
When there is no opening work-in-progress and no process loss
In such a case, valuation of work-in-progress in terms of equivalent production is
comparatively simple. Procedure followed in this type of situation is shown in the
following illustration.

Illustration 7
In process A-on 1 March, there was no work-in-progress. During the month of March,
2,000 units of material were issued at a cost of Rs. 18,000. Labour and overheads totalled
Rs. 9,000 and Rs. 6,600 respectively: On 31st March, 1,500 units were completed and
transferred to the next process. On the remaining 500 units, which are incomplete, degree
of completion was as follows:

Materials 100%
Labour 60%
Overhead 30%

Prepare (a) Statement of Equivalent Production (c) Statement of Evaluation

(b) Statement of Cost (d) Process Account.

Solution :

(a) Statement of Equivalent Production

Input Output Equivalent units

Units Items Units Labour Overiiead
Qty. % Qty % Qty
2.000 Finished output 1,50 1,500 1,500 1,500 %
Work-in- 0 100 500 100 300 100 150
progress 500 100 60 30
2,000 Total 2,000 2,000 1,800 — 1,650 ---
— —

87
 (b) Statement of Cost
Element of cost Cost Rs. Equivalent Cost per unit
(A) units Rs.
(B) (A-+B)
Material 18,00 2,00 9
Labour 0 0 5
Overhead 9,00 1,80 4
0 0 Total 18
6,60 1,65

(c) Statement of Evaluation

Rs.
Finished goods (1,500 units 18) 27,000
Value of work-in-progress : Rs.
Materials 500 units @ Rs. 9 per 4,500
Labour unit units @ Rs. 5 per
300 1,500
Overhead unit
150 units @ Rs. 4 per 600 6,600
unit
(d) Process A Account
Particulars Tonnes Rs. Particulars Tonnes Rs.
To Materials 2,000 18,00
To Labour 0 By Next process 1,50 27,00
To Overhead 9,000
6,600 (transfer) By Work-in- 0 0
2,000 33,600 progress c/d 2,000
500 33,600
6,600
When there is no opening work-in-progress but there are process losses— As
discussed earlier, .asses are inherent in process operations. Normal and abnormal process
losses are treated differently in the calculation of equivalent production.
Normal Loss— Equivalent units of normal loss are taken as nil. In other words,
normal loss is not; added in the equivalent production. However, realisable value of
normal scrap is deducted from the cost of material so as to calculate the net material
cost. This net material cost becomes the basis of calculating the material cost per unit in
the statement of cost.
Abnormal Loss— This is treated as if this were good production lost. Abnormal loss,
thus, is added to equivalent production with due consideration to its degree of completion.

88
Unless the degree of completion is specified, it may be assumed that abnormal loss units
are 100% complete in respect of all elements of cost.
Abnormal Gain— Units of abnormal gain are represented by good finished
production. It is therefore, always taken as 100% complete in respect of all elements of
cost i.e. material, labour and overhead. Abnormal gain is deducted to obtain equivalent
production.

Illustration 8
During January, 2,000 units were introduced into Process I. The normal loss was
estimated at 5% on input. At the end of the month 1,400 units had been produced and
transferred to next process, 460 units are uncompleted and 140 units had been scrapped.
It was estimated that uncompleted units had reached a rage in production as follows :
Material 75% completed
Labour 50% completed
Overhead 50% completed
The cost of 2,000 units introduced was Rs. 5,800.
Direct materials introduced during the process amounted to Rs. 1,440.
Direct labour cost was Rs. 3,340.
Production overhead incurred were Rs. 1,670.
Units scrapped realised Re. 1 each. The units scrapped have passed through the
process, so were 100% completed as regards material, labour and overheads.
You are required to (a) prepare a Statement of Equivalent Production, (b) evaluate the
cost of abnormal loss, finished goods and closing Stock, and (c) prepare the Process I
Account and Abnormal Loss Account.

Solution
Statement of Equivalent Production
Inpu Output Units Equivalent units
Unit Material Labour Overhead
Qty- % Qty Qty

89
2,00 Normal loss 10 - - - - -
Abnormal loss 0 40 100 - 40
0 Finished production 40 1,400 100 40 100 100
Work-in-progress 1,400 345 75 1,400 1,400
Total 460 100 100
2,00 2,000 230 50
Equivalent Production 1,785 1,670 1,670

Statements of Cost
Element of cost Cost Equivalent Cost per
Rs. (units) Rs.
(A) (B) (A±B)
Materials .
Units. Introduced 5,800
Direct materials 1,440
7,240
Less1- Scrap value of loss 100
Material cost 7,140 1,785 4
Direct labour 3,340 1,670 2
Overhead 1,67 1,670 1
12,150
Total 7
Statement of Evaluation
Particulars Element of Equivalent Cost per Cos Total
unit Rs t cost
cost production Rs. Rs.
Abnormal Loss Material 40 4 160 280
Labour 40 2 80
: Overhead 40 1 40
Material 1,400 4 5,600
Finished Labour 1,400 2 9,800
2,800
Production: Overhead 1,400 1 1,400
Material 345 4 1,380
Work-i'n- Labour 230 2 2,070
Overhead 230 460
progrcss : 1 230
12,150

Process I Account
Particulars Units Rs. Particulars Units Rs.
To Units introduced 2,000 5,800 By Normal loss 100 100
To Direct material 1,440 By Abnormal loss 40 280
To Direct wages 3,340 By Finished production
To Production 1,670 transferred to Process II 1,400 9,800
By Balance c/d (work-
overheads in- progress) 460 2,070
2,000 12,250 2,000 12,250

Abnormal Loss Account

90
Particulars Units Rs. Particulars Units Rs.
To Process I 40 280 By Sale of scrap 40 40
24
By Costing P & L A/c 0
40 280 40 280
i - ,»,

JOINT PRODUCTS AND BY-PRODUCTS

In many industries, two or more products are unavoidably produced from the same
process and same raw materials. These products are produced in natural proportions
which cannot be changed at the will of the management. For example in an oil refinery,
when crude oil is processed, many products are simultaneously produced from the same
raw material. Examples of these products are petrol, kerosene, diesel, grease etc. Such
products are known as joint products or by-products.

Joint products
The term joint products is used for two or more products of almost equal value
which are simultaneously produced from the same manufacturing process and the same
raw material. Joint Products thus represent two or more products separated in the course
of processing, each product being in such proportion and of such a nature that no single
one of them can be regarded as the main product. Characteristics. Characteristics of
joint products are :
(a) Joint products are produced from the same raw material in natural proportions. (b)
They are produced simultaneously by a common process,
(c) They are comparatively of almost equal value.
(d) They may require further processing after their point of separation.
A classic example of joint products as given above is found in oil refining where
items like petrol diesel naptha kerosene etc. are produced from the crude oil. Other
examples are in flour mill where joint products are white flour, brown flour, animal
feeding stuff; in meat canning where hide canned meat, fertilisers, etc. The term joint
product is also used to describe various qualities of the same product, as for example,
many grades of coal which may be produced in coal mining.
Joint Costs and Subsequent Costs
Joint (or common) costs are those costs which are incurred before that stage in
91
manufacture at which the products get separated.
Subsequent (or attributable) costs, on the other hand, are those costs which are
incurred after the separation or split-off point.
The distinction between joint costs and subsequent costs is important because when
accounting for products, the joint costs are the main problem. This is because joint costs
cannot be traced to individual products and the cost accountant is faced with the
problem of apportioning the joint costs incurred to various joint products produced.
Subsequent costs, on the other hand, pose no accounting problem because such costs
relate to individual products. These are, therefore, charged to the appropriate product
and not regarded as joint. It should be noted and remembered that selling and
distribution costs are virtually always subsequent costs.

Accounting for Joint Products

Accounting for joint products means the apportionment of joint cost to each of the
joint product. Such apportionment serves the following Methods of
objectives: Apportionment
Joint Cost of
(a) To determine the cost per unit of products. 1. Sales Value Method
2. Reverse cost Method
(b)To help in inventory valuation.
3. Physical Units
(c) To determine the profit or loss on each line of 4. Average Unit Cost
Method
product. 5. Survey Method
Method
(d)To determine the price of each product.

Methods. The main methods of apportionment of joint costs

are as follows :
1. Sales Value Method. Under this method, joint costs are apportioned to various
joint products on the basis of sales value of each such product. The sale value method
has the following variants :
(a) On the basis of unit prices. In this method, the selling prices per unit of various
joint products is taken as the basis for apportionment of joint costs. In other words, joint
cost is apportioned to various joint products in the ratio of selling prices of individual
joint products without any regard to the quantities. It is thus suitable when the number of

92
units of production of all the products are equal. It is illustrated below with assumed
figures.

Example

Joint cost Rs. 9,000

Products Selling price Apportioned cost
per unit (Ratio 12:8:4)
Rs (d)
Rs.
A 12 4,500
B 8 3,000
C 4 1,500

Joint cost 9,000

(b) On the basis of sales value. In this method, the apportionment is done on the
basis of weighted sales value i.e. number of units produced and sold * selling price per
unit. This method thus gives due consideration to the quantities of various joint products
produced. The difference between the method based on unit selling prices discussed
earlier and this method is that while the former gives no consideration to the quantities
of joint products produced, the latter gives due importance to the quantities. This method
will give satisfactory results even when number of units of different joint products are
widely different. The method is illustrated below with assumed figures:

Example
Joint cost Rs. 9,000.
Products Selling price Production Sales value Apportioned
per unit quantities
units (a) x (b) joint cost
(24 : 48 : 28)
(a) (b) (c) (d)
Rs. Rs. Rs.
A 12 200 2,400 2,160
B 8 600 4,800 4,320
C 4 700 2,800 2,520
Total 10,000 9,000
2. Reverse Cost Method. In this method, the joint cost is apportioned on the basis of
net value of each product. The net value is calculated by deducting the following from
the sales value :

(a) Estimated profit margin,

93
 (b)Selling and distribution costs, if any,
(c)After split off processing costs.

The net values of individual products so obtained are taken as the basis for
apportioning joint costs. This is known as reverse cost method because net values are
calculated by working backward from sales values. This method is particularly used
when products are not sold at their stage at split off point but require further processing.
Operation of this method is illustrated below :

Illustration 1

In processing a basic raw material, three joint products 'X'. 'Y' and 'Z' arc produced.
The joint expenses of manufacturing are: Materials Rs. 10,000; Labour Rs. 8,000;
Overhead Rs. 9,000 (Total Rs. 27,000). Subsequent expenses are as follows :

X Y Z
Rs. Rs. Rs.
Material 2,000 1,600 1,800
Labour 2,500 1,400 1,700
Overhead 2,500 1,000 1,500
Total 7,000 4,000 5,000

Sales Value 42,000 20,000 18,000

Estimated profit on sales 50% 50% 33 1/3 %
Show how you would apportion the joint costs of manufacture by Reserve Cost
Method.
The following data have been extracted from the books of Coke Co.Ltd.
Joint products Yield (in lb) of recovered
Products per tonne of coal
Coke 1,420
Coal tar 120
Benzol 22
Sulphate of ammonia 412
Gas 2,000
The price of coal is Rs. 80 per tonne. The direct labour and overhead costs to the
94
 point of split of Ta are Rs.40 and Rs. 60 respectively per tonne of coal. Calculate the
material, labour and total cost of each product on the basis of weight.
Solution:
Statement of Apportionment of Joint Costs
X Y z
Rs. Rs.
Rs.
Sales value Less: 42,00 20,00 18,00
Estimated profit on 0 0 0
sales Estimate total 21,00
21,00 10,00 6,00
12,00
cost Less: 0 0 0
Subsequent costs
Share in Joint costs (Rs. 27,000) 7,000
14,000 4,000
6,000 5,00
7,000

By-Products
By-products are products of relatively small value which are incidentally and
unavoidably produced in the course of manufacturing the main product. For example, in
sugar mills, the main product is sugar. But baggasse and molasses of comparatively
smaller value are incidentally produced and thus are by-products. Other examples of by-
products are oil cake produced in the extraction of edible oil, cotton seed produced in
cotton textile industry, etc. These by-products are unavoidably produced and are of
secondary value. The sales value of these by-products is much less as compared to the
main product. For example sales value of by-products bagasse and molasses is much less
than that of the main product sugar.
By-products may be—

{a) Those sold in their original form without further processing.

(b) Those which require furter processing in order to be saleable.

Distinction between Joint Products and By-products

There are no hard and fast rules to distinguish between joint products and by-
products. A product may be treated as a joint product in one business and the same
product may be treated as a by-product in another business. However, the following
factors should be considered to determine if a product is a joint product or a by-product.
(a) Relative sales value. If the sales value of all the products are more or less equal,
they are treated as joint products. If, however, there are wide differences in the relative

95
sales values of products, the product with the greater sales value is treated as the main
product and the products of lower value are treated as byproducts.
(b) Objective of manufacture. If the objective of manufacturing is product A, then
unwanted products B and C be treated as by-products.
(c) Policy of management. The management may decide to treat a particular product as
the main product and the other products as by-products. Alternatively, it may choose to
treat all products as joint products.

By-products, Scrap and Waste

By-products should not be confused with waste or scrap. Waste is used to describe a
material which has- no value or even negative value, if it has to be disposed of at some
cost. Examples of waste are gases, smoke and other unsaleable residues from the
manufacturing process.
Scrap is also different from by-products in the sense that it is the leftover part of the
raw materials whereas by-products are different from the material which went into the
production process. Small pieces of wood left in furniture manufacture or metal sheet
pieces left in utensil manufacture are examples of scrap, whereas minor chemicals, having
some value, emerging from a chemical process are classified as by-product. Sale value of
scrap is relatively less than that of by-products. However accounting treatment for scrap
and by-products is quite similar.

Accounting for By-products

Various methods of accounting for by-products are as follows:
(1) Where by-products are of small total value. In such a case it is not considered
practicable to apportion any part of the joint cost to by-products. The net income realised
by the sale of by-products may be treated, in any one of the following two ways:
(i) It may be treated as 'miscellaneous income' and credited to costing Profit and
Loss Account.
(ii) It may be credited to the process account in which the by-product has arisen.
In determining the net income from by-products, the following should be deducted
from the sales value of by-products: (i) any selling and distribution expenses incurred in
96
the sale of by-products and; (ii) any costs incurred in further processing of by-products to
make them saleable.
(2) Where by-products are of considerable total value. Where by-products are of
considerable sales value, it is proper to apportion a part of the joint cost to by-products.
Such apportioned cost of by-products is debited to by-product account and credited to the
main product account or the relevant process account.
Any cost incurred in further processing of the by-product is debited to by-product
account. The by-product account is credited with its sales value and any profit/loss
arising out of this account is transferred to costing Profit and Loss Account.
The apportionment of joint cost to by-products can be done by any of the four
methods discussed earlier in costing of joint products. These methods are: (i) Sales value
method, (ii) Physical units method, (iii) Average cost method, and (iv) Points value or
survey method.

(3) Where by-products require further processing. In such situations, the share of
by-product in joint- cost at the split-off point may be arrived at by subtracting the profit
and the further processing cost from the realisable value of the products i.e., by using
Reverse Cost Method. In case the cost of the by-products at the split off point is small or
negligible, it may be treated as per the method (a) discussed above. On the contrary, if it
is of considerable amount, it is treated as per method (b) discussed above, i.e. joint cost is
apportioned to by-products.

Illustration 2
Product Z yields two by-products A and B. The joint cost of manufacture is Rs.
65,800. From the following information, show how would you apportion the joint cost of
manufacture :
Z A B
(i) Sales Rs. 1,00,000 40,000 25,000
(ii) Manufacturing costs after separation 5000 4000

97
(iii) Estimated selling expenses on sales 20% 20%
(iv) Estimated profit on sales 25% 30%

Solution:

Statement of Cost of By-products A and B

A B
Rs. Rs.
Sales 40,000 25,000
Less : Profit 10,000 7,500
30,000 17,500
Less: After separation costs (-) 5,000 (-) 4,000
Selling (-) 8,000 (-) 5,000
17,000 8,500
Statement of Cost of Product Z
Rs.
Total joint cost 65,800
Less: Joint cost apportioned to A 17,000
B 8,500 25,500
Cost of Product X 40,300

(4) Where by-product is utilised in the undertaking itself. In those cases where by-
products are used by the company itself as a raw material for some other process, such
by-products may be priced at the opportunity cost. The opportunity cost is that cost
which would have been incurred had the by-product been purchased from an outside
firm. For example, a company is running a sugar plant as well as a paper plant. The
bagasse, a by-product of sugar plant, may be utilised as raw material in manufacture of
paper. So credit for the cost of the bagasse would be given to the sugar cost at the price
which the company would have otherwise paid to buy it from an outside firm for the
manufacture of paper.

INTERNAL PROCESS PROFITS

(Inter-process Profit)

In some businesses, it is a practice to charge the output of each process to the next
process not at cost but at a price showing profit to the transferor process. The transfer
price may be either the current market price or cost plus a fixed percentage. Thus each
98
process is charged with its input at current price and no process obtains the benefits of
saving or has to bear the losses caused by the efficiency or inefficiency of the earlier
processes. In brief, the objects of such internal process profit are:
(a)To show whether the cost in each process competes with the market prices.
(b)To make each process stand on its own efficiency and economy.
(c)To assist in making decisions such as to buy a partly processed material rather
than to process work internally or to sell a partly processed product or to process
it further.

Internal process profits have the disadvantage of complicating the costing records.
The complications brought into the accounts arise from the fact that inter-process profit
so introduced remains included in the price of process stocks, finished stocks and work-
in-progress. For balance sheet purposes such stocks have to be reduced to actual cost
because a firm cannot make profits by trading with itself.
The procedure involved in inter-process profits is demonstrated in the following

Illustration 3
A Ltd. produces product 'AXE' which passes through two processes before it is
completed and transferred to finished stock. The following data relate to October 2004
Processes Finished Stock
Particulars I 11
Opening stock Rs. 7,500 Rs. 9,000 Rs. 22,500
Direct materials 15,000 15,750 —
Direct wages 11,200 11,250 —
Factory overheads 10,500 4,500 —
Closing Stock 3,700 4,500 11,250
Inter-process profit included in opening stock 1,500 8,250

Output of Process I is transferred to Process II at 25% profit on the transfer price.

Output of Process II is transferred to finished stock at 20% profit on the transfer price.
Stocks in processes are valued at prime cost. Finished stock is valued at the price at
99
which it is received from Process II. Sales during the period is Rs. 1,40,000.

Required : Process Cost Accounts and Finished Stock Account showing the profit
element at each stage.

Solution:
Process I Account
Cost Profit Total Cost Profit Total
Rs. Rs. Rs. Rs. Rs. Rs.

To 7,500 7,500 By Process 40.500 13,500 54.000

Opening 15,000 — 15,000
stock To 11,200 11,200 11
Direct
Less: Closing 33,700 33,700
3,700 3,700
stock 30,000
To Factory — 30,000
10,500 10,500
overheads
To Profit 40,500 13,500 40,500
13,500
40,500 13,500 54,000 40,500 13,500 54,000

Process II Account
Cost Profit Total Rs. Cost Profit Total Rs.
Rs. Rs. Rs. Rs.
To Opening stock 7,500 1,500 9,000 By Finished 75,750 36,750 1,12,500
To Process I 40,50 13,500 54,000
To Direct material 0 15,750 stock a/c
To Direct wages 15,75 11,250
0
11,25
Less: Closing stock 75,000 15,000 90,000
0 750 4,500
To Factory 71,25 14,250 85,500
0 4,500
overheads 4,500
To Profit 75,750 14,250 90,000
- 22,500 22,500
75,750 36,750 1,12,500 75,750 36,750 1,12,500

Finished Stock Account

Cost Profit Total C Profit Total
Rs. Rs. Rs. o Rs. Rs.
s
100
To Opening stock 14,250 8,250 22,500 By Sales 82,500 57,500 1,40,000
75,750
To Process II 36,750 1,12,500
Less: Closing 90,000 45,000 1,35,000
7,500 3,750 11,250
stock
To Profit 82,500 41,250 1,23,750
16,250 16,250
82,500 57,500 1,40,000 82,500 57,500 1,40,000

Working Notes : 1. Reserve for unrealized profit in closing stock.

Process I. Nil
Process II.

Cost of stock = Cost x Closing stock = 75,000 x 4,500 = Rs. 3,750

Total 90,000
Profit = Total - Cost
= 4,500-3,750 = Rs. 750

2. Profit for the month

Rs. Rs.
Process I ... ... 13,500
Process II ... 22,500
Add: Unrealised profit in opening stock ... 1,500
24,000
Less; Unrealised profit in closing stock ... 750 23 250
Finished stock ... 16,250
Add: Unrealised profit in opening stock ... 8,250
24,500
Less: Unrealised profit in closing stock ... 3,750 20,750
Total Profit 57,500

PROBLEMS AND SOLUTIONS

Problem .1 (Process Losses)

A product passes through three processes to completion. During the quarter ending
31st March, 2004 the cost and production were as under :
Processes Total A B C

101
 Rs. Rs. Rs. Rs.

Direct material 84,820 20,000 30,200 34,620

Direct labour 1,20,000 30,000 40,000 50,000

Direct expenses 7,260 5,000 2,260 .—
Production overhead 60,000 — — —
Normal loss in input — 10% 5%,. 10%
Sale of scrap per unit — Rs. 30 Rs.50 Rs.60
Production in units — 920 units 870 units 800 units

1000 units of Rs. 50 per unit were introduced to process A. There were no stock of
materials or work-in-progress in any process department at the beginning or end of the
period.
Production overhead is allocated to each process on the basis of 50% of direct labour
cost.
Prepare process accounts.

Solution :
Process A Account
Particulars Units Rs. Particulars Units Rs.

To Units introduced 1,000 50,000 By Normal Loss 100 3,000

To Direct Materials 20,000 By Tr. to Process B 920 1,19,600
To Direct Wages 30,000 00
To Direct Expenses 5,000
To Prod. Overhead 15,000
To Abnormal Gain* 20 2,600
1,020 1,22,600 1,020 1,22,600

Rs. 1, 20,000-3,000
* Value of abnormal gain = Units 1,000-100 x 20 units = Rs. 2,600

Process B Account
Particulars Units Rs. Particulars Units Rs.

102
To Process A (Tr.) 920 1,19,600 By Normal Loss 46 2,300
To Direct Material 30,200 By Abnormal Loss 4 960
To Direct Labour 40,000 By Process C (Tr.) 870 2,08,800
To Direct Expenses 2,260
To Prod. Overhead 20,000
920 2,12,060 920 2,12,060

Finished stock ... 16,250

Add: Unrealised profit in opening stock ... 8,250
24,500
Less: Unrealised profit in closing stock ... 3,750 20,750
Total Profit 57,500
Rs. 2,12,060-2,300
Value of abnormal loss = Units 920 - 46 x 4 Units = Rs 960

Process C Account
Particulars Units Rs. Particulars Units Rs.
To Process B (Tr.) 870 2,08,800 By Normal Loss 87 5,220
To Direct Material 34,620 By Finished Stock 800 3,20,000
To Direct Labour 50,000 A/c
To Prod. Overhead 25,000
To Abnormal Gain 17 6,800

887 3,25,220 887 3,25,220

Rs. 3,18,420-5,220
Value of abnormal loss = Units 870 - 87 x 17 Units = Rs 6,800
103
Problem 2 (Process losses)
Product B is obtained after it passes through three distinct proceses. The following
information is obtained from the accounts for the week ending 31st October, 2003:
Items Total __________Process__________
/ // ///
Rs. Rs. Rs. Rs.
Direct materials 7,542 2,600 1,980 2,962
Direct wages 9,000 2,000 3,000 4,000
Production overhead 9,000
1,000 units at Rs. 3 each were introduced to Process I. There was no stock of
material or work-in-progress at the beginning or at the end of the period. The output of
each process passes direct to the next process and finally to finished stock. Production
overhead is recovered on 100% of direct wages. The following additional data are
obtained:

Process Output during the Percentage of normal Value of scrap

Week loss to input per unit
Process I 950 5% 2
Process II 840 10% 4
Process III 750 - 15% 5
Prepare process cost accounts and abnormal gain or loss accounts.

Solution :

Process I Account

Particulars Units Rs. Particulars Units Rs.

104
To Units introduced 1,000 3,000 By Normal loss 50 100
To Direct materials 2,600 By Process 11 950 9,500
To Direct wages 2,000 (Balance figure)
To Production overhead
(100% of direct wages)
2,00
1,000 0 9,600 1,000 9,600

Process II Account
Particulars Unit Rs. Particulars Units Rs:
To Process I (transfer) 950s 9,500 By Normal loss 95 380
To Direct materials 1,980 By Abnormal loss 15 300*
To Direct wages 3,000 By Process III (transfer) 840 16,800
To Production overhead 3,000

950 17,480 950 17,480

Rs. 17,480-Rs. 380
♦Abnormal loss = x 15 units = Rs. 300 (Rs. 20 per unit)
950 - 95 units

Process III Account

Particulars Units Rs. Particulars Units Rs.

To Process II (Transfer) 840 16,800 By Normal loss 126 630

To Direct materials 2,962 By Finished stock 750 28,500
To Direct wages 4,000
To Production overhead 4,000
To Abnormal gain 36 1,368*
876 29,130 876 29,130

105
 Rs.27,762 - Rs. 630 *
Abnormal gain = 840-126 units x 36 units = Rs. 1,368

Abnormal Loss Account

Particulars Units Rs. Particulars Units Rs.
To Process II 15 300 By Sale of scrap 15 60
(@ Rs.4 per unit) 240
By Costing P&L A/c
15 300 15 300
Abnormal Gain Account
Particulars Units Rs. Particulars Units Rs.
To Normal Loss A/c 36 180 By Process III 36 1,368
(shortfall in the sale of
normal loss @ Rs.5 per
unit)
To Costing P&L A/c 1,188
36 1,368 36 1,368

Normal Loss Account

Particulars Units Rs. Particulars Units Rs.
To Process I 50 100 By Cash (sales) 235 930
To Process II 95 380 By Abnormal gain A/c 36 180
To Process III 126 630

271 1,110 271 1,110

Problem .3 (Normal and Abnormal Loss)
600 kg. of a material was charged to Process A at the rate of Rs. 4 per kg. The direct

106
labour accounted for Rs. 200 and the other departmental expenses amounted to Rs. 760.
The normal loss is 10% of input and the net production was 500 kg. Assuming that
process scrap is saleable at Rs. 2 per kg., prepare a ledger account of process A clearly
showing the values of normal and abnormal loss.

Solution :

Process A Account
Particulars Kg- Rs. Particulars Kg Rs.
To Materials 600 2,400 By Normal loss 60 120
To Direct labour 200 By Abnormal loss 40 240
To Other expenses 760 By Process B A/c 500 3,00
600 3,360 (Transfer) 600 3,360
0
Working Notes:

Normal cost Rs. 3,360 - 120

Cost per unit = = = Rs. 6 per unit
Normal output 600 - 60 units
Abnormal loss = 40 units @ Rs. 6 = Rs. 240

Output transferred to Process B = 500 units @ Rs. 6 = Rs. 3,000

Problem 7 (Process Accounts and Statement of Profit or Loss)

In a factory, the product passes through two processes, A and B. A loss of 5% is
allowed in Process A and 2% in Process B, nothing being realised by disposal of the
wastage.
During April 10,000 units of material costing Rs. 6 each were introduced in Process
A. The other costs were as follows :
Process A Process B
Rs. Rs.
Materials --- 6,140
Labour 10,000 6,000
Overheads 6,000 4,600
The output was 9,300 units from Process A. 9,200 units were produced by Process B

107
 which were transferred to warehouse. 8,000 units of the finished product were sold @
Rs. 15 per unit, the selling and distribution expenses being Rs. 2 per unit.
Prepare (i) Process Accounts and (it) a Statement of Profit or Loss of the firm for
April, assuming there were no opening stocks of any type, (B.Com.)

Solution:
Process A Account
Particulars Units Rs. Particulars Units Rs.
To Materials 10,000 60,000 By Normal loss 500 -
To Labour 10,000 By Abnormal loss 200 1,600
To Overheads 6,000 By Transfer to Process B 9,300 74,400
(@ Rs. 8* per unit)
10,000 76,000 10.000 76,000
*Cost per unit - Rs. 76,000 + 9,500 units = Rs, 8
Process B Account
Particulars Units Rs. Particulars Units Rs.
To Tr. from Process A 9,300 74,400 By Normal Loss 186 ~

To Materials - 6,140 By Finished product A/c

To Labour - 6,000 (@Rs. 10* per unit) 9,200 92,000
To Overheads - 4,600
To Abnormal gain A/c 86 860
9,386 92,000 9,386 92,000

♦Cost per unit = Rs. 91,140 / 9,114 units = Rs. 10

Statement of Profit and Loss

Sales 8,000 units @ Rs. 15 each Rs. 1,20,000

Less: Cost of production of 8,000 units

@ Rs. 10 per unit 80,000
Selling and distribution expenses for 8,000 units @ Rs. 2 per 16,000 96.000
unit 24,000

108
Less: Abnormal loss in Process A 1,600
22,400
Add: Abnormal gain in Process B 860
Net Profit 23,260

Problem 8 (Process account with by-products)

The following details are extracted from the costing records of an oil refinery for the
week ended 30 Sept. 2004
Purchase of 500 tonnes of copra Rs. 2,00,000.
Crushing plant Refinery plant Finishing
Cost of labour 2,500 1,000 1,500
Electric power 600 360 240
Sundry material 100 2,000 —
Repairs to machinery and plant 280 330 140
Steam 600 450 450
Factory expenses 1,320 660 220
Cost of casks — — 7,500
300 tonnes of crude oil was produced. 250 tonnes of oil was
produced by refining process. 248 tonnes of refined oil was finished
for delivery. Copra sack sold Rs. 400. 175 tonnes of copra residue
sold Rs. 11,000. Loss in weight in crushing 25 tonnes. 45 tonnes
by-product was obtained from refining process valued at Rs. 6,750.
You are required to show the accounts in respect of each of the following stages of
manufacture for the purpose of arriving at the cost per tonne of each process and also the
total cost per tonne of finished oil,

(a) Copra crushing process, (b) Refining process, (c) Finishing process.
Copra Crushing Process Account
Particulars Tonnes Rs. Particulars Tonnes Rs.

109
To Copra used 500 2,00,000 By Sale of copra residue 175 11,000
To Labour 2,500 By Loss 25
To Electric power 600 By Sale of copra sacks 400
To Sundry material 100 By Cost of crude oil 300 1,94,000
To Repairs to 280 (Rs. 646.67 per tonne)
machinery 600
To Steam 1,320
500 2,05,400 500 2,05,400

Refining Process Account

Particulars Tonnes Rs. Particulars Tonne Rs.
s
To Crude oil (Tr.) 300 1,94,000 By Sale of by-products 45 6,750
To Labour 1,000 By Loss 5
To Electric power 360 By Cost of refining oil 250 1,92,050
To Sundry material 2,000 (Rs. 768.2 per tonne)
To Repair to machinery 330
To Steam 450
To Factory expenses 660

300 1,98,800 300 1,98,800

Finishing Process Account

Particulars Tonnes Rs. Particulars Tonnes Rs.

110
To Refining process (Tr.) 250 1,92,050 By Loss 2 1,94,600
To Labour 1,500 By Cost of finished oil 248
To Electric power 240 (Rs. 784.68 per tonne)
To Repair to machinery 140
To Steam 450
To Factory expenses 220
250 1,94,600 250 1,94,600
Finished Stock Account
Particulars Tonnes Rs. Particulars Tonnes Rs.

To Finishing process 248 1,94,600 By Balance 248 2,02,100

To Cost of casks 7,500 (Rs. 814.92 per tonne
248 2,02,100 248 2,02,100

Problem 9.(By-products - Reverse cost method)

B Ltd. manufactures product A, which yields two by-products B and C. The actual joint
expenses of manufacture for a period were Rs. 8,000. It was estimated that profits on
each product as a percentage of sales would be 30%, 25% and 15% respectively.
Subsequent expenses were:
A B C
Rs. Rs. Rs.
Material 100 75 25
Direct wages 200 125 50
Overheads 150 125 75

450 325 150

Sales 6,000 4,000 2,500

Prepare a statement showing the apportionment of the joint expenses of manufacture

over the different products. Also presume that selling expenses are apportioned over the
111
products as a percentage to sales.

Solution:

Statement of Apportionment of Joint Cost

Products Total

A B C (A + B + C)
Rs. Rs. Rs. Rs.

Sales 6,000 4,000 2,500 12,500

Less: 1,800 1,000 375 3,175
Profit
Total Cost 4,200 3,000 2,125 9,325
Less: Selling expenses* 192 128 80 400
Cost of Production 4,008 2,872 2,045 8,925
Less: Subsequent 450 325 150 925
expenses
Share in joint cost 3,558 2,547 1,895 8,000
*Working Note. Selling expenses are not given in the question. These are calculated as
follows :
Total cost (as calculated above) Rs. 9,325
Less: Cost of production (Rs. 8,000 +450 + 325 + 150) 8,925
Selling expenses 400

400

Selling expenses as a percentage to sales : 12,500 x 100 = 3.20%.

112
 Problem 9 (Reverse Cost Method)
In manufacturing the main product A, a company processes the resulting
waste material into two byproducts M{ and Mr Using the method of working
back from sales value to an estimated cost, you are required to prepare a
comparative Profit and Loss Statement of the three products from the following
data :
(i) Total cost up to separation point was Rs. 1,36,000
A M1 M2
(ii) Sales (all production) Rs. 3,28,000 32,000 48,000
(iii) Costs after separation Rs. - 9,600 14,400
(iv) Estimated net profit percentage to sales value - 20% 30%
(v) Estimated selling expenses as percentage of sales value 20% 20% 20%
Solution:

Statement of Apportionment of Joint Cost

By-Products

M1 M2
Sales Value 32,000 48,000
Less: Estimated Net Profit: 6,400 -
M1 (20% of sales value)
M2 (30% of sales value) - 14,400
Total Cost of Sales
25,600 33,600
Less: Estimated selling expenses (20% of sales value) 6,400 9,600
19,200 24,000
Less: Cost after separation 9,600 14,400
Total cost upto separation 9,600 9,600
Total cost upto separation point Rs. 1,36,000
Less: Cost upto separation point as shown above: By-
Product M, Rs. 9,600 By-Product
M2 Rs. 9,600 19,200

113
 Cost up to separation for Main Product A Rs. 1,16,800

Statement of Comparative Profit and Loss

Particulars Main By-Products
Product A
M, M,
Rs.
Rs. Rs.
Share in joint cost 1,16,800 9,600 9,600
After separation costs 9,600 14,400
Cost of 1,16,800 19,200 24,000
Production 65,600 6,400 9,600
Cost of
Selling 1,82,400 25,600 33,600
Sales Profit 1,45,600 6,400 14,400
Sales 3,28,000 32,000 48,000

114
 EXAMINATION QUESTIONS

SECTION-A

Short Answer Questions

1. What is Process Costing ? Mention the industries

2. Where it is applied. fiat is the difference between process costing and job
costing ?

3. Sate the names of three industries in which process costing can be used
4. What is meant by normal process loss ?
5. What is abnormal process loss ?
6. How will you treat abnormal process loss ?
7. What is meant by inter-process profits ?
8. What is meant by equivalent production ?
9. What purpose is served by inter-process profits ?
10. What is joint cost ?
11. Define joint products. Give two examples.
12. What is the difference between joint products and by-products ?
13. State any two methods of apportionment of joint cost.
14. How is by-product treated in cost accounts ?
15. List out two important methods of treatment of by-products.
16. Give three examples of by-products.
17. Distinguish between normal loss and abnormal gain.
18. How is abnormal gain treated in process cost accounts ?
19. Explain the term 'abnormal effectiveness.'
20. State any two characteristics of process costing.
21. Bring out the characteristics of joint products.
22. Distinguish between abnormal effective and abnormal loss.

115
SECTION-B

1. What are the main features of process costing.

2. What are the main points of differences between job costing and process
costing ?
3. Explain normal and abnormal wastage and state how they should be dealt
with in process cost accounts.
4. Distinguish between joint products and by-products and explain briefly the
methods used in accounting for joint products.
5. What is equivalent production ? Explain and illustrate the method of its
valuation.
6. What is meant by inter-process profits ? What various purposes are served
by it ?
7. State the characteristics and principles of process costing.

SECTION-C

Process Losses
1.An article undergoes three processes. From the following information, show
the cost of each process of manufacture and cost per article produced during
the month of January 2004.

Process A Process B Process C

Rs. Rs. Rs
Materials consumed 37,500 12,500 5,000
Labour 20,000 50,000 15,000
116
 Other direct expenses 6,500 18,000 6,250
The indirect expenses amounted to Rs. 21,250. These are apportioned on the
basis of wages. Articles produced during the month were 240.
(Ans. Cost per article-A Rs. 287.50; B Rs. 675; C Rs. 800)
2. 600 kg. of a material was charged to Process A at the rate of Rs. 4 per kg.
The direct labour accounted for Rs.200 and the other departmental expenses
amounted to Rs. 760. The normal loss is 10% of the input and the net
production was 500 kg. Assuming that process scrap is saleable at Rs. 2 per
kg. prepare a ledger account of process A clearly showing the values of
normal and abnormal loss.
(Ans. Tr. to Process B 500 kg. @ Rs. 6 = Rs. 3,000)
3. From the following information, prepare a process account.1,000 units at Rs.
40 per unit were introduced in Process I :
Labour cost Rs. 5,000
Material 20,000
Production overhead 3,500
The normal process loss has been estimated at 10% of the input which can be
sold at Rs. 10 per unit. Actual production was 920 units.
)
[Ans. Cost per unit Rs. 75; Abnormal gain 20 units-Rs. 1,500]
4. In manufacture of a product 1,000 kg. of raw materials at Rs. 8 per kg. were
supplied to a process. Other expenses on this process were as follows :
Labour cost Rs. 2,000, production expenses Rs. 1,000. Normal loss has been
estimated at 10% which could be sold at Rs. 2 per kg. The actual output in
this process was 880 kg. Calculate the value of abnormal loss.
[Ans. 20 units @ Rs. 12 = Rs. 240]
5. A product passes through two processes A and B and then to finished stock.
The normal wastage of each process is 3% and 5% of 'the units introduced in
each process respectively. The scrap of process A is sold at Re. 0.50 per unit
and that of process B at Re 1 per unit. 10,000 units are introduced to process
117
 A at a cost of Rs. 2.00 per unit.
The other expenses are :
Process A Process B
Rs. Rs.
Wages 12,000 19,000
Manufacturing Expenses 2,100 2,375
Actual Production is : Process A-9,500 units Process B-9,100 units.
Prepare Process Accounts.
[Ans. Cost per unit Process A Rs. 3.50; B Rs. 6]
6. X Manufacturing Company's product passes through two distinct processes A
and B and then to Finished Stock. It is known from past experience that
wastage occurs in the process as under: In Process A. 5% of the units
entering the process and in Process B, 10% of the units entering the process.
The scrap value of wastage in process A is Rs. 16 per 100 units and in
Process B is Rs. 20 per 100 units. The process figures are :

Process A Process B
Materials consumed Rs. 6,000 Rs. 3,000
Wages 7,000 4,000
Manufacturing expenses 2,000 2,000
5,000 units were brought into Process A, costing Rs. 5,000. The outputs were:
Process A - 4,700 units. Process B - 4,150 units. Prepare Process Accounts
showing the cost of the output.
[Ans. Cost per unit—A Rs. 4.20; and B Rs. 6.77]

7. The product of a manufacturing concern passes through two processes A and B

and then to finished stock. It is ascertained that in each process normally 5% of
the total weight is lost and 10% is scrap which from Process A and B realizes
118
 Rs. 80 per ton and Rs. 200 per ton respectively.
The following are the figures relating to both the processes :
Process A Process B
Materials in tons 1,000 70
Cost of materials in rupees per ton 125, 200
Wages in rupees 28,000 10,000
Manufacturing expenses in rupee 8,000 5,250
Output in tons 830 780
Prepare Process Accounts showing cost per ton of each process. There was no
stock of work-in-progress in any process.
[Ans. Cost per ton/* Rs. 180, 5 Rs. 210]
8. The product of a manufacturing company passes through two processes A and
B. It is ascertained that in each process 10% of the total weight is lost and 20%
is scrap. The realisation from scrap amounts to Rs. 160 per ton and Rs. 400 per
ton from process A and B respectively.
The process figures are as follows :
Process A Process B
Rs. Rs.
Materials consumed in tons 2,000 140
Cost per ton 250 400
Wages 36,000 24,000
Manufacturing expenses 12,000 10,000
Prepare process accounts showing the cost per ton of output in each process.

[Ans. Transfer to Finished stock 1078 units @ Rs. 418.18 = 4,50,800]

9. The product of a company passes through three distinct processes to
completion. From the past experience it is ascertained that wastage is incurred
in each process as under : Process A 2%; Process B 5%; Process C 10%. The
wastage of Processes A and B is sold at Rs. 10 per 100 units and that of
Process C at Rs. 80 per 100 units.
119
 Following is the information regarding the production of March 2004 :
Process A Process B Process C
Rs. Rs. Rs.
Materials 12,000 8,000 4,000
Direct Labour 16,000 12,000 6,000
Machine expenses 2,000 2,000 3,000
Other factory expenses 3,500 3,800 4,200
20,000 units have been issued to Process A at a cost of Rs. 20,000. The output
of each process has been as under:
Process A 19,500 Units
B 18,800 Units
C 16,000 Units
There was no stock of work-in-progress in any process in the beginning
and at the end of March. Prepare Process Accounts
]Ans. Tr. Process B 19500 units at Rs. 53,187; Tr. Process C 18,800 units at Rs.
80,060; Transfer to Finished stock 16,000 units at Rs. 90,550].
10. Department A conducts a process which requires mixing of materials and
cooking of the mixture in batches of 1,000 kg each. Cooking results in 10 per cent
loss of weight of the mixture. Also, past experience shows that two batches out of
every ten started in the process are spoiled. The production records for March,
2004 are following:
(a) Production started in the Process ; 50 batches of 1,000 kg each.
(b) Production completed and transferred to finished goods : 34,200 kg
(c) There is no inventory of work-in-progress at the beginning or at the end of
the month. Costs recorded during the month totalled Rs. 70,000.
Prepare the Account of the Process conducted by Department A.
[Ans. Cost per unit Rs. 2; Abnormal loss 800 units @ Rs. 2 = Rs. 1,600; Tr. to
finished stock 34,200 units @ Rs. 2 = Rs. 68,400]

120
11. From the following, prepare Process Accounts :
Process A Process B
Materials consumed Rs. 12,000 6,000
Direct labour Rs. 14,000 8,000
Manufacturing expenses Rs. 4,000 4,000
Input in process A (units) 10,000 -
Input in process A Rs. 10,000
Output (units) 9,400 8,300
Normal wastage 5% 10%
Value of normal wastage (per 100 units) Rs. 8 10
[Ans. Tr. to Finished stock A/c 8,300 units at Rs. 56,359]
12. The product of a company passes through three distinct processes to
completion. These processes are known as A, B and C. From past experience it
is ascertained that wastage is incurred in each process as under:
Process A 2 per cent; Process B 5 per cent and Process C 10 per cent. In each
case the percentage of wastage is computed on the number of units entering the
process concerned. The scrap value of wastage is—scrap of Process A and B,
Rs. 5 per 100 units and that of Process C Rs. 20 per 100 units. The following
information is obtained:
Processes
A B C
Rs. Rs. Rs.
Materials 4,000 2.000 1,000
Direct labour 6,000 4,000 3,000
Manufacturing expenses 1,000 1,000 1,500
20,000 units have been issued to Process A at a cost of Rs. 8,000. The output
of each process has been as under : Process A 19,000 units; Process B 18,000
unit and Process C 16,000 units. There is no stock or work-in-progress in any
process. Show the Process Accounts [Ans. Tr. to Finished Stock 16,000 units @ Rs. 1.86 =
Rs. 29,816]

121
Module-4
OPERATING COSTING

Operating costing is a method of ascertaining cost in those undertakings which

provide services. Examples of such undertakings are transport companies, electricity
companies, hospitals, hotels, hostels cinema houses, schools and colleges, etc. These
undertakings do not manufacture any tangible goods, cost of providing a service is
known as 'operating cost'.
Operating costing should not be confused with 'operation costing'. These are two
different methods. Whereas operating costing is applied to determine the cost of
providing a service, the operation costing is a separate method and is a refined and
detailed application of process costing.

Characteristics
The following characteristics are usually found in those undertakings which use
operating costing method.

1. Services provided are of unique type.

2. A large part of the total capital employed is invested in fixed assets and
comparatively less amount is required for working capital. For example, in a
passenger transport company, investment is in the purchase of buses. Comparatively
less amount is required for meeting a day expenses and payment of wages and
salaries. It is for this reason that interest on capital is generally included in cost in
such undertakings.

3. The distinction between fixed and variable costs is very important in

ascertaining the cost per unit. This is because the scale of operations
considerably affect the cost per unit of service rendered. As the major part of
the total cost is fixed cost, the cost per unit of service rendered will decrease if more
units of service are rendered. For example, in a transport company, if buses run full
capacity, the number of passengers will be large and the total cost remaining
unchanged, the cost per passenger will be lower.

122
TRANSPORT COSTING

Method of ascertaining cost in transport undertakings is known as transport

costing. Its main objects are as follows :

1. To ascertain the operating cost of running a vehicle per kilometer.

2. To fix the rates of cartage of goods and passengers on the basis of
operating costs.
3. To decide the hire charges where vehicles are given on hire.
4. To compare the cost of using own motor vehicles with that of using
alternative modes of transport.
5. To determine the cost to be charged to departments which use internal
transport facilities.

Daily Log Sheet

A log sheet is a record which is generally maintained by the driver of the vehicle
on daily basis. In this log sheet are recorded most of the details required for transport
costing, e.g., details of journeys, running time, capacity, distance covered in
kilometers, cost of petrol/diesel, lubricants, accidents, loading and unloading time
etc. These details not only help in ascertaining the operating cost but also enable the
management to avoid idleness of vehicles, prevent waste of capacity and exercise
other controls.

OPERATING COST SHEET

The procedure of ascertaining costs in transport undertakings is to prepare an

operating cost sheet. The following steps are taken in preparing an operating cost sheet.

1. Determination of Cost Unit or Unit of Service. A basic problem in transport

costing is the adoption of a suitable cost unit. Cost unit in transport costing may be of
the following two types.
123
 (i) Simple cost unit, e.g., per kilometer or per mile, i.e., ascertaining the cost of
running a vehicle per km. or per mile.

(ii) Composite cost unit, e.g., per passenger kilometer or per tonne kilometer, i.e..,
cost of transporting a passenger or a tonne of goods for one kilometer. Thus if 50
passengers in a bus travel for 100 kilometers, it will represent 5,000 (i.e., 50 x 100)
passenger kilometers.

2. Compilation of Costs. In transport costing, costs are classified and compiled in an

operating cost sheet as follows :

(i) Fixed costs. These are constant costs and do not change with the increase or
decrease in the: number of units of service rendered by the company. Examples are
wages of drivers and conductors, garage rent, office expenses, license fees,
insurance of vehicles, road lax, etc.

(ii) Variable or operating costs. These are running costs and are incurred only
when the vehicles run. Examples are petrol or diesel oil, lubricating oil,
depreciation, tyres and tubes, wages of drivers (if the payment is according to
distance or trips) etc., Depreciation is a semi-variable cost. It may be treated as
fixed or variable item depending upon the method of charging depreciation. In
operating cost sheet, depreciation is mostly treated as variable cost,

3. Determining Cost per Unit of Service. As the service rendered by transport

undertakings is of uniform type, the cost per unit of service is the average cost, i.e.. the
total cost divided by the number of units of service. For example, if total cost per
month in a transport company is Rs. 24,000 and the bus has run for 48,000 km. during
the month, the operating cost per kilometer will be Rs. 24,000 + 48,000 kms. = 50
paise.

Absolute tonne-km and commercial tonne-km

In transport costing, composite cost units may be computed n two ways —
(a) absolute tonne km, and (b) commercial tonne km.
In absolute tonne km, cost units between each two stations are calculated
separately in tonne kms and then totalled up. But in commercial tonne km, the trip is
considered as a whole and it is arrived at by multiplying the total distance in km by
124
average load quantity

Illustration .1
A truck starts with a load of 10 tonnes of goods from station P. It unloads 4
tonnes at station Q and rest of the goods at station R. If reaches back directly to station
P after getting reloaded with 8 tonnes of goods at station R. The distances between P to
Q, then Q to R and then from R t o P are 40 km; 60 km and 80 km respectively.
Compute absolute tonne km and commercial tonne km.

Solution

Absolute tonne km = (40 km x 10 tonnes) + (60 km x 6 tonnes) +

(80 km x 8 tonnes)
= 400 + 360 640 = 1400
Commercial tonne km = Average load x total kms
10 + 6 +8 tonnes x 180 kms
3
= 8 tonnes x 180 km = 1440 km.

Specimen Operating Cost Sheet

Vehicle No. ………………………… Period ……………………
Cost Unit …………………………… No.of cost units ………..
Total Per km.
Rs. Rs.
Fixed Costs (or Standing charges)
Garage Rent
Road Ta
Insurance
Manager’s Salary
Office expenses
Interest on Capital
Driver’s wages
Total (A)
Variable (Running Costs)
Depreciation
125
Petrol or diesel
Lubricating oil
Repairs and Maintenance
Tyres and tubes
Total (B)
Grand Total (A +B)

PROBLEMS AND SOLUTIONS

Problem 1

From the following information, calculate (i) total kilomeres, and (ii) total
passenger kilometers

No. of buses 4
Days operated in a month 30
Trips made by each bus 2
Distance of route 100 km (one side)

Capacity of each bus 40 Passengers

Average passengers travelling 75 % of capacity.
Solution

(i) Total No. of Kilometers

= No. of buses x No. of days x No. of trips x Distance per trip
= 4 x 30 x 2 x 200 = 48,000 km.
(ii) Total No. of Passenger kilometers
x
= No. of buses x No. of days x No. of trips Distance per trip x Capacity
x Normal capacity utilised
= 4 x 30 x 2 x 200 x 40 x 75% = 14,40,000 passenger km.
.Problem 2
A transport company, is running a fleet of six buses between two towns 75 km apart.
Seating capacity of each bus is 40 passengers. The following particulars are available for
the month of June 2005.

126
 Rs. Rs.
Wages of drivers, conductors and 3,600 Taxation, insurance, etc 2,400
cleaners
Salaries of office and other staff 1,500 Depreciation 3,900
Diesel and other oils 10,320 Interest on capital 3,000
Repairs and maintenance 1,200

Actual passengers carried were 80 per cent of the seating capacity. All the buses ran
on all days of the month. Each bus made one round trip per day.
Find out the cost per passenger-kilometer.

Solution

Passenger kms for the month are calculated as under :

= No. of buses x Distance x Capacity of each bus x Actual capacity
utilised x Round trip x No. of days.
= 6 x 75 x 40 x 80% x 2 x 30 = 8,64,000 passenger kms.

Operating Cost Sheet

for the Month of June 2005
Passenger km. = 8,64,000
Rs. is.

landing Charges:
1.Wages of drivers, conductors and claners 3,600
2. Salaries of office and supervisory staff 1,500
3. Taxation, insurance, etc. 2,400
4. Interest on capital 3,000 10,500
Variable Charges:
1. Diesel and other oils 10,320
2. Repairs and maintenance 1,200
3. Depreciation 3,900 15,420
Total Cost 25,920
Cost per passenger km.. = Total Cost + No. of Passenger km
= Rs. 25,920
passenger km.+ 8,64,000 passenger km = 3 Paise

Problem 3
127
 From the following data relating to two different vehicles A and B, compute
the cost per nze mile:
Vehicle A Vehicle
Mileage run (annual) Rs. 15,000 Rs. 6,000
Cost of vehicle Rs. 25,000 Rs. 15,000
Road licence (annual) Rs. 750 Rs. 750
Insurance (annual) Rs. 700 Rs. 400
Garage rent (annual) Rs. 600 Rs. 500
Supervision and salaries Rs. 12,000 Rs. 1,200

Driver's wages per hour Rs. 3 Rs. 3

Cost of fuel per gallon Rs. 3 Rs . 3
Miles run per gallon 20 miles 15 miles
Repairs and maintenance per mile Rs. 1.65 Rs. 2.00
Tyre allocation per mile Re. 0.80 Re. 0.60
Estimated life of vehicles 1,00,000 miles75,000 miles
Charge interest at 5% per annum on cost of vehicles. The vehicles run 20 miles on an
average.

Solution

Operating Cost Sheet for the year ending.

No. of cost units — A : 15,000 miles; B : 6,000 miles

Particulars Vehicle A. Vehicle S

Rs. Rs
Fixed cost per annum :
Road licence 750 750
Insurance 700 400
Garage rent 600 500
Supervisory salaries 1,200 1,200
Interest 5% on cost of vehicle 1,250 750
Total 4,500 . 3600
Fixed cost per mile (A) 0.30 0.60

128
Variable cost per mile:
Drivers's wages (Rs. 3 per hour for 20 miles) 0.15 0.15
Fuel cost per mile 0.15 0.20
Repairs & maintenance 1.65 2.00
Tyre allocation 0.80 0.60
Depreciation (cost + estimated life) 0.25 0.20
Variable cost per mile (B ) 3.00 3.15
Total Cost Per Running Mile (A + B) 3.30 3.75

Problem 4

Union Transport Company supplies the following details in respect of a truck of 5-

tonne capacity :

Cost of truck Rs. 90,000

Estimated life 10 years
Diesel, oil, grease Rs. 15 per trip each way
Repairs and maintenance Rs. 500 per month
Cleaner's wages Rs. 250 per month
Driver's wages Rs. 500 per month
Insurance Rs. 4,800 per year
Tax Rs. 2,400 per year
General supervision charges Rs. 4,800 per year

The truck carries goods to and from city covering a distance of 50 miles each
way.
While going to the city, freight is available to the extent of full capacity and on
return 20% of capacity. Assuming that the truck run on an average 25 days a month,
work out —
(i) Operating cost per tonne-mile, and
(ii) Rate per trip that the company should charge if profit of 50% on,
freightage is to be earned.

129
 Solution
(i) Operating Cost Statement for the month ending.
Tonne miles = 7500*
Per month Per tonne-
Rs. Rs.
mile
Fixed Costs:
Driver's wages 500
Cleaner's wages 250
Insurance 400
Taxes 200
General supervision 400 1,750 0.233
Running (or Variable) Costs:
Diesel oil, etc. (15 x 2 x 25) 750
Repairs & Maintenance 500
Depreciation 90,000 x 1 x 1 750 2,000 0.267
10 12
Total 3,750 0.500
*Note . Tonne,-miles are computed as under :
[(50 x 5) + (50 x l)] x 25 days = 7,500 tonne-miles

(ii) Calculation of Freight Rate Per Tonne-mile & Quotation

Cost per tonne-mile Re. 0.50
Profit per tonne-mile (50% on freightage is 100% on cost) Re. 0.50
Freight rate per tonne-mile Re. 1.00
Freight rate per trip both ways = Re. 1 x 300 tonne miles = Rs. 300.
Note. In one trip (both ways) there are 300 tonne miles i.e., (50 x 5) + (50 x l) = 300.

Problem 5
Prakash Automobiles distributes its goods to a regional dealer using a single lorry.
The dealer's premises are 40 kilometers away by road. The Lorry has a capacity of 10

130
"tonnes and makes the journey twice a day full loaded on the outward journeys and
empty on return journeys. The following informations are available for a Four Weekly
Period during the year 2006:

Petrol consumption 8 kilometers per litre

Petrol cost Rs. 13 per litre
Oil Rs. 100 per week
Driver's wages Rs. 400 per week
Repairs Rs. 100 per week
Garage rent Rs. 150 per week
Cost of lorry (excluding tyres) Rs. 4,50,000
Life of tyres 80,000 kilometers
Insurance Rs. 6,500 per annum
Cost of tyres Rs. 6,250 Life of tyres
25,000 kilometers
Estimated sale value of lorry at end of its life Rs. 50,000
Vehicle licence cost Rs. 1,300 per annum
Other overhead cost Rs. 41,600 per annum
The lorry operates on a five-day week
Required:
(a) A statement to show the total cost of operating the vehicle for the
four weekly period.
(b) Calculate the vehicle cost per kilometer and per tonne-kilometer.

Solution
Operating Cost Sheet
Particulars Per four
weeks Rs.
Fixed Costs: 600
Garage rent (150 x 4)
Insurance 6,500 x 4 weeks 500
52 weeks

License cost 1,300 x 4 weeks 100

52 weeks

131
Other overhead 41,600 x 4 weeks 3,200
52 weeks
Total Fixed Cost 4,400

Running Costs:
Petrol* 5,200
Oil expenses 400
Driver's wages 1,600
Repairs 400

Tyre cost Rs. 6,250 x 3200 800

25,000
Depreciation x 3,200 16,000
Rs. 4,50,000 - 50,000
80,000 kms kms*

Total Running Cost 24,400

Total Cost (Fixed + Running) 28,800

Cost per km = Rs. 28,800 ÷ 3,200 kms = Rs. 9

Cost per tonne-km = Rs. 28,800 ÷ 16,000 tonne km = Rs.1

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*Notes :
Petrol cost for four weeks is computed as follows :
Kms travelled = 40 kms * 2 return trip x 2 trips x 20 days = 3,200 kms

Total consumption of petrol in four weeks = 3,200 kms = 400 litres.

8 kms
Cost of petrol = 400 litres @ Rs. 13 = Rs. 5,200
Total tonne-km = 40 kms x 2 trips x 20 days x 10 tonnes = 16,000 tonne km.

Problem 6
Joseph owns a fleet of taxis and the following information is available from the
records maintained by
Number of taxis 10
Cost of each taxi Rs. 20,000
Salary of manager Rs. 600 p.m.
Salary of accountant Rs. 500 p.m.
Salary of cleaner Rs. 200 p.m.
Salary of mechanic Rs. 400 p.m
Garage rent Rs. 600 p.m.
Insurance premium 5% per annum
Annual tax Rs. 600 per taxi
Driver's salary Rs. 200 p.m. per taxi
Annual repair Rs 1000 per taxi
Total life of a taxi is 2,00,000 km. A taxi runs in all 3,000 km. in a month of which
30% it runs empty. Petrol consumption is one litre for 10 km. @ 11.80 per litre. Oil and
other sundries are Rs. 5.00 per 100 km. Calculate the cost of running a taxi per km.

133
Solution

Operating Cost sheet for the period.....

Per Per Km
Rs. Rs.
Month
Fixed costs (for 10 taxis)
Manager's salary 600.00
Accountant's salary 500.00
Salary of cleaner 200.00
Salary of mechanic 400.00
Garage rent 600.00
Total fixed cost 2,300.00
Fixed cost per taxi (2,300 + 10) 230.00

1 Insurance premium (Rs. 20,000 x 5% x 1) 83.33

12
Taxes per taxi (600 ÷ 12) 50.00
Driver's salary per taxi 200.00
Total fixed cast per taxi 563.33
Fixed cost per taxi (563.33 + 2.100*) Per km. 0.27

Variable cost per km.

(a) Depreciation
Effective kms. = 2,00,000 x 70% = 1,40,000
Per effective km. = [20,000 + 1,40,000] 0.14
(b) Petrol (11.80 x 3,000 = Rs. 3,540 per month,
10

Per effective km.=Per effective km.= 3540= Rs. 1.69) 1.69

2,100

(c) Repairs 1,000 x 1 0.04

2,100 12

(ft) Oil and other sundries (150 ÷ 2,100) 0.07

134
Total cost per km. 2.21

135
*Note. It, has been assumed that 30% empty run of the taxis is a normal loss. Therefore, all costs
have been inflated to cover this normal loss.
Effective km per month = 3,000 less 30% =2,100 km.
Effective working life = 2,00,000 less 30% = 1,40,000 km.

Problem 7
The following were the expenses incurred by a company in operating two lorries (for the
conveyance of 'raw materials) and a bus (for the conveyance of staff) during a related
month :

Monthly Cost
Lorry A Lorry B Bus C
Rs. Rs. Rs.
Driver's salaries 110 115 120
Coolie's wages 120 120 60
Petrol 170 240 110
Oil 18 25 20
Repairs 150 150 100
Depreciation 330 220 350
Supervision 70 70 70
General garage overhead 130 110 75
Road and other taxes 45 45 30
Other overhead expenses 35 40 20

The above vehicles carried the following raw materials and passengers during the
month :

Lorry A 100 tonnes of raw materials

Lorry B 120 tonnes of raw materials
Bus C 25 passengers daily for 25 days

At the same time, their respective mileage, during the same period, were

Lorry A 3,000
Lorry B 4,500
Bus C 2,000

From the above statistics you are required to prepare an operating cost sheet in

136
summary form for the three vehicles. In addition, you should briefly explain the 'units of
cost' which you select for the purpose of making your calculations.

Solution
Operating Cost Sheet for the month of …….
Lorry A Lorry B Bus G

Monthly Monthly Monthly :

cost cost cost
Rs. Rs. Rs.

Fixed charges:

Depreciation 330 220 350

Supervision 70 70 70
Road and other Taxes 45 45 30
Other overhead expenses 35 40 20
Repairs 150 150 100
General garage overhead 130 110 75

Operating costs: *

Drivers' salaries 110 115 120

Coolie's wages 120 120 60
Petrol 170 240 110
Oil 18 25 20

Total 1,178 1,135 955

Tonne miles/Passenger miles 12,000 21,600 50,000
Cost ficr tonne/Passenger mile 82 Paise 5.25 Paise 1.91 Paise

The unit of cost for lorry A and lorry B carrying raw materials is per 'tonne-mile' and
unit for bus C carrying passengers is per 'passenger-mile'. The total number of units for
each have been calculated as below :

Lorry A Lorry B
Tonnes carried per day 1 0 0 ÷ 2 5 = 4 120 ÷ 25=4.8
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 Mileage per day 3,000 H÷ 25 = 120 4,500 ÷ 25 = 180
Tonne miles (Tonnes x Miles x Days)120 x 4 x 25 180 x 4.8 x 25
= 12,000 = 21,600
Bus C - Passenger miles :
Passengers per day =25
Miles per day . = 2,000 - 25 = 80
Passenger miles (Passengers x = 25 x 80 x 25 = 50,000
miles x days)

Problem 8

A transport company operates two trucks. The following is the data regarding the
monthly cost of operating them :
Truck A Truck B
Rs. Rs.
Drivers salaries 250 275
Cleaners' wages 150 160
Petrol 300 350
Mobil oil 25 30
Garage rent 125 125
Taxes and Insurance 50 50
Depreciation 560 620
Expenses of supervision 100 100
Repairs 120 140
Overheads 40 40

Two trucks carried 150 tonnes of goods each during the month of November 2005.
The distances covered were 3,500 km, and B 5,000 km. respectively. Prepare an Operating
Cost Sheet for November from the above data.

138
Solution

Operating Cost Sheet

Truck A Truck B

Rs. Rs.
Fixed charges :

Drivers' salaries 250 275

Cleaners' wages 150 160
Garage rent 125 125
Taxes and Insurance 50 50
Supervision 100 100
Overheads 40 40
Total Fixed charges 715 750
Variable charges : Petrol
Mobil oil 300 350
Depreciation 25 30
Repairs 560 620
Total cost 120 140
Cost per tonne-km. 1,005 1,140
1,720 1,890

A= 1,720 ÷ 17,500 = Re.0.098

B= 1,890 ÷ 25,000 = Re. 0.076
*Working Note
Calculation of tonne km in Nov. (30 days) Truck A Truck B
Distance per day = 3,500 km. = 5,000 km.
30 days 30 days
Tonnes Per day (150 ÷ 30 days) 5 Tonnes 5 Tonnes
Tonne Km. = Distance x tonnes x No. of days

Truck A = 3500 x 5 x 30 = 17,500 tonne km.

30

139
 Truck B = 5,000 x 5 x 30 = 25,000 tonne km.
30
Problem 9
A person owns a bus which runs between Delhi and Chandigarh and back, for 10 days
in a month. The distance from Delhi to Chandigarh is 240 kms. The bus completes the trip
from Delhi to Chandigarh and back in the same day. The bus goes another 10 days in a
month to Agra and the distance covered being 200 kms. The trip is also completed in the
same day. For the rest of 4 days it runs in the local city. Daily distance covered in local
city is 60 kms. Calculate the rate, the person should charge from passenger when he wants
to earn a profit of 33⅓ % on his takings. The other particulars are given below :

Cost of bus Rs. 2,00,000.

Depreciation 20% per annum.
Salary of driver Rs. 1,600 per month.
Salary of conductor Rs. 1,500 per month.
Salary of part time accountant Rs. 400 per month.
Insurance Rs. 2,000 per annum.
Diesel consumption : 6 kms. per litre costing Rs. 4.00 per litre.
Token tax Rs. 600 per annum.
Repairs Rs. 1,000 per month.
Normal capacity 50 passengers.
The bus generally occupied 90% of the capacity when it goes to Chandigarh and 80%
when it goes to Agra. It is always full when it runs within the city.

Solution
Passengers km. are calculated as under :
1. Delhi to Chandigarh = 50 passengers x 90% capacity x 10 days x
480 kms = 2,16,000 passenger km.
2. Delhi to Agra = 50 passengers x 80%. capacity x 10 days x
400 s = 1,60,000 passenger kms
3. Local city = 50 passengers x 4 days x 100% x 60kms.
140
 = 12,000 kms.
Total passenger kms. = 2,16,000 + 1,60,000 + 12,000 = 3,88,000
Total kms. travelled in month :
Delhi to Chandigarh (480 kms. x 10 days) = 4,800 kms
Delhi to Agra (400 kms x 10 days) = 4,000 kms
Local (60 kms. x 4 days) = 240 kms
Total 9,040 kms

Operating Cost Sheet for the month

Per month

Standing Charges Rs. Rs.

Salary of Driver 1,600
Salary of Conductor 1,500
Salary of Part-time Accountant 400
Insurance (Rs. 2,000 + 12 months) 167
Token Tax (Rs. 600 + 12 months) 50 3,717
Variable Cost :
Depreciation (Rs. 40,000 ÷ 12 Months) 3,333
Repairs 1000
(
Diesel 4^\ (9,040 kms. x 4/6)
consumption 6,027 10,360
Total Cost per month 14,077

Cost per passenger km. (14,077 ÷ 3,88,000) 0.0363

Profit (1/3 of takings or 1/2 of cost) 0.0181
Rate per passenger km. 0.0544

Rate per passenger to be charged

(i) Delhi to Chandigarh = 240 km @ Re. 0.0544 = Rs. 13.06
(ii) Delhi to Agra. = 200 km @ Re 0.0544 = Rs. 10.88

Problem 10

Shiva has been promised a contract to run a tourist car on a 20 km long route for the
chief exec^-of a multinational firm. He buys a car costing Rs. 1,50,000. The annual costs

141
of insurance and taxes are Rs. 4,500 and Rs. 900 respectively. He has to pay Rs. 500 per
month for a garage where he keeps the car it is not in use. The annual repair costs are
estimated at Rs. 4,000. The car is estimated to have a life : years, at the end of which the
scrap value is likely to be Rs. 50,000.
He hires a driver who is to be paid Rs. 300 per month plus 10% of the takings as
commissicr. incidental expenses are estimated at Rs. 200 per month.
Petrol and oil will cost Rs. 100 per 100 kms. The car will make 4 round trips each day.
Assuming that a profit of 15% on takings is desired and that the car will be on the road for
25 days on an average month, what should he charge per round trip?

Solution

Operating Cost Sheet

Per Per month
annum
Standing Charges :
Depreciation 10,000
Insurance 4,500
Taxes 900
Garage (Rs. 500 x 12) 6,000
Annual repairs 4,000
Driver's salary (Rs. 300 x 12) 3,600
Other expenses (Rs. 200 x 12) 2,400
Total 31,400 2,616.67
Variable Expenses :
Petrol and oil : (4,000x km x1 km x Rs.100) 4,000.00
100
Total Cost (without commission) 6,616.67

*Note :
• Total km during the month is calculated as follows:
25 days x 20 kms x 2 x 4 round trips = 4,000 km.

Calculation of Charge per Round Trip

Let X be the total takings per month:

Driver's commission = 10% of X = X
142
 10
Profit = 15% of X = 15 x 3X
100 20

Total taking per month = Total cost + Driver's commission + Profit

X = Rs. 6,616.67 + X + 3X
10 20
X - 3X - X = Rs. 6616.67
20 10

Or 20 X - 3X – 2X = Rs. 6,616.67
20
Or Rs.6616.67 x 20 = Rs. 8,822.22
15
Total number of round trips per month : 25 days x 4 round trips per day = 100

Hence the charge per round-trip = Rs. 8,822.23 = Rs. 8.22

100

Problem 11
A vehicle costs Rs. 15,600 and its life is estimated at 5 years, after which its residual
value is estimated at Rs. 600. Standing charges per annum are estimated at the following
figures:
Insurance Rs. 850. Licence Rs. 750. Administration overheads Rs. 2,000
Fuel costs Rs. 2 pef gallon and based on an estimated mileage of 30,000 per year, the
cost of lubricants is Rs. 150. The estimated consumption of fuel is 20 miles per gallon. A
set of tyres costs Rs. 1,400 and their expected mileage is 16,000. The driver is paid Rs. 50
per week of 44 hours and is entitled to a fortnight's paid holiday per annum. The
Company's contribution towards National Insurance Scheme is Rs. 10 per week. For each
night spent away from home, the driver is paid a subsistence allowance of Rs. 10. It is
estimated that the vehicle will run 220 days per annum and depreciation is regarded as a
running cost. Repairs over the life of the vehicle are estimated at Rs. 5,000.
(a) Compute figures which may by used as a basis for quoting, if company adds 10%
to the total cost for profit, (b) Prepare a quotation for a journey of 100 miles and return,
assuming no return load and a total time of two days.

Solution

143
 Operating Cost Sheet
Per annum Per mile
Rs. Rs.
Standing Costs :
1. Insurance 850
2. Licence 750
3. Administration overheads 2,000
4. National insurance for 52 weeks 520
5. Driver's wages for 52 weeks (including paid 2,600
holidays) Total 6,720 0.224
6,720
Running or Variable Costs :
1. Depreciation 15,600 - 600 0.100
5 x 30,000

2. Tyres (1,400+ 16,000) 0.088

3. Fuel (2 ÷ 20) 0.100
4. Lubricant (150÷30,000) 0.005
5. Repairs 5,000 0.33
5x30,000

Total 0.326
Total Cost (Fixed + Variable) 0.550

Standing charges per day = Rs. 6,720 + 220 days = Rs. 30.5

Statement of Quotation for Journey

Rs.
Standing charges for 2 days @ Rs. 30.55 per day. 61.10
Running expenses for 200 miles (Re. 0.326 * 65.20
Subsistence
200 miles) allowance for 1 night 10.00
Operating cost 136.30
Add: 10% Profit 13.63
Quotation Price 1493

144
EXAMINATION QUESTIONS
SECTION-A
1. What is operating costing ?
2. State any three types of business activities in which operating costing is used.
3. What is a daily log sheet ?
4. Name any two cost units in transport costing.

SECTION-B
1. What is operating costing? To what industries is this method of costing
applicable?
2. Write a short note on operating cost.
3. What do you understand by operating costs? Describe its essential features and
state where it can be usefully implemented.

SECTION-C
1. From the following data calculate the cost per mile of a car :
Cost of car Rs. 15,000 Miles per litre 8
Road licence fee per year 500 Tyre and maintenance per mile Re. 0.20
Insurance charges per year 100 Estimated life 1,50,000 miles
Garage rent per year 600 Estimated annual mileage 6,000 miles
Driver's wages per month 200 Ignore interest on capital
Cost of petrol per litre Rs. 8
(Ans. Re. 1.90)

2. From the following data, calculate the cost per kilometer of a vehicle :
Estimated life 2,00,000 kms Insurance charges per annum Rs. 1,800
Estimated annual kms. 7.500 kms Driver's salary per month. Rs. 500
Value of the vehicle Rs. 25,000 Cost of petrol per litre Rs. 8
Road licence per annum Rs. 700 Kms. per litre 16
Proportionate charges per km. for tyre maintenance per km. Re. 0.70.
(Ans. Operating charges Rs. 1.325 and fixed charges Rs. 1.133 Total Rs. 2.458; )

145
3. A transport company maintains a fleet of lorries for carrying goods from Delhi to
Panipat, 100 kms off. Each lorry, which operates 25 days on an average in a month, starts
every day from Delhi with a load of 4 tonnes and returns from Panipat with a load of 2
tonnes. Calculate the total commercial tonne-kms and cost per commercial tonne-km
when the total monthly charges for a lorry are Rs. 27,000. What rate per tonne should the
company charge if it plans to earn a gross profit of 20% on the freightage?
(Ans. Total tonne km. = 15,000, cost Rs. 1.80 per tonne km. Freight = Rs. 2.25 per tonne
km.)
4. From the following data you are required to ascertain the cost of running the motor lorry
per ton-mile. Total tonnage carried in a week : 30; Total mileage in a week : 600 miles

Details of the above are :

Miles Tons Expenses for the week:
Monday 120 6 Driver’s salary Rs. 600 p.m
Tuesday 125 5 Cleaner’s salary Rs.200p.m
Wednesday 110 4 Petrol, oil etc Re. 1 per mile
Thursday 100 5.5 Repair & maintenance Rs.300p.m
Friday 80 4.5 Depreciation Rs.4,800 p.a
Saturday 65 5.0 Other expenses Rs.500p.m
600 Assume : 4wek in a
month

(Ans. Re. 0.37 per ton-mile)

5. Ascertain the cost of carrying one ton of goods for a distance of one km. from the
following particulars.
Cost of Truck Rs. 3,00,000; Estimated scrap value Rs. 25,000; Life 5 years; Capacity 4
tons; Average daily distance covered 200 km (100 outward and .100 return) Working days
in a month 25.
Freight : Full capacity outward, 50% on return journey.

Miles Expenses for the week:

Annual charges Driver’s salary Rs. 750
146
 Insurance @ 2% Coolie Rs.500
Repair & maintenance Rs. 4,500 Petrol, oil etc Rs. 100 for every
100kms.
Garage rent Rs.3,600
Taxes Rs.6,1000
Interest @ 18%
Tyre, Battery, etc Rs.6,500

6. The Shakthi Transport Company supplies the following details in respect of a truck
having 5 ton capacity :
Cost of the truck : Rs. 1,80,000
Estimated life : 10 years
Diesel; oil, grease : Rs. 60 per trip each way
Repairs and maintenance : Rs. 1,000 per month
Driver's wages : Rs. 600 per month
Cleaner's wages : Rs. 250.per month
Insurance : Rs. 3,600 per year
Tax : Rs. 4,800 per year
General supervision charges : Rs. 6,000 per year.
The truck carries goods to and from the city covering a distance of 80 kilometers each
way. On outward trips freight is available to the extent of full capacity and on return trip
20% of capacity. Assuming that the truck runs on an average 25 days in a month work
out :
(a) Operating cost per ton-kilometer.
(b) Rate per ton per trip that the company should charge if a profit of 50% on
freightage is to be earned. [Ans. Operating cost per ton-km = 63 paise
Rate per ton per trip = Rs. 604.80 _,
Ton km. = 12,000 per month]

7. Calcutta Transport Company maintains a fleet of buses as follows :

No. of buses Carrying capacity
10 60 passengers each
5 40 passengers each
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 Each bus makes four tips (return journey in a day covering a distance of 5 miles on each
trip). On an average 75% of the seats are occupied in each trip. Assuming that the
company operated its fleet 25 days in a month, ascertain the operating cost per
passenger mile, taking into account the following further information :

Wages of 15 drivers @ Rs. 250 per month.

Petrol, oil etc. Rs. 300 p.m.
Repairs etc., Rs. 1,500 p.m.
Tyres, tubes, etc. Rs. 375 p.m.
Depreciation Rs. 90,000 p.a.
Garage rent Rs. 9,000 p.a.
Interest on capital Rs. 12,000 p.a.
General supervision Rs. 3,000 p.a. (Ans. Re. 0.05)

Module-5
Standard Costing and Variance Analysis

148
Introduction
In general, costs may be divided into two broad categories :
(a) Historical costs; and (b) Pre-determined costs.

Historical cost means the actual or past cost and historical costing is a system in which
actual costs incurred in the past are ascertained. Ascertainment of actual costs does not
serve any useful purpose and has certain limitations.

Firstly, such costs are obtained too late and cannot be used for price quotations.

Secondly, historical costs do not serve the purpose of cost control because the cost has
already been incurred before cost figures are available for managerial control.

Thirdly, historical costs do not provide any yardstick against which efficiency can be
measured.

These limitations encouraged the development of a more satisfactory standard costing

approach based on predetermined costs. Standard costing is not a method of costing like
job order on process costing. It is a special technique to control costs and can be used in
conjunction with any other system like job costing, process costing or marginal costing,
etc.

Standard costing is one of the most important tools to control costs. In this technique, all
costs are pre-determined, i.e., costs are determined in advance of production. Such pre-
determined costs are then compared with the actual costs. The difference between the
actual costs and pre-determined costs, known as variances, are then analysed and
investigated to know their reasons. Variances are reported to management for taking
remedial steps so that actual costs adhere to pre-determined or standard costs.

Meaning and Definition of Standard Cost

The word standard means 'a norm' or a criterion. Standard cost is thus a criterion cost
which may be used as a yardstick to measure the efficiency with which actual cost has been
incurred. In other words, standard costs are pre-determined costs or target costs that should
be incurred under efficient operating conditions.

According to Chartered Institute of Management Accountants (C.I.M.A.), London,

"Standard cost is the pre-determined cost based on technical estimates for materials,
labour and overhead for a selected period of time for a prescribed set of working

149
conditions ".
In the words of Brown and Howard, "the standard cost is a predetermined cost which
determines what each product or service should cost under given circumstances". Thus
standard costs are planned costs that should be attained under a given set of operating
conditions. The main object of standard cost is to look forward and assess what the cost
'should be' as distinct from what the cost has been in the past.

Meaning and Definition of Standard Costing

Standard costing is simply the name given to a technique whereby standard costs are
computed and subsequently compared with the actual costs to find out the differences
between the two. These differences (known as variances) are then analysed to know the
causes thereof so as to provide a basis of control. The C.I.M.A. London has defined
standard costing as "the preparation of standard costs and applying them to measure the
variations from actual costs and analysing the courses of variations with a view to
maintain maximum efficiency in production". Brown and Howard have defined it, "as a
technique of cost accounting which compares the standard cost of each product or service
with the actual costs, to determine the efficiency of the operations so that any remedial
action may be taken immediately".
Steps. Standard costing system involves the following steps :
1. The setting of standard costs for different elements of cost, i.e., material, labour
and overheads.
2. Ascertaining actual costs.
3. Comparing standard with actual costs to determine the differences between
the two, known as 'variances'.

4. Analysing variances for ascertaining reasons thereof.

5. Reporting of these variances and analysis thereof to management for appropriate

corrective action, where necessary.

Applicability of Standard Costing

The application of standard costing requires certain conditions to be fulfilled. These are :
(a) A sufficient volume of standard products or components should be produced.
(b) Methods, operations and processes should be capable of being standardised.
(c) A sufficient number of costs should be capable of being controlled.
150
 Industries producing standardised products which are repetitive in nature, i.e., industries
using process costing method, fulfill all the above conditions and thus the system can be
used to the best advantage in such industries, Examples are fertilizers, cement, steel, sugar,
etc.

In jobbing industries, it is not worthwhile to develop and employ a full system of

standard costing. This is because in such industries each job undertaken may be different
from another and setting standards for each job may prove difficult and expensive. In such
industries, therefore, a partial system may be adopted in appropriate circumstances. For
example, certain processes and operations performed may be of a repetitive nature and thus
the principles of standard costing may be applied by setting standard for each such process
or operation.
Standard Costs and Estimated Costs – Comparison Both standard costs and stimated costs
are predetermined costs computed in advance of production. But their objectives are
normally different. The differences between the two are summarised as under:

Basis Standard cost Estimated cost

1. Nature. Standard cost aims at what the cost Estimated cost is an assessment of what
SHOULD be. the cost WILL be.

2. Basis. Standard costs are planned costs Estimated costs are based on average of
which are determined on a scientific the past figures, taking into consideration
basis after taking into account certain anticipated changes in future.
level of efficiency.

3. Relation to In standard costing system, standard Estimated costs are used as statistical data
accounts. costs are usually incorporated into the for comparing with actual figures. Such
accounts, from which variances of costs are not entered in the books of
actual from standard are ascertained. accounts.

151
4. Use. Standard costs are meant to be used Estimated costs may be used in any
for a concern operating on a standard concern operating on a historical cost
costing system. system.

5. Purpose. Standard costs serve the purpose of Estimated costs do not serve the purpose
cost control. of cost control. Such costs serve other
purposes, like quoting selling price of
new products, decision to buy or
manufacture, etc.

Standard Costing and Budgetary Control — Comparison

Standard costing and budgetary control have the common objective of cost control by
establishing predetermined targets. The actual performances are measured and compared
with the predetermined targets for control purposes. Both the techniques are of
importance in their respective fields and are complementary to each other.

Points of Similarity

There are certain basic principles which are common to both standard costing and
budgetary control. These are :

1. The establishment of predetermined targets of performance.

2. The measurement of actual performance.
3. The comparison of actual performance with the predetermined targets.
4. The analysis of variances between the actual and the standard performance.
5. To take corrective measures, where necessary.

Points of Difference

In spite of so much similarity between standard costing and budgetary control, there are
some important differences between the two, which are as follows :

152
 Basis Standard costing Budgetary control
1. Scope. Standard costs are developed mainly for Budgets are compiled for different
the manufacturing function and functions of the business such as sales,
sometimes also for marketing and purchases, production, cash, capital
administration functions. expenditure, research and development,
etc.

2. Intensity. Standard costing is intensive in Budgetary control is extensive in nature

application as it calls for detailed and the intensity of analysis tends to be
analysis of variances. much less than that in standard costing.
3. Relation to In standard costing, variances are In budgetary control, variances are
accounts. usually revealed through accounts. normally not revealed through accounts
and control is exercised by statistically
putting budgets and actuals side by side.

4. Usefulness. Standard costs represent realistic Budgets usually represent an upper limit
yardsticks and, are therefore, more on spending without considering the
useful for controlling and reducing effectiveness of the expenditure in terms of
costs. output.

5. Basis. Standard costs are usually established Budgets may be based on previous year's
after considering such vital matters as costs without any attention being paid to
production capacity, methods employed efficiency.
and other factors which require
attention when determining an
acceptable level of efficiency.

6. Projection. Standard cost is a projection of cost Budget is a projection of financial

accounts. accounts.

153
ADVANTAGES OF STANDARD COSTING

The advantages to be derived from a system of standard costing will vary from one
business to another. Much depends upon the degree of sophistication achieved and the
acceptance by the management of utility of the system. Possible advantages are as follows
:
1. Effective cost control. The most important advantage of standard costing is that it
facilitate? the control of costs. Control is exercised by comparing actual performance with
standards and taking action on the basis of variances so revealed.
2. Helps in planning. Establishing standards is a very useful exercise in business
planning which instills in management a habit of thinking in advance.
3. Provides incentives. Standards provide incentives and motivation to work with
greater effort Schemes may be formulated to reward those who achieve or surpass the
standard. This increases efficiency and productivity.
4. Fixing prices and formulating policies. Standard costs are a valuable aid to
management in determining prices and formulating production policies. For example,
prices may be fixed by adding a standard margin of profit to standard cost. Similarly,
standard costing furnishes cost estimates while planning production of new products.
5. Facilitates delegation of authority. In order that responsibility for off-standard
performance may be identified directly with the persons concerned, an organisation chart
is prepared which shows delegated authority and establishes responsibility of each
executive.
6. Facilitates coordination. While establishing standards, the performance of different
departments such as production, sales, purchases etc. is taken into account. Thus through
the working of standard cost system, coordination of various functions is achieved.

154
 7. Eliminates wastes. By fixing standard, certain waste such as material wastage, idle
time, lost machine hours, etc. are reduced,
8. Valuation of stocks. Standard costing simplifies the valuation of stock because the
stock is valued at standard cost. The difference between standard and actual cost is
transferred to a variance account. This ensures uniform pricing of stocks in the form of
raw materials, work-in-progress and finished goods.
9. Management by exception. Reporting of variances is based on the principle of
management by exception. Only variances beyond a predetermined limit may be
considered by the management for corrective action. This also reduces the cost of
preparing reports. ,
10.Economical and simple. Standard costing is an economical and simple means of
cost accounting
and generally results in savings in the cost of costing system. It results in reduction in
paper work
in accounting and needs fewer number of forms and records. This leads to considerable
saving in
clerical labour.

LIMITATIONS OF STANDARD COSTING

Standard costing system may suffer from certain disadvantages. This may be because of
lack of education and communication and resultant misunderstanding on the part of
managerial staff. Possible disadvantages are :
1. The system may not be appropriate to the business.

2. The staff may not be capable of operating the system.

3. A business may not be able to keep standards up-to-date. In other words, a
business may not revise standards to keep pace with the frequent changes in
manufacturing conditions. Firms may avoid revising standards as it is a costly
affair.
4. Inaccurate and unreliable standards cause misleading results and thus may not
enjoy the confidence of the users of the system.
5. Operation of the standard costing system is a costly affair and small firms cannot
afford it.
155
 6. Standard costing is expensive and unsuitable in job order industries which are
manufacturing non-standardised products.

PRELIMINARIES IN ESTABLISHING A SYSTEM OF STANDARD

COSTING

In establishing a system of standard costing, there are a number of preliminaries to be

considered. These are as follows :

ESTABLISHMENT OF COST CENTRES

The first step in the establishment of a system of standard costing is the establishment
of cost centers with clearly defined areas of responsibility. In this context it may be noted
that in establishing ::' centres, there should be no doubt about the responsibility of each
cost centre so that in case of ::": standard performance, responsibility may be identified.

CLASSIFICATION OF ACCOUNTS

Accounts are classified according to the purpose in hand. Classification may be by

function, revenue item, etc. For speedy collection and analysis of accounts, codes and
symbols may re used.

156
 VARIANCE ANALYSIS

Cost Variance-Difference between standard and actual is known as variance. Cost variance is
the "difference between a standard cost and the comparable actual cost incurred during a
period." C.I.M.A., London.
Variance analysis is the process of analysing variances by sub-dividing the total variance in
such a way that management can assign responsibility for any off standard performance.
According to C.I.M.A., London, Terminology, variance analysis is "the process of computing the
amount of variance and isolating the causes of variance between actual and standard." An
important aspect of variance analysis is the need to separate controllable from uncontrollable
variances. A detailed analysis of controllable variances will help the management to identify the
persons responsible for its occurrence so that corrective action can be taken.

FAVOURABLE AND UNFAVORABLE VARIANCES

Where the actual cost is less than standard cost, it is known as 'favourable'' or lcredit' variance.
On the~ other hand, where the actual cost is more than standard cost, the difference is referred to
as 'unfayourable\ 'adverse' or 'debit' variance.
In other words, any variance that has a favourable effect on profit is favourable variance and
any variance which has an adverse or unfavourable effect on profit is unfavourable variance.
Many students experience difficulty in ascertaining whether a variance is favourable or
adverse. In the formulae given in this book, positive (+) variance will indicate favourable
variance and negative (-) variance will indicate adverse variance. Favourable variances will be
designated by (F) and Adverse by (A).

CONTROLLABLE AND UNCONTROLLABLE VARIANCES '

If a variance can be regarded as the responsibility of a particular person, with the result that
his degree of efficiency can be reflected in its size, then it is said to be a controllable variance.
For example, excess usage of material is usually the responsibility of the foreman concerned.
However, if the excessive usage is due to material being defective, the responsibility may rest
with the Inspection Department for non-detection of the defects.
If a variance arises due to certain factors beyond the control of management, it is known as
uncontrollable variance. For example, change in the market prices of materials, general increase
in the labour rates, increase in the rates of power or insurance premium, etc. are not within the
control of the management of the company. Responsibility for uncontrollable variances cannot
157
be assigned to any person or department.
The division of variances into controllable and uncontrollable is extremely important. The
management should place more emphasis on controllable variance as it is these variances which
require investigation and possibly corrective action. The uncontrollable variances, on the other
hand. may be ignored. This follows the well known "principle of exception" whereby those
matters which are going right are ignored and any deviations from efficient performance are
investigated.

METHODS VARIANCE

While setting standards, specific methods of production are kept in view. If, for some reason
or the other, a different method of production is adopted, it will give rise to a different amount of
cost, thereby resulting in a variance. Such a variance is known as methods variance. Thus a
methods variance arises due to the use of methods other than those specified. According to
C.I.M.A., London Terminology, methods variance is "the difference between the standard cost
of a product or operation produced or performed by the normal method and the standard cost of
a product or operation produced or performed by the alternative method actually employed."

REVISION VARIANCE

After setting standards, sometimes standard cost has to be revised on account of unavoidable
changes in prices of various factors like wages, materials etc. The standard costs once set are not
disturbed every now and then to account for these uncontrollable factors. Rather a revision
variance is created and the basic standard cost is allowed to stand. This revision variance is the
difference between the standard cost originally set and the revised standard cost.

Thus :

Revision 1 Original standard _ Revised standard

variance " cost of actual output cost of actual output

Creation of revision variance is only an interim adjustment which allows the standard costing
system to operate usefully even when there are changes in standard costs.

158
MATERIAL VARIANCES

Material Cost Variance

This is the difference between the standard st of direct materials specified for the output
achieved and the actual cost of direct materials used. It is calculated as :

Material Cost Variance = Standard cost of actual output - Actual cost

MCV = SC - AC

Standard quantity Standard Actual Actual

Or Material Cost Variance = x - x
for actual output price quantity price
MCV = (SQ x SP) - (AQ x AP)

159
Example
A furniture company uses sunmica tops for tables. It provides the following data :
Standard quantity of sunmica per table 4 sq. ft.
Standard price per sq. ft. of sunmica Rs. 5
Actual production of tables 1,000
Sunmica actually used 4,300 sq. ft.
Actual purchase price of sunmica per sq. ft. Rs. 5.50 Material cost variance will be
calculated as under : MCV = (SQ x SP) - (AQ x AP) MCV = (1,000 x 4 x RS. 5) - (4,300 x
Rs. 5.50) = 20,000 - 23,650 = 3,650 (A) The material cost variance may be further divided
into price variance and usage variance.

Material Price Variance

This is "that portion of the material cost variance which is due to the difference between the
standard price specified and the actual price paid".* It is calculated by the following formula :

Material Price Variance = (Standard price - Actual price) x Actual quantity

MPV = (SP - AP) x AQ

Thus, this is the difference between standard price and actual price multiplied by actual
quantity.

Example

With the figures in Example given above, the material price variance will be calculated as
follows : MPV = (SP - AP) x AQ MPV = (5 - 5.50) x 4,300 = Rs. 2,150 (A)

Reasons for Material price Variance. This variance usually arises due to the following
reasons :
1. Change in the market prices of materials.
2. Failure to purchase the specified quality, thereby resulting in a different price being paid.
3. Change in the quantity of materials, purchased, thereby leading to lower/higher quantity
discount.
4. Not availing cash discounts, when standards set took into account such discounts.
5. Inefficient purchasing.
6. Change in the delivery costs.
7. Rush purchases.
160
 8. Purchase of a substitute material on account of non-availability of the material specified.
9. Change in the rates of excise duty, purchase tax, etc. 10. Off-season
purchasing for certain seasonal products like jute, cotton, etc.

Material Usage (or Quantity) Variance

This is "that portion of the material cost variance which is due to the difference between the
standard quantity specified and the actual quantity used'''. Its formula is :

Standard quantity Actual Standard

Material Usage Variance - - x
for actual output quantity price
MUV = (SQ-AQ) x SP

Thus, this is the difference between standard quantity and actual quantity multiplied by the
standard price.

Example
Continuing example given above, material usage variance will be calculated as under:
MUV = (SQ - AQ) x SP
= (4,000 - 4,300) x 5
= Rs. 1,500 (A)

Reasons for Material Usage Variance. The material usage variance may be caused by some
or all of the following reasons :
1. Use of defective or sub-standard materials.
2. Carelessness in the use of materials.
3. Pilferage.
4. Poor workmanship.
5. Defect in plant and machinery.
6. Change in the design or specification of the product.
7. Change in the quality of materials.
8. Use of substitute materials.
9. Use of non-standard material mixture.
10. Yield from materials in excess of or less than standard yield.

Check

161
 The algebraic sum of material price variance and material usage variance should be equal to
material cost variance. Thus :
MCV = MPV + MUV 3,650 (A) = Rs. 2,150 (A) + Rs. 1,500 (A)
Figure 3.3 shows the graphic analysis of material variances which has been prepared with the
figures of the above example. In this chart, the solid rectangle indicates the standard cost (4,300 x
Rs. 5.50) and the dotted rectangle shows the actual cost (4,300 x Rs. 5.50).

MPV = (Rs. 5 - Rs. 5.50) x 4,300 = Rs. 2,150 (A)

MUV = (4,000 - 4,300) x Rs. 5 = Rs. 1,500 (A)

The difference between the areas of standard cost rectangle and the actual cost rectangle i.e.
shaded area represents material cost variance, which has been analysed into material price
variance and material usage variance. The variances are adverse because the actual cost rectangle
is larger in size than the standard cost rectangle.

Illustration 1

The standard cost card shows the following details relating to material needed to produce 1 kg
of groundnut oil :—
Quantity of groundnut required 3 kg.
Price of groundnut - Rs. 2.50 per kg.
Actual production data :
Production during the month 1,000 kg.
Quantity of material used 3,500 kg.
Price of groundnut Rs. 3 per kg.

Calculate : (a) Material Cost Variance (b) Material Price Variance (c) Material Usage
162
 Variance.
(B.Com. Calicut)

Solution
Basic Data
Standard Quantity (SQ) = 1,000 kg. of production x 3 kg. = 3,000 kg.
Standard Price (SP) = Rs. 2.50 per kg.
Actual quantity (AQ) = 3,500 kg.
Actual price (AP) = Rs. 3 per kg.
Calculation of Variances
(a) Material Cost Variance = SC-AC
= (SQ x SP) - (AQ x AP)
= (3,000 x 2.50) - (3,500 x 3) = Rs. 3,000 (A)
(b)Material Price Variance = (SP - AP) x AQ
= (2,50 - 3) x 3,500 = Rs. 1,750 (A)
(c) Material Usage Variance = (SQ - AQ) x SP
= (3,000 - 3,500) x 2.50 = Rs. 1,250(A)
Check
Material Cost Variance = Price Variance + Usage Variance
3,000 (A) = 1,750 (A) + 1,250(A)

Classification of Material Usages Variance

Material usage variance is further sub-divided into :

(a) Material mix variance
(b) Material yield variance. (Or Material sub-usage variance)

Material Mix Variance

This is sub-variance of material usage variance. It arises only where more than one type of
material is used for producing the finished product. A company may be using a mixture of
materials which does not comply with the predetermined standard mixture. This gives rise to
material mix variance.
The material mix variance is defined as that portion of the material usage variance which is
due to the difference between standard and actual composition of materials. It may arise in
industries like chemicals, rubber, etc. where a number of raw materials are mixed to produce a
163
final product. Change from the standard mix may be due to non-availability of one or more
components of the mix or due in non-purchase of materials at proper time. Increase in the
proportion of cheaper materials results - favourable mix variance and vice versa, the use of more
expensive materials in larger proportion results in adverse variance.
This variance is calculated with the help of the following formula :
Revised standard Actual Standard
Material mix variance = - x
quantity quantity price
MMV = (RSQ - AQ) x SP

The revised standard quantity is nothing but the standard proportion of total of actual
quantities of all the materials. This is calculated as under :

Standard quantity of one material Total of actual quantities

x
Total of standard quantities of all materials of all materials

illustration .2

From the following data, calculate material mix variance. Also calculate price and usage
variances.
Raw material Standard Actual

X 40 units @ Rs. 50 per unit 50 units @ Rs. 50 per unit

Y 60 units @ Rs. 40 per unit 60 units @ Rs. 45 per unit
Total 100 units 110 units

Solution

Calculation of Revised Standard Quantity (RSQ).

RSQ of X = 40 x 110 = 44 units

100
RSQ of Y = 60 x 110 = 6 6 units
100

Material Mix Variance = (RSQ - AQ) x SP

Material X = (44 - 50) x 50 = Rs. 300 (A)
Material Y = (66 - 60) x 40 = Rs. 240 (F)
164
 MMV = Rs. 60 (A)

Material Price Variance = (SP - AP) x AQ

Material Y = (50 - 50) x 50 = Nil
Material Y = (40 - 45) x 60 = Rs. 300 (A)
MPV = Rs. 300 (A)

Material Usage Variance = (SQ - AQ) x SP

Material X = (40 - 50) x 50 = Rs. 500 (A)
Material Y = (60 - 60) x 40 = Nil
MUV = Rs, 500 (A)

Material Sub-usage (or Material Revised Usage) Variance

This is a sub-variance of the material usage variance and represents that portion of the
material usage variance which is attributed to reasons other than those which give rise to
material mix variance. Thus the algebraic sum of this revised usage variance and material mix
variance is equal to material usage variance. Its formula is :

Material revised Standard Revised standard

— x Standard price
usage variance quantity quantity

MRUV = (SQ - RSQ) x SP In Illustration 12.2 material revised usage variance

is calculated as follows : MRUV = (SQ - RSQ) x SP
X = (40 - 44) x 50 = Rs. 200 (A)
Y = (60 - 66) x 40 = Rs. 240 (A)
MRUV = Rs. 440 (A)
Check
MUV = MMV + MRUV
500(A) = 60 (A) + 440 (A)

Material Yield Variance

165
 This is also a sub-variance of material usage variance. It arises in process industries, like
chemicals, where loss of materials in production is inevitable. While setting standards, the normal
or standard loss is taken into account. But actual loss may differ from normal or standard loss.
This results in actual yield or output being different from standard yield.

Thus material yield variance is that portion of the material usage variance which is due to the
difference between standard yield specified and actual yield obtained. The standard yield is the
output expected to be obtained from the actual usage of raw materials. It should be noted that
yield variance as used in standard costing is the same thing as abnormal loss or abnormal gain in
the other costing systems.
One important feature of yield variance which differentiates it from other material variances
(price, usage and mix variances) is that yield variance is an output variance while others are
input variances. In other words, yield variance represents a gain or loss on output in terms of
finished production, while other variances represent a gain or loss on the cost of material input.
Its formula is as follows :

Material Yield Actual Standard Standard

— x
Variance yield yield output price

MYV =(AY-SY) x SOP

Standard output price (SOP) is the standard material cost per unit of output.
Illustration .3
During the month of May, the following data applies:

Raw material Standard mix Actual mix

Units Kg Price Amount Units Price Amount
Rs. Rs. Kg. Rs. Rs.
X 60 25 1,500 56 25 1,400
Y 40 50 2,000 44 50 2,200

Total Less: 100 3,500 100 3,600

Loss 30 26

Yield 70 74

The standard loss is 30%. Calculate:

166
 (a) Material yield variance (b) Material mix variance.

Solution
(a) Material Yield Variance (AY- SY) x SOP
MYV = (74 - 70) x 50* = Rs. 200 (F) *Standard
material cost per unit of output is calculated as follows :

SOP = Standard material cost = Rs. 3,500 = Rs. 50

Standard output 70
(b) Material Mix Variance = (RSQ - AQ) * SP
Material X = (60 - 56) x 25 = Rs. 100 (F)
Material Y = (40 -44) x 50 =Rs. 200 (A)
MMV = Rs. 100 (A)

Note. In this case, standard quantity and revised standard quantity (RSQ) is the same because
total actual quantity of all the materials and total standard quantity is the same, i.e., 100 units.

167
Illustration 4

The standard mix to produce one unit of product is as follows:

Material A 60 units @ Rs. 15 per unit = 900
Material B 80 units @ Rs. 20 per unit = 1,600
Material C 100 units @ Rs. 25 per unit = 2,500
240 units 5,000

During the month of July, 10 units were actually produced and consumption was
as follows:

Material A 640 units @ Rs. 17.50 per unit = 11,200

Material B 950 units @ Rs. 18.00 per unit = 17,100
Material C 870 units @ Rs. 27.50 per unit = 23,925
2460 units 52,225

Calculate all material variances.

Solution
Material Standard for 10 units Actual for 10 units

Qty- Rate Amt. Rs. Qty- Rate Amt.

units Rs. Units Rs. Rs.
A 600 15 9,000 20 640 17.50 11,200
B 800 16,000 25 950 18.00 17,100
C 1,000 25,000 870 27.50 23,925

Total 2,400 50,000 2,460 52,225

1. Material Cost Variance = Standard cost - Actual cost

= Rs. 50,000 - Rs. 52,225 (A)
MCV = Rs. 2,225(A)
2. Material Price Variance = (St. Price - Actual Price) x Actual Qty.
Material A = (15 - 17.50) x 640 = Rs. 1,600 (A)
Material B = (20 - 18) x 950 = Rs. 1,900 (F)
Material C = (25 - 27.50) x 870 = Rs. 2,175 (A)
MPV = Rs. 1,875 (A)

168
 3. Material Usage Variance= (St.Qty. - Actual Qty.) x St. Price
Material A = (600 - 640) x 15 = Rs. 600 (A)
Material B = (800 - 950) x 20 = Rs. 3,000 (A)
Material C = (1,000 - 870) x 25 = Rs. 3,250 (F)
MUV =Rs. 350 (A)

4. Material Mix Variance = (Revised St. Qty. - Actual Qty.) x St. Price
Material A = (615* - 640) x 15 = Rs. 375 (A)
Material 5 = (820* - 950) x 20 = Rs. 2,600 (A)
Material C = (1,025* - 870) x 25 = Rs. 3,875 (F)
MMV = Rs. 900 (F)
•Revised Standard Quantity (RSQ) is calculated as follows:

Material A =
2460 X 600 = 615 units
2400
Materials B = 2460 x 800 = 820 units
2400
Material C = 2460
x 1,000 = 1,025 units
2400
5. Material Yield Variance

For yield variance, certain basic calculations have to be made as follows:

Actual usage of materials 2460
Standard yield = = = 10.25 units
standard usage per unit of output 240
SOP (St. material cost per unit of output) = Rs. 50,000 / 10 units = Rs. 5,000 Material
Yield Variance = (AY- SY) x SOP
MYV = (10 - 10.25) x 5,000 = Rs. 1,250(A)

Material Revised Usage (or Sub-usage) Variance (MRUV)

= (Standard Quantity - Revised Standard Quantity) x Standard Price
Material A = (600 - 615) x 15 = Rs. 225(A)
Material B = (800 - 820) x 20 = Rs. 400(A)
Material C = (1,000 - 1,025) x 25 = Rs. 625(A)
MRUV =Rs. l,250(A)
Note. Either MYV or MRUV is calculated. These two are always equal.
Check
169
 (i) MUV = MMV + MYV (Or MRUV)
Rs. 350 (A) = Rs. 900 (F) + Rs. 1,250 (A)
or
(ii) MCV = MPV + MMV + MYV (Or MRUV)
Rs. 2,225 (A) = Rs. 1,875 (A) + Rs. 900 (F) + Rs. 1,250 (A)

LABOUR VARIANCES
The analysis and computation of labour variances is quite similar to material variances.
Labour Cost Variance
This is the difference between the standard direct labour cost specified for the activity
achieved and the actual direct labour cost incurred. It is calculated as under:

St. labour cost Actual labour

Labour Cost Variance = of actual output cost

LCV = SC-AC

Or,

St.hours St rate Actual Actual rate

Labour Cost Variance = x — x
for actual output per hour hours per hour

LCV = (SH x SR) - (AH x AR)

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Example

The following information is given :

Standard hours per unit 15
Standard rate Rs. 4 per hour
Actual data:
Actual production 1,000 units
Actual hours 15,300 hours
Actual rate Rs. 3.90 per hour
Calculate labour cost variance.

Solution
Labour Cost Variance = (SH for actual output x SR) - (AH x AR)
= (1,000 x 15 x 4) - (15,300 x 3.90)
LCV = Rs. 330 (F)
Labour cost variance is further divided into rate variance and efficiency variance.

Labour Rate Variance.

This is that portion of the labour cost variance which is due to the difference between
the standard rate specified and the actual rate paid. Its formula is:
Labour Rate Variance = (Standard rate - Actual rate) x Actual hours
LRV = (SR - AR) x AH
Thus this is the difference between standard and actual rates of wages, multiplied by
actual account
Example
Using the data given in above example :
LRV = (SR- AR) x AH
= (4 - 3.90) x 15,300 = Rs. 1,530 (F)

Reasons for labour rate variance. Usual reasons are :

1. Change in the basic wage rates.
2. Use of a different method of wage payment.
171
 3. Employing workers of grades different from the standard grades specified.
4. Unscheduled overtime.
5. New workers not being paid at full rates.

Often, labour rate variance will be an uncontrollable variance as labour rates are
usually determined by demand and supply conditions in the labour market, backed by
negotiable strength of the rate union. Where this variance is due to the use of a grade of
labour other than that specified will be such acceptable explanations as non-availability
of the labour grade specified but foreman carelessly employs a wrong grade of labour on
a job, he may be held responsible

Labour Time (or Efficiency) Variance

This is that portion of the labour cost variance which is due to the difference between
labour time specified for actual output and the actual labour hours expended. This
variance is calculated as follows :
St. hours for Actual
Labour Efficiency Variance = - x Standard rate
actual output hours
LEV = (SH -AH) x SR
Thus this variance is the difference between standard and actual time valued at
standard rate.

Example

Using the data given in above example

LEV = {SH for actual output - AH) x SR
= (15,000 - 15,300) x 4 - Rs. 1,200 (A)
The total of labour rate variance and labour efficiency variance is equal to labour cost
variance.
Thus: LCV = LRV+LEV

Rs. 330 (F) = Rs. 1,530 (F) + Rs. 1,200 (A).

Reasons for labour efficiency variance. This variance is usually caused by one or more
of the following reasons :
1. Poor working conditions, e.g., inadequate lighting and ventilation, excessive
heating, etc.

172
 2. Defective tools and plant and machinery.
3. Inefficient workers.
4. Incompetent supervision.
5. Use of defective or non-standard materials.
6. Time wasted by factors like waiting for materials, tools or machine
break-down, etc.
7.Insufficient training of workers.
8. Change in the method of operation.
9. Non-standard grade of workers.

Classification of Labour Efficiency Variance

Labour efficiency variance is further divided into the following sub-variances.

a) Idle time variance

b) Labour mix variance

c) Labour Yield Variance (or Labour revised-efficiency variance)

Idle Time Variance

this variance represents that portion of the labour efficiency variance which is due to
abnormal idle time such as time lost due to machine break-down, power failure, strike,
etc. It is calculated by calculating idle hours at standard rate. Thus:

Idle Time Variance = Idle hours x Standard rate

ITV = IH x SR

As idle hours represent a loss, idle time variance is always unfavorable

Some accountants do not treat Idle Time Variance as a part of labour efficiency
variance but treat as apart of labour cost variance.

173
Example

Using the data give in the above example and further assuming that idle time is
200 hours, then the idle time variance would be:
ITV = 200 x 4 = Rs. 800 (A)
When idle time variance is treated as a sub-variance of labour cost variance and not of
labour efficiency variance, then for labour efficiency variance, the actual time would
be 15,300 - 200 = 15,100 hours. Labour efficiency variance will be calculated on the
basis of 15,100 hours. Thus
Labour Efficiency Variance = (SH - AH) x SR
= (15,000 - 15,100) x 4 = Rs. 400 (A)
In this case, the total of Labour Rate Variance, Labour Efficiency Variance and Idle
Time variance would be equal to Labour Cost Variance. Thus
LCV = LRV + LEV + ITV 330 (F)
= 1,530 (F) + 400 (A) + 800 (A)

Labour Mix Variance (Gang Composition Variance)

This variance is similar to material mix variance. It arises only when more than
one grad of workers are employed and the composition of actual grade of workers
differ from those specified. It is calculated with the help of following formula :

Labour Mix Variance= Revised standard Actual x Standard rate

Hours hours

I
LMV = (RSH - AH) x SR

Illustration 5

Coates India Ltd. manufactures a particular product, the standard direct labour cost
of which is Rs. 120 per unit whose manufacture involves the following :

Grade of Hours Rate Amount

workers__________________________ Rs._________Rs._____
A 30 2 60
B 20 3 60
50 120
174
 During a period, 100 units of the product were produced, the actual labour cost of
which was as follows:
Grade of Hours Rate Amount
_____workers____________________________Rsr________Rs._____
A 3,200 1.50 .4,800
B 1.900 4.00 7,600

5.100 12.400

Calculated (a) Labour Cost Variance (b) Labour Rate Variance

(c) Labour Efficiency Variance (d) Labour Mix Variance.
Solutation

Grade of Standard for 100 units Actual for 100 units

worker Hours Rate Amt. Hours Rate Amt.
Rs. Rs. Rs. Rs.
A 3,000 2 6,000 3,200 1.50 4,800
B 2,000 3 6,000 1.900 4.00 7,600

Total 5,000 12,000 5,100 12,400

(a) Labour Cost Variance = SC - AC

LCV = 12,000 - 12,400 = Rs.400 (A)
(b) Labour Rate Variance = (SR - AR) x AH
A = (2 - 1.50) x 3,200 = Rs. 1,600 (F)
B = (3 - 4.00) x 1,900 = Rs. 1,900 (A)
LRV = Rs. 300 (A)

(c) Labour Efficiency Variance = (SH - AH) x SR

A = (3,000 - 3,200) x 2 = Rs. 400 (A)
B = (2,000 - 1,900) x 3 = Rs. 300 (F)
LEV= Rs. 100 (A)
Check LCV = LRV + LEV
400 (A) = 300(A) + 100(A)
(d) Labour Mix Variance = (RSH* - AH) x SR
A = (3,060 - 3,200) x 2 = Rs. 280 (A)
B = (2,040 - 1,900) x 3 = Rs. 420 (F)
175
 LMV = Rs. 140 (F)

Calculation of Revised Standard Hours (RSH)

St. hours of the grade

RSH = x Total actual hours
Total st. hours

Grade A= 3000 x 5100 = 3,060 hrs. Grade B = 2000 x 5,100 = 2,040 hrs.
5,000 5,000
Labour Revised Efficiency Variance. (Or Labour Sub-efficiency Variance) This is
similar to material Revised Usage Variance and is a sub-variance of labour efficiency
variance. It arises due to factors other than those which give rise to idle time variance
and labour mix variance. Thus, these issues of labour efficiency variance left after
idle time and mix variance have been separated. Its formula is :

Labour Revised Efficiency Variance =

LREV •= (SH -RSH) x SR
Example

Using the data given in Illustration 12.5.

Labour Revised Efficiency Variance = (SH - RSH) x SR
Grade A = (3,000 - 3,060) x 2 = Rs.120 (A)
Grade B = (2,000 - 2,040) x 3 = Rs.120 (A)
LREV = Rs.240 (A)
Check
LEV = LMV + LREV
Rs. 100(A) = Rs. 140 (F) + Rs. 240 (A)
Labour Yield Variance. This is quite similar to Material Yield Variance. This
variance reveals thf effect on labour cost of actual output or yield being more or less
than the standard yield. Its formula +is:

Labour Yield Variance =

Illustration .6

Standard output 500 units.

Actual output 450 units.
Standard time 1000 hrs.

176
 Standard rate Rs. 20 per
hour.
Calculate Labour Yield Variance

Solution

St. time per unit = 1000 hrs + 500 units = 2 hrs.

St. cost per unit = 2 hrs @ 20 = Rs. 40.

Labour Yield Variance =

= (450 - 500) x RS. 40 = Rs. 2,000 (A)
Illustration 7
The standard labour employment and the actual labour engaged in a week for a job
are as under
Skilled Semi-skilled Unskilled
workers workers workers
Standard no. of workers in the gang 32 12 6
Actual no. of workers employed 28 18 4
Standard wage rate per hour 3 2 1
Actual wage rate per hour 4 3 2
During the 40 hours working week, the gang produced 1,800 standard labour hours
of wen Calculate :
(a) Labour Cost Variance (b) Labour Rate Variance
(c) Labour Efficiency Variance (d) Labour Mix Variance

(e) Labour Yield Variance

(B. Com Hons Delhi)

Solution

Standard Actual

Category of Hrs.* Rate Amoun Hrs,* Rate Amoun

workers Rs. t Rs. Rs. t Rs.
Skilled 1,280 3 3,840 1,120 4 4,480
Semi-skilled 480 2 960 720 3 2,160
JJnskilled 240 1 240 160 2 320

177
 2,000 5,040 2,000 6,960

*Hrs. = No. of workers x 40 hours.

Rs. 5,040

St. cost of actual output 2000hrs 1,800 hrs. = Rs. 4,536

Labour Cost Variance = St. cost of actual output - Actual cost
LCV = Rs. 4,536 - 6,960 = Rs. 2,424 (A)
Labour Rate Variance = (SR - AR) x AH
Skilled = (3 - 4) x 1,120 = Rs. 1,120 (A)
Semi-skilled = (2 - 3)',* 720 = Rs. 720 (A)
unskilled = (1 - 2) x 160 = Rs. 160 (A)
LRV = Rs. 2,000 (A)
Labour Efficiency Variance= (*SH for actual output - AH) x SR
Skilled = (1,152 - 1,120) x 3 = RS. 96(F)
Semi-skilled = (432 - 720) x 2 = Rs. 576 (A)
Unskilled = (216 - 260) x 1 = Rs. 56 (F)
LEV = Rs. 424 (A)
•St hrs. for actual output are calculated as follows :
1800
1,800 Skilled = 2000 x1.280 =1,152 hrs.
1800
1,800 Semi-skilled = 2000 x 480 = 432 hrs.
1800
1,800 Unskilled = X 240
2000 =216 hrs.

labour Mix Variance = (Revised st. hrs. - AH) x SR.

Skilled = (1,280 - 1,120) x 3 = Rs. 480 (F)
Semi-skilled = (480 - 720) x 2 = Rs. 480(A)

Unskilled = (240 - 160) x l = Rs. 80 (F)

LMV = Rs. 80 (F)

Labour Yield Variance

Check
(i) LCV= LRV + LEV
Rs. 2,424 (A) = Rs. 2,000 (A) + Rs. 424 (A)
(ii) LEV= LMV + LYV
Rs. 424 (A) = Rs. 80 (F) + Rs. 504 (A)
178
 SUMMARY OF FORMULAE

Material Variances
(i) Material Cost Variance = St. cost of actual output - Actual cost
= (St. qty. for actual output x St. price) - (Actual qty. x Actual price)
(ii) Material Price Variance = (St. price - Actual price) x Actual qty.
(iii) Material Usage Variance = (SQ for actual output - Actual qty.) x St.
price
(iv) Material Mix Variance = (Revised SQ - Actual qty.) x St. price
(v) Material Yield Variance = (Actual yield - St. yield) x St. output price
(vi) Material Revised Usage Variance = (SQ. for actual output - Revised SQ.)
x St. price
Labour Variances
(i) Labour Cost Variance = St. cost of actual output - Actual cost
= (St. hrs. for actual output x St. rate) - (Actual hours x Actual rate)
(ii) Labour Rate Variance = (St. rate - Actual rate) x Actual hours
(iii)Labour Efficiency Variance = (St. hrs. for actual output – Actual hrs.) x St.
rate
(iv)Idle Time Variance = Idle hours x Standard rate
(v) Labour Mix Variance = (Revised st. hours - Actual hours) x St. rate.
(vi) Labour Yield Variance
= (Actual yield - St. yield for actual hours) x St. cost per unit of output
(vii) Labour Revised Efficiency Variance
= (St. hours for actual output - Revised standard hours) x Standard rate

179
Problem .1 (Material Variances)
From the following particulars, compute:
(a) Material cost variance, (b) Material price variance, and (c) Material usage variance
Quantity of materials purchased 3,000 units
Value of materials purchased Rs. 9,000
Standard quantity of materials required per ton of output 30 units
Standard price of material Rs. 2.50 per unit
Opening stock of materials Nil
Closing stock of materials 500 units
Output during the period 80 tons
Solution
Basic calculations:
Actual quantity of material purchased = 3,000 units
Value of materials purchased = Rs. 9,000
Actual price per unit =Rs. 9,000 = Rs. 3 per unit
3,000 units

Standard price = 2.50 per unit

Standard quantity = 80 tons x 30 units = 2,400 units
-Actual quantity = Opening stock + Purchase - Closing stock
= Nil + 3,000 - 500 = 2,500 units Calculation
of variances
(a) Material Cost Variance = SC - AC
= (SQ x SP) - {AQ x AP)
= (2,400 x 2.50) - (2,500 x 3.00)
MCV = Rs. 1,500 (A)
(b) Material Price Variance = (SP - AP) x AQ
= (2.50 - 3.00) x 2,500
MPV = Rs. 1,250 (A)

(c) Material Usage Variance = (SQ - AQ) x SP

= (2,400 - 2,500) x 2.50
MUV = Rs. 250 (A)

180
Check
MCV = MPV + MUV
Rs. 1,500 (A) = Rs. 1,250 (A)+ Rs. 250 (A)
Rs. 1,500 (A) = Rs. 1,500 (A)

Problem .2 (Material Variances)

A manufacturing concern which has adopted standard costing furnishes the following
information

Standard :
Material for 70 kg finished products 100 kg
Price of material Re. 1 per kg
Actual :
Output 2,10,000 kg
Material used 2,80,000 kg
Cost of materials. Rs. 2,52,000
Calculate :
(a) Material usage variance, (b) Material price variance, (c) Material cost variance.
Solution

Standard Quantity (SQ) for actual output = 2,10,000 kg x 100 kg = 3,00,000 kg

70 kg
Actual Quantity (AQ) = 2,80,000 kg
Standard Price (SP) = Re. 1 per kg
Actual Price (AP) = (Rs. 2,52,000 t 2,80,000 kg) = Re 0.90 per kg.
(a) Material Usage Variance = (SQ - AQ) x SP
= (3,00,000 - 2,80,000 kg.) x 1 = Rs. 20,000 (F)
(b)Material Price Variance = (SP - AP) x AQ
= (1 - 0.90) x 2,80,000 = Rs. 28,000 (F)
(c) Material Cost Variance = (SQ x SP) - (AQ x AP)
= (3,00,000 x l) - (2,80,000 x 0.90) = Rs. 48,000 (F)

Check MCV Rs. 48,000 (F)

181
 MPV Rs. 28,000 (F) MUV Rs. 20,000 (F)

Problem .3 (Material Variances)

For making 10 kg. of gemco, the standard material requirement is :-

Material Quantity (kg.) Rate per kg. (Rs.)
A 8 6.00
B 4 4.00
During April, 1,000 kg. of Gemco were produced. The actual consumption of materials
is as under:
Material Quantity (kg.) Rate per kg. (Rs.)
A 750 7.00
B 500 5.00
Calculate (a) Material Cost Variance; (b) Material Price Variance; (c) Material usage
Variance.

Solution

Basic calculations

Standard for 1000 kg. Actual for 1000 kg.

Qty- Rate Amount Qty Rate Amount
A Kg. Rs. Rs. Kg- Rs. Rs.
B 800 6 4,800 750 75 5.250
Total 1,200
400 4 6,400
1,600 1,250
500 7,750

Calculation of Variances
(a) Material Cost Variance = SC for actual output -AC
MCV =6,400-7,750 = Rs. 1,350 (A)

(b) Material Price Variance = (SP - AP) * AQ

A = (6 - 7) x 750 = Rs. 750 (A)
B = (4 - 5) x 500 = Rs. 500 (A)

182
 MPV = Rs. 1,250 (A)
(c) Material Usage Variance = (SQ - AQ) * SP
A = (800 - 750) x 6 = Rs. 300 (F)
B = (400 - 500) x 4 = Rs. 400 (A)
MUV = Rs. 100 (A)
Check
MCV Rs. 1,350 (A)

MPV Rs. 1,250 (A) MUV Rs. 100 (A)

Problem .4 (Material Variances)

From the following information compute :

(a) Mix, (b) Price, and (c) Usage variances:

Standard Actual
Quantit Unit Total Quantit Unit Total
y (kg-) price y (kg.) price
Material A 4 Rs. Rs. 2 Rs. Rs.
1.00 4.00 1 3.50 7.00
Material B 2 2.00 4.00 3 2.00 2.00
Material C 2 4.00 8.00 3.00 9.00
Total 8 2.00 16.00 6 3.00 18.00

183
Solution

Material Price Variance = (SP - AP) x AQ

Material A = (1 - 3.50) x 2 Rs. 5 (A)
Material B = (2 - 2) x 1 = Nil Material C
= (4 - 3) x 3 = Rs. 3 (F)
MPV = Rs. 2 (A)
Material Usage Variance = (SQ - AQ) x SP
Materials = (4 - 2) x 1 = Rs.2(F)
Material B = (2 - 1) x 2 = Rs.2 (F)
Material C = (2 - 3) x 4 = Rs.4 (A)
MUV = Nil
Material Mix Variance = (Revised SQ - AQ) x SP
Material A = (3 * - 2) x 1 = Re.[(F)
Materials = (1.5 * - 1) x 2 = Re.1(F)
Material C = (1.5 * - 3) x 4 = Rs.6 (A)
MMV = Rs. 4 (A)

* Revised standard quantity is calculated as follows:

Standard quantity of material item x Total actual quantity

Total standard quantity

Material A = 4 x 6 = 3 kg. Material B = 2 x 6 = 1.5 kg.

8 8
Material C = 2 x 6 = 1.5 kg
8

Problem 5 (Material Variances)

The standard cost of a chemical mixture is as follows:

40% material A at Rs. 20 per kg

60% material B at Rs. 30 per kg

A standard loss of 10% of input is expected in production. The cost records for a
period showed the following usage:
90 kg material A at a cost of Rs. 18 per kg

184
 110 kg material B at a cost of Rs. 34 per kg
The quantity produced was 182 kg of good product.
Calculate all material variances.
Solution

Basic calculations:

Material Standard for 180 kg. output Actual fo 182 output

Qty. Rate Ami, Qty- r Rate
kg. Ami.
kg. Rs. 20 Rs. 1,600 Rs. Rs.
A 80 80 230 3,600 kg. 18 1,620
B 120 0 90
110
Total 20 _ 5,200 200 5,360
Less: 0 18
Loss 180
20 5,200 182 5,360

St. cost of actual output = Rs. 5,200 x 182 = Rs. 5,257.78

180
Calculation of Variances
1. Material Cost Variance = (SC of actual output - AC)
= (5,257.78 - 5,360) = Rs. 102.22 (A)
2. Material Price Variance = (SP - AP) x AQ
Material A = (20 - 18) x 90 = Rs. 180 (F)
Material B = (30 - 34) x 110 = Rs. 440 (A)
MPV = Rs. 260 (A)

3. Material Usage Variance = (SQ for actual output - AQ) x SP

Material A = 80 x 182 -90 x 20 = Rs. 182.22 (A)
180
Material B = 120 x 182 -110 x 20 = Rs. 182.22 (A)
180
MUV = Rs. 157.78 (F)
4. Material Mix Variance = (Revised SQ - A) x SP
Material A = (80 - 90) x 20 = Rs. 200 (A)
Material B = (120 - 110) x 30 = Rs. 300 (F)
185
 MMV = Rs. 100 (F)

5. Material Yield Variance = (AY - SY) x St. material cost per unit of output
MYV = (182 - 180) x 5,200 = Rs.57.78 (F)
180
Check
MCV Rs. 102.22 (A)

MPV Rs. 260 (A) MUV Rs. 157.78 (F)

MMV Rs. 100 (F) MYV Rs. 57.78 (F)

Problem .6 (Material Variances)

The standard material cost to produce one tonne of chemical X is :

300 kg. of material A @ Rs. 10 per kg.

400 kg. of material B @ Rs. 5 per kg.
500 kg. of material C @ Rs. 6 per kg.
During a period, 100 tonnes of chemical X were produced from the usage of :
35 tonnes of material A at a cost of Rs. 9,000 per tonne
42 tonnes of material B at a cost of Rs. 6,000 per tonne
53 tonnes of material C at a cost of Rs. 7,000 per tonne
Calculate material variances.
Solution
Basic Calculations : Conversion Rate is 1 tonne= 1,000 kg.
Material Standard for 100 tonnes Actual for 100 tonnes
Qty. Rate Amt. Qty- Rate Amt.
Kg. Rs. Rs. Kg. Rs. Rs.
A 30,000 10 . 35,000 9 3,15,000
B 40,000 56 3,00,000 42,000 6 2,52,000
C 50,000 2,00,000 53,000 7 3,71,000
Total 1,20,000 8,00,000
3,00,000 1,30,000 - 9,38,000
Less : Loss 20,000 30,000 -

Output 1,00,000 - 8,00,000 1,00,000 - 9,38,000

Calculation of Variances
186
1. Material Cost Variance = SC of actual output - AC
MCV = 8,00,000 - 9,38,000 = Rs. 1,38,000 (A)
2. Material Price Variance = (SP - AP) x AQ
A = (Rs. 10 - Rs. 9) x 35,000 = Rs.35,000 (F)
B = (Rs. 5 - Rs. 6) x 42,000 = Rs.42,000 (A)
C = (Rs. 6 - Rs. 7) x 53,000 = Rs.53,000 (A)
MPV = Rs.60,000 (A)
3. Material Usage (or Quantity) Variance = (SQ - AQ) x SP
A = (30,000 - 35,000) x Rs.10 = Rs.50,000 (A)
B = (40,000 - 42,000) x Rs. 5 = Rs.10,000 (A)
C = (50,000 - 53,000) x Rs. 6 = Rs. 18,000 (A)
MUV = Rs. 78,000 (A)
4. Material Mix Variance = (Revised SQ* - AQ) x SP
A = (32,500 - 35,000) x 10 = Rs. 25,000 (A)
B = 1,30,000 – 42,000 x 5 = Rs. 6,667 (F)
3
C = 1,62,500 -53,000 x6 = Rs. 7,000 (F)
3
MMV = Rs.11,333 (A)
* Revised Standard Quantity is calculated as follows :
= Total AQ x SQ A = 1,30,000 x 30,000=32,500 kg.
Total SQ 1,20,000
B = 1,30,000 x 40,000 = 1,30,000 kg C = 1,30,000x50,000 =1,62,500kg
1,20,000 3 1,20,000

5. Material Yield Variance (MYV)

= (Actual yield - St. yield) x *St. cost per unit of output
= 100 – 1,300* x 8,000 = Rs. 66,667 (A).
12
*Working Notes:
1. Std. cost per unit of output = Total standard cost = Rs. 8,00,000
Total standard output 100 tonnes

187
 = Rs. 8,000 per tonne
2. Std. yield = Actual output xTotal AQ= 100 Tonnesx1,30,000 = 1,300 tonnes
Total SQ 1,20,000 12
Check
MCVRs 1,38,000 (A)

MPV Rs. 60,000 (A) MUV Rs. 78,000 (A)

MMV Rs. 11,333 (A) MYV Rs. 66,667 (A)

Problem .7 (Material Variances)

80 kgs. of material A at a standard price of Rs. 2 per kg and 40 kgs of material B at a

standard price of Rs. 5 per kg. were to be used to manufacture 100 kgs. of a chemical.
During a month, 70 kgs. of material A priced at Rs. 2.10 per kg. and 50 kgs. of
material B priced at Rs. 4.50 per kg. were actually used and the output of the chemical
was 102 kgs.
Find out the material variances.

Solution

Basic calculations :
St. cost of 100 k. of output Actual cot of 102 kg. of output
Material Qty. Rate Amount Qty- Rate Amount
A kg. Rs. Rs. kg. Rs. Rs.
80 2 160 70 2.10 147
40 5 200 50 4.50 225

120 kg 360 120 kg. 372

188
St. cost of actual output = Rs. 360 x 102 kg = Rs. 367.20
100 kg
St. output price = Rs. 360 + 100 kg = Rs. 3.60

Calculation of Variances
Material Cost Variance = St. cost of actual output - Actual cost
= 367.20 - 372 = Rs. 4.80 (A)
Material Price Variance = (St. price - Actual price) x Actual quantity
A = (2 - 2.10) x 70 = Rs. 7 (A)
B = (5 - 4.50) x 50 = Rs. 25 (F)
MPV =Rs. 18(F)

Material Mix Variance = (Revised St. Qty. - Actual Qty.) x S.P

A = (80 - 70) x 2 = Rs. 20 (F)
B = (40 - 50) x 5 = Rs. 50 (A)
MMV = Rs. 30 (A)

Material Yield Variance = (Actual yield - St. yield) * St. output price
MYV = (102 - 100) x RS. 3.60 = Rs. 7.20 (F)
Note : SQ given is Revised St. Qty because the total of actual quantities of materials
consumed and that of standard quantities is equal.

189
Check
MCV Rs. 4.80 (A)

MPV RS. 18 (F) MUV RS. 22.80 (A)

MMV M, 30 (A) MYV Rs. 7.20 (A)

Problem .8 (Material Variances)
The standard material cost for production of 100 kg. of Chemical D is made up of:
Chemical A 30 kg. @ Rs. 4.00 per kg.
Chemical B 40 kg. @ Rs. 5.00 per kg.
Chemical C 80 kg. @ Rs. 6.00 per kg.
In a batch, 500 kg. of Chemical D was produced from a mix of :
Chemical A 140 kg at a cost of Rs. 588
Chemical B 220 kg at a cost of Rs. 1,056
Chemical C 440 kg at a cost of Rs. 2,860
How do the yield, mix and the price factors contribute to the variance in the actual cost
per 100 per kg. of Chemical D over the standard cost?

Solution

Basic calculations : Variances are calculated for 100 kg. of Chemical D as required.
Material Standard for 100 kg. Actual for 100 kg.
Qty- Rate Amt. Qty- Rate Amt.
Kg. Rs. Rs. Kg. Rs. Rs.
A 30 4 120 28 4.20 117.60
B 40 5 200 44 4.80 211.20
C 80 6 480 88 6.50 572.00
Total 150 800 160 900.80
Actual price per kg A = 588 = Rs. 4.20; B = 1,056 = Rs.4.80 C = 2,860 = Rs. 6.50
140 220 440
Actual quantity per 100 kg Chemical D
A = 140 = 28 kg.; B = 220 - 44 kg.; C = 440 = 88 kg.
5 5 5

190
Calculation of Variances
Material Cost Variance = SC - AC = 800 - 900.80 = Rs. 100.80 (A)
Material Price Variance = (SP - AP) x AQ
A = (4 - 4.20) x 28 = Rs. 5.60 (A)
B = (5 - 4.80) x 44 = Rs. 8.80 (F)
C = (6 - 6.50) x 88 = Rs. 44.00 (A)
MPV = Rs. 40.80 (A)

Material Usage Variance = (SQ – AQ) x SP

A = (30 - 28) x 4 = Rs.8 (F)
B= (40 - 44) x 5 = Rs.20 (A)
C = (80 - 88) x 6 = Rs. 48 (A)
MUV = Rs. 60 (A)
Material Mix Variance = (RSQ - AQ) x SP
A = (32 - 28) x 4 = Rs. 16.00 (F)
B = (42 2 - 44) x 5 = Rs. 6.65 (A)
3
C = (85 1- 88) x 6 = Rs. 16.02(A)
3
MMV = Rs. 6.67 (A) RSQ
(Revised St. Quantity) is computed as below:
A =160 x 30 = 32 kg C = 160 x 80 = 851 kg
150 150 3
B =160 x 4 0 = 4 2 2 kg
150 3

Material Yield Variance= (AY - SY) x St. output price

MYV = (100 - 106 2) x 8 = Rs. 53.33 (A)
3
St. yield = 160 x 100 = 106-2 kg
150 3
St. output price = Rs. 800 ÷ 100 kg. = Rs. 8

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Problem .9 (Material Variances

PK Chemicals Ltd. Manufactures PXE by mixing three raw materials. For each batch of
100 kg. of PXE, 125 kg. of raw materials are used. In March 60 batches are prepared to
produce an output of 5600 kg of PXE. The standard and actual particulars for June are as
follows :
Raw materials Standard Actual Quantity of
Rs. Mix. % Price per Mix % Price per kg. raw materials
kg. Rs. purchased kg.

A 5 20 6 21 8 6 5000
B 0 10 0 2000
C 5 1200
3
Calculate all variances 2
Solution
Basic calculations
Standard for 6,000 kg output Actual for 5,600 kg output
Material Rs. Kg. Rate Amt Kg Rate Amt.
Rs. . Rs. Rs.
AB 3,750 20 75,000 4,500 21 94,500
C 2,250 10 22,500 1,500 8 12,000
1,500 5 7,500 1,500 6 9,000
Total 7,500 1,05,000 7,500 1,15,500

Standard cost of actual output = Rs. 1,05,000 x 5,600 kg = Rs. 98,000

Material Cost Variance = SC of actual output - AC

MCV = 98,000 - 1,15,500 = Rs. 17,500 (A)

Material Price Variance = {SP - AP) x AQ

A = (20 - 21) x 4,500 = Rs. 4,500 (A)
B = (10 - 8) x 1,500 = Rs. 3,000 (F)
C = (5 - 6) x 1,500 = Rs. 1,500 (A)
MPV = Rs. 3,000 (A)

Material Usage Variance = (SQ for actual output - AQ) x SP

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 A = 3,750 x 5,600 - 4,500x 20
6,000
= (3500 - 4500) x 20 = Rs. 20,000 (A)
B = 2,250 x 5,600 - 1,500x 10
6,000
= (2100 - 1500) x 10 = Rs. 6,000 (F)
C = 1,500 x 5,600 - 1,500x 5
6,000
= (1400 - 1500) x 5 = Rs. 500 (A)
MUV = Rs. 14,500 (A)

Material Mix Variance = (Revised SQ - AQ) x SP

A = (3,750 - 4,500) x 20 = Rs.15,000 (A)
B = (2,250 - 1,500) x 10 = Rs. 7,500 (F)
C = (1,500 - 1,500) x 5 = Rs. Nil
MMV = Rs. 7,500 (A)
Material Yield Variance = (Actual yield - St. yield) x St. output cost per unit
MYV = (5,600 - 6,000) x 1,05,000 = Rs.7,000 (A)
6,000
Note: In the question, quantity of material purchased is given. It does not give quantity of
material consumed. It is thus assumed that quantity actually used, is 7,500 units. In case of
material C, it has been assumed that 300 units @ 6 were opening stock because purchased
quantity is only 1,200 kg. while consumed quantity is 1,500 kg.

Problem 10 (Material Variances)

The standard material input required for 1,000 kgs of a finished product are given below :

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 Material Quantity St. rate per kg.
kg Rs.
P 450 20
Q 400 40
R 250 60
1,100
Standard loss 100
Standard output 1,000
Actual production in a period was 20,000 kg. of finished product for which the actual
quantities of material used and the prices paid thereof were as under:
Material Quantities. Purchase price per kg.
(Kg.) Rs.
P 10,000 19
Q 8,500 42

R 4,500 65

Calculate (j) Material Cost Variance (ii) Material Price Variance (iii) Material Usage
Variance (iv) Material Mix Variance (v) Material Yield Variance.
Present a reconciliation among the variances.
Solution

Basic calculations :
Material Standard for 20,000 kg output Actual for 20,000 kg. output
Qty. Rate Amt. Qty. Rate Amt.
(kg) Rs. Rs. (kg) Rs. Rs.
P 9,000 20 1,80,000 10,000 19 1,90,000
Q 8,000 40 3,20,000 8,500 42 3,57,000
R 5,000 60 3,00,000 4,500 65 2,92,500
Less: Loss 22,000 8,00,000 23,000 8,39,500
2,000 3,000
20,000 20,000

Calculation of Variances

194
(i) Material Cost Variance = SC - AC
MCV =8,00,000-8,39,500 = Rs. 39,500 (A)
(ii) Material Price Variance = (SP - AP) x AQ
P = (20 - 19) x 10,000 = Rs. 10,000 (F)
Q = (40 - 42) x 8,500 = Rs. 17,000 (A)
R = (60 - 65) x 4,500 = Rs. 22,500 (A)
MPV = 29,500 (A)
(iii) Material Usage Variance = (SQ - AQ) x SP
P = (9,000 - 10,000) x 20 = Rs. 20,000 (A)
Q = (8,000 - 8,500) x 40 = Rs. 20,000 (A)
R = (5,000 - 4,500) x 60 = Rs. 30,000 (F)
MUV = Rs. 10,000 (A)
(iv) Material Mix Variance = (RSQ* - AQ) x SP
P = 23,000x 9,000 -10,000 x 20 = Rs. 11,818 (A)
22,000
Q = 23,000 x 8,000 - 10,000 x 40 = Rs. 5,455 (A)
22,000
R= 23,000 x 5,000 - 4,500 x 60 = Rs. 43,636 (F)
22,000
MMV = 26,363 (F)
(v) Material Yield Variance = (AY - SY) x St. output price
= 20,000-23,0000 x 20,000 x 8,00,000
22,000 22,000
MYV = 20,000 -4,60,000 x 40 = Rs. 36,363 (A)
22
Reconciliation
(i) MCV = MPV + MUV
39,500 (A) = 29,500 (A) + 10,000 (A)
(ii) MCV = MPV + MMV + MYV
39,500 (A) = 29,500 (A) + 26,363 (F) + 36,363 (A)

Problem 11 (Material Variances)

Philips Ltd. produces an article by blending two basic raw materials. The following

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standards have been set up for raw material.
Material Standard Mix St. Price per kg.
A 40% Rs. 4
B 60% Rs. 3
The standard loss in processing is 15%. During September 2006 the company produced
1,700 kg. of finished output. The position of stock and purchases for the month of
September 2006 is as under :
Material Stock on Stock on Purchases during
1-9-2006 30-9-2006 Sep. 2006
Kg. Kg. Kg. Cost Rs.
A 35 5 800 3,400
B 40 50 1,200 3,000
Calculate all material variances assuming FIFO method of issue of materials. The
opening stock is to be valued at standard price.
Solution

Basic calculations :
(i) Calculation of standard quantity = 1,700 x 100 = 2,000 kg.
85
Material A = 2,000 x 40% = 800 kg.
Material B = 2,000 x 60% = 1,200 kg.
(ii) Actual consumption of materials
Material Op. stock + Purchases - Closing stock = Consumption
A 35 kg. + 800 kg. - 5 kg. = 830 kg.
B 40 kg. + 1,200 kg. - 50 kg. = 1,190 kg.
(iii) Calculation of actual price per kg.
Material A = 3,400 = RS. 4.25 B = 3,000 = Rs. 2.50
800 1,200

(iv) Calculation of standard and actual cost of actual output

Material Standard Actual
Qty Rate Amount Qty- Rate Amount
kg. Rs. Rs. kg. Rs. kg- Rs.
A 800 4 3,200 35 4.00 140
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 795 830 4.25 3378.75
B 1,200 3 3,600 40 3.00 120
150 1,190 2.50 2,875
2,000
2,020
Loss 300 320
1,700 6,800 6,513.75
1,700

Calculation of Variances
(a) Material Cost Variance = Standard cost - Actual cost
MCV = 6,800 - 6,513.75 = Rs. 286.25 (F)
(b) Material Price Variance = (SP - AP) x AQ
A = [(4 - 4) x 35]+[4 - 4.25) x 795] = Rs.198.75 (A)
B = [(3- 3) x 40] + [(3-2.50)x 1,150] = Rs.575.00 (F)
MPV = Rs.376.25 (F)
(c) Material Usage Variance= (SQ - AQ) x SP
A = (800 - 830) x 4 = Rs.120 (A)
B = (1,200 - 1,190) x 3 = Rs. 30 (F)
MUV= Rs. 90 (A)
(d) Material Mix Variance = (RSQ - AQ) x SP
A = (808 - 830) x 4 = Rs. 88 (A)
B = (1,212 - 1,190) x 3 = Rs. 66 (F)
MMV = Rs. 22 (A)
RSQ- A = 2,020 x 800 = 808 kg.
2,000
B = 2,020 x 1,200 = 1,212 kg.
2,000

(e) Material Yield Variance = (Actual yield - St. yield) x St. output price
MYV = (1,700 - 1,717) x -6,800 = Rs. 68 (A)
1,700
St. yield = 85kg x 2,020 = 1,717 Kg.
100kg
Check

MCV = MPV + MMV + MYV

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 286.25 (F)= 376.25(F) + 22 (A) + 68 (A)

Problem 13 {Material and Labour Variances)

From the particulars given below, compute: Material Price Variance, Material Usage
Variance, Labour Rate Variance, Idle Time Variance and Labour Efficiency Variance with
full working details.
One tonne of materials input yields a standard output of 1,00,000 units. The standard price
of material is Rs. 20 per kg. Number of employees engaged is 200. The standard wage rate per
employee per day is Rs. 6. The standard daily output per employee is 100 units. The actual
quantity of material used is 10 tonnes and the actual price paid is Rs. 21 per kg. Actual
output obtained is 9,00,000 units.
Actual number of days worked is 50 and actual rate of wages paid is Rs. 6.50 per day. Idle
time paid for and included in above time is 1/2 day.
Solution
/ tonne = 1,000 kg.
Material Price Variance= (SP - AP) x AQ
= (20 - 21) x 10,000 kg. = Rs. 10,000 (A)
Material Usage Variance = (SQ - AQ) x SP
= (9,000 kg -10,000 kg) x Rs.20 = Rs. 20,000 (A)
Labour Rate Variance = (St. rate - Actual rate) x Actual days
= (6 - 6.50) x 10,000 = Rs. 5,000 (A)
Note : Actual days = 200 employees x 50 days = 10,000
Labour Efficiency Variance = (St. days - Actual days) x St. rate
= (9,000 - 9,900) x 6 = Rs. 5,400 (A)

Idle Time Variance = Idle days x St. rate

= (200 employees x ½ ) x Rs. 6 = 600 (A)

Problem 14 (Material Variances)

One kilogram of product ‘K’ requires two chemicals A and B. The following were the
details of product ‘A’ for the month of June.
(a) Standard mix Chemical ‘A’50% and Chemical ‘B’ 50%.

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 (b) Standard price per kilogram of Chemical‘A’Rs.12 and Chemical ‘B’Rs.15.
(c) Actual input of Chemical ‘B’ 70 kilograms.
(d) Actual price per kilogram of Chemical ‘A’ Rs. 15.
(e) Standard normal loss 10% of total input.
(J) Materials cost variance total Rs. 650 adverse.
(g) Materials yield variance total Rs. 135 adverse.
You are required to calculate :
(1) Material mix variance (total). (4) Actual loss of actual input.
(2) Material usage variance (total). (5) Actual input of Chemical ‘A’
(3) Material price variance (total). (6) Actual price per kilogram of Chemical‘B’

Solution
Actual output is not given in the problem. The following solution is based on the
assumption that actual output is 90 kg. Working is shown as below:
(a) St. cost is calculated below :

Qty. Price Amount

Kg- Rs. Rs.
Chemical A 50 12 600
Chemical B 50 15 '750
100 1,350
Standard loss 10 -
Output 1,350
90

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 (b) St. rate per unit of output = Rs. 1,350 + 90 kg. = Rs. 15 per kg.
(c) St. yield for actual input is calculated as follows :
Material yield variance = (Actual yield - St. yield) x St. output price
Rs. 135 (A) = (90 kg. - St. yield) x 15
St. yield = 99 kg.

(d) Actual input for 99 kg. of output =100 x 99 kg.. = 110 kg.
90 kg.
(e) Actual input of Chemical A = 110 kg. - Actual input of chemical B
= 110 kg. - 70 kg. = 40 kg.
(f) Material Cost Variance is given as Rs. 650 (A). Hence the actual cost of actual mix
of Chemicals A and B will be Rs. 1,350 + Rs. 650 = Rs. 2,000.
(g) The actual cost of 40 kg. of Chemical A @ Rs. 15 per kg. is Rs. 600. Thus the cost
of one kg. of Chemical B used is calculated as follows :
Rs. 2,000-Rs. 600
Rs. 2,000 – Rs.600 = 20 per kg.
70 kg.

(h) Revised St. Qty is calculated as under :

Chemical A = 110 x 50% = 55 kg.
(1) Chemical B = 110
Material Mix * 50%==(Revised
Variance 55 kg. St. Qty - Actual Qty.) x St. Price
Chemical A = (55 - 40) x Rs. 12 = Rs. 180 (F)
Chemical B = (55 - 70) x Rs, 15 = Rs. 225 (A)
MM V = Rs. 45 (A)

(2) Material Usage Variance = (Standard Qty - Actual Qty) - St. Price Chemical A =
(50 kg. - 40 kg.) x Rs. 12 = Rs. 120 (F)
Chemical B = (50 kg. - 70 kg.) x Rs. 15 = Rs. 300 (A)
MVV = Rs. 180 (A)

(3) Materials Price Variance = (Standard price - Actual price) x Actual Qty. Chemical
A = (Rs. 12 - Rs. 15) x 40 = Rs. 120 (A)
Chemical B = (Rs. 15 - Rs. 20) x 70 = Rs. 350 (A)
MPV = Rs. 470 (A)

200
(4) Actual Loss of Actual Input
Actual total input = 110 kg. Less :
Actual output = 90 kg. Actual loss
20 kg.

(5) Actual Input of Chemical A = 40 kg. (as calculated above)

(6) Actual Price per kg. of Chemical B = Rs. 20 (as calculated above)
MCV = MPV + MMV + MYV
650 (A) = 470 (A) + 45 (A) + 135 (A)

Problem 15 (Material and Labour Variances)

The standard cost on 'Material' and 'Labour' for the making of a unit of a certain product
estimated as under : are
Material 80 kg. at Rs. 1.50 per kg.
Labour 18 hrs. at Rs. 1.25 per hr.
On completion of the production of a unit, it was found that 75 kg. of material costing Rs. 1.75
per kg. has been consumed and that the time taken was 16 hours, the wage rate being Rs. 1.50,
hour.
per
You are required to analyse material and labour variances.
Solution
Material Variances :
Material Cost Variance = Standard cost - Actual cost
= (SP x SQ) - (AP x AQ)
= (Rs.1.50 x 80 kg.)- (Rs.1.75 x 75 kg.)
= Rs. 120 -Rs. 131.25 = Rs.1.1.25 (A)
Material Price Variance = (SP - AP) x AQ Rs.
= (1.50- 1.75) x 75 = Rs. 18.75 (A)
Material Usage Variance = (SQ-AQ)* SP
= (80- 75) x 1.50 = Rs. 7.50 (F)
Labour Variances :
Labour Cost Variance = Standard cost - Actual cost =
(SR x SH) - (AR x AH)
= (1.25 x 18) - (1.50 x 16) = Rs.1.50 (A)
Labour Rate Variance = (SR - AR) x AH
= (1.25 - 1.50) x 16 = Rs. 4(A)
Labour Efficiency Variance = (SH - AH) x SR
= (18 - 16) x 1.25 = Rs. 2.50 (F)
Rs.

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Problem 16 (Labour Variances)
From the following, calculate labour variances for department A and B.
Dept. A Dept. B
Actual direct wages Rs. 2,000 Rs. 1,800
Standard hours produced 8,000 6,000
Standard rate per hour 30 paise 35 paise
Actual hours worked 8,200 5,800

Solution
Labour Cost Variance = SC - AC
Dept. A = (8,000 x 0.30) - 2,000 = 400 (F)
Dept. B = (6,000 x 0.35) - 1,800 = 300 (F)
Labour Rate Variance = (SR - AR) x AH Rs.

A = 0.30 – 2,000 x 8,200

Dept. = Rs. 460 (F)
8,200

Dept. B = 0.35 – 1,800 x 8,200 = Rs. 230 (F).

5,800
Labour Efficiency Variance = (SH - AH) x SR
Dept. A = (8,000 - 8,200) x 0.30 = Rs. 60 (A)
Dept. B = (6,000 - 5,800) x 0.35 = Rs. 70 (F)
Check

Labour Cost Variance = Rate Variance + Efficiency Variance

Dept. A 400 (F) = 460 (F) + 60 (A)

Dept. B 300 (F) =230 (F) + 70 (F)

Problem 17 (Labour Variances)

Standard hours for manufacturing two products M and N are 15 hours per unit
and 20 hours per unit respectively. Both products require identical kind of labour and the
standard wage rate per hour is Rs. 5. In a year 10,000 units of M and 15,000 units of N
were manufactured. The total of labour hours actually worked were 4,50,500 and the
actual wage bill came to Rs. 23,00,000. This included 12,000 hours paid for @ Rs. 7 per
hour and 9,400 hours paid for @ Rs. 7.50 per hour, the balance having been paid at Rs. 5
per hour. You are required to compute the labour variances.

Solution

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Labour Cost Variance = Standard cost for actual output - Actual cost.
Standard cost :
For product M = 10,000 units x 15 hrs. x Rs. 5 = Rs. 7,50,000 For
product N = 15,000 units x 20 hrs. x Rs. 5 = Rs. 15,00,000
Total standard cost = Rs. 22,50,000
Total actual cost = Rs. 23,00,000
Labour cost variance = Rs. 22,50,000 - Rs. 23,00,000 = Rs. 50,000 (A)
Labour Efficiency Variance = (St. hrs. - Actual hrs.) x St. rate
= (4,50,000 - 4,50,500) x 5 = Rs. 2,500 (A)
Labour Rate Variance = (St. rate - Actual rate) x Actual hrs.
= [(5 - 7) x 12,000] + [(5 - 7.50) x 9,400] + [(5 - 5) x 4,29,100]
= Rs. 47,500 (A)

Problem 18 (Labour Variances)

The details regarding the composition and the weekly wage rates of labour force
engaged on a job scheduled to be completed in 30 weeks are as follows :

Standard Actual
Category of No. of Weekly wage rate No. of Weekly wage
workers workers per worker workers rate per worker
Skilled 75 Rs. 60 70 Rs. 70
Semi-skilled 45 Rs. 40 30 Rs. 50
Unskilled 60 Rs. 30 80 Rs. 20

The work is actually completed in 32 weeks. Calculate the all labour variances.

203
Solution

Basic calculations:
Standard Actual
Category of Weeks (No. of Rate Amt. Weeks (No. of Rate Amount
workers workers x No. of workers x No. of
weeks Rs. Rs. weeks) Rs. Rs.
Skilled 75 x 30 = 2,250 60 1,35,000 70 x 32 = 2,240 70 1,56,800
Semi-skilled 45 x 30 = 1,350 40 54,000 30 x 32 = 960 80 50 48,000
Unskilled 60 x 30 = 1,800 30 54,000 x 32 = 2,560 20 51,200
Total 5,400 2,43,000 5,760 2,56,000
Calculation of Variances
Labour Cost Variance = (SC - AC)
= 2,43,000-2,56,000 = Rs. 13,000 (A)

Labour Rate Variance = (Standard rate - Actual rate) x Actual time

Skilled = (60 - 70) x 2,240 = Rs.22,400 (A)
Semi-skilled = (40 - 50) x 960 = Rs. 9,600 A)
Unskilled = (30 - 20) x 2,560 = Rs. 25,600 (F)
LRV = Rs. 6400 (A)

Labour Efficiency Variance = (Standard time - Actual time) x Standard rate.

Skilled = (2,250 - 2,240) x 60 = Rs. 600 (F)

Semi-skilled = (1,350 - 960) x 40 = Rs. 15,600 (F)

Unskilled = (1,800 - 2,560) x 30 = Rs. 22,800 (A)
LEV = Rs. 6,600 (A)

Labour Mix Variance = (*Revised standard time - Actual time) x Standard rate
Skilled = (2,400 - 2,240) x 60 = Rs. 9,600 (F)
Semi-skilled = (1,440 - 960) x 40 = Rs. 19,200 (F)
Unskilled = (1,920 - 2,560) x 30 = Rs. 19,200 (A)
LMV = Rs. 9,600 (F)

204
*Revised standard time is calculated as under.
Revised Standard time = St. time of grade x Total actual time
Total standard time
Skilled = 2,250 x 5,760 = 2,400 weeks
5,400
Semi-skilled = 1,350 x 5,760 = 1,440 weeks
5,400
Unskilled = 1,800 x 5,760 = 1,920 weeks
5,400
Labour Revised Efficiency Variance = (St. time - Revised st. time) x S.R.
Skilled = (2,250 - 2,400) x 60 = Rs. 9,000 (A)
Semi-skilled = (1,350 - 1,440) x 40 = Rs. 3,600 (A)
Unskilled = (1,800 - 1,920) x 30 = Rs. 3,600 (A)
LREV = Rs. 16,200 (A)

Labour Yield Variance = (AY - SY) * SOR

LYV = 1-5,760 x Rs. 2,43,000 = Rs. 16,200 (A)
5,400

Check

(i) LCV = LRV+ LEV

Rs. 13,000 (A) = Rs. 6,400 (A) + Rs. 6,600 (A)
(ii) LEV = LMV + LREV (Or LYV)
Rs. 6,600 (A) = Rs. 9,600 (F) + Rs. 16,200 (A)

Problem 19 (Labour Variances)

The standard output of ‘X’ is 25 units per hour in a manufacturing department of

a company employing 100 workers. The standard wage rate per labour hour is Rs. 6.
In a 42 hour week, the department produced, 1,040 units of 'X' despite 5% of the
time paid was lost due to abnormal reason. The hourly rate actually paid were Rs. 6.20,
Rs. 6 and Rs. 5.70 respectively to 10, 30 and 60 workers.

Compute relevant variances.

Solution
Basic calculations :
Standard hours per unit = 100 + 25 = 4
Standard hours for actual output = 1,040 units x 4 hours = 4,160
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 Standard cost of actual output = 4,160 hrs x Rs. 6 = Rs. 24,960
Actual cost is calculated as follows :
No. of Actual hours Idle Effective Rate per Amount.
workers paid* hours hours hour Rs. Rs.
10 420 21 399 6.20 2,604
30 1,260 63 1,197 6.00 7,560
60 2,520 126 2,394 5.70 14,364
Total 4,200 210 3,990 24,528

*Actual hours paid is No. of workers x 42 hours.

Calculation of Variances

Labour Cost Variance = St. cost - Actual cost

= 24,960 - 24,528 = Rs. 432 (F)
Labour Efficiency Variance = (SH - AH) x SR
= (4,160 - 3,990) x 6 = Rs. 1,020 (F)
Labour Rate Variance = (SR - AR) x AH
= [(6 - 6.20) x 420] + [(6 - 6) x 1,260]
+ [(6 - 5.70) x 2,520)]
= 84 (A) + Nil + 756 (F) = Rs. 672 (F)
Idle Time Variance = Idle hours * St. rate
= 210 x 6 = Rs. 1,260 (A)
Check

Labour cost = Efficiency + Rate + Idle time

variance variance variance variance
432 (F) = 1,020 (F) + 672 (F) + 1,260 (A)

Note : Idle time variance has been calculated as a sub-variance of labour cost
variance. Alternatively, it may be calculated as a sub-variance of efficiency variance.

206
Problem 22 (Materials and Labour Variances)

From the following data of A Co. Ltd. relating to budgeted and actual
performance for the month of March, compute direct materials and direct labour cost
variances :
Budgeted data for March :
Units to be manufactured 1,50,000
Units of direct material required (based on standard rates) 4,95,000
Planned purchase of raw materials (units) 5,40,000
Average unit cost of direct material Rs. 8
Direct labour hours per unit of finished goods 3/4 hour
Direct labour cost (total) Rs. 29,92,500
Actual data at the end of March :
Units actually manufactured 1,60,000
Direct material cost (purchase cost based on units
actually issued) Rs. 43,41,900
Direct material cost (purchase cost based on units
actually purchased) Rs. 45,10,000
Average unit cost of direct material
8.20
Total direct labour hours for March 1,25,000
Total direct labour cost for March 33,75,000
Solution
Material Variances :
(a) Material Cost Variance = (SC - AC)
= (1,60,000 units x Rs. 8 x 3.30*) - 43,41,900 = Rs. 1,17,900(A)

*Standard material quantity per unit of finished product is :

= (4,95,000 * 1,50,000) = 3.30 units

(b) Material Price Variance = (SP - AP) x AQ

= (8 - 8.20) x 43,41,900 = Rs. 1,05,900 (A)

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 8.20
(c) Materials Usage Variance = (SQ - AQ) x SP
= 1,60,000 x 3.30 - 43,41,900 = Rs. 12,000 (A)
8.20
Labour Variances :
(a)Labour Cost Variance = SC — AC
= (1,60,000 x 19.95*) - 33,75,000 = Rs. 1,83,000 (A)
* St. rate per unit = 29,92,500 * 1,50,000 = Rs. 19.95
(b) Labour Rate Variance = (SR - AR) % AH
= (26.60 - 27) x 1,25,000 = Rs. 50,000 (A)
St. rate per hour = [29,92,500 ÷ (1,50,000 x 3/4 hrs.)] = Rs. 26.60
Actual rate per hour = (33,75,000 ÷1,25,000) = Rs. 27
(c) Labour Efficiency Variance = (SH-AH) x SR
= (1,60,000 x 3/4 -4,25,000) x 26.60 = Rs. 1,33,000 (A)

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SECTION-A

1. What is meant by standard cost?

2. Define standard costing.
3. What are the characteristics of standard costing ?
4. What is the difference between standard cost and estimated cost ?
5. What is the difference between standard costing and budgetary control ?
6. What is meant by standard hour ?
7. State the various types of standards.
8. What is meant by cost variance ?
9. What is meant by variance analysis ?
10. State any three advantages of standard costing.
11. What are the limitations of historical costing ?
12. What do you mean by favourable variance and unfavourable variance ?
13. What is meant by material usage variance ? Give its formula.
14. State three reasons why material quantity variance arises.
15. What is material price variance ? Give its formula.
16. What is material mix variance ? Why this variance arises ?
17. List the various variances that arise in respect of material cost.
18. List the various variances that arise in respect of labour cost.
19. What is labour rate variance ? How is it computed ?
20. What is labour efficiency variance ? Give its formula.
21. What is meant by labour mix variance ?
22. State any two reasons of labour time variance.
23. Name the various overhead cost variances.
24 What is idle time variance ?
25. What is yield variance ?
26. What is the significance of variance analysis ?

Essay Type Questions

1. Define and
explain the concept of 'standard cost' and 'standard costing'.

209
2. Explain briefly the significance of standard costing as a technique of cost
control.
3. Distinguish
between standard cost and estimated cost.
4. Define standard costing. In what type of industries is standard costing
employed?
5. Point out the differences between historical costing and standard costing.
6. Discuss the advantages and limitations of standard costing.
8. Distinguish between standard costing and budgetary control.

9. What is
'standard costing'? Bring out clearly the relationship between standard costing and
budgetary control.

SECTION-C

1. The following particulars are regarding the standard and actual production of
product X.
Standard quantity of material per unit 5 kg.
Standard price per kg. Rs. 5
Actual number of units produced 400
Actual quantity of materials used 2,200 kg.
Price of materials Rs. 4.80 per kg.
Calculate (i) Material price variance (ii) Material usage variance
[Ans. (i) Rs. 440 (F) (ii) Rs. 1,000 (A)]
3. Given that the cost standards for material consumption are 40 kg. @ Rs. 10 per kg,
compute the variance when actuals are:

(a) 48 kg. at Rs. 10 per kg. (b) 40 kg. at Rs. 12 per kg.
(c) 48 kg. at Rs. 12 per kg. (d) 36 kg. for a total cost of Rs. 360.
[Ans. MPV (a) Nil, (b) Rs. 80 (A), (c) Rs. 96 (A),
(d) Nil,; MUV (a) Rs. 80 (A), (b) Nil, (c) Rs. 80
(A), (d) Rs. 40 (F)]

210
4. In a factory, standard estimates for material for the manufacture of 1,000 units of
product Z is 400 kg. at Rs. 2.50 per kg. When 2,000 units of product Z are produced it
is found that 825 kg of materials are consumed at Rs. 2.70 per kg. Calculate material
variances. [Ans. MCV Rs. 227.50(A), MPV Rs. 165(A) MUV Rs. 62.50 (A)]

4. Calculate the mix variance

Material Quantity (kg.) Rate Rs.
Standard A 10 2
B 15 3
Actual A 8 2.50
B 17 2.50

[Ans. Mix Variance Rs.

2 (A)]

5. The standard cost card for one unit of product shows the following costs for
material and labour.
Material 4 pieces @ Rs. 5.00
Labour 10 hours @ Rs. 1.50
5,700 units of the product were manufactured during the month of March, with the
following material and labour costs:

Material - 23,000 pieces @ Rs. 4.95

Labour - 56,800 hours @ Rs. 1.52

Calculate appropriate material and labour variances.

[Ans. (/) MCV Rs. 150 (F); MPV Rs. 1,150 (F); MQV Rs.
1,000 (A) (ii) LCV Rs. 836 (A); LRV Rs. 1,136 (A); LEV
Rs. 300 (F)]

5. For a unit of product A, the standard data is given below:

Material ... 5 kg. @ Rs. 40 per kg. Rs. 200
Labour ... 40 hrs. @ Re. 1.00 per hour Rs. 40
Rs. 240
Actual data
Actual production 100 units
Materials: 490 kg. @ Re. 42 each Rs. 20,580

211
 Labour: 3,960 hrs. @ Rs. 1.10 per hour 4,356
24,936
Calculate:
1. Material cost variance 2. Material price variance
3. Material usage variance 4. Labour cost variance
5. Labour rate variance 6. Labour efficiency variance
[Ans. 1. Rs. 580 (A). 2. Rs. 980 (A), 3. Rs. 400 (F), 4. Rs. 356 (A), 5. Rs. 396 (A),
6 Rs. 40 (F)]

7. The standard cost on 'material' and 'labour' for the making of a unit
of a certain product are estimated as under:
Material 80 kg. at Rs. 1.50 per kg.
Labour 18 hrs. at Rs. 1.25 per hr.
On completion of the production of a unit, it was found that 75 kg. of material
costing Rs. 1.75 per kg. has been consumed and that the time taken was 16 hours, the
wage rate being 1.50 per hour. Your are required to calculate material and labour
variances.
[Ans. MPV-Rs. 18.75 (A), MUV Rs. 7.50 (F), LRV Rs. 4 (A), LEV
Rs. 2.50 (F)]
8. From the following data, calculate material mix variance.
Material Standard Actual Price
quantity quantity per unit
X 50 45 14
Y 40 35 12
Z 30 40 11
Due to shortage of X, it was decided to reduce its consumption by 10 and increase the
consumption of Y and Z by 6 and 4 respectively.
[Ans. MMV Rs. 4 (A)]
(Hint. Adjust standard qunatities)
9. From the following calculate:
(a) Price variance, (b) Usage variance, (c) Mix variance, and (d) Revised usage
variance:
Material Standard Actual
Qty. Rate Ami. Qty- Rate Amt.
A 10 2 20 5 3 15
B 20 3 60 10 6 60
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 C 20 6 120 15 5 75
[Ans. (a) Rs. 20 (A), (b) 70 (F), (c) Rs. 10 (A), (d) Rs.
80 (F)]

10. From the following compute : (i) Material price variance (ii) Material quantity
variance (iii) Material mix variance, and (iv) Material cost variance.

Material Standard Actual

- Quantit Unit Quantit Unit
y Kg- price Rs. y Kg- Price Rs.
A 10 2 5 3
B 20 3 10 6
C 20 6 5 5
50 30
[Ans. (i) Rs. 20 (A), (ii) Rs. 70 (F), (Hi) Rs 10 (A), (iv)
Rs 50 (F)]

11. Philips Company manufactures Product 'P' by mixing three raw materials. For every
100 kg. of P, 125 kg. of raw materials are used. In April there was an output of 5,600
kg of P. The standard and actual particulars for April are as follows:

Raw Material Standard Actual

Mix Price per Mix Price per
Kg. Rs. Kg. Rs.
I 50% 40 60% 42
II 30% 20 20% 16
III 20% 10 20% 12

Calculate all material variances assuming actual quantity of materials consumed

was 7,000 kg.
[Ans. MCV Rs. 19,600 (A), MPV Rs. 5,600 (A), MUV Rs. 14,000 (A)
MMV Rs. 14,000 (A), MYV Nil]

12. From the following data, calculate material variances.

Material St. Qty. St.Rate Actual Qty. Actual Rate

213
 X 8,000 kg. Rs.1.05 7,500 kg. Rs 1.20
Y 3,000 kg. Rs.2.15 3,300 kg. Rs 2.30
Z 2,000 kg. Rs.3.30 2,400 kg. Rs 3.50

Also write a note on the relationship of various variances that you compute.
[Ans. MCV Rs. 3,540 (A); MPV Rs. 2,100 (A);
MQV Rs. 1,440 (A); JyMMV Rs. 1,110 (A); MRQV Rs. 330 (A)]

13. Birla & Co. Ltd. manufactures product P and uses a standard cost system. Standard
product and cost specification for 1,000 kg. of product are as follows:
Material Qty in kg. Price Cost
Rs. Rs.
A 800 2.50 2,000
B 200 4.00 800
C 200 1.00 200
Input 1,200 5 3,000
Output 1,000

Material records indicate:

Consumption in April
A 1,57,000 kg. @ Rs. 2.40
B 38,000 kg @ Rs. 4.20
C 36,000 kg @ Rs. 1.10
Actual finished production for the month of January is 2,00,000 kg. Calculate material
variances.
[Ans. MPV-Rs. 4,500 (F), MUV Rs. 19,500 (F), MMV Rs. 3,000 (A), MYV-Rs. 22,500
(F), MCV Rs. 24,000 (F)]

14. Pieco Ltd. is producing a 'standard mix' by using 60 kg. of material X and 40
kg. of material Y. The standard loss of production is 30%. The standard price
of X is Rs. 5 per kg. and that of Y Rs. 10 per kg.
The actual mixture and yield were as follows:
X 80 kg. @ Rs. 4.50 per kg.
Y 70 kg. @ Rs. 8 per kg.
Actual yield is 115 kg.
214
Calculate material variances.
[Ans. MCV Rs. 230 (F); MPV Rs. 180 (F); MQV Rs. 50 (F); MMV Rs. 50 (A); MYV
Rs. 100 (F)]

15. Following are the particulars in respect of a product where two types of
materials A and B are used:

Material Standard Actual

input Tons Rate Tons Rate
Rs. Rs.
A 120 10.00 140 9.50
B 80 7.50 60 9.00

Less: Loss 200 200

20 18

Net production 180 182

You are required to calculate:

(a) Material Price Variance (b) Material Mix Variance,
(c) Material Yield Variance (d) Material Usage Variance
[Ans. (a) Rs. 20 (A); (b) Rs. 50 (A); (C) Rs. 20 (F); (d) Rs. 30 (A)]
16. The standard cost of a certain chemical mixture 'AB' is:
40% material A at Rs. 400 per kg.
60% material B at Rs. 600 per kg.
A standard loss of 10% is anticipated in production :
The following particulars are available for the month of December.
180 kg. of material A has been used at Rs. 360 per kg.
220 kg. of material B has been used at Rs. 680 per kg.
The actual production of 'AB' is 369 kg.
Calculate:
(a) Material Cost Variance (b) Material Price Variance
(c) Material Usage Variance (d) Material Mix Variance
(e) Material Yield Variance

[Ans. (a) MCV Rs. 1,200 (A), (b) MPV Rs. 10,400 (A), (c) MUV Rs. 9,200 (F),
(d) MMV Rs. 4000 (F); MYV Rs. 5200 (F)].

17. The standard cost of a certain chemical mixture is:

215
 35% material A at Rs. 25 per kg.
65% material B at Rs. 36 per kg.

A standard loss of 5% is expected in production. During a period there is used: 125

kg. of material A at Rs. 27 per kg., and 275 kg. of material B at Rs. 34 per kg. The
actual output was 365 kg. Calculate:
(a) Material Cost Variance (b) Material Price Variance
(c) Material Mix Variance (d) Material Yield Variance
[Ans. (a) Rs. 372.97 (A), (b) Rs. 300 (F),
(c) Rs. 165 (A), (d) Rs. 507.97 (A)]

18. The standard mix of product A 2 is as follows :

Kgs Material Price per kg. (Rs.)
45 X 6.00
25 Y 4.50
30 Z 9.50
The standard loss in production is 10% of input. There is no scrap value. Actual
production for a month was 7,425 kgs. of A2 from 80 mixes. Actual purchases and
consumption of material during the month were :
Kg Material Price per kg. (Rs.)
4,200 X 6.50
1,700 Y 4.25
2,600 Z 9.75
You are required to calculate the following variances for presentation to the
management:
(i) Material cost variance (ii) Material price variance
(iii) Material mix variance (iv) Material yield variance,
(v) Material usage variance
Ans. (i) Rs. 4806.25 (A), (ii) Rs. 2,325 (A); (Hi) Rs. 812.50 (A),
(iv) Rs. 1668.75 (A) (v) Rs. 2481.25 (A)]

19. Modern Tiles Ltd. makes plastic tiles of standard size of 6" x 6" x 1/8". From the
following information, you are required to calculate direct materials:
(i) the cost variance in total.
216
 (ii) the cost variance sub-divided into (a) price; and (b) usage.
(iii) the usage variance analysed into (a) mix; and (b) yield.
A standard mix of the compound required to produce an output of 20,000 square feet
of tiles 1/8" thick is as follows:
Direct Materials Quantity (Kgs.) Price Per Kg. (Rs.)
A 600 0.90
B 400 0.65
C 500 0.40
During December, eight mixes were processed and actual materials consumed were:

Direct Materials Quantity (Kgs.) Price Per Kg. (Rs.)

A 5,000 0.85
B 2,900 0.60
C 4,400 0.45
Actual production for December was 6,20,000 tiles.

[Ans. MCV Rs. 220 (A), MPV Rs. 175 (F), MMV Rs. 55 (F);
MYV Rs. 450 (A)]

[Hint. Area covered per tile = 6" x 6" = 36"

Area per sq. ft = 12" x 12" = 144"
Tiles required per sq. ft = 144 x 36 = 4
Tiles required for 20,000 sq. ft = 20,000 x 4 = 80,000,
St. output from 8 mixes = 80,000 x 8 = 6,40,000 tiles.
Actual output = 6,20,000 tiles.]
20.The standard labour cost of manufacturing a product shows the following
standards:
Materials Quantity Standard Price per kg. Amount
Rs. Rs.
A 40 kg. 75 3,000
B 10 kg. 50 500
C 50 kg. 20 1,000
Material cost per unit (Total) 4,500

The standard labour input mix is 100 kg. and the standard output of the finished
product is 90 kg. The actual results for period are :
217
 Materials used :
A 2,40,000 kg. @ Rs. 80 per kg.
B 40,000 kg. @ Rs. 52 per kg.
C 2,20,000 kg. @ Rs. 21 per kg.
Actual output of the finished product is 4,20,000 kg.
You are required to calculate the material price, mix and yield variances.
[Ans. MCV Rs. 49,00,000 (A), MPV Rs. 15,00,000 (A), MUV Rs. 34,00,0.00 (A),
MMV Rs. 19,00,000 (A), MYV Rs. 15,00,000 (A)]

21.The standard cost of a product is: 10 hours per unit at Rs. 5 per hour
The actual data is:
Production 1,000 units
Hours taken:
Production 10,400 hours
Idle time 400 hours
Total time 10,800 hours
Payments made Rs. 56,160 at Rs. 5.20 per hour. Calculate:
(a) Labour cost variance (6) Labour efficiency variance
(c) Labour rate variance (d) Idle time variance.
[Ans. (a) Rs. 6,160 (A), (b) Rs. 4,000 (A), (c) Rs. 2,160 (A), (d) Rs.
2,000 (A)]

22.Find out different Labour Variances.

Standard Actual
Output: 1,000 units 1,200 units
Rate of payment : Rs. 6 per unit Wages paid with bonus : Rs. 8,000
Time taken : 50 hours 40 hours.
[Ans. LCV Rs. 800 (A), LRV Rs. 3,200(A), LEV Rs.
2,400 (F)] [Hint. St. rate per hour Rs. 120, Actual
rate per hour Rs. 200]

23. A job is scheduled to be completed in 30 weeks with a labour employment

of 100 skilled operatives, 40 semi-skilled operatives and 60 unskilled
operatives. The standard weekly wage of each type of operatives are - skilled
Rs. 60, semi-skilled Rs. 36 and unskilled Rs. 24. The work is actually completed in
32 weeks with a labour force of 80 skilled, 50 semi-skilled and 70 unskilled
218
 operatives and the actual weekly wage rates average Rs. 65 for skilled, Rs. 40 for
semi-skilled and Rs. 20 for unskilled labour. Analyse the variance in the labour
cost due to various reasons.

[Ans. LCV Rs. 8,800 (A), LRV Rs. 10,240 (A),

LEV Rs. 1,440 (F), LMV Rs. 19,200 (F), LREV
Rs. 17,760 (A)]

24. A gang of workers usually consists of 10 men, 5 women and 5 boys paid at standard
hourly rates of Re.1.25, Re. 0.80 and Re. 0.70 respectively. In a normal working week
of 40 hours, the gang is expected to produce 1,000 units of output.
In a certain week, the gang consisted of 13 men, 4 women and 3 boys; actual hourly
rates being Re. 1.20 Re. 0.85 and Re. 0.65 respectively. Two hours were lost due to
abnormal idle time and 960 units of output were produced.
Calculate appropriate labour variances.

[Ans. LCV Rs. 70 (A), LRV Rs. 24 (F), LEV Rs. 94 (A),LMV Rs. 58.90 (A),
LITV Rs. 43.10 (A), LREV Rs. 8 (F)]
25. The standard labour composition and the actual labour composition engaged during
the month are given below :
Skilled Semi-skilled Unskilled
(a) Standard number of workers in a group 30 10 10
(b) Standard wage rate (Rs. per hour) 5 3 2
(c) Actual number of workers employed 24 15 12
during the month in the group
(d) Actual wage rate per hour (Rs.) 6 2.5 2
During the month of 200 working hours, the group produced 9,600 standard hours of
work.
Required : Calculations showing Wage rate variance, Labour (revised) efficiency
variance, Labour mix variance and Total labour cost variance.
[Ans. Wage rate variance Rs. 3,300 (A); Labour efficiency
(revised) variance Rs. 2,400 (A); Labour mix variance Rs. 3,000
(F); Total labour cost variance
Rs. 2,700 (A)]
219
26. From the following data, prepare unit cost statement showing prime cost of products
A and B together with analysis of variances:
Materials Product A Product B
Standard 600 kg. @ Rs. 5.00 90 kg. @ Rs. 3.00
Actual 580 kg. @ Rs. 5.50 100 kg. @ Rs. 2.80
Labour: Standard 80 hrs. @ Rs. 2.00 16 hrs. @ Rs. 2.80
Actual 92 hrs. @ Rs. 1.75 14 hrs. @ Rs. 2.60
)
[Ans. Product A : Standard total cost Rs. 3,160; Product B : Rs. 314.80;
Actual total Cost Rs. 3,351; product B.: Rs. 316.40;
Total cost variance : A Rs. 191 (A) B Rs. 1.60 (A)
Material : A : MPV Rs. 290 (A) MUV Rs. 100 (F) MCV Rs. 190 (A);
B : MPV Rs. 20 (F) MUV Rs. 30 (A) MCV Rs. 10 (A),
Labour : A : LRV Rs. 23 (F) LEV Rs. 24 (A) LCV Rs. 1,00 (A);
B : LRV Rs. 2.80 (F) LEV Rs. 5.60 (F) LCV Rs. 8.40 (F)]

220
Module-6
Budgetary Control

One of the primary functions of the management is to plan for the future and to
ensure that plans are put into effect. One way of planning is through budgets. A
budget is merely a plan relating to a period of time, expressed in quantitative
terms, in the business world, a budget is the formal expression of the expected
incomes and expenditure for a definite future period. Comprehensive budgeting
control procedures provide invaluable aid for scientific management.

Meaning of Budget

The Chartered Institute of Management Accountants (C1MA) UK has defined

a budget as "a plan quantified in monetary terms prepared and approved prior to
a defined period of time, usually showing planned income to be generated
and/or, expenditure to be incurred during the period and the capital to be
employed to attain a given objective.”
According to Brown and Howard, "A budget is a pre-determined statement of
management policy sun'ng a given period which provides a standard for
comparison with the results actually achieved."
3. A budget is prepared for a definite future period,

221
 4. It shows planned income and expenditure and also the capital to be
employed.
5. Purpose of a budget is to implement the policies formulated by the
management for attaining the given objectives.

Budgeting
The act of preparing budgets is called budgeting. In the words of Batty, "the
entire process of preparing the budgets is known as budgeting.
Meaning of Budgetary Control
Budgetary control is a system of controlling costs through preparation of
budgets. Budgeting is thus only a part of the budgetary control. According to
C1MA., "Budgetary control is the establishment of budgets relating to the
responsibilities of executives of a policy and the continuous comparison of the
actual with the budgeted results, either to secure by individual action the
objective of the policy or to provide a basis for its revision."
Characteristics. The main characteristics of budgetary control are :
1. Establishment of budgets for each function/department of the
organisation.
2. Comparison of actual performance with the budgets on a continuous
basis.
3. Analysis of variations of actual performance from that of the budgeted
performance to know the reasons thereof.
4. Taking suitable remedial action, where necessary.
5. Revision of budgets in view of changes in conditions.

The technique of budgetary control is now widely used in the business world.
Many businesses fail because of the lack of efficient planning which could have
revealed that the business should not have been started or that one should have
been prepared to face serious dangers ahead.

Forecast and Budget

222
 It is important to note carefully the distinction between a forecast and a budget.
A forecast is a prediction of what may happen as a result of a given set of
circumstances. It is an assessment of probable future events. A budget, on the
other hand, is a planned exercise to achieve a target. It is based on the pros and
cons of a forecast. Forecasting thus precedes the preparation of a budget.
Thus the main point of distinction between the two is that forecast is concerned
with 'probable events' while budget relates to 'planned events'. Furthermore,
forecast can be made by anybody, whereas a budget, being an enterprise objective,
can be set only by the authorised management.

Objectives of Budgetary Control

The following are the objectives of a budgetary control system:
1. Planning. A budget provides a detailed plan of action for a business over a
definite period of time. Detailed plans relating to production, sales, raw material
requirements, labour needs, advertising and sales promotion performance, research
and development activities, capital additions etc. are drawn up. By planning many
problems are anticipated long before they arise and solutions can be sought
through careful study. Thus most business emergencies can be avoided by
planning. In brief, budgeting forces the management to think ahead, to anticipate
and prepare for the anticipated conditions.
2. Co-ordination. Budgeting aids managers in co-ordinating their efforts so
that objectives of the organization as a whole harmonise with the objectives of its
divisions. Effective planning and organization contributes a lot in achieving
coordination. There should be co-ordination in the budgets of various departments.
For example, the budget of sales should be in coordination with the budget of
production. Similarly, production budget should be prepared in co-ordination with
the purchase budget, and so on.
3. Communication. A budget is a communication device. The approved budget
copies are distributed to all management personnel which provides not only
adequate understanding and knowledge of the programmes and policies to be

223
followed but also gives knowledge about the restrictions to be adhered to. It is not
the budget itself that facilitates communication, but the vital information is
communicated in the act of preparing budgets and participation of all responsible
individuals in this act.
4. Motivation. A budget is a useful device for motivating managers to perform
in line with the company objectives. If individuals have actively participated in the
preparation of budgets, it acts as a strong motivating force to achieve the targets.
5. Control. Control is necessary to ensure that plans and objectives as laid
down in the budgets are being achieved. Control, as applied to budgeting, is a
systematised effort to keep the management informed of whether planned
performance is being achieved or not. For this purpose, a comparison is made
between plans and actual performance. The difference between the two is reported
to the management for taking corrective action.
6. Performance evaluation. A budget provides a useful means of informing
managers how well they are performing in meeting targets they have previously
helped to set. in many companies, there is a practice of rewarding employees on the
basis of their achieving the budget targets or promotion of a manager may be linked
to his budget achievement record.

Advantages of Budgetary Control

Budgetary control provides the following advantages :
1. Budgeting compels managers to think ahead i.e. to anticipate and prepare
for changing conditions
2. Budgeting co-ordinates the activities of various departments and functions
of the business.
3. It increases production efficiency, eliminates waste and controls the costs.
4. It pinpoints efficiency or lack of it.
5. Budgetary control aims at maximisation of profits through careful planning
and control
6. It provides a yardstick against which actual results can be compared.

224
 7. It shows management where action is needed to remedy a situation.
8. It ensures that working capital is available for the efficient operation of the
business.
9. It directs capita! expenditure in the most profitable direction.
10. It instills into all levels of management a timely, careful and
adequate consideration of all factors before reaching important decisions.
11. A budget motivates executives to attain the given goals.
12. Budgetary control system creates necessary conditions for the
introduction of the standard costing technique.
13. Budgeting also aids in obtaining bank credit.
14. A budgetary control system assists in delegation of authority and
assignment of responsibility.
15. Budgeting creates cost consciousness and introduces an attitude of
mind in which waste and efficiency cannot thrive.

Limitations of Budgetary Control

The list of advantages given above is impressive, but a budget is not a cure all
for organisational ills. Budgetary control system suffers from certain limitations
and those using the system should be fully aware of them.
1. The budget plan is based on estimates. Budgets are based on forecasts and
forecasting cannot be an exact science. Absolute accuracy, therefore, is not
possible in forecasting and budgeting. The strength or weakness of the budgetary
control system depends to a large extent, on the accuracy with which estimates are
made. Thus, while using the system, the fact that budget is based on estimates
must be kept in view.
2. Danger of rigidity. A budget programme must be dynamic and continuously
deal with the changing business conditions. Budgets will lose much of their
usefulness if they acquire rigidity and are not revised with the changing

225
circumstances.
3. Budgeting is only a tool of management. Budgeting cannot take the place
of management but is only a tool of management. 'The budget should be regarded
not as a master, but as a servant.' Sometimes it is believed that introduction of a
budget programme alone is sufficient to ensure its success. Execution of a budget
will not occur automatically. It is necessary that the entire organisation must
participate enthusiastically in the programme for the realisation of the budgetary
goals.
4. Expensive technique. The installation and operation of a budgetary control
system is a costly affair as it requires the employment of specialised staff and
involves other expenditure which small concerns may find difficult to incur.
However, it is essential that the cost of introducing and operating a budgetary
control system should not exceed the benefits derived therefrom.

Essentials of Effective Budgeting

A budgetary control system can prove successful only when certain conditions
and attitudes exist, absence of which will negate to a large extent the value of a
budget system in any business. Such conditions and attitudes which are essential
for effective budgeting are as follows :
1. Support of top management. If the budget system is to be successful, it
must be fully supported by every member of the management and the impetus and
direction must come from the very top management. No control system can be
effective unless the organisation is convinced that the top management considers
the system to be important.
2. Participation by responsible executives. Those entrusted with the
performance of the budgets should participate in the process of setting the budget
figures. This will ensure proper implementation of budget programmes.
3. Reasonable goals. The budget figures should be realistic and represent
reasonably attainable goals. The responsible executives should agree that the
budget goals are reasonable and attainable.

226
 4. Clearly defined organisation. In order to derive maximum benefits from the
budget system, well defined responsibility centres should be built up within the
organisation. The controllable costs for each responsibility centres should be
separately shown.
5. Continuous budget education. The best way to ensure the active interest of
the responsible supervisors is continuous budget education in respect of objectives,
potentials and techniques of budgeting. This may be accomplished through written
manuals, meetings etc. whereby preparation of budgets, actual results achieved etc.
may be discussed.
6. Adequate accounting system. There is close relationship between
budgeting and accounting. For the preparation of budgets, one has to depend on
the accounting department for reliable historical data which primarily forms the
basis for many estimates. The accounting system should be so designed so as to set
up accounts in terms of areas of managerial responsibility. In other words,
responsibility accounting is essential for successful budgetary control.
7. Constant vigilance. Reports comparing budget and actual results should be
promptly prepared and special attention focussed on significant exceptions i.e.
figures that are significantly different from those expected.
8. Maximum profits. The ultimate object of realising the maximum profit
should always be kept uppermost.
9. Cost of the system. The budget system should not cost more than it is
worth. Since it is not practicable to calculate exactly what a budget system is
worth, it only implies a caution against adding expensive refinements unless their
value clearly justifies them.
10. Integration with standard costing system. Where standard costing
system is also used, it should be completely integrated with the budget programme,
in respect of both budget preparation and variance analysis

227
Type of Budgets
Budgets may be classified into :
(a) Functional budgets, and
(b) Fixed and flexible budgets.

FUNCTIONAL BUDGETS

A functional budget is one which relates to a function of the business, e.g.,

Sales Budget, Production Budget, Purchase Budget, etc. There are many types of
functional budgets, of which the following are important:
Types of Functional Budgets
• Sales Budget.
• Production Budget.
• Production Cost Budget.
• Raw Materials Budget.
• Purchases Budget.
• Labour Budget,
• Production Overhead Budget.
• Selling and Distribution Cost Budget.
• Administration Cost Budget
• Capital Expenditure Budget,
• Cash Budget.

Sales Budget
In most companies, the sales budget is not only the most important but also the
most difficult budget to prepare. The importance of this budget arises from the
fact that if the sales figure is incorrect, then practically all other budgets will be
affected. The difficulties in the preparation of this budget arise because it is not
easy to estimate consumer demand, particularly when a new product is introduced.
The sales budget is a statement of planned sales in terms of quantity and value.
It forecasts what the company can reasonably expect to sell to its customers during

228
the budget period. The sales budget can be prepared to show sales classified
according to products, salesmen, customers, temiories and periods, etc.
Factors. The factors to be considered in forecasting sales are the following:
1. Analysis of past sales to determine trends in the market.
2. Reports by salesmen of various markets of company products.
3. Any changes in companies policies and methods and their effect on sales.
4. Any changes in economic conditions and in business related-conditions and
policies.
5. Market research to measure potential demand for company products.

Production Budget
The production budget is an estimate of production for the budget period. It is
first drawn up in quantities of each product and when the remaining budgets have
been prepared and cost of production calculated, then the quantities of production
cost are translated into money terms, what in effect becomes a production cost
budget.
The production budget is the initial step in budgeting manufacturing operations.
In addition to production budget, there are three other budgets relating to
manufacturing activities of a company. These are raw materials budget, labour
budget and production overhead budget.
Factors. The principal considerations involved in budgeting production are :
1. Sales budget. When sales is the principal budget factor, the production budget
will be based on the volume of sales forecast by the sales budget.
2. Inventory policy. The management decision regarding quantities needed is
stock at all times to meet customer requirements is an important factor.
3. Production capacity. The production capacity of each department should be
worked out and budget figures should be within these limits.
4. Management policy. Production policy of the management plays an
important role in budgeting production. For example, management may decide to
buy a particular component part from outside instead of manufacturing it. This

229
will influence production budget.

Production Cost Budget

This budget shows the estimated Cost of production. The production budget
(explained above) shows the quantities of production. These quantities of
production are expressed in terms of cost in production cost budget. The cost of
production is shown in detail in respect of material cost, labour cost and factory
overhead. Thus Production Cost Budget is based upon Production Budget,
Material Cost Budget, Labour Cost Budget and Factory Overhead Budget.

230
Cash Budget
The cash budget is one of the most important and one of the last to be prepared.
It is a detailed estimate of cash receipts from all sources and cash payments for all
purposes and the resultant cash balance during the budget period. It makes certain
that the business has sufficient cash available to meet its needs as and when these
arise. It is a device for coordinating and controlling the financial side of the
business to ensure solvency and provide a basis for planning and financing required
to cover up any deficiency in cash. Cash budget thus plays an important role in the
financial management of a business undertaking.
Purposes. The main purposes of cash budget are outlined below :
1. It ensures that sufficient cash is available when required.
2. It indicates cash excesses and shortages so that action may be taken in time
to invest any excess cash or to borrow funds to meet any shortages.
3. It establishes a sound basis for credit.
4. It shows whether capital expenditure may be financed internally
5. It establishes a sound basis for control of cash position.

Preparation of Cash Budget

There are three methods of preparing cash budget:
1. Receipts and Payments Method.
2. Adjusted Profit and Loss Method and.
3. Balance Sheet Method.
Receipts and Payments Method. This method is usually used for short term
cash forecast and is much more detailed than the other two methods.
The cash budget begins with the opening balance of cash in hand and at bank.
To this will be added the estimated cash receipts from various sources and from this
will be deducted all estimated payments of cash, whether on capital or revenue
account. The resultant figure is closing cash balance.
Cash receipts in most situations arise from cash sales, collections from debtors,
interest on investments and loans, sale of capital assets and miscellaneous sources.

231
In the case of credit sales, adjustment should be made for the time lag between the
point of sale and realisation of cash.
Cash payments are made for raw material purchases, direct labour, out of
pocket expenses, capital expenditure projects, dividends, etc. The period of credit
appropriate to the payment concerned should be taken into account.
A cash budget may be presented in the following form:

Cash Budget
for the quarter ending 31st March...

Jan. Feb. March. Total

Opening balance
Receipts
Cash sales
Receipts from debtors
Dividend income
Issues of shares etc.

Total Receipts

Payments
Cash purchases
Trade creditors
Wages and salaries
Dividend payable
Capital expenditure
Taxes
Total Payments

Closing balance

232
 FIXED AND FLEXIBLE BUDGETS
Fixed Budget
A fixed budget is one which is prepared keeping in mind one level of output. It is
defined as a budget "which is designed to remain unchanged irrespective of the
level of activity attained."* If actual output differs from budgeted level of output,
variances will arise. Fixed budget is prepared on the assumption that output and sales
can be estimated with a fair degree of accuracy. This means that in those situations
where sales and output cannot be accurately estimated, fixed budget does not suit.

Flexible Budget
In contrast to a fixed budget, a flexible budget is one "which is designed to
change in relation to the level of activity attained.'"* The underlying principle of
flexible budget is that a budget is of little use unless cost and revenue are related to
the actual volume of production. Flexible budgeting has been developed with the
objective of changing the budget figures to correspond with the actual output
achieved. Thus a budget might be prepared for various levels of activity, say, 70%,
80% 90% and 100% capacity utilisation. Then whatever the level of output actually
reached, it can be compared with an appropriate level.
Flexible budgets are prepared in those companies where it is extremely difficult
to forecast output and sales. Such a situation may arise in the following cases:
1. Where nature of business is such that sales are .difficult to predict e.g. demand
for luxury goods is quite unpredictable.
2. Where sales are affected by weather conditions, e.g., soft drink industry,
woollen garments, etc.
3. Where sales are affected by changes in fashion e.g. readymade garments.
4. Where company frequently introduces new products.
5. Where large part of output is intended for export.

233
Uses of Flexible Budgets
The figures in flexible budgets are adaptable to any given set of operating
conditions. It is, therefore, more realistic than a fixed budget which is true only in
one set of operating conditions.
Flexible budgets are also useful from the control point of view. Actual
performance of an executive should be compared with what he should have
achieved in the actual circumstances and not with what he should have achieved
under quite different circumstances.
In brief, flexible budgets are more realistic, practical and useful. Fixed budgets,
on the other hand, have a limited application and are suited only for items like fixed
costs.

Preparation of Flexible Budgets

The preparation of flexible budgets necessitates the analysis of all costs into
fixed and variable components. This analysis, of course, not peculiar to flexible
budgeting, is more important in flexible budgeting than in fixed budgeting. This is so
because in flexible budgeting, varying levels of output are considered and each class
of overhead will be different for each level. In flexible budgeting, a series, of
budgets are prepared for every major level of activity so that whatever is the actual
level of output, it can be compared with appropriate budget or can be interpolated
between budgets of the activity levels on either side. For example, budgets may be
prepared for, say, 60%, 70%, 80%, 90% and 100% levels of activity. If the actual level
of activity is 85%, then the budget allowance for 85% activity should be computed.

Illustration 11.4. Prepare a flexible budget for production at 80 per cent and 100
per cent activity on the basis of the following information :
Production at 50% capacity 5,000 units
Raw materials Rs. 80 per unit
Direct labour Rs. 50 per unit
Direct Expenses Rs. 15 per unit
234
 Factory Expenses Rs. 50,000 (50% fixed)
Administration expenses Rs. 60,000 (60% variable).
(B.Com. Bangalore)

Solution
Flexible Budget
for the period............
:
80% Capacity 100% Capacity
8,000 units 10,000 units
Cost Per unit Total Per unit Total
Rs. Rs. Rs. Rs.
Raw materials 80.00 6,40,000 80.00 8,00,000 ,
Direct labour 50.00 4,00,000 50.00 5,00,000
Direct expenses 15.00 1,20,000 15.00 1,50,000
Prime cost 145.00 11,60,000 145.00 14,50,000
Factory expenses :
Variable . 5.00 40,000 5.00 50,000
Fixed . 3.125 25,000 2.50 25,000
Works cost 153.125 12,25,000 152.50 15,25,000
Administration expenses :
Variable 7.20 57,600 7.20 72,000
Fixed 3.00 24,000 2.40 24,000
Total cost 163 .325 13,06,600 162.10 16,21,000

In flexible budgets, the following important points should be noted :

1. Total fixed costs for each level remains unchanged.
2. Per unit fixed cost decreases when level of output increases and vice versa.
3. Total variable cost increases in proportion to increase in the level
of output and.
4. Per unit variable cost remains unchanged at each level.

Illustration 11.5. G. Ltd. is currently operating at 75% of its capacity. In the

235
past two years, the level of operations were 55% and 65% respectively. Presently,
the production is 75,000 units. The company is planning for 85% capacity level
during 2005-06. The cost details are as follows :

236
 Particulars 55% 65% 75%

Rs. Rs. Rs.

Direct materials 11,00,000 13,00,000 15,00,000

Direct labour 5,50,000 6,50,000 7,50,000

Factory overheads 3,10,000 3,30,000 3,50,000
Selling overheads 3,20,000 3,60,000 4,00,000
Administrative overheads 1,60,000 1,60,000 1,60,000

Profit is estimated @ 20% on sales. The following increases in costs are

expected during the year :
Direct materials 8% Direct labour 5%
Variable factory overheads 5% Variable selling overheads 8%
Fixed factory overheads 10% Fixed selling overheads 15%
Administrative overheads 10%
Prepare a flexible budget for the period 2005-06 at 85% level of capacity and
ascertain the profit on sales,
(C.A. Inter, B.Com. Hons. Delhi)
Solution. Flexible Budget for the period 2005-06
____________________________________________________For 85,000 unit
Rs,
Direct materials (Rs. 20 + 8%) x 85,000 units 18, 36,000
Direct labour (Rs. 10 + 5%) x 85,000 units 8, 92,500
Factory overhead - Fixed (2, 00,000 + 10%) 2, 20,000
Variable (Rs. 2 + 5%) x 85,000 units 1, 78,500
Administration overhead (1, 16,000+10%) 1, 76,000
Selling overhead - Fixed (1, 00,000 + 15%) 1, 15,000
Variable (Rs. 4 + 8%) x 85,000 units 3, 67,200
Total Cost 37.85.200
Profit (25% on cost or 20% on sales) 9, 46,300
Sales_________________________________________ 47, 31,500
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 Note: Factory overhead and selling overhead are semi-yariable items' and are
segregated by the following
methods ;
Difference in overhead at two levels
Variable overhead =
Different in output
Rs. 3, 30,000-3, 50,000
Variable factory overhead = = Rs. 2 per unit
J
10,000 units
Fixed factory overhead = Rs. 3, 30,000 - (65,000 units * Rs. 2)
= Rs. 2, 00,000
Similar calculation may be made for selling overhead.

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 ZERO BASE BUDGETING (ZBB) v

Before preparing a budget, a base is determined from which the budget process
begins. Quite often current year's budget is taken as the base or the starting point
for preparing the next year's budget. The figures in the base are changed as per the
plan for the next year. This approach of preparing a budget is called incremental
budgeting since the budget process is concerned mainly with the increases or
changes in operations that are likely to occur during the budget period. For
example, sales of the current year's budget may be taken as the base and next
year's budget for sales will be current year's sales plus an allowance for price
increases and expected changes in sales volumes. The main drawback of this
conventional approach is that it perpetuates the past inefficiencies.
Zero base budgeting (ZBB) is an alternative to conventional or incremental
budgeting. ZBB was introduced at Texas Instruments in USA in 1969 by Peter
Phyrr, who is known as the father of ZBB. It is a managerial tool and is steadily
gaining acceptance in the business community. ZBB not based on incremental I
approach and previous year's figures are not taken as- the base, for preparing next
year's budget. Instead, the budget figures are developed with zero as the base,
which means that a budget will be prepared as if it is being prepared for a new
company for the first time.
Peter Phyrr has defined ZBB as "a planning and budgeting process which
requires each manager to justify his entire budget request in detail from scratch
(hence zero base). Each manager states why he should spend any money at all.
This approach requires that all activities be identified as decision packages which
will be evaluated by systematic analysis ranked in order of importance "It is also
defined as "a system whereby each budget item,' regardless of whether it is new or
existing, must be justified in its entirety each time a new budget is prepared." The
novel part of the ZBB is the requirement that the budgeting process starts at zero
with all expenditures completely justified. This contrasts with the usual •approach
in which a certain level of expenditure is allowed as a. starting point and the
budgeting process focuses on request; for incremental expenditures.
239
in ZBB, budget requests for appropriation are accepted on the basis of cost benefit
approach which ensures value for money. It questions long standing assumptions
and systematically examines and perhaps abandons any unproductive projects.
This means that those of the activities which are of no value find no place in the
forthcoming budget even though these might have been an integral part of the past
budget prepared under the traditional approach. ZBB in a way tries to locate those
activities which are not essential. Advantages : The main advantages of ZBB are as
follows :
1. In ZBB all activities included in the budget are justified on cost benefit
considerations which promote more effective allocation of resources. 2.
ZBB discards the attitude of accepting the current position in favour of an
attitude of questioning and challenging each item of budget.
3. It is an educational process and can promote a management team of talented
and skilful people who tend to promptly respond to changes in the business
environments.
4. It facilitates identification of inefficient and unnecessary activities and avoid
Wasteful expenditure.
5. Cost behaviour patterns are more closely examined.
Disadvantages: -
1. ZBB involves high cost of preparing budgets every year.
2. It also requires high volume of paper work.
3. In ZBB there is danger of emphasising short-term gains at the expense of
long-term ones.
4. It has a tendency to regard any activity not foreseen and sanctioned in the
most recent ZBB as illegitimate.

PROBLEMS AND SOLUTIONS

 Problem II.1. Draw up a flexible budget for overhead expenses on the basis
of the following data and determine the overhead rates at 70%, 80% and 90%
plant capacity.
At 80% Capacity
Rs.
Variable Overheads:
Indirect labour 12,000
Stores including spares 4,000
Semi-variable Overheads :
Power (30% fixed, 70% variable) 20,000
Repairs and maintenance (60% fixed, 40% variable) 2,000
Fixed Overheads :
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total Overheads 62,000
Estimated direct labour hours 1,24,000 hrs.
(BBM Bangalore: B. Com, Madurai)

Solution

Flexible Budget
for the period.......

At 70% . U 80% At 90%

capacity capacity capacity

Variable overheads: Rs. Rs. Rs.
Indirect labour 10,500 12,000 13,500

241
 Stores including spares 3,500 4,000 4,500
Semi-variable overheads:
Power : Fixed 6,000 6,000 6,000
Variable 12,250 14,000 15,750
Repairs and Maintenance :
Fixed 1,200 1,200 1,200
Variable 700 800 900
Fixed overheads:
Depreciation 11,000 11,000 . 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000

(A) Total overhead 58,150 62,000 65,850

(B) Estimated direct labour hours 1,08,500 1,24,000 1,39,500
Direct labour hour rate (A / B) Re 0.536 0.500 0.72

Working Notes :

1. Indirect labour cost at 70% = 12,000 x 70 = Rs. 10,500;

80
at 90% = 12,000 x 90 = Rs. 13,500
80

Similar calculation for other variable item i.e. stores.

2. Power - Fixed = Rs. 6,000, variable = Rs. 14,000.
Variable power at 70% = 14,000 x 70 = Rs. 12,250;
80
at 90% = 14,000 x 90 = Rs. 15,750
80

Similar calculation for repairs and maintenance

242
 2. Direct labour hours at 70% = 1,24,000 x 70 = 1,08,500;
80
at 90% = 1,24,000 x 90 = 1,39,500
80

Problem 11.3. From the following data, prepare a flexible budget for production of
40,000 units and 75,000 units, distinctly showing variable cost and fixed cost as well as
total cost. Also indicate element-wise cost per unit. Budgeted output is 1,00,000 units
and budgeted cost per unit is as follows:

Rs.
Direct Material 95
Direct labour 50
Production overhead (variable) 40
Production overhead (fixed) 5
Administration overhead (fixed) 5
Selling overhead (10% fixed) 10
Distribution overhead (20% fixed) 15
{BBM Bangalore Adapted; B.Com. Horn. Delhi, C.S. Inter)

Solution
Flexible Budget for the period
40,000 units 75,000 units

243
 Particulars Per Total Per unit Total
unit
Rs. Rs. Rs. Rs.
D. Material 95 38,00,000 95 71,25,000

D. Labour 50 20,00,000 50 37.50,000

Prod, overhead (variable) 40 16,00,000 40 30,00,000
Selling overhead (variable) 9 3,60,000 9 6,75,000
Dist. overhead (variable) 12 4,80,000 12 9,00,000

Total variable cost. (V) 206 82,40,000 206 1,54,50,000

Production overhead (fixed) 12.50 5,00,000 6.67 5,00,000

Administration overhead (fixed) 12.50 5,00,000 6,67 5,00,000

Selling overhead (fixed) 2.50 1,00,000 1.33 1,00,000
Distribution overhead (fixed) 7.50 3,00,000 4.00 3,00,000

Total Fixed cost (F) 35.00 14,00,000 18.67 14,00,000

Total Cost (F + V) 241 96,40,000 224.67 1,68,50,000

Problem 11.4. Z Limited has prepared the budget for the production of 1,00,000
units from a costing period as under :
Per unit
Rs.
Raw materials 10.08
Direct labour 3.00
Direct expenses 0.40
Works overhead (60% fixed) 10.00
Administration overhead (80% fixed) 1.60
Sales overhead (50% fixed) 0.80
Actual production in the period was only 60,000 units. Prepare budgets for the
original and revised levels of output.

244
 (B.Com., Madurai, Bangalore)
Solution
Flexible Budget for the period..
Original Budget Revised Budget
1,00,000 units 60,000 units
Items of cost Per unit Total Per unit Total
Rs. Rs. Rs. Rs.
Raw materials 10.08 10,08,000 10.80 6,04,800
Direct labour 3.00 3,00,000 3.00 1,80,000
Direct expenses 0.40 40,000 0.40 24,000
Prime cost 13.48 13,48,000 13.48 8,08,800
Works overhead :
Variable 40% 4.00 4,00,000 4.00 2,40,000
Fixed 60% 6.00 6,00,000 10.00 6,00,000
Works cost 23.48 23,48,000 27.48 16,48,000
Administration overhead :
Variable 20% 0.32 32,000 0.32 19,200
Fixed 80% 1.28 1,28,000 2.13 1,28,000
Cost of production 25.08 25,08,000 29.93 17,96,000
Selling overhead :
Variable 50% 0.40 40,000 0.40 24,000
Fixed 50% 0.40 40,000 0.67 40,000
Total cost 25.88 25,88,000 31.00 18,60,000
SECTION-A

1. Define a budget.
2. What are the characteristics of a budget ?
3. Define budgetary control.
4. What are the characteristics of budgeting control ?
5. What are the objectives of budgetary control.
6. State any three advantages of budgetary control.
7. State any two limitations of budgetary control.
8. Enuemerate the various functional budgets.
9. What is a principal budget factor ?

245
 10. What is a fixed budget ?
11. What is a flexible budget ?
12. What is the difference between forecast and budget ?
13. State any two points of difference between standard costing and
budgetary control.
14. What are the points of similarity between standard costing and
budgetary control ?
15. State any three essential requirements of a budgetary control
system.
16. What are the main steps in budgetary control ?
17. What is zero base budgeting (ZBB) ?
18. Why flexible budget is better than a fixed budget ?

SECTION-B

1. What is a budgetary control system ? State the advantages of budgetary

control system in an organisation.

2. Define 'budget' and 'budgetary control'. State the advantages of budgetary

control in an organisation.

3. Discuss the advantages and limitations of budgetary control.

4. Describe the types of budgets.

.
5. What do you understand by budgetary control ? What are the essentials for
the success of a budgetary control system.

6. What are the different kinds of budgets ? What is master budget ?

246
 )
7. Differentiate between fixed budgeting and flexible budgeting.
8. Define and explain the term flexible budget. How is a flexible budget
constructed and what difficulities do you expect in the construction of flexible
budget ? Explain the usefulness of a flexible budget to management.

12. What purpose

is served by instituting a budgetary control system in an organisation having
both manufacturing and selling activities ?
)
13. What is ZBB ? What are its advantages and limitations ?
SECTION-C
1. With the following data at 60% activity, prepare a budget
at 80% and 100% activity:
Production at 60% capacity 600 units.
Materials Rs. 120 per unit.
Labour Rs. 50 per unit
Expenses Rs. 20 per unit.
Factory expenses Rs. 60,000 (40% fixed)
Administration expenses Rs. 40,000 (60% fixed)
(Ans. Total cost at 80% Rs.2, 69,333; At 100% Rs. 3, 24,667)
2. Production costs of Oriental Enterprises Limited are as follows:
Level of Activity
60% 70%
80%
Output (in units) ,200 1,400 1,600
Costs (in Rs.) :
Direct materials 24,000 28,000 32,000
Direct labour 7,200 8,400 9,600

247
 Factory overheads 12,800 13,600 14,400
Works cost 44,000 50,000 56,000
A proposal to increase production to 90% level of activity is under the
consideration of the management. The proposal is not expected to involve any
increase in fixed factory overheads. Prepare a statement showing the prime
cost, total marginal cost and total factory cost at 90% level of activity).
(Ans. Factory cost at 90% Rs. 62,000)

248
Module -7
ACTIVITY BASED COSTING
Objectives:

Introduction
In any system of costing direct costs are easier to handle as these are directly charged
to the end products but indirect costs are difficult to handle because they need to be
allocated to the end products by following a suitable basis of allocation. Traditionally,
indirect costs have been allocated to the end products in three steps : first from ledger
accounts to production and service departments, taken from service departments to
production departments following reapportionment methods of allocation and then finally
allocating the indirect costs of production departments to the end products.
In traditional costing there is no general basis of allocation of indirect costs and it is
left to the judgment of the cost accountant to select the most appropriate basis of
allocation. Indirect costs so allocated do not truly reflect the resources consumed by the
end products and unnecessarily result in inflated or reduced costs of the end products.
Inaccurate cost information thus provided by the traditional costing methods may lead to
wrong decisions if used for control purposes or for fixing selling prices or sending
quotations. Inaccurate cost information is further aggravated if the indirect costs are more
as compared to the direct costs which is more likely to be the case with more and more
automation taking place in the present world.
To quote Professor Vipui, "Activity Based Costing had its genesis in the increasing
importance of indirect costs in the manufacturing operations. The direct processing costs
which are easier to handle are being relegated to the background with each passing day
due to automation. In this changing scenario where indirect costs far outweigh the direct
processing costs in many a situations, one cannot be content with rough and ready
methods of yesteryears in dealing with the indirect costs. "

249
 Now-a-days many organisations have adopted advanced manufacturing technology
with the result that indirect costs are increasing enormously and direct costs are becoming
a smaller portion of total costs. Traditional costing systems which absorb indirect costs
on a direct labour basis are, therefore, not relevant in the present set up of advanced
manufacturing technology, In the present set up, ABC is a better approach of cost
allocation. The CIMA Official Terminology defines ABC as "Cost attribution to cost
units on the basis of benefit received from indirect activities e.g. ordering, setting up,
assuring quality."

Concept of ABC

Activity based costing (ABC) is a new term developed for finding out the cost. The
basic feature of ABC is its focus on activities as the fundamental cost objects. It uses
activities as the basis for calculating the costs of products and services. To quote
Homgren. Foster and Datar, "ABC is not an alternative costing system to job costing or
process costing. Rather, ABC is an approach to developing the cost numbers used in job
costing or process costing systems. The distinctive feature of ABC is its focus on
activities as the fundamental cost objects. In contrast, more traditional approaches to
developing the cost numbers used in job or process costing systems rely on general
purpose (generic) accounting systems not tailored to the activities found in individual
organisations. The ABC approach is more expensive than traditional approaches. ABC
has the potential, however, to provide managers with information they find more useful
for costing purposes". It is an effective method of exercising cost control and can be used
in designing either a job costing system or process costing system. ABC approach is used
to refine a costing system to get better results. In ABC approach, the first step is to
identify the activities for which costs are to be collected and controlled. The various
activities may be identified as direct activities and indirect activities. Direct activities
may be taken as direct materials and direct labour. Indirect cost pools may be identified
as order processing, materials handling, machine insertion of parts, manual insertion of
parts, repairs and maintenance, quality testing etc. The next step is the selection of
suitable cost allocation base for assigning indirect costs to various activities so that all
activities are suitably burdened.
In today's environment of globalisation, when each organisation has to

250
continuously improve its products and benchmark its activities with the most efficient in
the world, a firm cannot do without activity based costing. A firm can have a hold on the
market only if it manages properly the value chain at-each stage. Value added at each
stage is to be compared with the costs associated and on that basis decisions are taken
about cutting the unnecessary activities or adding the new activities. Activity based
costing makes available exact cost information which improves the quality of managerial
decisions. In activity based costing the focus of attention is an activity rather than a
department. A department may have a number of activities which may be non-value
adding. Such activities are targeted in down sizing exercise with the help of activity
based costing for better effectiveness of the department.
Activity based costing (ABC) aims at rectifying the inaccurate cost information. It
is modern approach of indirect cost allocation. ABC does not restrict itself to the
allocation of indirect costs to departments as is done in the traditional approach but it
recognises individual activity as the lowest unit for indirect cost allocation. Costs
allocated to each activity represents the resources consumed by it.
Activity based costing is based on the belief that activities give rise to costs.
Therefore, a link should be made between activities and products by assigning cost of
activities to products based on an individual product.

Traditional Versus ABC Approach to Designing a Costing System

In traditional approach, there is lack of cause and effect relationship between the cost
allocation bases and indirect cost pools because one or a few cost pools for each
department or entire plant having little homogeneity are used. In ABC approach, many
homogeneous indirect cost pools for various activity areas rather than a department or
entire plant are used. There is a cause and effect relationship between the cost allocation
bases and the indirect cost pools. The traditional approach usually uses a few pools of
indirect costs, so cost allocations are often based on broad averages. The costs of
products thus ascertained may be either over recovered or under recovered which may
lead managers to make wrong pricing decisions resulting in loss of market share by fixing
higher selling prices or selling prices for some products may be below the costs incurred
to produce them. Activity based costing is a rational way of assigning indirect costs to

251
various activities and pricing decisions taken by managers will be rational.
The activity based job costing method or process costing method is helpful in
ascertaining areas where cost reductions are possible. Activity based costing can lead to
improved decision making such is fixing selling price and pinpointing the area where
cost reduction is possible because it provides more detailed information about various
activities involved in a product or service.
Activity based principles can be successfully applied to the art of budgeting.
Activity based budgeting is an approach to budgeting that lays emphasis on budgeting
the costs of activities necessary to produce and sell products and services. Activity based
budgeting is especially useful in case of budgeting of indirect costs. Important steps in
activity based budgeting are as follows:
1. Determining the demand for each individual activity on the basis of budgeted
production.
2. Determining the budgeted cost of performing each activity.
3. Ascertaining the actual cost of each activity.
4. Comparing the actual cost with the budgeted cost of each activity, noting down
the difference and taking corrective action wherever necessary.

Implementation of Activity Based Costing

Since allocation of indirect costs to various products or departments on a reasonable
basis is a complicated job, activity based costing technique helps a cost accountant to
find out product cost to a greater accuracy. The following steps are involved in
implementing ABC to achieve the desired results :
I. Identifying the functional areas (like material management, production, quality
control etc ) involved. Identifying the key activities involved in each functional
area.
II. Allocating the common indirect costs to various activities in each functional
area.
III. Identifying the most suitable cost driver in each activity under functional areas
for better allocation of indirect costs to get accurate cost information. A cost
driver is any factor that influences cost. A change in the cost driver will lead to a
change in the total cost of a related cost object.

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 V. Preparing the statement of expenditure activity wise and comparing it with the
value addition activity wise to know the activities which are to be eliminated or
need improvement for better performance of the organisation.

Functional areas may be as follows :

(a) Material Management, (b) Stores Management, (c) Production Management, (d)
Quality Control Management, (e) Personnel Management, (/) Sales Management, (g)
Repairs & Maintenance, (h) Administration and (i) Public Relation.

Some of the functional areas along with activities involved and cost drivers are given
below:

Functional Areas Activities Involved Cost driver

Material 1 Issuing tenders No. of tenders issued
management
2 Receiving of indents No. of indents
3 Analysis of offers from suppliers No. of purchase orders
4 Issue of purchase orders No. of purchase orders
5 Inspection of materials No. of purchase orders
6 Information to stores for No. of purchase orders
receiving the materials No. of
purchase orders
Store 1 Storing the materials Value of materials stored
management
2 Servicing of requisitions No. of requisitions
3 Inspection and verification No. of times inspected
4 Taking perpetual stock taking Value of stock handled
1 Receipt of samples
Quality control 2 Testing the samples No.of batches produced
3 Issue of test certificate
1 Recruitment No.of employees
recruitment
2 Maintenance of records of No.of employees
Personal attendance, leave, increment etc
management Training No.of employees
3
4 Industrial relations No.of employees
5 Settlement of industrial disputes No.of employees
6 Labour turnover No.of employees replaced

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 1 Demand creation % increase in Sales
2 Advertising effort % increase in Sales
Marketing 3 Analysis of feedback from sales Time spent with
distributors, customers
4 Preparation of Sales Forecasts Time spent

BENEFITS OF IMPLEMENTING ABC

The following are the main benefits of implementing ABC :
1. Cost Management and Downsizing
ABC helps to reduce costs by providing meaningful information on the opportunities
available for reducing costs. If the company's financial performance is not satisfactory, it
may have to resort to extreme measures like layoffs. ABC helps in making the right
decisions as it clearly defines the various activities. Thus one can focus on value adding
activities and eliminating the non-value adding activities.
2. Determination of Products Service Costs
Nowadays, non-manufacturing costs can no longer be neglected as they constitute a
substantial portion of the total cost. e.g., soft drink giants of the world, Coke and Pepsi
have huge Marketing and Advertising Costs. On the contrary manufacturing costs
constitute a very small proportion of the total cost. These non-manufacturing costs can be
allocated easily using ABC because the relationship between costs and its causes is better
understood. Wrong allocation of these costs leads to a tendency c overvaluing the high
volume products and undervaluing the low volume products which causes subsidization
of one product by the other unknowingly. This may lead to a faulty pricing policy.

3. Improvements in Performance

ABC involves preparing the statement of expenditure activity-wise and

comparing it with the corresponding value addition to know the activities which are to be
eliminated or need improvement for better performance of the organisation. ABC
provides accurate cost information which is essential
4. Product/service pricing
ABC enables the management to fix the product/service prices by formulating an
effective pricing policy. ABC helps in price fixation by providing information about

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 the product/service cost.
5. Make or Buy Decision
ABC enables the manager to decide whether he should get the activity done within
the firm or subcontract the same to an outside agency. Subcontracting may be done if
the firm is incurring higher overhead cost as compared to the subcontractor. On the
contrary if the cost is not going to decrease or the resources fed by sub-contracting can
not be economically diverted elsewhere, the company should get the activity done
internally.
6. Transfer Pricing

ABC helps to determine the cost of each activity. Thus when finished good of
department 'A' is transferred to department 'B’ the cost of the product to department B
can be easily known. Moreover, accuracy of indirect cost allocation to the product being
transferred is very important as the performance evaluation of both departments A and B
depends on the proportion of indirect costs being passed on to Department B. ABC
provides accurate cost information to evaluate the performance of the transferor and
transferee departments.

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