COST AND MANAGEMENT

ACCOUNTING
(BBA 201)

Jaipur National University

Directorate of Distance Education
_________________________________________________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
(Recognised by Joint Committee of UGC-AICTE-DEC, Govt. of India)
 COST AND MANAGEMENT ACCOUNTING
Cost Accounting: Introduction, Elements of cost, Material, Purchasing, storing and pricing of stores issued inventory
control.

Inventory System, Selective Stock Control Systems, Concept and classification of material losses.

Labor: Methods of remuneration, incentive plans.

Time keeping and Time booking Idle and overtime-concept and treatments; Various methods of Remuneration; Various
Incentive Schemes.

Accounting and Control of overheads: Allocation, Appointment and Re-apportionment and Absorption of overheads;
Determination of overhead rates; Under and over absorption of overhead.

Job costing – Concept and Job Cost Accounts; Contract Costing – Concept, Contract Account and Determination of Profit
or Loss on incomplete contract,

Presentation of Contract particulars in the Balance Sheet: Retention money, Cost Plus Contract Escalation clauses,

Process costing – concept and Process Accounts with Process Losses and Gains,

Process Losses (Normal and Abnormal) and Gains-concepts and Module X: Accounting Treatment. Equivalent
Production, Inter Process Profit, Joint Product, By-Product are excluded.

Concepts of Budget, Budgeting, Budgetary Control; Objectives, advantages and limitations of budget and Budgetary
Control, Planning, Budget Factors; Cast Budget and Flexible Budget.

Meaning of Standard Cost and Standard Costing; Advantages and limitations of Standard Costing; Standard Costing
vs. Budgetary Control; Types of standard; Analysis of Variances – material and labour (excluding mix variance and yield
variance).

Definition of Marginal Cost and Marginal Costing; Assumptions and uses of Marginal Costing; Differences between
Marginal Costing and Absorption Costing; Marginal Cost equation; Computation of Contribution,

Profit-Volume Ratio, Break Even Point, Margin of Safety, Angle of Incidence; Decision making with the held of
Marginal Costing.

Fund flow statement: Meaning, concept and preparation, Comparison between fund flow and cash flow statement.
 1
Cost Accounting
CONTENTS
Objectives
Introduction
1.1 Elements of cost
1.2 Material
1.3 Purchasing
1.4 Storing and Pricing of Stores Issued Inventory Control
1.5 Summary
1.6 Keywords
1.7 Self Assessment Questions
1.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain the elements of cost
Understand material in cost accounting
Explain briefly about purchasing
Explain the storing and pricing of stores issued inventory control

Introduction
Cost accounting is the process of accounting for costs. It embraces the accounting procedures
relating to recording of all income and expenditure and the preparation of periodical statements and
reports with the object of ascertaining and controlling costs . It is, thus, the formal mechanism by
means of which the costs of products or services are ascertained and controlled. Other hand, Cost
accounting is a branch of accounting and its purpose is to lay down the principles and procedures to
ascertain the costs correctly, analyze them scientifically and suggest measures to control them
efficiently. In any manufacturing activity understanding the nature and behaviour of costs is of
fundamental significance. The success of an enterprise in a highly competitive wo rld depends upon
the ability of the organization to ascertain and control its costs. This is where cost accounting plays
a vital role. Cost accounting analyzes the cost of each product, process and department. It mainly
helps the management in decision making responsibilities. The main functions of cost accounting
can be classified as cost ascertainment, cost analysis, cost distribution, cost reporting and cost
control. Cost accounting is regarded as the process of collecting, analyzing, summarising and
evaluating various alternative courses of action involving costs and advising the management on the
most appropriate course of action based on the cost efficiency and capability of the management.
The organizations and managers are most of the times intereste d in and worried for the costs. The
control of the costs of the past, present and future is part of the job of all the managers in a
company. In the companies that try to have profits, the control of costs affects directly to them.
Knowing the costs of the products is essential for decision-making regarding price and mix
assignation of products and services.

1.1 Elements of cost

One of the main functions of cost accounting is to classify the costs. Costs may be classified
according to its elements. We can distinguish three basic elements in the manufacturing cost of any
product or services. They are material cost, labour cost and other overheads.
Material Costs: The cost of commodities supplied to an undertaking.
Labour Costs: The cost of remuneration of labourers.
Overheads: These are the other expenses incurred.

The expenditure on these various elements of costs may be either d irect or indirect. A direct
expenditure is one, the whole of which can be conveniently charged to a particular product, job or
service whereas an indirect expense is an expense which cannot be identified with any particular
product or job. Therefore, such expenses are allocated on suitable basis. (See Figure 1.1)

1.1.1 Elements of Costs

Elements of costs are given below:

Figure 1.1: Elements of cost.

Direct Cost
It is that element of cost in which we can include the cost of direct material and direct labour. If we
take its total, it will be prime cost.
a) Direct Material Cost
Direct material is that material which we find in finished product and easily measures its cost. For
example, for making furniture, woods are direct material and its cost will be the part of direct cost.

b) Direct Labour Cost

Direct labour is used for producing the product. We pay wages for making product to labourers and
this cost will be the direct labour cost.

c) Direct Expenses Cost

Except direct material and direct labour, all direct expenses will be direct expenses cost.

d) Direct Overheads
The cost of special pattern, dyes drawings tools etc made for specific product.

Indirect Cost
a) Indirect Materials
Lubricants and cotton waste used in maintaining machinery.

b) Indirect Labour
Wages to those who are aiding manufacturing activities by way of supervision, maintenance, tools
setting etc.

c) Overheads
When we cannot charge an expense directly on the product, we can say it is indirect expense or
overhead. In overhead, we can include indirect material cost, indirect labour cost and other
following indirect expenses.
i) Manufacturing overheads
ii) Administrative overheads
iii) Selling overheads
iv) Research and development cost

1.1.2 Applications of Costing

Cost accounting is not applicable only to manufacturing concerns. Its applications are in fact much
wider. All types of activities, manufacturing and non -manufacturing, in which monetary value is
involved, should consider the use of cost accounting. Wholesale and retail businesses, banking and
insurance companies, railways, airways, shipping an d road transport companies, hotels, hospitals,
schools, colleges and universities, all may employ cost accounting techniques to operate efficiently.
It is only a matter of recognition by the management of the applicability of these concepts and
techniques in their own fields of Endeavour.

1.1.3 Methods of Costing

The basic principles of ascertaining costs are the same in every system of cost accounting. However,
the methods of analyzing and presenting the cost may vary from industry to industry. The method to
be used in collecting and presenting costs will depend upon the nature of production. Basically there
are two methods of costing, namely. Job costing and Process costing.

Job Costing: Job costing is used where production is not repetitive and is done against orders. The
work is usually carried out within the factory. Each job is treated as a distinct unit, and related costs
are recorded separately. This type of costing is suitable to printers, machine tool manufacturers, job
foundries, furniture manufactures etc.

Batch Costing: Where the cost of a group of product is ascertained, it is called ‗batch costing. In
this case a batch of similar products is treated as a job. Costs are collected according to batch order
number and the total cost is divided by the numbers in a batch to find the unit cost of each product.
Batch costing is generally followed in general engineering factories which produce components in
convenient batches, biscuit factories, bakeries and pharmaceutical industries.

Contract Costing: A contract is a big job and, hence, takes a longer time to complete. For each
individual contract, account is kept to record related expenses in a separate manner. It is usually
followed by concerns involved in construction work e.g. building roads, br idge and buildings etc.

Process Costing: Where a step has to undergo distinct processes before completion, it is often
desirable to find out the cost of that step at each process. A separate account for each process is
opened and all expenses are charged thereon. The cost of the product at each stage is, thus,
accounted for. The output of one process becomes the input to the next process. Hence, the process
cost per unit in different processes is added to find out the total cost per unit at the end. Proces s
costing is often found in such industries as chemicals, oil, textiles, plastics, paints, rubber, food
processors, flour, glass, cement, mining and meat packing.

Output/Unit Costing: This method is followed by concerns producing single steps or a few topics
which are identical and capable of being expressed in simple, quantitative units. This is used in
industries like mines, quarries, oil drilling, cement works, breweries, brick works etc.

For example, a tone of coal in collieries, one thousand bricks in brick work etc. The object here is to
find out the cost per unit of output and the cost of each item of such cost. A cost sheet is prepared
for a definite period. The cost per unit i s calculated by dividing the total expenditure incurred during
a given period by the number of units produced during the same period.

Operating Costing: This method is applicable where services are rendered rather than goods
produced. The procedure is same as in the case of unit costing. The total expenses of the operation
are divided by the units and cost per unit of service is arrived at. This is followed in transport
undertakings, municipalities, hospitals, hotels etc.

Multiple Costing: Some products are so complex that no single system of costing is applicable.
Where a concern manufactures a number of components to be assembled into complete steps, no one
method would be suitable, as each component differs from the other in respect of materials and the
manufacturing process. In such cases, it is necessary to find out the cost of each component and also
the final product by combining the various methods discussed. This type of costing is followed to
cost such products as radios, aero planes, cycles, watc hes, machine tools, refrigerators, electric
motors etc.

1.1.4 Techniques of Costing

In addition to the different costing methods, various techniques are also used to find the costs. These
techniques may be grouped under the following heads:

Historical Absorption Costing: It is the ascertainment of costs after they have been incurred. It is
defined as the practice of charging all costs, both variable and fixed, to operations, process or
products. It is also known as traditional costing. Since costs are a scertained after they have been
incurred, it does not help in exercising control over costs. However, it is useful in submitting
tenders, preparing job estimates etc.

Marginal Costing: It refers to the ascertainment of costs by differentiating between fixed costs and
variable costs. In this technique fixed costs are not treated as product costs. They are recovered from
the contribution (the difference between sales and variable cost of sales). The marginal or variable
cost of sales includes direct material, direct wages, direct expenses and variable overhead. This
technique helps management in taking important policy decisions such as product pricing in times of
competition, whether to make or not, selection of product mix etc.

Differential Costing: Differential cost is the difference in total cost between alternatives -evaluated
to assist decision making. This technique draws the curtain between variable costs and fixed costs. It
takes into consideration fixed costs also (unlike marginal costing) for dec ision making under certain
circumstances. This technique considers all the revenue and cost differences amongst the alternative
courses, of action to assist management in arriving at an appropriate decision.

Standard Costing: It refers to the ascertainment and use of standard costs and the measurement and
analysis of variances. Standard cost is a predetermined cost which is computed in advance of
production on the basis of a specification of all factors affecting costs. The standards are fixed for
each element of cost. To find out variances, the standard costs are compared with actual costs. The
variances are investigated later on and wherever necessary, rectification steps are initiated promptly.
The technique helps in measuring the efficiency of operation s from time to time.

1.2 Material
In cost accounting, material is defined as the part of inventory. Basically, material and raw material
are used for same purpose. This is main part of total cost of production. It can reduce or increase
according to the fluctuation in production. So, this is very flexible and controllable source of
production. For making furniture, wood is the material. 60% to 70% proportion in the total cost of
production will be material cost. So, it is very necessary for producing any new product. Its cost will
reflect the profit of company directly. This input can be stored and transported from one place to
another. (See Figure 1.2)

Figure 1.2: Total cost of finished product.

To record and control over the material cost is necessary because:

1. Conciliation for Proper Quality with Price of Material
If company buys high quality material, its price will be high. If company buys low quality material,
its price will less. Company has to compromise quality with price of material. Quality will not less
than minimum standard. At that level, company has to pay price of material.

2. Purchase at Competitive Price

If company is selling the products in competitive market, its price must be same with other
competitors. It will be only possible, if company will buy products at competitive price. For buying
competitive price, company has to check past records of purchased material and compare prices with
other competitors.

3. Continue Supply of Material

It is main objective and feature of material that for continue operating of machinery, it is very
necessary that we should have to continue supply of raw material for production. Without, this our
fixed cost will be increased. That is not good. So, it is needed that store keeper must record when he
issues the goods to production department. He also alerts to purchase department for new buying of
material.

4. Equilibrium in the Stock of Material

Over-stocking and under-stocking both are harmful for concern. Equilibrium in stock of material
means optimum stocking of materials. It can be only possible, if company records and control the
stock and use different techniques for measuring level of stock.

5. To Reduce the Wastage and Losses

To reduce normal and abnormal wastage and losses of material in production should be also the a im
of material record and control.

1.2.1 Material Control

Material control is control over materials. With this, we have to save every loss of money which will
be invested in material. Not only save overstocking and under -stocking problem, but to check every
miss-management of material. Material control is very small term of cost accounting but its
deepness can only guesstimate when a cost accountant does this function practically with co -
operation of other employees. (See Figure 1.3)

Figure 1.3: Material control.

1.2.2 Scientific Material Purchasing

Scientific material purchasing is helpful to control material. Scientific purchasing is done by
purchase department but all other department like finance, research, production and marketing also
have to participate in this function indirectly.
Because
a) Production department will provide correct demand of material for production.
b) Finance department will disclose the minimum money resources for fulfilling that demand.
c) Store department will tell what quantity of material already in store.
d) Purchase department will search same goods in market.
e) Purchase department will finally order for purchasing.
f) Receiving department will receive the material and make receiving of material note.
g) Again finance and accounting department will pay the money of purchased goods.
If above process will be done under proper way, cost of material can be controlled by stopping
purchase of inferior quality material at higher price.

1.2.3 Techniques of Material Control

Material is main current asset of business which is needed for finished product. It also has big
proportion in total cost. These two points attract businessman to control the material, so that supply
of stock should be continue without any delay an d also it should be at optimum level without any
over-stocking problem. For this, cost accountant has to use following techniques for controlling the
material or inventory.

1st Technique: Setting of Various Stock Level

In this technique of material control, one should study control by calculating different level of
quantity of stock. With past records, the data of normal usage, maximum usage, minimum usages,
re-order quantity and minimum and maximum period and its mid will be average period. With this
data, one can find following stock level.
a) Re-Ordering Level
It is the level of stock quantity between minimum and maximum level and material order was sent
for getting fresh stock.
Formula
Maximum usage of stock X maximum delivery period

b) Minimum Level
It is the minimum balance, which must be maintained in hand at all times, so that there is no
stoppage of production due to non availability of inventory.
Formula
Re-order level (Normal usage X average period)

c) Maximum Level
It shows maximum quantity which should be in the stock, if we buy more, it means we are wasting
money.
Formula
Re-order level X re-order quantity - (minimum usage X minimum period)

d) Average Stock Level

This is the average of minimum and maximum level and it can be calculated by a dding minimum
level and maximum level and divided by 2.
Formula
minimum level + maximum level / 2

e) Danger Level
It is the level at which normal issues of the raw material inventory are stopped and emergency issues
are only made.
Formula
average consumption X lead time for emergency purchases

2st Technique: ABC Analysis

ABC analysis is that technique of material control in which we divide our material into three
categories and investment is done according to the value and nature of that category‘s materials.
After this, we control of material according to their level of investment. We need not to control all
the categories but we have to control those materials which are in a category.

3st Technique: Two Bin System

Two bin systems are used for the material control. It is that technique of material control in which
we have two bins, one is used for in use minimum stock and second bin is used for reserve stock or
to keep the remaining quantity of material. First bin is utilized for issuing the materia l for
production and then, second bin is used. Its record is done on bin cards and store ledger card.
4st Technique: Continuous Stock Verification
Continuous stock verification is that technique of material control in which company appoints some
experts who verifies all the stock physically with its record. It is just like internal audit of store.
These experts are independent from store and they have right to check the material at any time
without providing advance information to store staff. This surprise checking through continuous
stock verification makes store staff more responsible for duty. There are also other benefits of
continuous stock like it will make store keeper more sober and moral to do the duty. He knows that
the store is also controlled by experts. He tries to best to reduce all inherent shortcomings.
Continuous stock verification will also helpful to remove all discrepancies between actual stock and
book record of stock and expert can identify for this mistake and take action against him.

1.3 Purchasing
Purchasing refers to a business or organization attempting for acquiring goods or services to
accomplish the goals of the enterprise. Though there are several organizations that attempt to set
standards in the purchasing process, processes can vary greatly between organizations. Typically the
word ―purchasing‖ is not used interchangeably with the word ―procurement‖, since procurement
typically includes expediting, supplier quality, and traffic and logistics (T&L) in addition to
Purchasing.
The purchase price variance is the difference between the actual price paid to buy an item and its
standard price, multiplied by the actual number of units purchased.
The formula is:
(Actual price - Standard price) x Actual quantity = Purchase pr ice variance

A positive variance means that actual costs have increased, and a negative variance means that
actual costs have declined.
The standard price is the price that your engineers believe the company should pay for an item,
given a certain quality level, purchasing quantity, and speed of delivery. Thus, the variance is really
based on a standard price that was the collective opinion of several employees based on a number of
assumptions that may no longer match a company's current purchasing situati on.
There are a number of possible causes of a purchase price variance.
For example:
Layering Issue: The actual cost may have been taken from an inventory layering system, such as a
first-in first-out system, where the actual cost varies from the current market price by a substantial
margin.

Materials Shortage: There is an industry shortage of a commodity item, which is driving up the cost.

New Supplier: The Company has changed suppliers for any number of reasons, resulting in a new
cost structure that is not yet reflected in the standard.

Rush Basis: The Company incurred excessive shipping charges to obtain materials on short notice
from suppliers.
Volume Assumption: The standard cost of an item was derived based on a different purchasing
volume than the amount at which the company now buys.

1.3.1 Purchasing Procedures

Purpose: To ensure that goods and services are acquired at the lowest possible cost without
sacrificing quality or educational purpose; are within INR amounts and purpose as approved in th e
budget; comply with federal, state, town, and Westport Public Schools requirements, as well as
generally accepted business practices.
To insure oversight and accountability, purchasing is a two step process. Account managers may
initiate purchase requisitions but only the business office may create and send purchase orders. (A
computerized accounting software system converts approved purchase requisitions into purchase
orders.)

Purchasing Authority: Only designated cost centre managers, i.e., administrators and non- certified
managers, may initiate a purchase requisitions. Managers may designate other staff to prepare the
requisition. However, managers must always sign the purchase requisition.

Processing Procedure: Purchases may be made only by purchase order approved by the assistant
superintendent for business. Any individual who orders goods and services without a purchase order
approved by the Business Office is considered to be making a personal purchase. The Westport
Public School District is not responsible for paying these types of bills.
All prospective purchases must be submitted as requisitions through the accounting software and
also by hard copy prior to the event, purchase or planned reimbursement. The system automatically
tests for fund availability. If there are insufficient funds in the account to be charged, the manager
must complete a transfer of funds request form, attach that form to the purchase requisition and
forward to the business office.

1.3.2 Types of Purchase Requisitions

There are different types of purchase requisitions are given below:
1.Descriptive: This requisition should contain all the information needed to fill the order, quantity,
full product description (including model number, size, colour, etc.), individual unit pricing,
extension of total cost, freight where applicable, vendor discount if available, and complete account
coding. An attachment in lieu of order description may be used only in extreme circumstances.

2. Standing: (Encumbrance Only) this type of requisition should contain a brief description of the
item(s) that will be ordered and the individual(s) authorized to place item orders. These are
generally used for repairs or recurring weekly purchases of supplies.

3. Emergency Purchases: When uncontrollable circumstances require immediate acquisition of

goods or services the following procedure is to be used:
Requisition approved by account manager must be faxed to Business Office (341 -1008) with
cover note requesting emergency approval.
Accounts Payable must be alerted by phone (X2400) to expect the emergency fax.
 Once the emergency purchase is approved by the assistant superintendent for business, the order
may be faxed or called to the vendor, using the purchase order number.

1.3.3 Payment Process: The Business office must have evidence that materials or services have
been received in order to pay invoices:
1. The individual who receives an order must confirm receipt on -line.
2. If partial order has been received the cost centre should sen d the packing slip and a copy of the
pink section of the purchase order to accounts payable. This will allow the Business Office to pay
for the goods received, but keep the purchase order open waiting for the back ordered items to be
delivered.

1.4 Storing and Pricing of Stores Issued Inventory Control

The two functions of materials management, stores and purchase, are complementary to each other.
Apart from the close relationship that exits on a day -to-day basis in the purchase of various items of
stores there are other important activities which can be st be done by close cooperation between
stores and purchase.
These are:
Identification i.e. coding of material
Variety reduction
Inventory control value analysis
Salvaging operations etc.
Stores sends indents to purchase based on inventory levels determi ned in accordance with usage
and delivery lead times
Correct specification writing, code numbers, mention of units (e.g. pounds instead of kilos) etc.,
are all vital in this regard
Determination of ―lot sizes‖ for purchase which should suit production requ irements, transport,
handling and storage space
Purchase informs stores of orders placed and stores in turn informs purchase of receipts,
rejections, shortages, breakages, theft and loss, if any
Stores should inform purchase of changing production trends, slow or non-moving stock,
obsolete or surplus stock, scrap, etc.

Inventory control involves the procurement, care and disposition of materials. There are three kinds
of inventory that are of concern to managers:
Raw materials,
In-process or semi-finished goods,
Finished goods.

If a manager effectively controls these three types of inventory, capital can be released that may be
tied up in unnecessary inventory, production control can be improved and can protect against
obsolescence, deterioration and/or theft.
The reasons for inventory control are:
 Helps balance the stock as to value, size, colour, style, and price line in proportion to demand or
sales trends.
Help plan the winners as well as move slow sellers
Helps secure the best rate of stock turnover for each item.
Helps reduce expenses and markdowns.
Helps maintain a business reputation for always having new, fresh merchandise in wanted sizes
and colours.

Did You Know?

In the early industrial age, most of the costs incurred by a business were what modern accountants
call ―variable costs‖ because they varied directly with the amount of production.

Caution
All packing slips must be forwarded to the business office with the purchase order number written
on them.

Case Study-A Major Time Saver – Automatic Linking of Accounting Data into ICE Format
One concern with which most government services providers must contend is the large amount of
time required to input accounting data into the specific spreadsheet format required by the
government for all cost-plus contracts – ICE (Incurred Cost Electronically). Most accounting
systems cannot link general ledger data to spreadsheets because it is a complex process. Not long
ago, however, Alde baron introduced a new standard feature into its SYMPAQ solutio n that does
just what government contractors like FRC need. By integrating a package called F9 into SYMPAQ,
the software now has the capability to automatically export general ledger data to the ICE format.
FRC was an early adopter of this ICE capability a nd have realized great time savings as a result.
Julie Wheels, FRC‘s Controller explained, ―Before we had this capability, I had spreadsheet
templates that I had personally spent a great deal of time creating a few years ago.
When FRC got its first cost-plus contract, I had to use these to move our data into ICE. With them,
it took about 10 days to get everything done, much of that time spent re -keying data and checking to
make sure there were no mistakes. If I did not have those templates, I could not ima gine how long
the process would take – probably weeks and weeks. And now that we have implemented the new
linking capability in SYMPAQ, once everything was set up and ready to fly – mostly one-time set up
operations – the actual linking of the data from SYMPAQ into ICE took a matter of minutes. I still
spent about half a day checking the data, but that‘s nothing compared with typing all the data or
even using my personal spreadsheet templates.‖ Paul Jacobs, Senior Vice President and Chief
Financial Officer of FRC, added, ―I think the ICE module is quite good. We have found it to be a
very important addition to our SYMPAQ system.‖

Profitable Results
Making a profit when your company is primarily in the business of government contracting is a
delicate matter. There are strict rules and guidelines by which all government contractors must
comply – or risk long-term or permanent cancellation of all contracts. Although the DCAA audits
contractors to ensure they adhere to the rules, FRC has always made a point of o perating strictly by-
the-book, while still significantly increasing their profits year after year. ―I could not have foreseen
this increase and have the confidence that we have properly accounted for all costs without
SYMPAQ,‖ Paul stated. ―I know that everything is what it should be and I‘m willing to sign my
name to it as a CFO – with confidence,‖ he continued.
Audits are not a novelty to FRC. They regularly conduct self -audits, generally on a daily or weekly
basis. ―We have gone through two DCAA accounti ng audits and three outside independent industry
audits by a CPA firm – in 2002-2009, 2003 and 2004 – based on the SYMPAQ system. The fact that
an outside CPA will sign his name to his audit of FRC – that‘s pretty impressive,‖ Paul stated.

Today’s Situation
―FRC is highly successful and SYMPAQ has gotten us where we are today,‖ Paul explained. With
over 50 employees, most of whom are actively providing important services to government and
commercial clients, FRC is profitable, significantly increasing thei r revenue every year resulting in
a truly success story.

Questions
1. Explain the present scenario of automatic linking of accounting data into ice format.
2. What are the relation between FRC and ICE format?

1.5 Summary
Direct cost is that element of cost in which we can include the cost of direct material and direct
labour.
Cost accounting is only a matter of recognition by the management of the applicability of these
concepts and techniques in their own fields of Endeavour.
Cost accounting is quite useful for price fixation. It serves as a guide to test the adequacy of
selling prices. The price determined may be useful for preparing estimates or filling tenders.
A good cost accounting system helps in identifying unprofitable activities, losses or
inefficiencies in any form.
The application of cost reduction techniques, operations research techniques and value analysis
technique helps in achieving the objective of economy in concern ‘s operations.

1.6 Keywords
ABC analysis: It is that technique of material control in which we divide our material into three
categories and investment is done according to the value and nature of that category‘s materials.
Forecasting: It is the process of making statements about events whose actual outcomes (typically)
have not yet been observed. A commonplace example might be estimation of some variable of
interest at some specified future date.
Material: In cost accounting, material is defined as the part of inventory.
Planning: Planning (also called forethought) is the process of thinking about and organizing the
activities required to achieve a desired goal. Planning involves the creation and maintenance of a
plan.
Purchasing: It refers to a business or organization attempting for acquiring goods or services to
accomplish the goals of the enterprise.

1.7 Self Assessment Questions

1. Accounting is related to.....................
(a) management control (b) management function
(c) Both (a) and (b) (d) None of these.

2. The collection and presentation of accounting information come within the area of Cost
accounting.
(a) True (b) False

3. A study of sociology helps to understand the behaviour of man in groups.

(a) True (b) False

4. Cost accounting is.................. to management needs.

(a) low sensitive (b) highly sensitive
(c) Both a and b (d) None of these.

5. The accounting data required for managerial decisions is properly compiled and classified
is...............
(a) modifies data (b) provides data
(c) facilitates control (d) None of these.

6. Cost accounting is mainly concerned with the rearrangement of the information provided
by..............
(a) cost accounting (b) accounting
(c) financial accounting (d) None of these.

7. The financial data are so devised and systematically development that they become a unique tool
for management decision.
(a) True (b) False

8. CIS stands for.................

(a) Comparative Income Sheet (b) Comparative Income Statement
(c) Comparative Income Size (d) None of these.

1.8 Review Questions

1. Distinguish between ‗costing‘ and ‗cost accounting‘.
2. What are the advantages of costing?
3. ―A good system of costing serves as a means of control over expenditure and helps to secure
economy in manufacture‖. Discuss.
4. Describe the various methods of costing in brief.
5. What are the main benefits that may be expected from the installation of costing system in a
manufacturing business?
6. State the differences between financial accounting, cost accounting and manageme nt accounting.
7. Explain how financial accounts are inadequate to measure the performance of an industry.
8. Define cost accounting and management accounting.
9. What are the elements of cost accounting?
10. Explain the term purchasing in cost accounting.
Answers for Self Assessment Questions
1 (b) 2 (a) 3 (a) 4 (b) 5 (a)
6 (c) 7 (a) 8 (b) 9 (c) 10 (b
 2
Inventory System
CONTENTS
Objectives
Introduction
2.1 Inventory System
2.2 Selective Stock Control
2.3 Summary
2.4 Keywords
2.5 Self Assessment Questions
2.6 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain selective stock control systems
Understand concept and classification of material losses

Introduction
An inventory control system is a process for managing and locating objects or materials. In common
usage, the term may also refer to just the software components. Inventory control system is a
systematic way of handling the flow of material which will be beneficial for industries.
Modern inventory control systems often rely upon barcodes and radio -frequency identification
(RFID) tags to provide automatic identification of inventory objects. In an academic study
performed at Wal-Mart, RFID reduced out of stocks by 30 percent for products se lling between 0.1
and 15 units a day. Inventory objects could include any kind of physical asset: merchandise,
consumables, fixed assets, circulating tools, library books, or capital equipment. To record an
inventory transaction, the system uses a barcode scanner or RFID reader to automatically identify
the inventory object, and then collects additional information from the operators via fixed terminals
(workstations), or mobile computers.
2.1 Inventory System
Inventory generally refers to the materials in stock. It is also called the idle resource of an
enterprise. Inventories represent those items which are either stocked for sale or they are in the
process of manufacturing or they are in the form of materials, which are yet to be utilised. The
interval between receiving the purchased parts and transforming them into final products varies from
industries to industries depending upon the cycle time of manufacture. It is, therefore, necessary to
hold inventories of various kinds to act as a buffer between supply and demand for efficient
operation of the system. Thus, an effective control on inventory is a must for smooth and efficient
running of the production cycle with least interruptions.

Inventory refers to those idle resources which have economic valu e and thus it may be defined as
usable but idle resources that have economic value. Inventory is a stock of direct or indirect
material, from raw material to finished goods stocked in order to meet an unexpected future demand.
In other words inventory is a physical stock of goods kept for the future purposes. Inventory
management or control refers to maintaining, for a given financial investment, an adequate supply of
something to meet an expected demand pattern. It thus deals with determination of optimal policies
and procedures for procurement. Inventory is expressed in terms of both quantity and monetary
value. In terms of quantity, it can be expressed as the number of units of an item lying where as in
monetary terms it is the sum total of the monetary v alue of all its items.
Cost accounting information is designed for managers. Since managers are taking decisions only for
their own organisation, there is no need for the information to be comparable to similar information
from other organisations. Instead, the important criterion is that the information must be relevant for
decisions that managers operating in a particular environment of business including strategy make.
Cost accounting information is commonly used in financial accounting information, but first we are
concentrating in its use by managers to take decisions. The accountants who handle the cost
accounting information add value by providing good information to managers who are taking
decisions. Among the better decisions, the better performance of one's organisation , regardless if it
is a manufacturing company, a bank, a non -profit organisation, a government agency, a school club
or even a business school.
The cost-accounting system is the result of decisions made by managers of an organisation and the
environment in which they make them. Cost accounting is regarded as the process of collecting,
analyzing, summarizing and evaluating various alternative courses of action involving costs and
advising the management on the most appropriate course o f action based on the cost efficiency and
capability of the management. The organisation s and managers are most of the times interested in
and worried for the costs. The control of the costs of the past, present and future is part of the job of
all the managers in a company. In the companies that try to have profits, the control of costs affects
directly to them. Knowing the costs of the products is essential for decision -making regarding price
and mix assignation of products and services.
The cost accounting systems can be important sources of information for the managers of a
company. For this reason, the managers understand the forces and weaknesses of the cost accounting
systems, and participate in the evaluation and evolution of the cost measurement an d administration
systems. Unlike the accounting systems that help in the preparation of financial reports periodically,
the cost accounting systems and reports are not subject to rules and standards like the generally
accepted accounting principles. As a result, there is a wide variety in the cost accounting systems of
the different companies and sometimes even in different parts of the same company or organization.
The following are different cost accounting approaches:
standardized or standard cost accounting
lean accounting
activity-based costing
resource consumption accounting
throughput accounting
marginal costing/cost-volume-profit analysis

2.1.1 Applications
An inventory control system may be used to automate a sales order fulfilment process. S uch a
system contains a list of order to be filled, and then prompts workers to pick the necessary items,
and provides them with packaging and shipping. An inventory system also manages in and outwards
material of hardware. Real-time inventory control systems may use wireless, mobile terminals to
record inventory transactions at the moment they occur. A wireless LAN transmits the transaction
information to a central database.
Physical inventory counting and cycle counting are features of many inventory control systems
which can enhance the organisation.

2.1.2 Selective Inventory Control

To identify items, which bring significant benefit by proper management from among hundreds
and thousands of items managed by an organisation?
Determine the importance of items and thus allows different levels of control based on the
relative importance of items

2.1.3 Importance of Cost Accounting

The shortcomings inherent in financial accounting have made the management to realize the
importance of cost accounting. Whatever may be the type of business, it involves expenditure on
labour, materials and other items required for manufacturing and disposing of the product.
Moreover, big busyness requires delegation responsibility, division of labour and specialisation.
Management has to avoid the possibility of waste at each stage. Management has to ensure that no
machine remains idle, efficient labour gets due initiative, proper utilisation of by -products is made
and costs are properly ascertained. Besides management, credit ors and employees are also benefited
in numerous ways by installation of a good costing system in an industrial organisation. Cost
accounting increases the overall productivity of an industrial establishment and, therefore, serves as
an important tool in bringing prosperity to the nation.

2.1.4 Cost Accounting and Management

Cost accounting provides invaluable aid to management. It is so closely allied to management that it
is difficult to indicate where the work of the cost accountant ends and managerial control begins.
Adequate costing data help management in reaching certai n important decisions such as, whether
hand labour should be replaced by the machinery or not; whether a particular product line should be
discontinued or not etc.

Costing checks recklessness and avoids occurrence of mistakes. Costs can be reduced by proper
organisation of the plant and executive personnel. As an aid to management it also provides
important information to enable management, to maintain effective control over stores and
inventory, to increase efficiency of the business, and to check was te and losses. It facilitates
delegation of responsibility for important tasks and rating of employees. However, for all this, it is
necessary for the management to be capable of using in a proper way the information provided by
the cost accounts. The various advantages derived by managements on account of a good costing
system can be put as follows:
Useful in Periods of Depression and Competition
During trade depression the business cannot afford to have leakages which pass unchecked. The
management should know where economies may be sought, waste eliminated and efficiency
increased. The business has to wage a war for its survival. The management should know the actual
cost of their products before embarking on any scheme of reducing the prices or giving te nders.
Costing system facilitates this.
Helps in, Pricing Decisions
Though economic law of supply, demand and activities of the competitors, to a great extent,
determine the price of the product, cost to the producer does play an important part. The produc er
can take necessary guidance from his costing records.
Helps in Estimates: Adequate costing records provide a reliable basis upon which tenders and
estimates may be prepared. The chances of losing a contract on account of over -rating or the loss in
the execution of a contract due to under -rating can be minimised. Thus, ascertained costs provide a
measure for estimates, a guide to policy, and a control over current production.
Cost Accounting Helps in Channelizing Production on Right Lines : Costing makes possible for
the management to distinguish between profitable and non -profitable activities. Profits can be
maximized by concentrating or profitable operations and eliminating non -profitable ones.
Helps in Reducing Wastage: As it is possible to know the cost of the product at every stage, it
becomes possible to check various forms of waste, such as of time, expense etc., or in the use of
machinery, equipment and tools.
Costing Makes Comparison Possible: If the costing records are regularly kept, comparative cost
data for different periods and various volumes of production will be available. It will help the
management in forming future lines of action.

2.2 Selective Stock Control

A stock control system should keep you aware of the quantity of each kind of merchandise on hand.
An effective system will provide you with a guide for what, when, and how much to buy of each
style, colour, size, price and brand. It will reduce the number of lost sales resulting from being out
of stock of merchandise in popular demand. The size of your establishment and the number of
people employed are determining factors in devising an effective stock control plan.
A checklist, often provided by wholesalers, is another counting tool. The checklist provides space to
record the items carried, the selling price, cost price, and minimum quantities to be ordered of each.
It also contains a column in which to note whether the stock on hand is sufficient and when to
reorder. This is another very simple device that provides the level of in formation required to make
knowledgeable decisions about effective inventory management.
Smaller operations today, except for the very smallest, are using some form of a perpetual online
system to record the movement of inventories into and out of their fa cilities. In a retail operation,
the clerk at the register merely scans the ticket with a reader, and the system shows the current price
and removes the item from the inventory control system. A similar process occurs in a
manufacturing operation, except that the ―sale‖ is actually a transfer of the inventory from control to
production. This is a particularly critical system in a large operation such as a grocery store where
they regularly maintain 12,000 plus items. Often a vendor will provide on -site or computerized
assistance needed to help their smaller customers maintain a good understanding of their own
inventory levels and so keep them in balance.

2.2.1 Controlling Inventory

Controlling inventory does not have to be an onerous or complex proposition. It is a process and
thoughtful inventory management. There are no hard and fast rules to abide by, but some extremely
useful guidelines to help your thinking about the subject. A five step process has been designed that
will help any business bring this potential problem under control to think systematically thorough
the process and allow the business to make the most efficient use possible of the resources
represented. The final decisions, of course, must be the result of good judgment, and not the produc t
of a mechanical set of formulas.

Inventory Planning
Inventory control requires inventory planning. Inventory refers to more than the goods on hand in
the retail operation, service business, or manufacturing facility. It also represents goods that must be
in transit for arrival after the goods in the store or plant are sold or used. An ideal inventory control
system would arrange for the arrival of new goods at the same moment the last item has been sold or
used. The economic order quantity, or base orde rs, depends upon the amount of cash (or credit)
available to invest in inventories, the number of units that qualify for a quantity discount from the
manufacturer, and the amount of time goods spend in shipment.

Establish Order Cycles

If demand can be predicted for the product or if demand can be measured on a regular basis, regular
ordering quantities can be setup that takes into consideration the most economic relationships among
the costs of preparing an order, the aggregate shipping costs, and the econ omic order cost. When
demand is regular, it is possible to program regular ordering levels so that stock -outs will be
avoided and costs will be minimized. If it is known that every so many weeks or months a certain
quantity of goods will be sold at a steady pace, then replacements should be scheduled to arrive with
equal regularity. Time should be spent developing a system tailored to the needs of each business. It
is useful to focus on items whose costs justify such control, recognizing that in some cases control
efforts may cost more the items worth. At the same time, it is also necessary to include low return
items that are critical to the overall sales effort.
A given firm must recognize that if it begins to run out of product in the middle of a busy sea son,
other sellers are also beginning to run out and are looking for more goods. The problem is
compounded in that the producer may have already switched over to next season‘s production and so
is not interested in (or probably even capable of) filling any further orders for the current selling
season. Production resources are likely to already be allocated to filling orders for the next selling
season. Changes in this momentum would be extremely costly for both the supplier and the
customer.
On the other hand, because suppliers have problems with inventory control, just as sellers do, they
may be interested in making deals to induce customers to purchase inventories off season, usually at
substantial savings. They want to shift the carrying costs of purchas e and storage from the seller to
the buyer. Thus, there are seasonal implications to inventory control as well, both positive and
negative. The point is that these seasonable implications must be built into the planning process in
order to support an effective inventory management system.

Balance Inventory Levels

Efficient or inefficient management of merchandise inventory by a firm is a major factor between
healthy profits and operating at a loss. There are both market -related and budget-related issues that
must be dealt with in terms of coming up with an ideal inventory balance:
1. Is the inventory correct for the market being served?
2. Does the inventory have the proper turnover?
3. What is the ideal inventory for a typical retailer or wholesaler in thi s business?
To answer the last question first, the ideal inventory is the inventory that does not lose profitable
sales and can still justify the investment in each part of its whole.
An inventory that is not compatible with the firm‘s market will lose profitable sales. Customers who
cannot find the items they desire in one store or from one supplier are forced to go to a competitor.
Customer will be especially irritated if the item out of stock is one they would normally expect to
find from such a supplier. Repeated experiences of this type will motivate customers to become
regular customers of competitors.

Review Stocks
Items sitting on the shelf as obsolete inventory are simply dead capital. Keeping inventory up to date
and devoid of obsolete merchandise is another critical aspect of good inventory control. This is
particularly important with style merchandise, but it is important with any merchandise that is
turning at a lower rate than the average stock turns for that particular business. One of the important
principles newer sellers frequently find difficult is the need to mark down merchandise that is not
moving well.
Mark-ups are usually highest when a new style first comes out. As the style fades, efficient sellers
gradually begin to mark it down to avoid being stuck with large inventories, thus keeping inventory
capital working. They will begin to mark down their inventory, take less gross margin, and return
the funds to working capital rather than have their investment stand on the shelve s as obsolete
merchandise. Markdowns are an important part of the working capital cycle. Even though the
margins on markdown sales are lower, turning these items into cash allows you to purchase other,
more current goods, where you can make the margin you desire.
Information systems are a competitive tool when running alongside traditional stock control
systems. A computerised MRP system is reliant on the fact that the demand for low -level
components is brought about from the production of an end product of which the production level is
planned. The system itself will make it easy to put together the production schedule saving vast
amount of money that would otherwise be spent on labour time to do the same activity.

2.2.2 Material Flow Cost Accounting

Material Flow Cost Accounting is one of the environmental management accounting methods aimed
to reduce both environmental impact and costs at the same time, as a tool of decision making by
business executives and on-site managers. Material flow cost accounting seeks to reduce costs
through waste reduction, thereby improving business productivity.
Material flow cost accounting measures the flow and stock of ―materials,‖ which include raw
materials, parts and components in the manufacturing process, in terms of b oth physical and
monetary units. The costs are managed in the categories of material cost, system cost, and
transportation and waste treatment cost.
We can identify the costs of loss by defective products, waste and other emissions, through
calculating their quantities and the resources used in each manufacturing process and converting
them into monetary value.

In addition to the cost of raw materials, labour cost, depreciation cost and other processing cost are
allocated under such loss cost, and waste co st is calculated by the same means as production cost.
That is why waste is called ―negative product‖ in Material Flow Cost Accounting.
An increasing number of businesses are introducing material flow cost accounting in Japan, for the
following reasons.
Material flow cost accounting helps businesses reduce the amount of waste generation itself,
instead of expanding waste recycling.
Reduced waste generation directly leads to the reduction of material input and material cost,
which realizes direct cost reduction.
This also leads to increased efficiency in processing and waste treatment operations, thereby
enabling reduction of not only material cost but of manufacturing cost in general.
Reductions of waste generation and of material input (resource consumption) are one of the key
activities in environmental management, to lower the environmental impact of manufacturing
industry.

2.2.3 Material Loss in Cost Accounting

Four types of cost accounting are given below:
1. Wastes
2. Scrap
3. Spoilage
4. Defective

Waste
It represents the portion of basic raw material lost in processing having no recoverab le value. Waste
may be visible remnants of basic raw materials or invisible; e.g. Disappearance of basic raw
materials thorough evaporation smoke etc. sh rinkage of material due to natural causes may also form
a part of a material wastage.
Normal waste is absorbed in the course of net output, whereas abnormal waste is transferred to
the costing profit and loss account.
For effective control of wastage, normal allowance for waste and yield should be made from past
experience, technical factors and special features of the material process and product. Actual
yield and waste should be compared with anticipated figures and appropriate actions should be
taken wherever necessary.

Scrap
It has been defined as the incidental residue from certain types of manufacture, usually of a small
amount and low value, recoverable without further processing. Scrap may be treated in the cost
accounts in the following ways:
Where, the value of scrap is negligible, it may be excluded from the costs. In other words, the
cost of scrap is borne by the good units and income scrap is treated as other income .
The sales value of scrap net of selling and distribution cost, is deducted from overhead to reduce
the overhead rate. A variation of this method is to deduct the net realizable value form material
cost. This method is followed when scraps cannot be aggregated job or process wise.
When the scrap is identifiable with a particular job or process and its value is significant, the
scrap account should be charge with full cost. The credit is given to the job or process
concerned. The profit or loss in the scrap account, on realization, will be transferred to the
costing profit and loss account.

Spoilage
It is the term used for materials which are badly damaged in the manufacturing operations, and they
cannot be rectified economically and hence taken out of process to be disposed of in some manner
without further processing. Spoilage may either be normal or abnormal.
Normal Spoilage (i.e. which is inherent in the operation) cost are included in costs either
charging the loss due to spoilage to the production order or by charging it to production
overhead so that it is spread over all the products. Any value released form spoilage is credited
to the production order or production overhead account as the case may be.
The cost of abnormal spoilage (i.e. arising out of causes not inherent in manufacturing process)
is charged to the costing profit and loss account.

2.2.4 Waste from Manufacturing Process

In a processing-type manufacturing, waste and resource loss occur in various steps of the
manufacturing process. Waste generated from pr ocessing includes the following:
Material loss during processing (e.g. listing, swarf), defective products, impurities
Materials remaining in manufacturing equipment following set -ups
Auxiliary materials (e.g. solvents and other volatile materials, detergents to wash equipment
before set-ups)
 Raw materials, work-in-process and stock products discarded due to deterioration or other
unusable reasons

Material Flow Cost Accounting traces equally the both flows of final products and emissions
(wastes) in processes. And material flow cost accounting recognizes even the emissions as one
product. Material flow cost accounting calls products "positive products" and the emissions
"negative products". (See Figure 2.1)

Figure 2.1: Types of waste generated from manufacturing process.

2.2.5 Normal Loss in Cost Accounting

Normal loss is unavoidable losses arising due to the nature of the material or the process .
The reasons for such loss in output can be due to the following:
Evaporation
Breakage
Scrap due to high quality needed
Rejection on inspection
Defective Units
Loss inherent in large scale manufacturing
Chemical Change
Residue Material
Examples of normal losses are metal turnings, off -cuts, metal borings, edges, shreddage and
ends.
The quantity of normal loss anticipated is determined f rom past experience and from the material
specification.
The cost of normal loss is absorbed by the completed output.
The value of scrap of normal loss units is deducted from the direct material cost. Normal loss
never receives a share of the process cost.

2.2.6 Characteristics of Cost Accounting by Material Flow Cost Accounting

The calculation of manufacturing costs for a product is based on the following concepts in material
flow cost accounting:
(1) Dividing costs into positive and negative product cost s for calculation
Positive Product Cost: Costs put into process products (positive product) released to the next
process
Negative Product Cost: Costs put into wasted or recycled items (negative product)

(2) Calculating costs throughout all the process

Positive product cost of a process is added to the new input cost in the following process,
totalling the input costs for calculation.

(3) All manufacturing costs are categorized into the following four groups for the above calculation.
MC: Material costs (costs of materials including main materials put in from the initial process,
sub materials put in during midstream processes, and auxiliary materials such as detergents,
solvents and catalysts)
SC: System costs (Processing costs including labour, depreciation, overhead costs, etc.)
EC: Energy costs (Electricity, fuel, utility and other energy costs)
Waste treatment costs

Did You Know?

To record an inventory transaction, the system uses a barcode scanner or RFID reader to
automatically identify the inventory object, and then collects additional information from the
operators via fixed terminals (workstations), or mobile computers.

Caution
If the business experiences seasonal cycles, it is important to recognize the demands that will be
placed on suppliers as well as other sellers.

Case Study-Batch-production Inventory System

The plant of BASF under consideration consists of multiple parallel production lines, which produce
multiple products in a make-to-stock fashion for process industry. Complicating factors for
planning are the stochastic demand, setup times, batch processing and finite buffer capacities. The
main contribution is the development of a three -stage methodology integrating production and
inventory decisions, which can be used for the evaluation and optimization of a wide range of batch -
production/inventory systems.
Implementation of this methodology in a decision support tool enabled us to identify major
opportunities for improvement of current practice. BASF is the world‘s leading chemical company.
It has customers in over 170 countries and supplies about 8,000 products to almost all industries.
While the chemical, technical and business processes for the different products can be quite diverse,
there are, from the viewpoint of inventory planning and production scheduling, some key aspects
that occur frequently and that are also relevant in this case:

1) Changeover / Sequencing: Process plant productivity is very sensitive to product transitions, and
properly sequencing these transitions is extremely important to improving yields and reducing
changeovers. Cleanups must be taken into account, and product wheels and changeover matrices
provide critical planning criteria when planning product mix and sequencing.

2) Tanks / Silos: Inventory and work-in-process material is often stored in tanks or silos. Planning
for production in tanks and silos must not only address the time required for the operation, but the
volume of the material. The inflow from one operation and the outflow from the next dictate when
the tank is available, and upstream and downstream operations have to be scheduled synchronously
to ensure that the tank does not overflow.

The present case study which is an abbreviated version of [6], analyzes a plant of BASF that has two
buildings (A and B). In each of the two buildings two production lines are available for production.
Most products can be produced on the two lines in building A, whereas for only a small number of
products production is possible in building B. The planning of the plant is critically impacted by the
fact that production in all production lines has to take place in fixed batch sizes (implying that
production of partial batches is impossible).
There exists one major difference between the lay-outs of the production lines in the two buildings.
The production lines in building B start as two parallel lines, but share a single resource at end of
the production process (so-called post-processing). Between the productions of two different
products, this resource has to be cleaned and, thus, setup times are incurred. However, in building
.We distinguish two parallel lines during the complete production process.
Questions
1. What do you understand by BASF?
2. Explain the process plant productivity.

2.3 Summary
Inventory systems where multiple classes of demand may be distinguished .
Controlling inventory does not have to be an onerous or complex proposition. It is a process and
thoughtful inventory management
Inventory cost and service level given a critical level policy due to its analytical complexity the
optimisation of the critical level policy has not been given a lot of attention.
Material flow cost accounting traces equally the both flows of final products and emissions
(wastes) in processes.
Inventory is a physical stock of goods kept for the future purposes .
Computers are most useful in the inventory control if someone have a great many items he need
to order, count and replenish as stock.

2.4 Keywords
Control System: A stock control system should keep you aware of the quantity of each kind of
merchandise on hand.
Cost Accounting Systems: It can be important sources of information for the managers of a
company.
Inventory System: Inventory represents those items which are either stocked for sale or they are in
the process of manufacturing or they are in the form of materials, which are yet to be utilised .
Material Flow Cost Accounting: It seeks to reduce costs through waste reduction, thereby
improving business productivity.
Material Losses: In this form of wastes, scraps, spoilage, etc. should he control through proper
reports and abnormal losses should be avoided as far as possible.
Review Stocks: Items sitting on the shelf as obsolete inventory are simply dead capital.
Spoilage: It is the term used for materials which are badly damaged in the manufacturing operations.

2.5 Self Assessment Questions

1. .................perform a number of vital functions in the operations of a system, which in turn makes
them critical to the production sector as well
(a) Programming (b) Computer
(c) Inventories (d) None of these.

2. An introductory text on management science or operations research will contain a section on

linear programming.
(a) True (b) False

3. A computerized inventory control system can be use to manage ………..items.

(a) database (b) warehoused
(c) store inventory (d) All of these.

4. An inventory that is not compatible with the firm‘s market will lose .
(a) loss (b) database
(c) profitable sales (d) money value

5. A stock control system should keep you aware of the................of each kind of merchandise on
hand.
(a) quality (b) marketing managers
(c) organizations (d) quantity

6. A …………….device inventory can be a valuable asset in tort liability cases.

(a) inventory control (b) traffic control
(c) planning control (d) None of these.

7. An inventory system can be used for …………activities.

(a) many (b) two
(c) Three (d) one

8. Normal loss is unavoidable losses arising due to the nature of the material or the process.
(a) True (b) False
9. Normal waste is absorbed in the course of net output, whereas abnormal waste is transferred to
the Costing Profit and Loss Account.
(a) True (b) False

2.6 Review Questions

1. What do you understand by inventory system?
2. Explain the inventory management?
3. Classify material losses with suitable example.
4. What is the importance of stock control system?
5. When the material flow cost accounting is used? Explain
6. Define the normal loss.
7. Write a short note on inventory planning.
8. What are applications of inventory system?
9. What is cost accounting and management?
10. What is spoilage?

Answers for Self Assessment Questions

1 (c) 2 (a) 3 (b) 4 (c) 5 (d)
6 (b) 7 (a) 8 (a) 9 (a)
 3
Labour Costing
CONTENTS
Objectives
Introduction
3.1 Types of Labour Cost
3.2 Control of Labour Cost
3.3 Methods of Remuneration
3.4 Bonus or Incentives Schemes
3.5 Summary
3.6 Keywords
3.7 Self Assessment Questions
3.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Discuss types of labour cost and its controlling
Define various methods of remuneration
Understand about incentive schemes

Introduction
Labour productivity is fundamental to the success of any construction project. The best method to
control and monitor this resource is to understand the actual expenditure of each activity in
accordance with the priced tender allowable.
Bill of Quantity rates are normally made up of the following components:
Labour
Material
Plant
Subcontractors
Mark-up
The labour component is usually broken down into a team size (e.g. 1 Carpenter + 2 Helpers) that
can execute work at a determined productivity. Various factors can be applied to increase or reduce
the productivity as difficulty is decided at the tendering stage. Once this information is extracted
from the BOQ rates then the labour allowable for all trades can be entered into a spreadsheet; that is
the team size, productivity and quantity for each activity. This information will be used to compare
against actual costs.
Should you however not have the team detail in your priced BOQ then simply enter the labour
component and quantity into the template. This information will still allow you to calculate the
actual efficiency but will not assist you in determining team sizes or productivity required at the
start of a project.
Once the allowable, productivity outputs and team sizes are captured we can start feeding in the
daily costing and progress measurement into the template. The site foreman is required to record the
actual manpower used each day and identify t he activities and quantity of work that was executed.

For example, the following information will be recorded.

Placing concrete 11/03/10 1 artisan 8hrs 4 helpers 8hrs 35m3
Once all the daily record sheets are received, first check that the number of labour and hours
correspond with the clock in card information. It is very important to make sure all labour and hours
of work are accounted for, and that the labour not taking part in the direct works is removed from
the calculation. Failure in checking this will result in a fruitless exercise with meaningless results.

3.1 Types of Labour Cost

The labour cost can be classified into two types:
1) Direct Labour Cost.
2) Indirect Labour Cost.

Direct Labour Cost: Any labour cost that is specially incurred f or or can be readily charged to or
identified with a specific job, contract, work order or any other unit of cost is termed as direct
labour cost. Wages for supervision, wages for foremen, and wages for labours who are actually
engaged in operation or process are the examples of direct labour cost.
Indirect Labour Cost: Indirect labour is for work in general. The importance of the distinction lies
in the fact that whereas direct labour can be identified with and charged to the job, indirect labour
cannot be so charged and has, therefore to be treated as part of the factory overheads to be included
in the cost of production.
For example, salaries and wages of supervisors, storekeepers and maintenance labour etc.

3.2 Control of Labour Cost

Control of labour cost is a significant influence on the growth, profitability and cost of production.
Labour cost may become unduly high rate due to inefficiency of labour, ineffective supervision, idle
time, unusual overtime work etc. The primary objectives of the managem ent therefore are to
efficiently utilize the labour as economically as possible.
Techniques of Labour Cost Control
In order to achieve the effective utilization of manpower resources, the management has to apply
proper system of labour cost control. The labour cost control may be determined on the basis of
establishment of standard of efficiency and comparison of actual with standards.
The management applies various techniques for the effective control of labour costs as under:
1. Scientific method of production planning.
2. Use of labour budgets.
3. Establishment of labour standards.
4. Proper system of labour performance report.
5. Effective system of job evaluation and job analysis.
6. Devise a proper system of control over ideal time and unusual overtime work.
7. Establish a fair and equitable remuneration system.
8. Effective cost accounting system.

3.3 Methods of Remuneration

Remuneration is the total compensation that an employee receives in exchange for the service they
perform for their employer. Typically, this consists of monetary rewards, also referred to as wage or
salary. A number of complementary benefits, however, are increasingly popular remuneration
mechanisms.

There are two basic methods of wages payment:

(1) Time Wages System and
(2) Piece Wage System.
Under time wage system, wages are paid on the basis of time spent on the job irrespective of the
amount of work done. This is known as time rate or day wage system. The unit of time may be a
day, a week, a fortnight or a month. Under piece wage system, rem uneration is based on the amount
of work done or output of a worker. This is known as ―Piece Rate System‖ or ―Payment by Result.‖
Thus, a workman is paid in direct proportion to his output. A variety of bonus and premium plans
have been designed to overcome the drawbacks of two basic methods of wage payments.
A system of incentive plans also takes into consideration the primary principles of these two basic
plans known as Incentive or bonus or premium plan.
The following are the important methods of remuneration which may be grouped into:
1) Time Rate Systems
2) Piece Rate Systems

These may be further classified as under:

1) Time Rate System:
a) At Ordinary Levels
b) At High Wage Levels
c) Guaranteed Time Rates.
2) Piece Rate System:
a) Straight Piece Rate
b) Piece Rates with Guaranteed Time Rate
c) Differential Piece Rates:
i. Taylor‘s Differential Piece Rate System
ii. Merrick Differential Piece Rate System
iii. Gantt Task and Bonus Plan.

3.3.1 Time Rate System

There are three levels of time rate system:
Time Rate at Ordinary Levels: This is also termed as ―Day Wage System‖ or ―Flat Rate System‖.
Under this system, wages are paid to the workers on the basis of time spent on the job irrespective
of the quantity of work produced by the workers. Payment can be made at a rate per d ay or a week, a
fortnight or a month. The formula for calculation of payment of time rate of ordinary levels is as
follows:

Remuneration or Earnings = Hours Worked × Rate per Hour

Time wage system is suitable under the following conditions:

1. Where the units of output are difficult to measurable, e.g. watchman.
2. Where the quality of work is more important e.g., artistic furniture, fine jewellery, carving etc.
3. Where machinery and materials used are very sophisticated and expensive.
4. Where supervision is effective and closes supervision is possible.
5. Where the workers are new and learning the job.
6. Where the work is of a highly varied nature and standard of performance cannot be established.

Advantage
1. It is simple and easy to calculate.
2. Earning of workers is regular and fixed.
3. Time rate system is accepted by trade unions.
4. Quality of the work is not affected.
5. This method also avoids inefficient handling of materials and tools.

Disadvantages
1. No distinction between efficient and inefficient worker is made and he nce they get the same
remuneration.
2. Cost of supervision is high due to strict supervision used for high productivity of labour.
3. Labour cost is difficult to control due to more payment may be made for the lesser amount of
work.
4. No incentive is given to efficient workers. It will depress the efficient workers.
5. There are no specific standards for evaluating the merit of different employees for promotions.

Time Rate at High Levels: Under this system, efficient workers are paid higher wages in order to
increase production. The main object of this method designed to remove the drawbacks of time rate
at ordinary levels. This system is simple and easily understandable. When higher rate of wages are
paid, it not only reduces labour turnover but also increases production and efficiency.

Guaranteed Time Rates: Under this method the wage rate is calculated by considering to changes in
cost of living index. Accordingly, the wage rate is var ied for each worker according to the change in
cost of living index. This system is suitable during the period of raising prices.

3.3.2 Piece Rate System

This is also known as ―Piece Wage System‖ or ―Payment by Result.‖ Under this system, wages of a
worker are calculated on the basis of amount of work done or output of a worker. Accordingly, a
worker is paid in direct proportion to his output.
Advantages:
1. It facilitates direct relation between efforts and reward.
2. This system encourages the efficient workers to increase production.
3. Under this system efficient workers are recognized and rewarded.
4. It helps to reduce the cost of supervision and idle time.
5. Tenders or quotations can be prepared confidently and accurately.

Disadvantage:
1. Where a concern is producing large quantities, it is difficult to fix a piece rate.
2. In order to maximize their earnings, workers working with high speed may affect their health.
3. The quality of output cannot be maintained.
4. This system is not encouraging to the inefficient workers.
5. Temporary delays or difficulties may affect the earnings of the workers.

Piece Rate System is suitable where:

1. Quality and workmanship are not important.
2. Work can be measured accurately.
3. Quantity of output directly depends upon the efforts of the work er.
4. Production of standardized goods in a factory.
5. Job is of a repetitive nature.
There are three important methods of paying labour remuneration falling under this type:
a) Straight Piece Rate
(b) Piece Rates with Guaranteed Time Rates and
(c) Differential Piece Rates.

Straight Piece Rate: Under this system workers are paid according to the number of units produced
at a given rate per unit. Thus, total earnings of each worker are calculated on the basis of his output
irrespective of the time taken by him. The following formula is used for measuring piece work
earning:
Straight Piece Work Earnings = Units Produced × Rate per Hour

Piece Rate with Guaranteed Time Rates: Under this method, the worker earning from piece work
less than the guaranteed minimum wage, will get the fixed amount of guaranteed time rate. A
guaranteed rate would be paid per hour rate or day rate or week rate.

Differential Piece Rates: This system is designed to provide for variation of piece rates at different
levels of output. Accordingly increase in wages is proportionate to increase in output. Under this
system efficient workers get ample reward and at the same time inefficient workers are motivated to
earn more. The following are the important types of differential piece rates:
i. Taylor‘s Differential Piece Rates System.
ii. Merrick‘s Differential Piece Rates System.
iii. Gant Task Bonus Plan.

Taylor’s Differential Piece Rates system

F.W. Taylor, who is the father of scientific management, introduced this plan. Under this system,
two piece rates are applicable on the basis of standard of performance established. Accordingly one
is high rate and the other one is lower rate. Thus high piece rate is applicable for standard and above
the standard performance. Lower piece rate for those w orkers with below the standard performance.

Example
Calculate the earnings of workers A and B under straight piece rate system and Taylor‘s differential
piece rate system from the following particulars:
Standard time allowed 50 units per hour.
Normal time rate per hour INR 100
Differentials to be applied.
80% of piece rate at or above standard.
120% of piece rate at or above standard.
In a day of 8 hours a produced 300 units and B produced 450 units.

Solution
Calculation of Piece Rates:
Standard production per hour = 50 units.
Standard production for 8 hours = 50 × 8 = 400 units.
Rate per hour = INR 100.

Earnings
A produced 300 units (below standard) = 300 × 1.60
Therefore low Piece rate of INR 1.60 applicable = INR 480
B produced 450 units (below standard) = 450 × 2.40
Therefore high Piece rate of INR 240 applicable = INR 1080

Merrick Differential Piece Rate System

This is also termed as Multiple Piece Rate system. This plan is designed to overcome the drawback
of Taylor‘s Differential Piece Rate System. Under this method, three piece rates are applied with
different levels of performance.
Gantt’s Task Bonus Plan: This system is designed by Henry L. Gantt. Under this system standard
time for every task is fixed through time and motion study. The main feature of this system is a good
combination of time rate, differential piece rate and bonus. In this system day wages are guaranteed
to all workers.

3.4 Bonus or Incentives Schemes

Incentive Scheme of wage payment is also known as Premium Bonus Plans. Introduced in order to
increase production with ensuring proper industrial climate.
Wage incentive plans may be of two types:
a. Individual Incentive Plans
b. Group Incentive Plans.

3.4.1 Individual Incentive Plans

Under individual incentive plans, remuneration can be measured on the performance of the
individual worker. In the case of the group incentive scheme earnings can be measured on the basis
of the productivity of the group of worke rs or entire work force of the organization. Various types of
incentive schemes are combinations of time and piece rate systems. The following are the important
individual incentive plans discussed below:

Halsey Premium Plan

This Plan was developed by F.A. Halsey. This system also termed as split bonus plan or fifty-fifty
plan. Under this plan, Standard time is fixed for each job or operation on the basis of past
performance. If a worker completes his job within or more than the standard time then the worker is
paid a guaranteed time wage. If a worker completes his job within o r less than the standard time,
then he gets a bonus of 50% of the time saved plus normal earnings. Under this method, the total
earnings are calculated as follows:

Total Earning = Guaranted Time Wages + Bonus of 50% of time saved

(or)
Total Earning = T × R + 50% (S - T) R
Where T - Time Taken;
R - Hourly Rate;
S - Standard Time

Total Earnings = Time taken × hourly rate + 50 / 100(Time Saved × Hourly Rate)

Exercise
Calculate the total earnings of the worker under
Halsey Premium Plans:
Standard Time 12 hours
Hourly Rate INR 3
Time Taken 8 hours
Solution
Earnings under Halsey Premium Plan:
Standard Time = 12 hours
Time Taken = 8 hours
Time Saved = Standard Time - Time Taken = 12 - 8 = 4 hours
Rate per hour = INR 3
Total Earnings = T × R + 50% (S - T) R
50
= 8 × 3 +............ (4 × 3)
100
= 24 + 6 = INR 30
Total Earnings = INR 30

Merits
1. It is simple to understand.
2. Total earnings of each worker can be easy to calculate.
3. Both employer and employee get equal benefit of time saved.
4. This system not only benefits efficient worker but also provides average worker to get
guaranteed minimum wages.
5. This system is based on time saved and it can reduce the labour cost.

Demerits
1. Lack of co-operation among the employees.
2. Under this system establishment of standard is very difficult.
3. Earning is reduced at high level of efficiency.

The Halsey -Weir Scheme

Under this system the worker gets the bonus of 30% of the time saved instead of 50% of time saved
under Halsey Plan. Except for this, Halsey Plan and Halsey -Weir Systems are similar in all other
respects.

Rowan Plan
This plan was introduced by James Rowan of England. It was similar to the Halsey Plan in many
respects except that it differs in calculation of bonus. Under this system, bonus is determined as the
proportion of the time taken which the time saved bears to the standard time allowed. Under this
system the following formula is applied to calculation of bonus:

Example
From the following information, calculate total earnings of a worker under Rowan System:
Standard Time = 10 hours
Time Taken = 8 hours
Rate per hour = INR 3
Solution
Calculation of total earnings under Rowan Plan:
Standard Time = 10 hours
Time Taken = 8 hours

Emerdon’s Efficiency Sharing Plan

Under this plan, earning of a worker is by combining guara nteed day wages with a differential piece
rate. Accordingly the level of efficiency is determined on the basis of establishment of standard task
for a unit of time. If the level of worker‘s efficiency reaches 67% the bonus is paid to him at a
normal rate. The rate of bonus increases in a given rate as the output increases from 67% to 100%
efficiency. Above 100% efficiency, the bonus increases to 20% of the wage earned plus additional
bonus of 1% is added for each increase of 1% in efficiency.

Example
From the following particulars calculate total earnings of a worker under Emerson‘s Efficiency
Sharing Plan:
Standard output per day of 8 hours is 16 units
Actual output of a worker for 8 hours is 20 units
Rate per hour is INR 2.50

Solution
Calculation of earnings under Emerson‘s Sharing Plan:
Bonus Payable
At 100% efficiency = 20% of time wages
Further increase of 1% in the bonus is given for every 1% increase in the efficiency.
For next 25% efficiency @ 1% for = 25% of Time Wages each 1% increase in efficienc y
Total Bonus payable = 45% of Time wages.
Earning
Time Wages for 8 hours @ INR 2.50 per hour = INR 20.
45
Add: 45% bonus of time wages = ......................... × 20 = INR 9
100
Total Earning = INR 20 + INR 9 = INR 29

Barth Variable Sharing Plan

This scheme is introduced to attract newly recruited and skilled employees who are motivated to
learn work. It provides sufficient incentives to inefficient workers who are motivated to increase
productivity.

Bedaux Point Premium System

Under this plan, standard time fixed for each operation or job is expressed in terms of Bedaux point
or ‗B‘.
For example, a standard time of 360 B means the operation or job should be completed within 360
minutes. The chief advantage of this plan is that it can be applied to any kind of job. Under this
system, worker is paid at the time for actual hours worked and 75% of the wages for the time saved
are paid as bonus to the worker and 25% to the foremen, supervisors etc. The following is the
formula for calculation of total wages of a worker:

Total earnings = S × R + 75% of R (S — T)

Accelerating Premium Bonus Plan

Under this plan, bonus is determined on the basis of time saved unlike a fixed percentage under
Halsey Plan and as decreasing percentage under Rowan Plan. The bonus is paid to workers at an
increased rate. This provides increasing incentives to efficient workers.

Did You Know?

Bedaux point premium system plan was introduced by Charles E. Bedaux in 1911.

3.4.2 Group or Collective Bonus Plan

The incentive schemes explained so far are applicable to individual performance depending directly
on production. However it is not the individual workers who produce the goods or services
(operation) alone but group of several other workers are required to jointly perform a single
operation. It is, therefore, essential that a group incentive scheme should be introduced. Bonus is
calculated for a group incentive scheme. The bonus is calculated for a group of workers and the total
amount is distributed among the group of worker s on any one of the following basis:
a. Equally by all the workers of the group.
b. Pro rate on the time rate basis.
c. Pre determined percentage basis.
d. Specified proportion basis.
The following are the important types of group incentive bonus plans:
1. Budgeted Expenses bonus plan
2. Priest Man bonus Plan
3. Towne‘s Gain-sharing Plan
4. Scanlon Plan

Budgeted Expenses Bonus Plan

Under this method, bonus is determined on the basis of savings in actual expenditure compared with
total budgeted expenditure.

Priest man Bonus Plan

Under this plan standard performance is fixed by the management and committee of works. The
group of workers get bonus when actual performance exceeds the standard performance irrespective
of individual‘s efficiency or inefficiency.

Towne’s Gain-sharing Plan

Under this plan, bonus is calculated on the basis of savings in labour cost. The group of workers get
bonus when actual costs is less than the standard costs, one -half of the savings is distributed among
workers including foremen in proportion wi th the wages earned.

Scanlon Plan
Scanlon Plan is designed with the chief aim of reducing the cost of operations in order to increase
the production efficiency. This plan is generally applicable in industries where the operation cost is
high. Under this scheme, bonus is determined on the basis of standard costs or wastages and
percentage of the reduction in operation cost.

3.4.3 Indirect Monetary Incentive

Indirect schemes are regarded beneficial to both employers and workers.
In this regard, under indirect monetary incentives by giving them a share of profit and introducing
co-partnership scheme or as they have become partners in the business in order to make a very
profitable enterprise.

Profit Sharing: Profit Sharing and bonus is also known as profit sharing bonus. Under this scheme,
there is an agreement between the employer and employee by which employee receives a share,
fixed in advance of the profits. Accordingly profit sharing bonus refers to the distribution of profit
on the basis of a certain percentage of one‘s monthly earnings. The amount to be distributed depends
on the profits earned by an enterprise. The proportion of the profits to be distributed among the
employees is determined in advance.

Co-partnership: This system provides not only a worker to become partner in the business but also
to share in the profit of the concern. There are different degrees of partnership and share of
responsibilities allowed to the workers to take part in its control.

3.4.4 Non-monetary Incentive Schemes

Under this system, employees are provided better facilities, instead of additional monetary
payments. Some of the examples of non -monetary incentives are free education for children rent free
accommodation, medical facilities canteen facilities, welfare facilities, and entertainment facilities
etc.

Caution
It is very important to make sure all labour and hours of work are accounted for, and that the labour
not taking part in the direct works is removed from the cost calculation.

Case Study-National Manufacturing Company Limited

National Manufacturing Company is a public limited concern having its factory at Yamuna agar
with its registered office in Delhi. It employs 1,200 workmen, who are organised into a union called
the ―National Manufacturing Company Mazdoor Union‖. Ramjas, a fitter in the engineering
department, is the president of the union, and he commands conside rable .respect among the
workmen. On 30th April 1983, about 20 employees of the company led by Ramjas met the works
manager and asked him that May I be declared a holiday. The works manager expressed his inability
to oblige the union. Then the situation took an ugly turn. There was exchange of hot words. Ramjas
accused the works manager of being anti -working class and a callous despot.

The same evening, Ramjas addressed a gate meeting. He asked the workers to observe May Day in a
fitting manner. A resolution condemning the attitude of the works manager was also adopted at the
meeting. At the start of the shift at 8:00 a.m. the next day, i.e. May Day, Ramjas went to the factory,
collected a number of workmen, including several office -bearers of the .union, and went from
department to department urging the workmen to stop work. Within a short time a large number of
workmen left their‖ work place and streamed out. A flag hoisting ceremony was held outside the
factory gate. Ramjas exhorted the workers to join th e May Day rally later in the evening. The
factory did not work for the rest of the day.

The punishment inflicted upon Ramjas was assailed by the union on the following grounds:
1. The charge of insubordination and subversive of discipline in passing resol ution condemning the
works manager was not misconduct and, as such, no enquiry could be held against him.
2. The charge-sheet was invalid inasmuch as the management being biased against him had already
made up its mind to dismiss him and that holding of th e enquiry was just a legal formality.
3. No opportunity was given to him to defend myself.
4. The proceedings of the enquiry recorded in his absence were not binding on him and no
punishment could be awarded on the basis of the same.

Questions
1. Explain the different type of labour acts in India?
2. Describe the properties of international comparison of Indian labour laws?

3.5 Summary
The labour component is usually broken down into a team size (e.g. 1 Carpenter + 2 Helpers)
that execute work at a determined productivity.
Control of labour cost is a significant influence on the growth, profitability and cost of
production.
In order to achieve the effective utilization of manpower resources, the management has to apply
proper system of labour cost control.
A variety of bonus and premium plans have been designed to overcome the drawbacks of two
basic methods of wage payments.
A system of incentive plans takes into consideration the primary principles of these two basic
plans known as incentive or bonus or premium plan.

3.6 Keywords
Direct Labour Cost: Any labour cost that is specially incurred for or can be readily charged to or
identified with a specific job, contract, work order or any other unit of cost is termed as direct
labour cost.
Indirect Labour Cost: The importance of the distinction lies in the fact that whereas direct labour
can be identified with and charged to the job, indirect labour cannot be so charged and has, therefore
to be treated as part of the factory overheads to be include d in the cost of production.
Piece Wage System: Under piece wage system, remuneration is based on the amount of work done or
output of a worker. This is known as ―Piece Rate System‖ or ―Payment by Result.‖
Rowan Plan: Under this system, bonus is determined as the proportion of the time taken which the
time saved bears to the standard time allowed.
Straight Piece Rate: Under this system workers are paid according to the number of units produced
at a given rate per unit.
Time Wages System: Under time wage system, wages are paid on the basis of time spent on the job
irrespective of the amount of work done. This is known as Time Rate or Day Wage System.

3.7 Self Assessment Questions

1. The labour rate variance can be calculated by the following equation:
a) Budgeted labour costs - actual labour costs
b) (Standard wage rate - actual wage rate) * actual hours worked
c) (Standard hours - actual hours) * actual wage rate
d) (Standard wage rate - actual wage rate) * standard hours worked

2. The efficiency ratio can be defined as:

a) Standard hours produced/actual labour hours worked
b) Actual hours worked/budgeted labour hours
c) Standard hours produced/budgeted labour hours
d) Actual hours worked/actual production based on standard hours

3. An adverse labour efficiency variance together with a favourable labour rate variance may mean
that:
a) The business is paying a higher hourly rate than the standard
b) More products are being made per hour
c) Less labour hours are needed to make the same amount of output
d) Less skilled staff is being used in production

4. In most companies, direct labour is treated as:

a) Product cost b) Period cost
c) Fixed cost d) Sunk cost

5. Section 2(n) of the Factories Act, 1948 defines …….

a).Occupier b) Employee
c).Owner d).Manager

6. The Power or exempt, any factory, during public emergency is given in which section of the
Factories Act, 1948?
a).Section 5 b).Section 6
c).Section 4 d).Section 2

7. The space for every worker employed in the Fa ctory after the commencement of Factories Act,
1948 should be ________ Cubic Meters.
a). 9.9 b). 10.2
c). 14.2 d). 13.2

8. A person who has ultimate control over the affairs of the factory under Factories Act,1948 is
called as................
a) Occupier b). Manager
c). Chairman d). Managing Director

9. An adult worker can up to .......... hrs in a day as per factories Act, 1948
a) 8 b). 9
c)10 d). 12

10. Obligations of Workers under the Factories Act 1947 was discussed in section ..........
a) 78 b) 101
c) 111 d) 99

3.8 Review Questions

1. What do you mean by labour costing?
2. What are the components of bill of quantity rates?
3. Define the types of labour cost.
4. How do we control the labour cost?
5. What is remuneration? Discuss the different methods of remuneration.
6. Differentiate between time and piece rate system?
7. Write a short note on Taylor‘s differential piece rates system.
8. Write a short note on incentive plans of employee.
9. Discuss and differentiate between individual and group incentive plans.
10. What is Rowan Plan? Compare it with Halsey Plan.
Answers for Self Assessment Questions
1. (b) 2. (a) 3. (a) 4.(b) 5.(a)
6. (a) 7.(c) 8.(a) 9.(b) 10.(c)
 4
Time Keeping and Time Booking
CONTENTS
Objectives
Introduction
4.1 Concept of Time Keeping and Time Booking
4.2 The Idle and Overtime Concept and Treatments
4.3 The Various Incentive Schemes
4.4 Summary
4.5 Keywords
4.6 Self Assessment Questions
4.7 Review Questions

Objectives
After studying this chapter, you will be able to:
Define the concept of time keeping and time booking
Understand the idle and overtime-concept and treatments
Describe the various incentive schemes

Introduction
The first step in accounting for labour cost is to prepare an accurate record of the time spent by each
employee. The most common form of attendance record is the clock card on which the employee
punches the time at which he comes in and leaves the factory a job card or job ticket is maintained
for every job. When a worker takes up a job, a job card bearing number of the job is given to him.
He shall record in it the time of taking up and finishing the job. This card is meant a job which
involves many operations or stages of completion. A sheet is given to each worker to record time on
a weekly basis. However, weekly time sheets should be filled up without much delay or on each day
failing which some inaccuracies are bound to occur on the time sheets. These card records the
attendance time of workers and work time of worker on a single sheet Preparation of the payroll
from clock cards, job or time tickets, or time sheets is done by the pay roll department the important
labour remuneration methods are discussed below:
Under this system the worker is paid on hourly, daily or weekly wage rate and his remuneration is
based on the time spent for production and wages.

4.1 Concept of Time Keeping and Time Booking

Time keeping and time booking are defined below:
4.1.1 Time Keeping
The first step in accounting for labour cost is to prepare an accurate record of the time spent by each
employee. Time keeping in labour costing and control is important because of the following reasons :
It accumulates the total number of hours worked by each employee so that his earnings can be
calculated.
Absence of a time-keeping arrangement will create frustration among those employees who are
punctual or bound by the attendance rules.
Certain benefits like pension and gratuity, leave with pay, provident fund, salary, promotion are
linked with continuity of service of employees. Attendance records, in this regard, can be helpful
and useful to employees.
Overhead costs being indirect costs are apportioned to different products on some equitable
basis. Time keeping is necessary if apportionment is to be done on the basis of labour hours

Methods of Recording Attendance Time

The most common form of attendance record is the clock card on which the employee punches the
time at which he comes in and leaves the factory. Each week, a new card is prepared for each
employee on the payroll. At the end of the week, the cards are collected and transferred to the
payroll department for calculation of gross earnings . (See figure 4.1)

Figure 4.1: Daily Time Report.

Clock cars provide a record of the total hours, employees were available on jobs. However, this card
does reveal as to how employees spend their time which is an important question to be solved before
entries can be made in the cost records. This information is supplied by time tickets or daily labour
summaries on which time keepers record the daily activities of direct labour: time spent on specific
orders, time spent on indirect labour operations such as machine maintenance, or idle time waiting
for reassignment or machine set-up.

4.1.2 Time-Booking
Time-booking like time-keeping is equally important. Time booking means recording the time spent
by a worker on each job, process or operation. Time-booking fulfils the following purposes:
1. To determine the cost of the product or job, the amount of labour cost time -booking is required.
2. To determine the quantity and value of work done.
3. To determine earnings like wages, bonus which depend o n the time taken by a worker in
performing job or jobs in a factory.

4.2 The Idle and Overtime Concept and Treatments

Idle time refers to the time for which workers or staff members are present on the work location, but
no work is carried out. It indicates the time lost. Idle time cost refers to the salaries or wages paid
for the lost time. Technically speaking, the attendance card shows the time, but it is not booked on
any job card or contract card. If not properly controlled, idle time losses co uld become very severe
and have a major impact on cost of an item. It also reflects poor efficiency. Idle time could be
caused by a variety of reasons some are beyond control of workers while they themselves are
responsible for the other reasons. The idle time which cannot be avoided and is inevitable is termed
as normal idle time and the idle time which caused due to reasons that are within control of
management and could have been controlled through management action is called as abnormal. Idle
Time is that time during which the workers spend their time without giving any production or
benefit to the employer and concern.

The idle time may arise due to non-availability of raw materials, shortage of power, machine
breakdown etc. The possible causes of normal and abnormal losses could found in situations within
the organisation and those outside the organi sation. These are given below:

Idle Facilities: The terms facilities has a wider connotation. It may include production capacity as
well. Facilities may be provided by the fixed assets such as building space, plant/equipment capacity
etc., or by various service functions such as material services, production services, personnel
services etc., if a firm is not able to make full use of all thes e facilities then the firm may be said to
have idle facilities. Thus, idle facilities refer to that part of total production facilities available
which remain unutilized due to any reason such as non -availability of raw-material, etc. Idle
facilities differ from idle time. A firm may have idle facilities even when it works full time; e.g.,
when facilities have been provided on too large a scale.

Treatment of Idle Time in Cost Accounting: Treatment of idle time in cost accounting depends
upon its nature. The cost of normal idle time is charged to the cost of production. This may be done
by inflating the labour rate or the normal idle time may be transferred to factory overhead for
absorption through factory overhead absorption rate. In relative terms, the cost of normal idle time
is generally nominal. As against normal idle time cost, the cost of abnormal idle time sometime may
be quite substantial. Since these costs are beyond the control of the management and being a bnormal
in nature, they do not form part of cost of production. Therefore, payment for them is not included
in cost of production and is transferred to costing profit and loss account.

Treatment of Idle Facilities in Cost Accounting: Normal idle facilities cost which arises due to
unavoidable reasons, should be included in the works overhead. On the other hand, abnormal idle
facilities cost which arises due to plants or machines/facilities remaining idle on account of trade
depression or for want of work etc., should be written off to costing profit and loss account .

System of Controlling Idle Time: The system of idle time control aims at controlling the time for
which a worker has been paid but has not been utilised for productive purposes. Such a loss of time
is known as idle time. The control of idle time requires the use of a proper system of recording the
idle time, ascertaining its reasons for occurrence and initiating suitable administrative action to stop
its reoccurrence. To record the duration of idle time and to ascertain the reasons of its occurrence,
the format given as below may be used. This format not only records the time paid for but also the
standard time which a worker should take to produce a unit of output. The time actually paid on
comparison with standard time may reveal the element of idle time, if any. In this way a statement
of labour time utilization is usually prepared. Such a statement is quite useful to the officers who are
concerned with the control of idle time. In fact it ser ves as a sound basis for their actions to control
idle time. Such a statement clearly points out to persons responsible for the control of idle time the
reasons for the occurrence of idle time. Finally, the concerned officer may suggest the remedial
measures to minimize the occurrence of idle time in future . (See Table 4.1)

Tabel.4.1 Analysis of Idle Time.

Analysis of Idle Time
It is therefore necessary that a continuous analysis of idle time is carried out by the cost accountant.
There could be a system developed whereby the reason-wise analysis of idle time is done and
reported. The idle time can be collected from the time sheets (attendance records) and worker‘s job
sheets. The supervisors must keep vigil to record the actual time lost on the job. Each job card
shows the time that is spent on different job orders. The total time attended by the worker and the
time spent by him on the jobs has to be compared. Analysis and reporting of idle time helps
management to exercise better control on it by removin g or minimizing the effect of reasons causing
the loss due to idle time.
The reporting of idle time may be done at individual level and departmental level. These re -ports are
made at frequencies depending on need of each organisation. Any unusual time loss is immediately
escalated to higher levels. Reporting of idle time is done at individual level and departmental level
as below:

Types of Idle Time: It refers that any loss of time is inherent in every situation which cannot be
avoided. Any cost associated with the normal idle time is mostly fixed in nature.
The normal idle time arises due to the following reasons.
Time taken for personal affairs.
Time taken for lunch and tea break.
Time taken for obtaining work.
Time taken for changing from one job to another.
Waiting time for getting instructions, tools and or raw materials, spare parts etc.
Time taken by the workers to walk between factory gate and place of work.

4.2 1 Abnormal Idle Time

Abnormal idle time refers that any loss of time which may occur due to some abnormal reasons. The
abnormal idle time may arise due to the following avoidable reasons.
Faulty planning.
Lack of co-operation and co-ordination.
Power failure.
Time lost due to delayed instructions.
Time lost due to inefficiency of workers.
Time lost due to non-availability of raw materials, spare parts, tools etc.
Time lost due to strikes, lock outs and lay-off.

Normal Idle Time: Normal idle time wages is treated as a part of cost of production. Thu s, in case
of direct workers an allowance for normal idle time is built into labour cost rates. In the case of
indirect workers, normal idle time wage is spread over, all the products or jobs through the process
of absorption of factory overheads. Abnormal Idle Time: Abnormal idle time cost is not included as
a part of production cost and is shown as a separate item in the Costing Profit and Loss Account. So
that normal cost are not distributed
Did you know?
Abnormal idle time can be prevented through eff ective planning and control.

4.2.1 Overtime Concept

It is given below:
Overtime Premium: Overtime premium is paid to workers for the extra time worked than the normal
working hours specified in the Factories Act, 1948 or work agreement with the union. The extra time
is paid at a higher rate than the normal time rate, for example, if a worker works beyond 8 hours in a
day or 48 hours in a week, he is paid with double the wages for the extra time worked. The overtime
wages consists of two elements
(i) Normal wages for extra time and
(ii) Additional wages paid for the overtime worked, the accou nting
Treatment of overtime premium is given below:
Overtime hours at the normal rate are treated as direct labour cost and charged to production on
the same basis as time worked during normal hours but the premium paid during the overtime
period is not a direct charge against production but is recovered as production overhead through
overhead recovery rate.
Where the overtime is worked on a specific job to meet the time schedules or to carry out
specific rush orders for which extra price is recovered, than the entire labour cost can be charged
as direct labour to that job.
If overtime wages paid due to negligence or delay of worker of a particular department, it may
be charged to the concerned department.
If the overtime premium is paid due to abnormal causes, it should be charged to costing profit
and loss account.

How to Control Overtime Working: To control the overtime premium the following may be given
due consideration:
Careful production planning and scheduling analysis of reasons for overtime working frequency of
overtime working in each department if it is due to shortage of labour, steps may be taken to recruit
more workers. If overtime working is due to limiting mach ine hours available in the production
departments, purchase extra machines, working extra shift, sub -contracting etc., may be considered.

4.3 The Various Incentive Schemes

The employees working in any organisation are compensated by way of salaries, wages another
benefits. These payments are made in return of the services rendered by the employees. These
services could be:
Engaging in the process of transformation of raw material into finished product or supporting the
process of transformation by doing other functions the salaries, wages and statutory benefits put
together are called as remuneration. The incentives are payments and benefits given to stimulate
better performance or paid in return for a better performance. The incentives could be in monetary
as well as non-monetary terms. While the remuneration is always individual based, incentives could
be based on group performance.
Characteristics of a Sound Remuneration System
It should be easy to understand for everyone and easy to implement
It should provide for a reward for good work and penalty for bad workmanship
It should help keeping labour turnover within stable limits
It should be able to attract talent and reta in them
It should minimize absenteeism
It should reflect a fair return to employees in consistence with efforts put in by them
It should boost productivity and performance
It should be flexible enough to factor in effects of changes in cost of living, and systems of
similar companies in the same industry.

The payments could be broadly classified into those paid on the basis of time spent by an employee
irrespective of output produced by him, called time rate.
Those paid on the basis of output given by the employee irrespective of the time spent by him,
called piece rate based on these two basic payment methods, many variants thereof have been
developed over the last couple of centuries. Many of these systems were developed keeping in view
the manufacturing industry, where measurement of physical performance is relatively easier. In
modern times, especially for indirect workers, many of these plans will not work. Indirect workers
and staff and managers are usually paid on time basis only.

4.3.1 Time Based Payments

Under this method, payment is made on time basis like daily, weekly or monthly irrespective of the
results achieved during the time period. These payments are in conformity with the applicable laws
such as minimum wages act. The time based payments are useful in following situations a where
output is not distinguishable and measurable. In other words its use full when there‘s no relationship
between effort and output. Where a high level of skill and quality are required. Where supervision is
good. Where work is not repetitive this method is very easy to understand and operate, so less
clerical work is involved. But it does not motivate increased output. Advance estimation of labour
cost per unit becomes difficult. It does not distinguish between ef ficient and non-efficient workers.
The variants of time rate are discussed below. There is no incentive to produce more within the same
time as workers do not get additional remuneration for increased output. If overt ime is paid for,
there is a tendency among workers to go slow during normal time and earn more by working over -
time. There is a likelihood of output getting suffered. Standards are difficult to set and operate under
this method. Workers get paid for the time clocked and not as per time booked o n actual work. This
may lead to idle time which ultimately will increase cost of production .

Flat Time Rate

The rates and time are fixed in advance per day, week or month. If worker work overtime, they are
compensated at one and half or two times the ordinary rate. The earning therefore will vary as per
the time worked. If a time rate is fixed as INR 100 per day of 8 hours, and the worker works for four
hours; he will get INR 50. The merits and demerits are same as explained above.

High Wages System

This method is similar to the above except the fact that the time rate is fixed at a higher level
compared to the rates prevailing in the industry. This is done to attract efficient and high
performance workers and also to induce them to improve productivity as they would be satisfied
with high level of earnings. However, the level of performance cannot be guaranteed over a longer
period and it also may not be possible to keep wages always at higher level compared to industry.

Graduated Time Rate

Under this method, payment consists of two portions one based on regular time base payments and
the other is linked to cost of living and merit awards. As the cost of living is taken care of, the
system has an advantage. It is further enhanced by the fact that the method rewards individual
merits. However, merit rating is highly subjective and thus the method is difficult to implement. It is
difficult to calculate the cost of the cost unit. It is generally observed that trade unions prefer time
based payments as they do not have to guarantee output. The variations in the time based payments
do not really bring in any additional benefits and they are difficult to sustain in the longer run.

4.3.2 Results Based System (Piece Rates)

These methods are based on the output linked payments to workers. The payments are fixed per unit
of output irrespective of the time taken by the worker to produce a unit. The payment is simply
calculated as rate per unit x units produced. These payments may be released for a period e.g. day,
week or a month. The output produced by the workers during that period is multiplied by the pre -
fixed rate per unit. The objective here is to induce workers to produce more and thereby increase
sales. As workers get more money, they tend to produce more. Some -times under such systems, the
benefits of increased output are shared between workers and the business. T his method is simple to
understand and easy to operate. The workers also prefer it as they can earn more by producing more.
The labour cost per unit is known in advance and hence it helps in fixation of overhead rates based
on direct wages and therefore estimation of cost per unit is easy. If benefits are shared with
employees, they are motivated to put in their best efforts. However, fixing a piece rate itself is not a
simple job. Considerable amount of engineering estimations, time and motion study and as sessment
of physical efforts needed to perform a job are needed to arrive at a piece rate per unit. The nature
of job should be standard and repetitive for piece rate system to be successful. It cannot be applied
if the jobs are non-standard, and the specifications change for every order received. Further, in the
quest of increasing the earnings workers may compromise quality. It may increase supervision and
cost of rework as well. It also may add to fatigue and increase absenteeism. The variants of piece
rate system are discussed below:

Straight Piece Rate

This is the simplest form of payment by results. Under this a predetermined rate per unit of output is
applied. In a laundry, a worker may get INR 0.50 for pressing one shirt. If on a day he presses 100
shirts, he will get (100x0.50) i.e. INR 50. If he presses 200 shirts he will get INR 100 and so on.

Standard Hour system of Piece Rate

This is the result based payment with a time dimension factored into it. We have seen that time and
motion study and other engineering methods are used to determine time based piece rate per unit. In
addition, a standard time is set up per unit of product. Workers are supposed to complete pro -diction
of one unit within this allotted time. The rate is fixed per hour. If the worker completes the job
within the standard time, he is paid for the time he worked plus also for the time saved based on the
time rate. If he spends more than standard time per unit of output, he is paid at this time rate for the
time actually spent on the job. Thus this takes care of time performance as well.

The formula to work out the earnings as per this method is: When production is in excess of
standard performance; Earnings = (Actual hours w orked x hourly rate per day) + Hourly rate per day
x (standard hours produced – Actual hours worked) When production is at or below standard
performance; Earnings = Actual hours worked x hourly rate per day Consider in a factory the day
has 8 working hours. A base rate for a particular job is set as Rs 0.625 per hour and performance
standard is 0.16 hours per unit.

Differential Piece Rates

This system is based on the logic that workers should be rewarded for higher efficiency. The earning
method offers a motivation for increasing productivity. These systems are however difficult for
workers to understand. There are two variants of this system. One was developed by FW. Taylor and
the other by another expert Merrick. This method tries to penalize workers whe n they do not
perform as per standard by applying differential rates.

Taylor Plan
The payment scheme is based on fixing two or more pieces rates a base level piece rate is used for
workers who do not perform as per standard and a high earpiece rate is used for workers who
perform as per standard. The difference between these two rates is deliberately kept so wide that the
award for efficient worker is really goods and simultaneously, punishment for inefficient worker is
severe. Consider a factory operates an 8 hour day. The standard output is 100 units per hour and
normal wage is INR 50 per hour.
The company operates Taylor plan as 80% of piece rat e for workers performing below standard and
120% of piece rate for performance at or above standard. Hourly rate paid = INR 50 Standard output
per hour = 100 units Normal piece rate = (50/100) = INR 0.50 per unit for performance below
standard, the piece rate will be = 80% of INR 0.50 i.e. INR 0.40 per unit and for performance at or
above standard, it will be = 120% of INR 0.50 i.e. INR. 0.60 per unit. It can be found that there is a
differential of INR 0.20 between the two piece rates. This will induce an ambitious worker to
increase efficiency and earn more. On the other hand, inefficient worker gets penalized for not
achieving minimum standards. It will reduce fixed overheads per unit as it induces more production.
The success of this plan depends highly on setting a standard. Any error in fixation of the
differential rates could be disastrous. Also, this system does not guarantee any mini -mum wages.
Further the piece rates and standard are to be fixed in such a way that the earnings wo uld not fall
below minimum wages as per the law in force.

Merrick Plan
The punitive element under Taylor plan was quite severe. It tends to discourage and attract average
workers. Merrick modified this differential system b introducing more slabs and by removing the
punitive element. He advocated that performance up to a certain level should be rewarded at normal
piece rate and then progressive slabs are provided to recognise above standard performance.
So the worker will just ensure to perform at 100% or slightly above and then does not improve
further as there is no additional incentive for him to do so.

Combined Time and Piece Rates

The combination of time based and piece based methods of remuneration aim at combining the
benefits and removing the deficiencies of both specific time based and specific piece rate systems.
Basically this method has combo offering for the workers – a time rate, a piece rate and a bonus.
Essentially for workers who do not perform as per standards, there is a guaranteed time rate
payment. For workers performing above standard there are piece rates with bonuses applicable for
higher rewards. There are certain variants of this idea developed be experts.

Did You Know?

The overtime pay concept is applicable mostly to blue collar employees who receive wages for their
work. When these employees work beyond the stipulated working hours, they are entitled to receive
an overtime pay.

Caution
The occurrence of idle time should be ascertained and stated in the suitable column of the format.

Case Study-The U.S. Xpress Enterprises’ Dilemma

In the case of U.S. Xpress Enterprises, Inc. (U.S. Xpress), it had no means of determining where its
trucks had stopped, or for how long. With thousands of trucks on the highways, that was an immense
problem. Most importantly, in the low-margin, gas-hungry truckload services business, it meant
money was wasted on engine idle time, trucks were not being used as efficiently as possible, and
customer service was suffering.
The heart of the problem was data quality. Th e U.S. Xpress had a reliable in-cab system to tell them
everything about truck movements—from when a cab braked, to when it stopped, engine errors, and
location. The data relating to vehicle location wasn‘t clean though and could not be trusted for
decision making. And because of that, it was impossible to bring the truck idle time down and
operating margins up. By standardizing on Informatica, U.S. Xpress has introduced a comprehensive
system for managing truck idle time. Location information is now standardized, allowing teams to
immediately identify where a truck is located, where it‘s travelling to and from, and the amount of
idle time. Deployed in only four and a half months by individuals who were previously unfamiliar
with data quality management, the solution has significantly reduced the percentage of time U.S.
Xpress‘ thousands of trucks stand idle, saving the company millions every year —equivalent to a
return on investment in only three months.

Proving the reuse flexibility of the data qual ity solution, it has also saved the company millions
annually as part of its fleet maintenance system. And if that was not enough, an enterprise data
warehouse which is currently in the pipeline for development using Informatica, may potentially
save the company up to $20 million over two years. There could be a system developed whereby the
reason-wise analysis of idle time is done and reported. The idle time can be collected from the time
sheets (attendance records) and worker‘s job sheets. The supervisors must keep vigil to record the
actual time lost on the job.
Each job card shows the time that is spent on different job orders. The total time attended by the
worker and the time spent by him on the jobs has to be compared. Analysis and reporting of idle
time helps management to exercise better control on it by removing or minimizing the effect of
reasons causing the loss due to idle time. The reporting of idle time may be done at individual level
and departmental level. These re-ports are made at frequencies depending on need of each
organisation. Any unusual time loss is immediately escalated to higher levels.

Questions
1. Give details about the U.S. Xpress Enterprises, Inc. (U.S. Xpress).
2. In above case study, how reason-wise analysis of idle time was done?

4.4 Summary
The first step in accounting for labour cost is to prepare an accurate record of the time spent by
each employee.
The most common form of attendance record is the clock card on which the employee punches
the time at which he comes in and leaves the factory.
Idle time refers to the time for which workers or staff members are present on the work location,
but no work is carried out. The employees working in any organisation are compensated by way
of salaries, wages another benefits.
Overtime premium is paid to workers for the extra time worked than the normal working hours
specified in the Factories Act, 1948 or work agreement with the union.

4.5 Keywords
Abnormal Idle Time: It refers that any loss of time which may occur due to some abnormal reasons.
Idle facilities: It refer to that part of total production facilities available which remain unutilized
due to any reason such as non-availability of raw-material, etc.
Idle time: It refers to the time for which workers or staff members are present on the work location,
but no work is carried out.
Overtime Premium: Overtime premium is paid to workers for the extra time worked than the normal
working hours specified in the Factories Act, 1948 or work agreement with the union.
Time booking: It means recording the time spent by a worker on each job, process or operation.

4.6 Self Assessment Questions

1. Time booking means recording the time spent by a worker on each job, process or operation
(a)True (b) False

2. The most common form of attendance record is the........... on which the employee punches the
time at which he comes in and leaves the factory.
(a) identity card (b) clock card
(c)counter card (d) None of these.

3. These payments are made in return of the ..............rendered by the employees

(a) payments (b) employees
(c) services (d) None of these

4. The total time attended by the............ and the time spent by him on the jobs.
(a) worker (b) attended
(c) time Spent (d) None of these

5. To determine the.......... and value of work done.

(a) value (b) work
(c) quantity (d) None of these.

6. The supervisors must keep vigil to record the....... lost on the job.
(a) actual time (b) time spent
(c) services (d) None of these

7. This card records the attendance time of workers and work time of worker.
(a)True (b) False

8. The idle time may arise due to non-availability of raw materials

(a) Payments (b) Employees
(c) Idle Time (d) None of these

9. The extra time is paid at a higher rate than the normal time rate
(a)True (b) False
10. The first step in accounting for labour cost is to prepare an accurate record
(a) Labour cost (b) Value
(c) Work (d) None of these

4.7 Review Questions

1. What do you mean by time keeping? Explain
2. Define the concept of time booking in detail.
3. Write a short note on idle time?
4. What is abnormal idle time?
5. What are the various incentive schemes?
6. What do you mean by overtime concept?
7. Explain the term time based payments.
8. Write a short note on Merrick plan?
9. What do you understand by the Taylor plan?
10. What are characteristics of a sound remuneration system?

Answers for Self Assessment Questions

1. (a) 2.(b) 3.(c) 4.(a) 5.(c)
6. (a) 7.(a) 8.(c) 9.(a) 10.(a)
 5
Accounting and Control of Overheads
CONTENTS
Objectives
Introduction
5.1 Accounting
5.2 Overheads
5.3 Allocation
5.4 Apportionment and Re-apportionment
5.5 Absorption of Overheads
5.6 Determination of Overhead Rates
5.7 Under/Over Absorption of Overheads
5.8 Summary
5.9 Keywords
5.10 Self Assessment Questions
5.11 Review Questions

Objectives
After studying this chapter, you will be able to:
Understand the accounting
Explain the control of overheads
Define allocation
Define apportionment and re-apportionment
Explain the absorption of overheads
Explain the under and over absorption of overhead

Introduction
There is no unanimity among the management accountants to define this subject. There are various
definitions on the concept given by different experts. Some of them are:
―Any form of accounting which enables a business to be conducted more efficiently can be regarded
as Management Accounting‖
―Management Accounting is the presentation of accounting information in such a way as to assist
management in the creation of policy and in the day -to-day operations of an undertaking‖.
―Management Accounting includes the methods and concepts necessary for effective planning, for
choosing among alternative business performances‖.
Management accounting is the process of measuring and reporting information about economic
activity within organizations, for use by manager s in planning, performance evaluation, and
operational control:

Planning: For example, deciding what products to make, and where and when to make them.
Determining the materials, labour, and other resources that are needed to achieve desired output. In
not-for-profit organizations, deciding which programs to fund.

Performance Evaluation: Evaluating the profitability of individual products and product lines.
Determining the relative contribution of different managers and different parts of the organization.
In not-for-profit organizations, evaluating the effectiveness of managers, departments and programs.

Operational Control: For example, knowing how much work-in-process is on the factory floor, and
at what stages of completion, to assist the line manager in identifying bottlenecks and maintaining a
smooth flow of production.
Also, the management accounting system usually feed s into the financial accounting system. In
particular, the product costing system is usually used to help determine inventory balance sheet
amounts, and the cost of sales for the income statement.

Management accounting information is usually financial in nature and dollar-denominated, although

increasingly, management accounting systems collect and report nonfinancial information as well.
The mechanical process of collecting and processing information poses substantial and interesting
challenges to large organizations. Also, there are important conceptual issues about how to
aggregate information in order to measure, report, and analyze costs. Issues of how to allocate costs
across products, services, customers, subunits of the organization, and time period s, raise questions
of substantial intellectual content, to which there are often no clear answers. Management
accounting is used by businesses, not-for-profit organizations, government, and individuals:
Businesses can be categorized by the sector of the ec onomy in which they operate. Manufacturing
firms turn raw materials into finished goods, and we also include in this category agricultural and
natural resource companies. Merchandising firms buy finished goods for resale. Service sector
companies sell services such as legal advice, hairstyling and cable television, and carry little if any
inventory. Businesses can also be categorized by their legal structure: corporation, partnership,
proprietorship. Finally, businesses can be categorized by their size.
Not-for-profit organizations include charitable organizations, not -for-profit health care providers,
credit unions, and most private institutions of higher education. Government includes Federal, state
and local governments, and governmental agencies such as the post office and N.A.S.A.
All of these organizations use management accounting extensively. Also, individuals use the
economic concepts that form the foundation of management accounting in their personal lives, to
assist in decisions large and small: home and automobile purchases, retirement planning, and
splitting the cost of a vacation rental with friends.

5.1 Accounting
Accounting is a very old science which aims at keeping records of various transactions. The
accounting is considered to be essential for keeping records of all receipts and payments as well as
that of the income and expenditures.
Accounting is generally classified into three different disciplines as (See Figure.5.1)

Figure 5.1: Classification of accounting.

Financial Accounting
Accounting involves recording, classifying and summarizing of past events and thus is historical in
nature. It is historical accounting which is better known as financial accounting whose primary
intention is to prepare the statements revealing the income/loss and financial position of the business
on the basis of events, which have happened in the period being reckoned. But this information,
though of immense vitality does not adequately aid the management in planning, controlling,
organizing and efficiently conducting the course of the business as a result of which cost accounting
and management accounting are in place.

Cost Accounting
It shows classification and analysis of costs on the basis of functions, processes, products, centres
etc. It also deals with cost computation, cost saving, cost reduction, etc.

Management Accounting
Management Accounting begins where Financial accounting and Cost accounting ends. It deals with
the processing of data generated in financial accounting and cost accounting for managerial
decision-making. It also deals with application of managerial economics concepts for decision -
making. The scope of management accounting is broader than that of cost accounting. In other
words, it can be said that the management accounting can be considered as an extension of cost
accounting.
Management Accounting utilizes the principles and practices of financial accounting and cost
accounting in addition to other modern management techniques for efficient operation of a company.
The main thrust in management accounting is towards determining policy and formulating plans to
achieve desired objectives of management. Management accounting makes corporate planning and
strategies effective and meaningful.

5.2 Overheads
Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour and such
other expenses including services as cannot conveniently be charged direct to specific cost units.
Thus overheads are all expenses other than direct expenses. In general terms, overhead comprise all
expenses incurred for or in connection with the general organisation of the whole or part of the
undertaking i.e. the cost of operating supplies and service used by the undertaking and including the
maintenance of capital assets. The main groups into which overheads may be sub -divided are the
following:

5.2.1 Manufacturing or Production or Works Overhead

It is the indirect expenses of operating the manufacturing divisions of a concern and covers all
indirect expenditure incurred by the undertaking from the receipt of the order until its completion
ready for dispatch either to the customer or to the finished goods store. Examples of such expenses
are: depreciation and insurance charges on fixed assets like plant and machinery, works, building,
and electric equipments and floating assets; electricity charges; coal and other fuel charges; rent,
rates and taxes on works, land and properties, works office printing, stationery, postage, telegrams
and telephone charges; welfare services like canteen and recreation clubs; medical services like
dispensary and hospital and service department expenses.

Administration Overhead
It is the indirect expenditure incurred in formulating the policy, directing the organisation and
controlling the operations of an undertaking which is not related directly to a research, development,
production or selling activity or function. It consists of all expenses incurred in the direction,
control and administration (including secretarial, accounting and financial control) of an
undertaking. Examples are the expenses in running the general office e.g. office rent, light, heat,
salaries and wages of clerks, credit approval.

Selling Overhead
It is the cost of seeking to create and stimulate demand and of securing orders and comprises to cost
to products or distributors of soliciting and recurring orders for the products or commodities dealt in
and of efforts to find and retain customers. These include sales office expenses; salesmen's salaries
and commission; showroom expenses; advertisement charges.

Distribution Overhead
It is the expenditure incurred in the process which begins with making the packed product available
for despatch and ends with making the reconditioned return empty package, if any available for
reuse. It comprises all expenditure incurred from the time th e product is completed in the works
until it reaches its destination. Under these would be included warehouse rent; warehouse staff
salaries, insurance etc.
5.2.3 Classifications of Overhead
Classification is defined as, the arrangement of items in logica l groups having regard to their nature
(subjective classification) or the purpose to be fulfilled. ( Objective classification) In other words,
classification is the process of arranging items into groups according to their degree of similarity.
Accurate classification of all items is actually a prerequisite to any form of cost analysis and control
system.
Functional Classification
Under functional classification, the overhead expenditure is identified under a particular head based
on the purpose of the expenditure i.e. based on the functions that are accomplished by the
expenditure incurred. Functionally, the overh eads are classified under three or four heads.

Factory Overheads
The indirect expenses (overheads) incurred within the factory area are classified as factory
overheads.

Research and Development Overheads

In the modern days, firms spend heavily on research and development. Expenses incurred on
research and developments are known as R & D overheads.

Administration or Office Overheads

The indirect expenses (overheads) incurred within the administrative area are classified as
administrative or office overheads.

Selling Overheads
The indirect expenses (overheads) incurred in relation to the sales activities are classified as selling
overheads.

Distribution Overheads
The indirect expenses (overheads) incurred in relation to the distribution of the prod uct or services
are classified as distribution overheads.

Selling and Distribution Overheads

The indirect expenses (overheads) incurred in relation to the sales activities as well as distributing
the product or services are classified under a single head as ―selling and distribution overheads.‖

Behavioural Classification
Under functional classification, the overhead expenditure is identified under a particular head based
on its inclination to vary with the level of activity achieved (production/sales). Behaviourally, the
overheads are classified under three heads.

Variable Overheads
The overhead expenses which vary directly with activity level (production/sales) are called variable
overheads. These costs change with every small change in the activity le vel.
Fixed Overheads
The overhead expenses which do not vary with the activity level (production/sales) are called fixed
overheads. These costs would remain the same whatever may be the activity level achieved. They
are also called committed costs as they have to be borne even if the activity level achieved is not as
planned.

Semi-Variable Overheads
The overhead expenses which behave both like variable as well as fixed overheads are called semi -
variable overheads. These expenses remain fixed within ranges of activity levels. They vary
whenever the activity level crosses certain points.

5.2.4 Control of Overheads The overheads of any business must be identified, examined and
controlled at all times. As we all know income minus overheads equals profit. Obvio usly if you were
to reduce your overheads you would increase your profit without increasing your income. So if you
reduce overheads and increase your income you will boost your profits even further. This is what all
efficient businesses must strive to do.
Each business, regardless of the sphere of operations has overheads of one kind or another. It is vital
to identify all items of expenditure, particularly recurring overheads. Obviously if you are buying a
new piece of equipment that will be used for years , such as a new vehicle, that is not an overhead
but a Capital Expense item which is depreciated annually against tax. The cost of running that
vehicle or maintaining that piece of equipment is an overhead. Specify carefully your overhead
costs, particularly the ones that you are able to control. You can then monitor them, and where
possible reduce them and make savings.

There are some overheads that will have no control over such as Taxes, Rates, Rents, Employment
costs and several other costs. That is one of the reasons why one needs to identify the total cost of
overheads that can be control, and therefore wherever possible, make savings. Savings can be made
in most areas that are under control and the need for constant monitoring and examination is
obvious. With the high cost of operating a business today, it is negligent not to stri ve to reduce
overheads in whatever areas possible.
Each business will have differing overheads, but if the business is efficient opportunities will arise
where cost savings can be made. We are unable to go into detail of cost savings to be made in
business but one does know that savings can be made in all businesses. Think of the huge cost
savings that of some of the largest companies have made in recent times and consequently the
considerable increase in their profits. It is not suggesting that one follows the lead of the
multinationals, just examine regularly, in the same way they have, how to make cost savings.
Expenses that can be addressed and very often bring savings are the costs involved in the use of
outside service providers, so shop around and try to get reductions or rebates.
Things such as gas, electricity, telephones, fuel providers, cleaning services, courier services, postal
charges and many other service suppliers used in business today. Labour and employment costs are a
source of considerable expense and should be constantly monitored. See if it is possible to
amalgamate two jobs into one, make some jobs part time, use temporary contract labour, outsourcing
to specialists, consider if some other choice of labour cost saving is available. As we have said,
labour and employment costs are very high and considerable savings can be made by using your
employees in the most effective, efficient and cost conscious way. It has been proved recently that a
significant saving can be made in many business es by outsourcing rather than doing the same work
in-house.

Other cost savings can be made by increasing efficiency with the use of computers, the internet, text
messaging and the use of all the technical advances that have been made over recent years. If you
are interested in these developments but are not sure how to put them to use ask for advice. There
are many companies that are willing to help and a quick search on the Internet will provide all the
information you require. Lastly it is important to a ccept that overheads are part of running a
business but can be controlled. Everything from cleaning materials to the cost of vehicle operation,
machine maintenance, consumable materials and staff employment costs can, and must be kept as
low as possible.

5.3 Allocation
Cost allocation can be defined as, ‗the charging of discrete, identifiable items of cost to cost centres
or cost units. Where a cost can be clearly identified with a cost centre or cost unit, then it can be
allocated to that particular cost centre or unit. In other words, allocation is the process by which cost
items are charged directly to a cost unit or cost centre. For example, electricity charges can be
allocated to various departments if separate meters are installed, depreciation of ma chinery can be
allocated to various departments as the machines can be identified, salary of stores clerk can be
allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house
division. Thus allocation is a direct process of identifying overheads to the cost units or cost centre.
Costs incurred by cost centres are classified into two types:
a) Direct Costs
b) Indirect Costs
Costs which can be traced to the finished products manufactured are called ‗direct costs‘. In other
words a relationship between costs and finished products manufactured can be established.
Costs which cannot be traced to the finished products manufactured are called ‗indirect costs‘. They
are also known as ‗overheads‘. This implies overheads can only be apportioned to the finished
products.

Example: A unit manufactures two products leather shoes and leather wallets Material (Leather)
used for both the products are traceable to them individually. However, expenditure of a common
machine used in making both the products cannot be traceable to them.
Therefore in the above case ‗material‘ would be a direct cost and ‗machine expenses‘ would be
indirect cost.

5.3.1 Importance of Overhead Allocation

Total cost of product constitutes direct material, direct labour and overheads. Direct material and
direct labour are directly traceable to the products manufactured. Accuracy of product cost
computation depends on accurate distribution of overheads to products. Inaccuracies wou ld lead to
incorrect decisions especially the pricing decisions.
However, the method of overhead distribution should be chosen by considering time and cost factors
in addition to accuracy.

Traditional Distribution
Traditionally overhead apportionment to products was made in the foll owing three step approach.
(See Figure 5.2)
I) Primary Distribution (Allocation and Apportionment)
II) Secondary Distribution (Re-apportionment)
III) Absorption

Figure 5.2: Apportionment allocation and absorption of overheads.

Allocation and Apportionment (Primary Distribution)

Primary distribution of overheads which is also called as ‗Departmentalization‘ of overheads
involves allocation and apportionment. Allocation of overheads is made when they are traceable to
cost centres. Overheads are apportioned when they a re not traceable to cost centres. Apportionment
is made using the most suitable bases.

5.4 Apportionment and Re-apportionment

Apportionment and re-apportionment are defined below:
5.4.1 Apportionment
Apportionment really only means sharing out any relevant costs properly and fairly between funded
and other projects, or between two or more different funded projects, being delivered by one
organisation.
Whichever situation applies one must:
Choose an approved method for apportioning eligible costs
Apply the method/s you choose consistently
 Have a written explanation for the method/s cho ice.

Some costs will fall clearly only within the eligible costs incurred by the project.
For example, beneficiary costs such as travel, dependent care, training allowances and/or subsidies,
and staff costs for people employed only on the project being cost. There may also be other kinds of
costs and charges that can be directly attributed to the project.
For example, for the telephone where there is a separate line/number for the project and therefore a
separate bill. These will not need to be apportioned, and will eventually be charged to the project at
their actual cost, which will be fully documented and verifiable.
Other costs will be shared across the organisation and therefore will have to be apportioned, For
example, staff costs where staff members are working on more than one project, or overheads such
as building costs where only some of the activities taking p lace in the building are part of the project
being casted and there is no separate billing involved. For all such costs, you will need to work out
which method of apportionment you are going to use, and apply it consistently:
When you work out your initial budget at project development stage?
When you fill in your application for European funding?
When you are making claims for payment?
And remember, you must:
choose an approved method for apportioning eligible costs
Use the method/s you choose consistently
Have a written explanation for the method/s you choose Apportionment methods you can use:
For example, the Baggins Foundation is an organisation that currently provides horticultural training
to socially excluded people on three training programmes, though only one of these is European -
funded.

5.4.2 Re-apportionment
Re-distribution of overhead from various service departments to production departments is known as
re-apportionment or secondary distribution. Accordingly, allocation and apportionment of overheads
from service departments or centres to pro duction centres or departments.

The following are the important bases adopted for apportionment of secondary distribution:
Methods or Re-Apportionment or Re-Distribution
The following are the important methods of re -distribution of service department overheads to
Production department:
Direct re-distribution method
Step distribution method
Reciprocal Service Method. This method further grouped into:
a. Repeated Distribution Method
b. Simultaneous Equitation Method
c. Trial and Error Method
The following figure explains more about the method of re -apportionment of service department
cost. (See Figure 5.3)

Figure 5.3: Method of secondary distributions.

5.5 Absorption of Overheads

The most important step in the overhead accounting is ‗Absorption‘ of overheads. Absorption can be
defined as, ‗the process of absorbing all overhead costs allocated or apportioned over a particular
cost centre or production department by the units produced.‘
In simple words, absorption means charging equitable share of overhead expenses to the products.
As the overhead expenses are indirect expenses, the absorption is to be made on some suitable basis.
The basis is the ‗absorption rate‘ which is calculated by dividing the overhead expenses by the base
selected. A base selected may be any one of the basis given below. The formula used for deciding
the rate is as follows:

Overhead Absorption Rate = Overhead Expenses/Units of the base selected.

5.5.1 Methods Used for Absorption

Various methods of absorbing manufacturing overheads may be used for distribution of overheads.
These may be:
Direct material cost method.
Direct labour cost method.
Prime cost method.
 Labour hour rate method.
Machine hour rate method.

Direct Material Cost

Under this method, the overheads are absorbed on the basis of percentage of direct material cost.
The following formula is used for working out the overhead absorption percentage.
Budgeted or Actual Overhead Cost/Direct Material Cost X 100
Thus if the overhead expenses are INR. 2,00,000 and Direct Material Cost is INR. 4,00,000 the
percentage of overheads to direct material cost will be, 2,00,000/4,00,000 X 100 = 50%. Overheads
will be thus absorbed on the basis of percentage of 50% to material costs.

Illustration: A firm produces two products, A and B. Direct material costs for A are INR. 2,50,000
and for B, INR. 1,50,000. The overheads will be charged to these products as shown in the following
statement, assuming the rate of absorption as 50% as shown above.

This method is suitable in those organizations where material is a dominant factor in the total cost
structure. Simplicity to understand and operate is also one of the positive points of this method.
However it has been observed that the material prices are fluctuating and hence overhead absorption
may become difficult.

Direct Labour Cost Method

This method is used in those organizations where labour is a dominant factor in the total cost. Under
this method, the following formula is used for calculating the overhead absorption rate.
Budgeted or Actual Overheads/Direct Labour Cost X 100
Thus if the overheads are INR. 3,00,000 and Direct Labour Cost are INR. 4,00,000 the % of
absorption will be 3,00,000/4,00,000 X 100 = 75%. Overheads will be charged to each product as
75% of labour cost.
This method is also simple to understand and easy to operate. However, it ignores the time taken by
each worker for completion of the job. Similarly it ignores the work performed by machine where a
labour is a mere attendant.

Prime Cost Method

This method is an improvement over the first two methods. Under this method, the Prime Cost is
taken as the base for calculating the percentage of absorption of overheads by using the following
formula:

Budgeted or Actual Overheads/Prime Cost X 100

Illustration: A manufacturing firm produces two products, A and B. The direct material cost for A is
INR. 5,00,000 and for B INR. 3,00,000, direct labour cost is INR. 3,00,000 and Rs. 2,00,000
respectively for A and B, direct expenses are INR. 1,00,000 and INR. 2,00,000 respectively for A
and B. The overhead expenses are INR. 9,60,000. The statement of cost will appear as follows.

Note: Overhead absorption rate is calculated as 9,60,000/16,00,000 X 100 = 60%

Production Unit Method

This method is used when all production units are similar to each other in all respects. Total
overhead expenses are divided by total production units for computing the r ate per unit of overheads
and overheads are absorbed in the product units. If a firm produces more than one product and if
they are not uniform to each other, equivalent units are calculated to find out the rate of overheads
per unit. The formula of absorption of overheads is as follows.
Overhead absorption rate = Budgeted or Actual Overheads/Production Units

Direct Labour Hour Method

Under this method, the rate of absorption is calculated by dividing the overhead expenses by the
direct labour hours. The formula is as follows.
Budgeted or Actual Overhead Expenses/Direct Labour Hours
This method takes into account the time spent by the labour in production of each unit where the
production units are not uniform or identical. However it is not suitable if th e firm is capital
intensive and highly mechanized.

Machine Hour Rate

Where machines are more dominant than labour, machine hour rate method is used. Machine hour
rate may be defined as ‗actual or predetermined rate of cost apportionment or overhead absorp tion,
which is calculated by dividing the cost to be appropriated or absorbed by a number of hours for
which a machine or machines are operated or expected to be operated‘. In other words, machine hour
rate is the cost of operating a machine on per hour ba sis. The formula for calculating the machine
hour rate is, budgeted or actual overhead expenses/machine hours actual or budgeted.

Selling Price Method

In this method, selling price of the products is used as a basis for absorbing the overheads. The logic
used is that if the selling price is high, the product should bear higher overhead cost. Ratio of selling
price is worked out and the overheads are absorbed.

5.6 Determination of Overhead Rates

The apportionment of overhead expenses is done by adopting suitable basis such as output,
materials, prime cost, labour hours, machine hours etc. In order to determine the absorption of
overhead in costs of jobs, products or process, a rate is calculated and it is called as ―Overhead
Absorption Rate‖ or ―Overhead Rate‖. The overhead rate can be calculated as below:

Different overhead rates are applied based on the features and objectives of the business
organization.
The following are the important overhead absorption rates generally employed:
Actual overhead rate
Predetermined overhead rate
Blanket overhead rate
Multiple overhead rate
Normal overhead rate
Supplementary overhead rate

Actual Overhead Rate: Actual overhead rate as otherwise called the historical rate. This rate is
calculated by dividing the actual overhead absorbed by the actual quantity or value of the base
selected for a particular period. Assuming that overhead rate is calculated on monthly basis, the
following formula is expressed as:

Predetermined Overhead Rate: Predetermined Overhead rate is determined in advance of actual

production and the rate is computed by dividing the budgeted overhead for the accounting period by
the budgeted base for the period. The formula is:

Blanket Overhead Rate: Blanket overhead rate is also termed as single overhead rate. A single
overhead rate when computed for the entire factory is known as blanket rate. It is calculated as:

Single rate may be applied suitably in small concerns and only where a single product is
manufactured.

Multiple Overhead Rates: Multiple overhead rates involve computation of separate rates for each
production department, service department, cost centre, each product or line and for each production
factor. The following formula is used for calculating multiple overhead rates:
Normal Overhead Rate: Normal Overhead Rate is a predetermined rate calculated with reference to
normal capacity. It is calculated as:

Supplementary Overhead Rates: These rates used to carry out adjustment between overhead
absorbed and overhead incurred. These are used in addition to some other rates and are calculated as
under:

5.7 Under/Over Absorption of Overheads

We have seen in the absorption of overheads that by using any method, a rate o f absorption is
computed and then the overheads are charged to the products. The rate of absorption may be either
predetermined or historical. The meaning of this is that there may be a predetermined rate which is
based on budgeted overhead expenses and budgeted units of base. Alternatively the rate may be
based on historical data, i.e. actual overhead costs and actual units of the base. The main advantage
of the historical rate is that there is no possibility of under/over absorption of overheads.
If predetermined rate is used, there is every possibility of under or over absorption of overheads.
The following illustration will clarify the point.

Illustration: A manufacturing company uses direct material cost as the basis for absorption of
overheads. The absorption rate is worked out as follows:
Budgeted overheads INR 50,000/ Budgeted Material Cost INR 1,00,000 X 100 i.e. 50%
Now if the actual overheads are INR. 70,000 and the actual direct material cost is INR. 1,20,000, the
overheads absorbed will be INR 60,000 i.e. 50% of the direct material cost and there will be under
absorption of INR. 10,000 as the actual overheads incurred are INR. 70,000. Thus it can be seen that
there is a possibility of over/under absorption of overheads if predetermined rates ar e used for
absorption. The reason for this is that there is always a possibility that budgeted expenses and actual
expenses may not be exactly the same. There is bound to be some variation in the same. In spite of
this limitation, predetermined rate is widely used as it looks in the future and estimates the expenses
while in case of historical rates, information is available after the period is over. Once the
under/over absorption is noticed, the following corrective steps are to be taken to rectify the sam e.

Use of supplementary Rate: The under/over absorption can be rectified by using the supplementary
rate. This rate is calculated by dividing the under/over absorbed amount of overheads by the units of
the base. The rate so arrived is known to be supplementary rate. Carrying forward to future period:
If the amount of under/over absorption of overhead is small, it may be carried forward to the future
period hoping that it will be rectified in the future.

Writing off to Profit and Loss A/c: Amount of under/over absorption can be written off to costing
profit and loss account and thus not reflected in the total costs.
The under absorption or over absorption of overheads arises due to following reasons:
Error is estimating overhead expenses.
Unexpected charges in the methods of production affecting the amount of overheads.
Unanticipated changes in the production capacity.
Seasonal fluctuations in the overhead expenses from period to period.
Actual working hours may be more or less than hours ant icipated.

Case Study-Cost per Student Using ABC Approach

Cost Per Student Present Approach
Prior to the introduction of ABC, cost per student is traditionally determined using number of
students as the sole cost driver. In the university‘s financial system costs are collected at sixty one
responsibility centres under four categories. Excel software is used and cost per student is using the
following formula:

The faculty cost is divided by the number of students in that faculty. The average administrative cost
per student of RM6,496 is added to arrive at the annual cost per student. Average cost per student
for 2009. As a public university, the annual fee being charged to students is determined by MOHE.
Therefore the difference between cost and fee is regarded as contribution by government.

Cost Per Student ABC Approach

Four critical steps were performed in ABC approach; (1) improve data quality, (2) develop ABC
model for cost per student, (3) identify assumptions and (4) apply ‗SAS Activity-Based Management
select Edition‘ software. Data quality improvement include traci ng of general cost to related
responsibility centres, excluding cost of asset purchases, including depreciation expense,
categorizing responsibility centres according to its main roles, using various cost drivers, and
detailing the cost according to student categories. Fifty eight responsibility centres and are
categorized as follow: Infrastructure provides services to UKM staffs, students, community and
public. Eight infrastructure responsibility centres include academic museum, Islamic centre and
publisher. Institutional support provides services to all staffs and students. Eight institutional
supports include bursary, registrar, Information Technology and h ealth centre. Academic support
provides services to institutes and faculties. Sixteen academic suppo rts include library, centre of
academic development, centre of graduate management, and student development. Institute research
in specific areas of expertise. Faculty manage graduate and undergraduate programs, and other
activities related to teaching and learning. There are fourteen institutes and twelve faculties
respectively. Clinical cost is charged to four faculties that impose clinical requirements on their
programs. (See Figure 1)
 Figure 1: ABC Model.
Figure 1 shows the ABC model indicating the cost flows to determine cost per student per program.
Examples of various cost drivers include number of transactions, number of students, number of
staffs, credit hours, weighted costs, percentage of activities, duratio n of academic programs. (See
Table 1)
Table 1: Comparison of annual cost per student.

Annual cost per student per program is determined using ‗SAS Activity-Based Management Select
Edition‘ software. Table 1 shows a comparison of average annual cost per student for each faculty
(exchange rate RM1 = USD0.33 = GBP0.20). Data gathering is a challenging process as it involves
various parties within the organization. Kaplan and Anderson (2004, 2007) note that the procedure
for estimating ABC model has proved to be difficult especially if the current accounting system does
not support the collection of the needed information. According to Kaplan and Anderson (2007)
updating ABC model through interviews and surveys further increase its time and resource
consumption. Therefore, in situations where actual data is unavailable, assumptions are used in the
model.
Questions
1. How can we improve data quality by ABC approach?
2. Describe ‗SAS Activity-based Management Select Edition‘.

5.8 Summary
Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour and
such other expenses including services as cannot conveniently be charged direct to specific cost
units.
Cost allocation can be defined as, ‗the charging of discrete, identifiable items of cost to cost
centres or cost units.
Costs which can be traced to the finished products manufactured are called ‗direct costs‘.
Costs which cannot be traced to the finished produ cts manufactured are called ‗indirect costs‘.
Re-distribution of overhead from various service departments to production departments is
known as re-apportionment or secondary distribution.
Absorption can be defined as, ‗the process of absorbing all overhead costs allocated or
apportioned over a particular cost centre or production department by the units produced.‘
Management accounting is the process of measuring and reporting information about economic
activity within organizations, for use by managers in planning, performance evaluation, and
operational control

5.9 Keywords
Apportionment: The legal term apportionment means distribution or allotment in proper shares.
Budget: A budget is an important concept in microeconomics, which uses a budget line to illustrate
the trade-offs between two or more goods. In other terms, a budget is an organizational plan stated
in monetary terms.
Managerial Economics: Managerial economics as defined by Edwin Mansfield is ―concerned with
application of economic concepts and economic analysis to the problems of formulating rational
managerial decision.‖
Overhead: Overhead the ongoing operating costs of running a business.
Solicitation: It means ―urgently asking‖. It is the action or instance of soliciting; petition; proposals.

5.10 Self Assessment Questions

1.............................is the process of measuring and reporting information about economic activity
within organizations, for use by managers in planning.
(a) Management control (b) Management function
(c) Management accounting (d) None of these.

2. Management Accounting helps the management to conduct the business in a more efficient
manner.
(a) True (b) False

3. Overheads may be defined as the aggregate of the cost of indirect materials.

(a) True (b) False

4. The overhead expenses which vary directly with activity level are called.......
(a) variable overheads (b) fixed overheads
(c) semi variable overheads (d) None of these.

5. The overhead expenses which do not vary with the activity level are called......
(a) variable overheads (b) fixed overheads
(c) semi variable overheads (d) none of these.

6. Actual overhead rate as otherwise called the......................

(a) blanket rate (b) multiple rate (c) historical rate (d) none of these.

7. Blanket overhead rate is also termed as....................

(a) single overhead rate (b) multiple overhead rate
(c) Both (a) and (b) (d) None of these.

8. .................overhead rate is determined in advance of actual production and the rate is computed
by dividing the budgeted overhead for the accounting period by the budgeted base for the period.
(a) Multiple (b) Predetermined (c) Single (d) None of these.

5.11Review Questions
1. What do you mean by accounting?
2. Explain the classification of overheads?
3. Define overhead control.
4. Define the allocation.
5. Define managerial economics
6. What is apportionment and re-apportionment?
7. Describe the absorption of overheads?
8. How many types of methods used for absorption?
9. Write Short note on:
a. Actual Overhead Rate
b. Predetermined Overhead Rate
c. Blanket Overhead Rate
d. Multiple Overhead Rate
10. Describe the under/over absorption of overheads?
Answers for Self Assessment Questions
1. (c) 2.(a) 3.(a) 4.(a) 5.(b)
6. (c) 7.(a) 8.(b)
 6
Job Costing
CONTENTS
Objectives
Introduction
6.1 Concept of Job Cost Accounts
6.2 Contract Costing and Concept
6.3 Contract Account
6.4 Determination of Profit or Loss on Incomplete Contract
6.5 Summary
6.6 Keywords
6.7 Self Assessment Questions
6.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain the concept of job cost accounts
Define contract costing and concept
Understand the contract account in job costing
Describe profit or loss on incomplete contract

Introduction

Job costing is the process of tracking the expenses incurred on a job against the revenue produced by
that job. Job costing is an important tool for those who are pairing a relatively high dollar volume
per customer with a relatively low number of customers. For example, building contractors,
subcontractors, architects and consultants often use job costing, whereas a hardware stor e or
convenience store would not use job costing.

Job costing using accounting software enables you to track a number of factors and analyze the
results to aid decision making. A Job costing report helps you ensure that all costs involved in a job
have been properly invoiced to the customer. Estimates and actual report compares quoted costs to
actual costs, and quoted revenues to actual revenues so that you can analyze any variances between
your quote and the actual result. You can then use the results of your analysis to create more
accurate quotes when you bid on future jobs.
Using job costing will allow you to identify the most and least profitable areas of your business, so
that you can focus on the profitable elements, and try to make the less profitab le aspects of your
business more efficient. It will help you to quote new jobs more accurately, and assist you in
managing jobs in progress.

6.1 Concept of Job Cost Accounts

Job costing is the process of tracking the expenses incurred on a job against the revenue produced by
that job. Job costing is an important tool for those who are pairing a relatively high rupees volume
per customer with a relatively low number of customer s.
For example, building contractors, subcontractors, architects and consultants often use job costing,
whereas a hardware store or convenience store would not use job costing.
Job costing using accounting software enables you to track a number of factors and analyze the
results to aid decision making. A Job costing report helps you ensure that all costs involved in a job
have been properly invoiced to the customer. An estimate vs. actual report compares quoted costs to
actual costs, and quoted revenues to actual revenues so that you can analyze any variances between
your quote and the actual result. We can then use the results of your analysis to create more accurate
quotes when you bid on future jobs.
Using job costing will allow you to identify the most and least profitable areas of your business, so
that you can focus on the profitable elements, and try to make the less profitable aspects of your
business more efficient. It will help you to quote new jobs more accurately, and assist you in
managing jobs in progress.

6.1.1 Job Costing and Process Costing Systems

Job costing and process costing system are given below:
Job-Costing System: In this system, the cost object is a unit or multiple units of a distinct product or
service called a job. Each job uses a different amount of resources. The product or service is often a
single unit, such as a specialized machine made at Hitachi, a cons truction project managed by
Bechtel Corporation, a repair job done at an Audi Service Centre, or an advertising campaign
produced by Saatchi and Saatchi. Each special machine made by Hitachi is unique and distinct.
An advertising campaign for one client at Saatchi and Saatchi differs greatly from advertising
campaigns for other clients. Job costing is also used to cost multiple units of a distinct product, such
as the costs incurred by Raytheon Corporation to manufacture multiple units of the Patriot missi le
for the U.S. Department of Defence. Because the products and services are distinct, job costing
systems accumulate costs separately for each product or service.

Process-Costing System: In this system, the cost object is masses of identical or similar units of a
product or service. For example, Citibank provides the same service to all its customers when
processing customer deposits. Intel provides the same product (say, a Pentium 4 chi p) to each of its
customers. Customers of Minute Maid all receive the same frozen orange juice product. In each
period, process-costing systems divide the total costs of producing an identical or similar product or
service by the total number of units produced to obtain a per-unit cost. This per-unit cost is the
average unit cost that applies to each of the identical or similar units produced in that period. (See
Figure 6.1)

Figure 6.1: Costing system.

Many companies have costing systems that are neither pure job costing nor pure process costing but
have elements of both. Costing systems, therefore, need to be tailored to the underlying operations.
For example, Kellogg Corporation uses job costing to calculate the total cost to manufacture each of
its different and distinct types of products—such as Corn Flakes, Crispix, and Froot Loops but
process costing to calculate the per unit cost of producing each identical box of Corn Flakes.

6.1.2 Components of Job Costing

There are numerous aspects to job costing, and you may use many, some or none of them. If you
want to use job costing, you need to:
1. Track the costs involved in the job
2. Make sure all of the costs are invoiced to the customer
3. Produce reports showing details of costs and revenues by job
The fundamental components of job costing are:
Quotes – also known as estimates, bids, or proposals
Fixed fee jobs
Time and materials jobs
Revenues
Items
Direct costs
Standard costs
Let us take a look at the meaning of each of these components and how you might use them in job
costing.

Quotes
Most people are familiar with quotes. Quotes are non -posting transactions. They do not affect your
financial statements or your general ledger. You prepare a quote to give your customer an estimate
of projected costs, before a job is awarded. However, quotes also provide a means to track costs as
the job progresses, so that costs do not get out of line, or so that cost variances can be identified and
dealt with quickly.
Fixed Fee Jobs
Fixed fee jobs are an agreement to complete a job for a customer for a set price, no matter what
costs are incurred. While this may seem like a good deal for the customer, an experienced estimator
will set a price high enough to cover any contingencies, which may result in a higher price than a
time and materials job.

Time and Materials Job

On a time and materials job, costs of labour and materials are passed on to the customer. A mark -up
for overhead and profit may be built-in as a percentage of each item or stated as a separate line item.
Time and materials jobs are often preferred by the seller, as any unforeseen costs may be passed on
to the customer.

Revenues
Revenues are critical to the life of any business. In job costing, revenues are not only categorized by
account, but also by customer, job and item. Think of jobs as sub-categories of customers and items
as sub-categories of revenue/expense. This creates a new way of analyzing your revenues and the
costs incurred to produce them. Expenses become revenues; as costs are incurred f or a job, they are
marked up and passed on to the customer as revenues. To be able to compare your costs to the
revenues they produce, you should create matching categories in your revenue accounts and cost of
goods sold accounts (COGS).

Items
Items represent the products and services that business sells. One may have many items for each of
the revenue/expense account categories in chart of accounts. Using items, o ne enter the details about
what one can buy and sell, then ―map‖ or link the detailed items t o the more generalized accounts in
the chart of accounts. One can map many detailed items to a single account in chart of accounts.
This allows a greater level of detail in the item list while keeping the chart of accounts list concise.

6.1.4 Secrets of Job Costing

The people who are frustrated with job costing most likely do not understand these concepts.
Job costing uses items. One should use items when purchasing as well as when selling goods and
services if you want to use job costing. This means using an item type instead of an expense type
on a check, bill or credit card charge.
Items must be set up properly. In the new item dialog box, you select the I buy this item check
box for items that are purchased, I sell this item check box for items that are sold, and fill out
the standard cost field if you are using standard costs.
The same items used to record costs for a job must be used to invoice for the job. Expenses
become revenues, and to be able to compare direct costs to gross revenues, you must use the
same item on both sides of the transaction.
Of these three secrets, the third may be the most difficult to achieve. Often the bookkeeper
meticulously enters bills and records checks using items, and has the items set up properly, only to
have the owner invoice the job using a generic item rather than the items used to record costs for the
job. If this is your situation, you have two options: either re -educate the owner about proper
invoicing procedures, or, if the owner insists on a simple invoice for the job, let the owner create job
invoices in Excel or Word, and create a matching invoice in Small Business Accounting using the
proper items.

6.1.5 Cost Accounting

Cost accounting information is designed for managers. Since managers are taking decisions only for
their own organization, there is no need for the information to be comparable to similar information
from other organizations. Instead, the important criterion is that the information must be relevant for
decisions that managers operating in a particular environment of business including strategy make.
Cost accounting information is commonly used in financial accounting information, but first we are
concentrating in its use by managers to take decisions. The accountants who handle the cost
accounting information add value by providing good information to managers who are taking
decisions. Among the better decisions, the better performance of one ‘s organization, regardless if it
is a manufacturing company, a bank, a non -profit organization, a government agency, a school club
or even a business school. The cost-accounting system is the result of decisions made by managers
of an organization and the environment in which they make them. Cost accounting is regarded as the
process of collecting, analysing, summarising and evaluating various alternative courses of action
involving costs and advising the management on the most appropriate course of action based on the
cost efficiency and capability of the management

6.2 Contract Costing and Concept

Contract costing is ―A form of specific order costing; attribution of costs to individual contracts‖. A
contract cost is ―Aggregated costs of a single contract; usually applies to major long term contracts
rather than short term jobs‖.
Features of Long Term Contracts:
By contract costing situations, we tend to mean long term and large contracts: such as civil
engineering contracts for building houses, roads, bridges and so on.
We could also include contracts for building ships, and for providing goods and services under a
long term contractual agreement.
With contract costing, every contract and each development will be accounted for separately;
and does, in many respects, contain the features of a job costing situation.
Work is frequently site based.
We might have problems with contract costing in the following areas:
Identifying direct costs
Low levels of indirect costs
Difficulties of cost control
Profit and multi period projects

6.2.1 Features of a Contract:

The end product
The period of the contract
The specification
 The location of the work
The price
Completion by a stipulated date
The performance of the product

6.2.2 Collection of Costs:

Desirable to open up one or more internal job accounts for the collection of costs. If the contract not
obtained, preliminary costs be written off as abortive contract costs in P&L In some cases a series of
job accounts for the contract will be necessary:
to collect the cost of different aspects
to identify different stages in the contract

6.2.3 Special Features

Materials delivered direct to site.
Direct expenses
Stores transactions.
Use of plant on site

6.2.4 Possible Accounting Methods:

Where a plant is purchased for a particular contract and has little further value to the business at the
end of the contract. Where a plant is bought for or used on a contract, but on completion of the
contract it has further useful life to the business alternatively the plant may be capitalised with
Maintenance and running costs charged to the contract.

6.3 Contract Account

Contract Accounting is a great way for business owners to meet the company‘s objectives while
maintaining operational flexibility. Contract Accounting does offer unique requirements that
employers and candidates should consider. In the construction industry, two accounting approaches
have developed over the years regarding the recognition of revenue. The first approach -the
completed-contract method-does not recognize any profit until the construction project is complete.
The second approach-the percentage-of-completion method-recognizes profit on a piecemeal basis.
The logic behind the percentage-of-completion method is that both the buyer and seller have
obtained enforceable rights. The buyer has the right to require specific perf ormance on the contract;
the seller has the right to require progress payments. Thus the facts seem to indicate that a
continuous "sale" is in progress. The percentage method should be used if estimates of progress
toward completion, revenues, and costs are reasonably dependable, and all the following conditions
exist: The contract clearly specifies the rights regarding goods or services to be provided, and the
consideration to be exchanged. The buyer can be expected to satisfy all the contractual obligatio ns.
The contractor can be expected to perform the contractual obligations. If these conditions have not
been met, then the completed-contract method should be used. It should be emphasized that the total
profit on the construction project is the same under both methods.
6.3.1 The Completed-Contract
This method defers all the profit on the construction project until the completion date. During the
construction period, all costs incurred are debited to an inventory account called "Construction in
Process". This is similar to the Work in Process account used in cost accounting. Billings are
debited to Accounts Receivable and credited to an account called "Billings on Construction". This is
not a revenue account since this method does not recognize any revenue or profit until completion.
Rather, it is a contra asset to the Construction in Process Account. Finally, at completion, the
construction and billings accounts are closed, and the difference between them is recognized as
gross profit. If the parties to an agreement could specify their respective rights and duties for every
possible future state of the world, their contract would be complete. There would be no gaps in the
terms of the contract.

6.3.2 Financial Benefits of Contract

An average contractor rate can easily be double that of a full time employee, or even more.
Contractors are paid very high rates due to their skills and flexible nature of the relationship and
the fact that many positions can be relatively short -term.
Depending on your individual skills, the state of the industry in which you work (or the market
in general) and the location of a contract, you can command very high rates of pay.
Contracting through your own limited company is the most tax efficient way possible and is not
as hard or time consuming as you might think, for more information see our 1,2,3 guide to going
limited.
As a contractor, you may be paid for every hour that you work, as well as having the opportunity
to work overtime at very good rates.
If you operate through a limited company you have far better tax planning opportunities which
can reduce your overall tax burden and increased your take home pay. Forming your own limited
company just takes 5 minutes.
You can offset all of your business expenses against your income to further reduce your tax bill.

6.3.3 Flexibility
Contractors have the ability to be far more independent than permanent employees. Visit SJD's
comprehensive careers section for hints and tips on CV's and job hunting.
You have the freedom to work when you choose, where you choose and for however long you
like.
Changing contract can often be far easier than changing jobs.
Contractors can take as much or as little holiday as they prefer, most permanent employed
people do not get paid for any holiday entitlement unused during the year, as a contractor you
will.
The company you work for is not your employer, but is instead your client, which puts a whole
different flavour on the relationship!
Contract roles will give you much more flexibility when it comes t o agreeing working
conditions.
As a contractor you also have more flexibility over the payment terms that you can negotiate.
You have the opportunity to develop your career in a way that suits your personal circumstances
 at any given time.

6.3.4 Skills Development

Working as a contractor gives you the opportunity to test out other industry sectors to see if you
can widen your experience.
Contractors tend to gain a really good insight into different company cultures, processes,
operations and structures.
Working in many different companies gives you the ability to build up a wide -ranging CV and to
establish an extensive list of reference contacts.
A good contractor will become known within their own field for their excellent work and you
may even find that your services become sought-after, rather than you having to apply for new
positions all the time.
As your experience and network grows opportunities will come along with other contractors
contacting you with regards to opportunities with their clients.
Carrying out project work in different organisations and environments gives a contractor the
opportunity to develop existing skills and to learn new ones – making you an even more valuable
commodity in both the contracting and permanent world.
As a contractor you will be exposed to many different styles of working, not only in relation to
your peers, but also in relation to your managers and your subordinates. This helps you to
develop as an individual, in more ways that just your core skill set.
Depending on the type of contractor you are, you will gain added experience of different types of
products and/or services which will all widen your experience and make you more attractive and
interesting to future clients.
Contractors often come into new client organisations as the ‗industry expert‘, which is not only a
nice position to be in, it also adds to your credibility as an industry professional, widens your
experience further and helps increase your daily rate.
Working for different organisations gives you the ability to advance your career and your
knowledge, without being limited by a single employer‘s processes, procedures or business
ethos.

6.4 Determination of Profit or Loss on Incomplete Contract

Under Contract Accounting it may be noticed that certain contracts are completed, while others are
still in progress at the end of a financial year. These incomplete contracts may require a few more
years for their completion. The figures of profit made (the excess of credit over the debit items in a
contract) on completed contracts can be safely taken to the credit of
Profit and Loss Account, but this practice is not being followed in the case of incomplete contracts.
In the case of incomplete contracts the entire profit is not being credited to Profit a nd Loss Account
because some provision is to be made for meeting contingencies and unforeseen losses. There are no
hard and fast rules regarding the calculation of figure of profit to be taken to the credit of profit and
loss account.
However, the following principles may be followed:–
th
(i) If the amount of work certified is less than 1/4 of the contract price, no profit should be
 taken to Profit and Loss Account. The entire amount in such contracts should be kept as
reserve for meeting out contingencies.
th
(ii) If the amount of work certified is 1/4 or more but less than 1/2 of the contract price, then
1/3rd of the profit disclosed as reduced by the percentage of cash received from the contract
should be taken to the Profit and Loss Account. The balance shoul d be allowed to remain as a
reserve.
(iii) If the amount of work certified is 1 or more of the contract price, then 2/3 rd of the profit
disclosed as reduced by the percentage of cash received from the contracts, should be taken to
the Profit and Loss Account. The balance should be treated as reserve.
(iv) If the contract is near completion, the total cost of completing the contract may be estimated if
possible. By deducting the total estimated cost from the contract price, the estimated total
profit of the contract should be calculated. The proportion of total estimated profit on cash
basis, which the work certified bears to the total contract price should be credited to profit and
loss account.
(v) The entire loss, if any, should be transferred to the Profit and Loss Ac count.

The portion of profit to be credited to, profit and loss account should depend on the stage of
completion of the contract. This stage of completion of the contract should refer to the certified
work only. For this purpose, uncertified work should n ot be considered as for as possible. For
determining the credit for profit, all the incomplete contracts should be classified into the following
four categories.
Contract less than 25% complete
Contracts between 25% and 50% complete
Contracts between 50% and 90% complete
Contracts nearing completion, say between 90% and 100% complete.

The transfer of profit to the profit and loss account in each of the above cases is done as under:
(i) Contract less than 25% complete: if the contract has just started or it is less than 25% complete,
no profit should be taken into account.
(ii) Contract between 25% and 50% complete: In this case one third of the notional profit reduced in
the ratio of cash received to work certified, may be transferred to the profit and loss account .
The amount of profit to be transferred to the profit and loss account may be determined by using
the following formula:
1 Cash received
Notional profit
3 Work certified
(iii) Contract between 50% and 90% complete: In this case, two third of the notional p rofit,
reduced by the portion of cash received to work certified may be transferred to the profit and
loss account. In this case the formula to be used is as under:
2 Cash received
Notional profit
3 Work certified
(iv) Contract nearing completion: When a contract is nearing complet ion or 90% or more work has
been done on a contract. The amount of profit to be credited to profit and loss account may be
 determined by using any one of the following formula.

Did You Know?

The SAP Contract Accounts Receivable and Payable is suitable for worldwide implementation. It
covers various statutory requirements and country -specific processes.

Caution
Profit should be considered in respect of certified and uncertified work and should be valued at cost.

Case Study-Equators Helps Ensure the Health and Welfare of a Global Manufacturing and
Services Firm’s Employees through Benefits RFP Support.
Nearing the end of its 10-year contract term with a health and welfare benefits administration
outsourcing provider, a global, diversified manufacturing and services company was dissatisfied
with the supporting technology and levels of service centre support. Equators helped by providing
expert guidance throughout the RFP (request for proposal) process, and advisory services during the
evaluation and selection process, enabling the client to select a new, best -fit provider to support and
manage its benefits programs for its employees.

The client had been outsourcing its health and welfare benefits administration processes to the same
provider for nearly 10 years. But the technological component of the existing solution, which was
the primary focus of the original contract, was not as robust as required, especially around timely
and appropriate handling of dependents and audits.

Additionally, the provider was delivering only thin service centre support to the client‘s employees,
causing an undue and unplanned drain on in-house HR staff members‘ time. As it was nearing the
end of its contract term with its existing provider, the client wanted to evaluate the te chnological
and service centre support capabilities of others in the marketplace, and issue an RFP to potential,
vetted providers.
Educated the benefits operations and procurement teams on objectives, requirements, business
terms, etc., that should be included in a services RFP (as opposed to a
technology/materials/commodity RFP)
Provided them with appropriate, industry-ready RFP templates, scoring and evaluation tools, and
methodology and evaluation guidance
Assisted in defining the scope of services to be included in the RFP
Developed a list of seven potential, viable service providers (the client wanted an initial large
pool of providers prior to down-select)
Questions
1. Discuss contract in terms of above case study.
2. What is request for proposal (RFP) process?

6.5 Summary
Cost accounting information is designed for managers.
 Fixed fee jobs are an agreement to complete a job for a customer for a set price, no matter what
costs are incurred
Job cost reports can be used to compare the actual expenditure s against the budgeted amounts to
watch the progress of a job.
The Job costing system transfers the costs of a job to a work in process account while the job is
in progress, and transfers those costs to the proper expense accounts when the job is completed.
The job costing system can be accessed from the select, reports and maintenance sections off the
main accounting system menu.

6.6 Keywords
Complete Contract: A complete contract is an important concept from contract theory . If the parties
to an agreement could specify their respective rights and duties for every possible future state of the
world, their contract would be complete. There would be no gaps in the terms of the contract.
Contract: A contract is an agreement entered into voluntarily by two parties or more with the
intention of creating a legal obligation, which may have elements in writing, though contracts can be
made orally. The remedy for breach of contract can be ―damages‖ or compensation of money.
Costing: Costing is an accounting technique used to determine the exact expenses for materials,
labour and overhead incurred in operations. Job order costing records the actual materials and labour
expenses for specific jobs, and assigns overhead to jobs at a pre dete rmined rate.
Job Costing: Job costing is the process of tracking the expenses incurred on a job against the
revenue produced by that job.
Process-costing: A process-costing system is a costing system in which the cost of a product or
service is obtained by assigning costs to masses of like or similar units.

6.7 Self Assessment Questions

1. Interest rate risk is a type of:
(a) Credit risk (b) Market risk
(c) Operational risk (d) All of these.

2. What is the beta factor for corporate finance under Standardized approach ?
(a) 15% (b) 18%
(c) 12% (d) None of the above

3.Fall in interest rate cause the rate causes the bond prices also to fall.
(a) False (b) True

4 Which of the following equations properly represents a derivation of the fundamental accounting
equation?
(a) Assets + liabilities = owner's equity. (b) Assets = owner's equity.
(c) Cash = assets. (d) Assets - liabilities = owner's equity.
5.Which of these items would be accounted for as an expense?
(a) Repayment of a bank loan. (b) Dividends to stockholders.
(c) The purchase of land. (d) Payment of the current period's rent.

6.The primary private sector agency that oversees external financial reporting standards is the:
(a) Financial Accounting Standards Board. (b) Federal Bureau of Investigation.
(c) General Accounting Office. (d) Internal Revenue Service.

7. The accounting for direct ............. labour is similar to the accounting described for direct
materials.
(a) Manufacturing (b) Person
(c) Materials (d) Account

8. Job costing using accounting software enables you to track a number of factors and analyze the
results to aid decision making.
(a) False (b) True

9. To use of job...........method will be useful for accounting system

(a) Labour (b) Person
(c) Costing (d) Accountant

10. Robinson calculates the allocation rate for its single manufacturing overhead cost pool.
(a) False (b) True

6.8 Review Questions

1. Discuss the implications of cost-plus contracts from the view points of:
(a) The manufacturer
(b) The customer.
2. Difference between job costing and processing costing?
3. Discuss the job costing?
4. What do understand about contract?
5. Write a sort note on completed-contract?
6. Discuss briefly the principles to be followed while taking credit for profit on incomplete
contracts?
7. Differentiate between completed-contract and contract?
8. What do understand about processing costing?
9. What is the relevance of escalation clause provided in the contracts?
10. What do know about fixed fee job?

Answers for Self Assessment Questions

1. (b) 2.(b) 3.(b) 4.(d) 5.(b)
6. (d) 7.(a) 8(a) 9(c) 10(a)
 7
Presentation of Contract particulars in
the Balance Sheet
CONTENTS
Objectives
Introduction
7.1 Balance Sheet
7.2 Retention money
7.3 Cost Plus Contract Escalation clauses
7.4 Summary
7.5 Keywords
7.6 Self Assessment Questions
7.7 Review Questions

Objectives
After studying this chapter, you will be able to:
Define the Balance Sheet
Explain the Retention money
Define Cost plus contract

Introduction
The accounting equation concept stated that any financial transaction generates dual effects, and
therefore, equality of assets on the one hand and owner‘s equity plus liabilities on the other is
attained. Therefore, in all balance sheets, the assets on the one side and the liabilities on the other
are equal. This is precisely the reason why the statement is called a ‗balance sheet‘. The balance
sheet shows the financial status of a farm business at a given points o f time and hence it is a ‗stock
report‘. A balance sheet is otherwise called a ‗net worth statement‘ or a ‗statement of financial
position‘ or a ‗statement of affairs‘. It is prepared usually at the end of the agricultural
year/accounting period. It contains information on what the enterprises/farmer owns as well as what
owes to others. The balance sheet communicates the financial strength of the farm. It is used to
measure liquidity and the ability to meet cash commitments without disrupting the ongoing na ture of
the business. Net worth shows whether the business is expanding or shrinking. The business is said
to be solvent when the net worth or equity is greater than zero.

7.1 Balance Sheet

Balance sheet is for the farm business, only the assets, liabilities and net worth of the farm business
should be entered. The personal assets such as the household dwellings, personal liabilities and net
worth associated with personal assets should be exc luded. These types of balance sheet are probably
most appropriate for partnership and corporate farming operations. A balance sheet for a farm
operator should include both business and personal items, although they would be listed separately
for analytical purpose.
A company‘s financial position or health is shown on the balance sheet, also called the statement of
condition or statement of financial position. It shows the business‘s financial position on a particular
date.
The typical balance sheet displays the business‘s assets on the left side of the page and liabilities
and net worth on the right side like this:
Debt = Credit
BALANCE SHEET
Assets = Liabities + Net Worth

Assets are normally debit balances and are what a business owns. Assets are broken i nto two main
categories: current assets and fixed assets. Current assets usually mean anything that can be
converted into cash within one year. Fixed assets, often called long term assets, are more permanent
items like buildings and major equipment.
Liabilities are normally credit balances and are what a business owes. Liabilities are divided into
two main categories just like assets. They are shown as current liabilities (that which is owed within
one year) and long term debt. Current liabilities include b ills for such items as included in accounts
payable, inventory, rent, salaries, etc. Long term debt includes items that by agreement do not need
to be paid back quickly, such as a mortgage or long term note.
The difference between assets and liabilities equals net worth, which is often called stockholders‘
equity for publicly-traded corporations.

That is, after all the bills and notes are paid, anything left over is called net worth. Another
definition is that net worth is what is due the owner(s)/stockho lders of the business once all
liabilities have been paid.

Assets – Liabilities = Net Worth

or
Assets = Liabilities + Net Worth

Why is it called a “Balance Sheet”?

The key word is balance. Because the total assets equal the total liabilities plus the net worth. This
is true even if the liabilities exceed the assets. In this case, net worth becomes negative and it must
be subtracted from the liabilities, instead of being added.
A balance sheet uses the principle of double entry accounting. It is called dou ble entry because each
business action affects two or more accounts.
For example, a sale will increase cash or accounts receivable but decrease inventory. An account can
be cash, inventory, money you owe (accounts payable), or owed to you (accounts receiv able), etc.
Accounts payable and accounts receivable are called accrual accounts. The balances in these
accounts represent cash that must be paid to suppliers or will be received from customers at some
future time.
Accounts are organized on the balance sheet in categories with current and fixed assets on the left
side of the sheet and current and long term liabilities as well as net worth on the right side of the
sheet. Remember, assets and liabilities plus net worth must always balance.
Note that business action affected three accounts which are on the asset side of the balance sheet,
one account, Inventory, decreased because product was sold, Cash increased because the business
received cash for part of the sale, Accounts receivable was added/increased bec ause part of the
product was sold on credit.
Current assets are listed on the balance sheet in the order of when the account will be converted to
cash.
For example, accounts receivable is listed before inventory because the business expects to be paid
cash from credit customers before it expects to sell its entire inventory. The same holds true for
current liabilities. They are listed in the order of when the business will pay cash for the amount it
owes in the account.
To complete the balance sheet, the company name has been added to the top of the sheet along with
the date. The balance sheet shows a company‘s health or how it stands at a particular point in time.
The Balance Sheet and Income Statement are divided into sections, and each section is divi ded into
accounts. Similar items are grouped together under a single account name for each section. Different
kinds of items are separated into different accounts. It is important to know not only how much the
business owns, but also whether this amount co nsists of bank deposits, investments, inventory, or
buildings and equipment. These differences determine how readily the business has access to its
wealth and, therefore, its ability to repay its creditors. Similarly, it is significant whether the
liabilities consist of bank loans, money owed to suppliers and long term notes, bonds and mortgages.
These differences can be reflected by using different accounts. Descriptive account names help to
provide a more detailed financial picture of the business

7.1.2 Why we need Balance Sheet?

As discussed earlier, commercialisation of agri -business activities and global marketing of
agricultural produce necessitates more capital and requires huge investments. This necessitates
farmers to depend upon banks and other institutions for credit. For obtaining credit, the analysis of
the nehvorth is a pre-requisite. Bankers are interested in the continuous net worth statement in order
to compare the financial stability and to estimate the management potential of the farmers. Net
worth statements over time will show the equity of the farmer over different years. Considering the
importance let us first discuss the balance sheet.
7.1.3 Cost/Market Value Basis
A cost basis balance sheet lists assets at their original cost to the farm less accumulated
depreciation. These values may be higher or lower than their current market value. A current market
at basis balance sheet lists assets at their estimated current market value. This form of balance sheet
is often favoured by lenders who are interested in knowing the current equity of the farm operator.
Most reports present balance sheet in a horizontal form. The list of assets is presented on the right
side and the liabilities and owner‘s equity on the left side or vice versa.
Liabilities and net worth associated with personal assets should be excluded. This type of balance
sheet is probably most appropriate for partnership and corporate farming operations. A balance sheet
for a farm operator should include both business and persona l items, although they would be listed
separately for analytical purpose.

7.1.4 Cost/Market Value Basis

A cost basis balance sheet lists assets at their original cost to the farm less accumulated
depreciation. These values may be higher or lower than their current market value. A current market
mane basis balance sheet lists assets at their estimated current market value. This form of balance
sheet is often favoured by lenders who are interested in knowing the current equity of the farm
operator. Most reports present balance sheet in a horizontal form. The list of assets is presented on
the right side and the liabilities and owner‘s eq uity on the left side or vice versa.
The assets indicate the business worthiness and the liabilities indicate what the business owes. The
net capital or net worth or equit y is the balance item which is the sum that would remain with the
owner if the business or farm was sold and all the liabilities paid. If there was not capital deficit
instead of a surplus i.e., loss, this would be included on the assets side of the balance sheet, and it
would mean that the business was insolvent. The details on the asset side of the balance sheet shows
how the capital is being used in the business and those on the liabilities side the sources of that
capital. The farmer is generally more concerned about the immediate solvency than the ultimate
solvency. It is, therefore, necessar y to classify the assets and liabilities to know the real position of
the farm business at a point of time and compare the nature of the liabilities to the assets.
Assets
It is sub-divided into different types according to the time period involved: They are
Current assets.
Intermediate/working assets.
Long-term/fixed assets.

7.1.5 Budgeted or Projected Balance Sheet

A projected balance sheet represents the exiwctss.1 financial position at a particular date. The
projected balance sheet is prepared from the budgeted balance sheet at the beginning of the budget
/scrim and the expected changes in the account balances reflected in the operating budgets capital
expenditure budgets and cash budget. The projected balance sheet also automatically determines the
arithmetical accuracy of other budgets since they are used in preparing the forecasted balance sheet.

7.1.6 Budgeted Statement of Changes in Financial Position

The projected statement of changes in financial position is usually prepared from data in the
budgeted income statement and changes between the projected balance sheet at the beginning of the
bud g et period and projected balance sheet at the end of the budget period. This projected statement
is very useful to management in the financial planning process.

7.1.7 Master Budget

A master budget sometimes called a comprehensive budget is the summary or total budget package
for business rim. It is the end product of the budget making process. It shows the budgeted profit
and loss account for the budget period and the budgeted balance sheet at the end of the period. It
reveals the top management‘s goals of revenues, expenses, net income, cash flows, and financial
position. The other budgets prepared by a business firm arc specific. That is, they deal wit h separate
distinct activities of the organisation such as sales, production, selling and distribution and
administrative activities. They incorporate plans and budgetary goals for a small segment of 4
business enterprise.
However to achieve business objectives it is necessary to have coordination among different budgets
reflecting diverse activities of a business firm. For example, there should be coordination between
sales and production departments and the goals of the production department should match the goals
oldie sales department. In the absence among the budgets, a business firm may have problems, such
as surplus inventory, shortage of stock, now availability of raw materials and other resources,
employee‘s dissatisfaction etc. A master budget takes the macro (aggregate) view of the business
enterprise and coordinates sales with production: raw materials, manpower, machinery and other
resources with production targets, and the like. The master budget is an integrative tool that cuts
across divisional boundaries in order to coordinate the firms‘ diverse activities. While master
budgets provide plans for an entire system, operating budgets provide plans for the organization‘s
subsystem. That is, operating budgets constitute the building blocks used to complete the master
budget.

Revision of Budgets
As stated earlier in the chapter successful budgets should have adequate flexibility to meet changing
business conditions. Since budgets are used for planning. operation, coordination and control, they
should be revised if changes occur in the environment Revision of budgets may be necessary due to
the following factors some of which might have been considered earlier in the development of
budgets:
Errors committed in preparing the budgets which may subs equently be known.
Emergence of unforeseen and unanticipated situations which may cause the budget to be revised.
Changes in internal factors, for example production, forecast, capacity utilization. etc.
Changes in external factors, for example, market trends, nature of the economy, prices of inputs
and resources, consumers‘ tastes and fashions.

Changes in the above factors do not affect a firm‘s budgets if they are of minor significance. Some
changes. Owner, considerably affect budgets and in this situ ation management is faced with two
problems:
Whether only individual budgets should be changed: and
Whether the master budget be changed.
7.2 Retention money
As an additional guarantee Silver Book sub -clause. ―Application for Interim Payments contemplates
that a percentage of the payments from the employer to the contractor may he retained as retention
money, if specified in the particular conditions. There may also be a fixed maximum amount of
retention. The employer may thus retain a certain portion of each interim payment. These funds will
then be returned to the contractor by virtue of sub -clause 14.9 ―Payment of Retention Money‖: one
half upon the issuance of the taking-over certificate and the other half at the end of the defects
notification period.

7.2.1 Meaning of Retention

In the context of construction contracts, an amount retained from construction contract payments (5 -
15% of the contract price) to ensure the contractor completes the construction before the retention is
returned. Prior to a new issue, the percentage of securities given to an underwriting syndicate to
place with investors after making allowances for any underwriters that are not part of the syndicate
as well as placement with institutional investors.
The securities that are distributed to members of an underwriting syndicate after accounting for the
portion of the new issue retained for sales to institutions and members of the selling group who are
not also part of the syndicate.

7.2.2 Overview of Retention Money

The employer may want to withhold a portion of each interim payment, an amount known as
retention money, as a form of security for performance. This will increase the contractor‘s incentive
to complete the works, particularly in the later stages of construction . This retention money is then
refunded to the contractor at some specified time. Under the Silver Book, half of the retention
money is returned upon successful taking over of the works by the employer and the other half upon
the expiry of the defects notification period. Amounts may generally be withheld from these
repayments for incomplete or defective work.
Another method of performance guarantee similar to or in conjunction with retention money is the
use of bonds to provide the same type of security. This method is contemplated under the ENAA
Contract. Where the employer is to withhold retention money, the contractor may provide a bond in
lieu of this retention or to recover money already retained.
The guarantee will be a separate agreement between the contractor and the guarantor, often a bank,
which provides an amount of compensation upon the occurrence of a certain event. The guarantee
may require the employer to provide a form or amount of proof of the occurrence of the event (or
none at all) before the sum is paid out.‖ It is this latter burden of proof that causes some
disagreement concerning the use of guarantees rather than actual retention. The greater the amount
of proof required calling the guarantee, the less security the employer obtains since the contractor
may be able to oppose a call made by the employer on the guarantee.

This system has been criticised by certain commentators due to the form of guarantee provided by
the ENAA in the appendix. The guarantees require a claims procedure specifying the contractor‘s
default, that the contractor was requested to remedy the default and that the cont ractor has not done
so. It is arguable that this procedure may impede the employer‘s claim under the guarantee.‖ The
ENAA Contract guide notes defend the form of guarantee, stating that it is of an on demand nature
and reflects the approach adopted by the International Chamber of Commerce.
The employer considering using retention bonds should also realise the added cost of lost interest,
tinder standard retention money clauses, the employer withholds a certain portion of the money to be
paid to the contractor for each payment period. This money is held by the employer until the end of
the contract period. The interest earned by the employer on such sums can be considerable.

7.2.3 Advance payments

The employer may want to provide the contractor with advance payments to offset substantial outlay
of capital during the early stages of construction: Depending on the stipulations of the contract,
these advance payments can be reimbursed over the period of the contract or not reimbursed where
they are considered to be an integral part of the contract price.
The Silver Book provides for such payments for design and mobilization. The advance payment is
secured by a bank guarantee, which is reduced as the advance payment is repaid. The employer then
makes percentage deductions in future interim payments to repay the advance payment.

7.2.4 Final payment and discharge

Unlike interim payments, the final payment expresses completion of the contractor‘s duties to design
and construct the works under the contract as well as the end of the employer‘s payment obligations.
The Silver Book procedure involves the preparation of a draft final statement followed by the
parties‘ agreement on the actual final statement, which is the basis for final payment. The contractor
is also required to provide the employer with a discharge of liability to obtain final payment.

7.2.5 Payment of Retention Money’

When the Taking-Over Certificate has been issued for the Works, and the Works have passed all
specified tests (including the Tests after Completion, if any), the first half of the Retention Money
shall be paid to the Contractor. If a Taking-Over Certificate is issued for a Section, the relevant
percentage of the first half of the Retention Money shall be paid when the Section passes all tes ts.
Promptly after the latest of the expiry dates of the Defects Notification Periods, the outstanding
balance of the Retention Money shall be paid to the Contractor.
If a Taking-Over Certificate was issued for a section, the relevant percentage of the se cond half of
the Retention Money shall be paid promptly after the expiry date of the Defects Notification Period
for the Section. However, if any work remains to be executed under Clause Ii (Defects Liability‘ or
Clause 12, the Employer shall be entitled to withhold the estimated cost of this work until it has
been executed. The relevant percentage for each Section shall be the percentage value of the Section
as stated in the Contract. If the percentage value of a Section is not stated in the Contract, no
percentages of either half of the Retention Money shall be released under this Sub -Clause in respect
of such Section. During the life of the contract, retention money is subtracted from each payment as
a performance security for the employer. Silver Book su b-clause sets forth the contract requirements
for the payment of retention money to the contractor.

Once the taking-over certificate has been issued for the works and the works have passed all tests,
the first half of the retention money must be repaid to the contractor. In order to avoid any tardy
release of the first half of the retention money, some commentators suggest that the contractor may
wish to establish a date for the tests after completion. The author would not recommend such a
practice. If a taking-over certificate is issued for a section, half of the section‘s proportionate value
to the overall contract is used to calculate the retention money payment. Note that no retention
money is released for the taking over of a part of the works.
The FIDIC Guide explains this exclusion as difficulty might arise in determining an appropriate
release amount. The outstanding balance of the retention money is paid to the contractor after the
latest of the expiry dates of the defects notification periods, as applied to the works generally or to a
specific section. However, the employer is entitled to withhold from this retention money repayment
the estimated cost of any work remaining to be executed until it is completed. The Silver Book
further indicates that the percentage value of each section must be stated in the contract in order for
corresponding percentages of either half of the retention money to be released under this sub -clause.

Orange Book sub-clause is very similar to the Silver Book provisions but slightly less
comprehensive. It does not contain a prohibition against retention money repayments if the sectional
percentages are not stated in the appendix to tender. It also does not specifically provide for the
repayment of a portion of the second half of the retention money upon the expiry of a defects
correction period relating to a particular section. Rather, the second half of the retention money is
released at the end of the contract period, subject to other justified withholding under the sub -
clause, such as for out-standing work.
Red Book sub-clause 14.9 contains provisions similar to Silver Book 14.9, subject to several
differences. Under the Red Book, a retention money repayment must be ce rtified by the engineer,
and the first half is repaid simply upon taking over. This is because the Red Book contains no tests
after completion. Therefore all testing should be completed by taking over under the Red Book. The
Red Book also sets forth a specific calculation to be used in the event retention money repayments
are made for individual sections. It further states that adjustments for changes in legislation and
changes in cost under sub-clauses 13.7 and 13.8 shall not be considered in calculating t hese
proportional repayments.

7.3 Cost Plus Contract Escalation clauses

A cost-plus contract, also termed a Cost Reimbursement Contract, is a contract where a contractor is
paid for all of its allowed expenses to a set limit plus additional payment to allow for a profit. Cost
reimbursement contracts with fixed price contract, in which the contractor is paid a negotiated
amount regardless of incurred expenses. Cost plus contracts first came into use in the United States
during the World Wars to encourage wartime production by large American companies.
Contracts with escalation clause are beneficial to contractor as well as the contracted in case of high
rise in the prices of materials, labour or other services. It protects the contractor from cost increas es.
At the same time, the customer is freed from paying more amounts unnecessarily. All future
deliveries are governed by this clause.
Sometimes called a cost reimbursement contract. In addition, the contractor may also receive
additional compensation that will ensure that a profit is made on the job. There are several
variations on this type of contract in common use today.
The provisions of the cost-plus contract are different from those associated with the fixed price
contract. With the latter, the contractor commits to only charging a specific amount for the job
covered by the terms and conditions outlined in the agreement. Should the actual expenses exceed
the costs associated with fulfilling the obligation made in the agreement, the contractor cannot p ass
those costs on to the client. Instead, the contractor must absorb those costs, which may result in a
net loss on the project.
Four common variations of the cost-plus contract are used today. The cost plus fixed fee contract
allows the contractor to collect a fixed amount of compensation at a specified time during the
project. Additional expenses and fees are billed at a later date.

7.3.1 What are cost-plus contracts?

Cost-plus, or cost reimbursement, contracts pay a contractor for all of its allowed expenses,
typically up to a set limit. The ‗plus‘ refers to an additional payment that allows a contractor to
make a profit. Three key types of cost plus contracts provide different incentives
Between 1995 and 2001 fixed fee cost-plus contracts constituted the largest sub group of cost-plus
contracting in the U.S. defence sector. Starting in 2002 award -fee cost plus contracts took over the
lead from fixed fee cost plus contracts.
The distribution of annual contract values by sector category and award types indicates that cost
plus contracts in the past carried the largest importance in research, followed by services and
products. In 2004, however, services replaced research as the dominant sector category for cost plus
contracts. For all other contract vehicles combined the relative ranking is reversed to the original
cost-plus order, meaning that products leads, followed by service and research.
With cost-plus contracting being primarily designed for research and development tasks, the percent
share of cost-plus contracting within a contract is expected to be in correlation with the percent
share of research undertaken in any given program. However, several programs, such as the F -35,
the Trident II, the CVN 68, and the CVN 21 deviate from this pattern by con tinuing to make
extensive usage of cost-plus contracting despite programs progressively moving beyond the research
and development state.
7.3.2 Types of Contracts
Contracts are classified into:
Fixed-price contract with escalation clause
Cost-plus contract.

Fixed-Price Contract with Escalation Clause

Contracts of some nature extend over a long period, covering more than a few accounting periods.
During such a lengthy period, there may be changes in the prices of materials, labour, and so on. At
the time of acceptance of a contract, such factors have to be foreseen and estimated properly. If such
factors are not taken into account, then the contractor may not be able to attain the profit target; and
on account of this, even the work may come to a standstill. In order to safeguard against this, a
special clause known as ―escalation clause‖ is incorporated in fixed -price contracts Escalation
clause is a provision in a contract which provides the formula to determine the amount of escalation,
namely, the amount by which the contract price is to be modified w hen the prices of goods or
services forming part of the contract change.

Cost-Plus Contracts
Under this type of contract, the contract agrees to pay the contractor the contract price plus an
agreed percentage above the contract price or a fixed fee. Cost -plus contracts are generally used in
Government only.
Where the estimates cannot be made or predetermined, this is suitable.
If the service is innovative and no precedent is available, then cost -plus contracts may fit.

The cost-plus incentive fee contract is another form of the cost-plus contract that can sometimes be
to the advantage of the client. With this arrangement, the contractor receives a higher fee for saving
money on materials or labour associated with fulfilling the terms of the agreement. Howe ver, the
larger fee can sometimes offset the savings.
A cost plus award fee arrangement is a type of cost -plus contract that will award a bonus if the
contractor demonstrates performance that is considered to be above the terms of the contract. The
awarding of this fee is usually left to a third party, such a s a review board. Cost-plus contract
arrangements of this type are much more common when contracting work for companies and
government agencies, but rarely used for residential construction, such as home building or
renovations.
One final variation of the cost-plus contract is known as the cost-plus percentage of cost agreement.
Essentially, this type of contract makes it possible for the contractor to adjust charges for materials
upward in the event that the market price for those materials increases. Thi s is one of the least
favourable forms of the cost-plus agreement, since it provides no incentive at all for the contractor
to keep expenses within the range originally defined in the agreement.
Many individuals and businesses prefer to go with a fixed -price contract, simply because there is
more control on the part of the client. Cost -plus contracts generally do not provide any motivation
for the contractor to monitor costs closely. However, if quality rather than price is the main
objective of the client, a cost-plus construction contract is likely to be the best option.

Guidelines to be Followed in Cost-Plus Contracts

Allocation and apportionment of expenses are to be based on the principles of equity.
The contract should contain clear-cut definitions of cost.
Depreciated charge of special equipments should be charged suitably.
Abnormal gains and losses should be excluded.
The method of pricing the issue of materials and the methods of labour remuneration should be
agreed.
Predetermined rates should form a part or contract.
The ―plus‖ factor should be included in the contract. It should be specified in an unambiguous
manner.

Advantages
The contractor is assured of some extra amount, thereby getting a definite profit.
The customer feels contended as he is charged at a reasonable fixed price to execute the work. In
 the contractor is relieved of unnecessary and elaborates calculations as in the case of escalation -
clause contracts.

Disadvantages
―Plus‖ factor is determined on the total cost. In order to attain more profit, the contractor is
interested in increasing the cost. The customer gets affected.
The customer is not in a clear cut position to know exactly the cost of work till it gets
completed.

7.3.3 Incomplete Contracts and Profit

As already stated, contracts may extend beyond an accounting period. In practice, it may be found
that only a certain portion of the contract has been completed and the remaining is under progress. It
may take time to complete. So, proper care should be taken while ascertaining the profits for the
completed as well as the incomplete work. There is no problem in crediting the profit on the
completed work to profit and loss account (P&L A/c). But the real difficulty arises in assess ing the
profit for the contracts that are still under progress.

7.3.4 Guidelines to Assess Profit on Incomplete Contracts

Standard costing principles should be adopted for the recognition of profit for each period. In case
of incomplete contracts, only a certain portion of the profit can be taken to P&L A/c based on the
work completed. The firm must provide for the unforeseen losses and contingencies. The following
are the general guidelines that may be followed for the assessment of profit on incomplete c ontracts:
Profit should be completed on the basis of ―work certified‖.
Uncertified work should he valued at

7.3.5 Reasons for Cost plus or Time and Material contracts not done
The following list are some of the major reasons that a contractor in a construction related business
should not do Cost Plus or Time & Material contracts or billing to their customers.

There are two major reasons construction related business owners use Cost Plus or Time &
Material Contracts:
1. Difficulty estimating jobs. Many contractors don‘t know or understand how to estimate, and
others do not have a good estimating system in place that will allow them to accurately estimate
construction projects. They default to Cost Pl us because they believe these contracts will allow
them to bill for all their job costs, all their overhead and make a profit. Unfortunately, this
seldom happens
2. Not knowing how to establish a sales price. The book was written to help contractors know how
to price their jobs to cover their overhead expenses and make a reasonable profit.
This list applies to all general contractors and most specialty contractors in the construction
industry. An exception would be using Time and Material billing for serv ice work such as
electrical, plumbing or HVAC service calls. Those agreements should be kept to a maximum of
INR 1,25,000.
7.3.6 Escalation Clauses
First let‘s paint an escalation clause in a brilliant light. Let‘s say that you are a 1st time home buyer
who plans to finance your new home with an FHA loan. This means that your offer is most likely
going to be up against at least one other all cash offer and one thing you can do to ―win‖ the bid is
to simply bid a little more than the other guys. An escalati on clause in your offer will do that for
you. And there is really only one way that it can work Using an escalation clause like this will only
be considered brilliant if you also make the property value subject to appraisal. In other words, if
after the escalation clause your offer ends up being and the property only appraises for then if you
have a ―subject to appraisal‖ clause in there the lender will have to decide to drop the sales price to
put it back on the market.
Where this can work (and I have seen it work) is the lender will choose your offer above all other
cash offers because it is the highest only to have to lower their sales price because of the ―subject to
appraisal‖ clause to now let‘s paint it in the stupidity light. If you do use an escalation clause but
don‘t include a ―subject to appraisal‖ clause, then you are really setting yourself up for financial
pain. You could easily end up paying more than the property is worth in cash because you won‘t be
able to finance it into the loan. That is the worst possible scenario. Another possible ―bad‖ scenario
that could happen is that you could put the escalation clause in, put the subject to appraisal clause in
only to have the lender refuse to lower the sales price and ends up putting it back on th e market.
Even though you haven‘t lost any money per se you have lost time and effort. Are escalation clauses
bad or good? It depends. And a lot of what it depends on is luck. Luck as in it depends on decisions
that the lender who owns the home makes.

Did you know?

The number of units allocated to an underwriting syndicate member less the units held back by the
syndicate manager for facilitating institutional sales and for allocation to non -member firms.

Caution
The cost plus contract is a legal agreement that allows a contractor to be paid in full for all expenses
allowed by the terms of the contract, up to a set limit that is defined in the terms and conditions.

Case study-Managing Stress in a Bank’s Balance Sheet by Bernd Morgenschweis

One consequence of the critical development of the German real estate markets in recent years is a
clearly increased proportion of non-performing loans on the balance sheets of many financial
institutions. This in turn had adverse effects on their profitability as the loa n default rate increased
and demand for new real estate loans went down. The financial institutions affected, therefore,
needed to optimize their loan portfolios, for example by reducing the proportion of non -performing
loans in order to stabilize their own corporate value and once again increase their new lending
business.
Traditional German mortgage bond banks (Hypotekenbanken) also had to contend with other
aspects, requiring new direction for the balance sheet assets:
The repeal of the German Mortgage Banks Act and its replacement by the Mortgage Bonds Act
(Pfandbriefgesetz) led to changes in the regulatory powers and increased market pressure. The result
was the abolition of the advantageous position of those banks which had hitherto dominated the
entire sector and where the only players in the market who could issue mortgage bonds. This led to
unprecedented competition with other German banks in this field.
Particularly in view of the overall saturation of the banking market, competition for loans func tions
through the relevant margins. The main target must, therefore, be to generate adequate profit
margins for the lending business as a result of risk orientated pricing methods. In this context, it
was, therefore, of fundamental importance to calculate the relevant risk driving factors and the costs
of existing non performing loans.

The increasing importance of the capital market and the resulting increase in pressure made it
necessary for financial institutions to optimize their own portfolio structure . This involved
increasing the proportion of income earning loans in the overall portfolio and reducing the
proportion of non-performing loans by outsourcing or sale. Finally, the new Basle II regulations on
the provision of risk orientated equity required the development and implementation of a
conservative risk strategy for new lending; this strategy would mean to take more low risks on to the
books rather than buy additional high risk assets.

Origins of Stress
Increasing importance of the capital market and consequently greater pressure to enhance interest
margins and reduce bad loans Optimize portfolio structure: push good loans and: adjust portfolio by
outsourcing or selling non performing loans

Pressure due to Basel II from the obligation to provide risk adjusted equity develop and implement a
conservative loan risk strategy for new lending business (prevent and increase in risk portfolio)
reduce risk loan portfolio to cut cost (employees, operating and risk costs)
and save equity costs Basle II also brought the reduction of the risk portfolio more strongly into
focus not least to generate significant cost savings (costs associated with the workout team,
operational costs of the processing / restructuring and of course depreciations / value adjustmen ts).

Question
1: How the manage stress balance sheet.
2: Explain the Origins of Stress.

7.4 Summary
Contract cost may he defined as the aggregate costs relative to a single contract designated a
cost unit. Contract costing is a form of job costing.
The balance or unpaid amount on the value of work certified is termed as ‗Retention money‘
The customer would pay to the contractor on the basis of certificate. Usually the entire amount
will not be paid
Contracts with escalation clause are beneficial to contr actor as well as the contracted in case of
high rise in the prices of materials, labour or other services
The employer may want to withhold a portion of each interim payment, an amount known as
retention money, as a form of security for performance
7.5 Keywords
Balance Sheet: Shows a snapshot at a given point in time of the net worth of the business. It details
the assets, liabilities and owner‘s equity.
Contract Costing: A form of specific order costing which applies wherever work is undertaken to
specific requirements of customers, work being long duration.
Fixed-Price Contract with Escalation Clause: To compensate the price rise in future, a special
clause is incorporated into fixed-price contracts.
Cost-Plus Contracts: The actual allowable costs incurred in executing a contract plus an agreed
percentage of these costs or a fixed fee payable to contractors.
Retention Money: The amount which the customer retains till the date of final completion of work.
Work Certified: Percentage of work completed to be approved by the contracted or his nominee,
forming the basis for payment and profit computation.
Incomplete Contracts: Contracts that have not been completed and treated as WIP.

7.6 Self Assessment Questions

1. When no estimates can he possible, the suitable method is
(a)Fixed-price contract (b) Cost-plus contract
(c)Fixed-price contract with escalation clause (d) all of these

2. Where the job is of large and longer duration, the suit able method of costing is
(a)Contract costing (b) Job costing
(c)Batch costing (d) back lush costing

3. To compensate the price rise, one of the following clauses is provided:

(a)Penalty clause (b) Bonus clause
(c)Escalation clause (d) none of these

4. Profit in incomplete contract is known as notional profit because

(a)It is not real profit
(b) Real profit will be ascertained when the work is complete
(c)There is no such incomplete contract
(d) The profit is only an approximation

5. Loss arising to incomplete contract is

(a)Transferred to P&L A.ic (b) Debited to Will
(c)Debited proportionately to WIP (d) Not dealt in cost accounts

6. WIP in contract means

(a)Work certified (b) Work certified and work uncertified
(c)Work uncertified only (d) none of these
7. Contract Costing is suitable of
(a)Bakery (b) Brick
(c)Construction (d) Chemicals

8. Cost of a contract is determined by preparing

(a)Cost sheet (b) Profit and Loss Account
(c)Balance Sheet (d) Separate ledger account

9. When a contract work is completed to the extent of 20% of the contract price, profit to be
credited to P&L A/c is
(a) NIL (b) Full amount
1 2
(c) 2 of profit 3 (d) 3 of profit 3

10. Profit remaining as Reserve is

(a)Transferred to P&L A/c (b) Deducted from WIP
(c)Not taken into account in costs (d) Debited to cost price of contract

7.7 Review Questions

1. What do you mean by ―contract costing‖?
2. What are the main features of contract costing?
3. Advantage of Escalation clauses?
4. Distinguish between job costing and contract costing?
5. Name the industries that are suitable for contract costing?
6. What are the two types of contracts?
7. Explain: ―Escalation clause‖.
8. What is ―Retention money‖?
9. How would you deal with ―Materials‖ in contract costing
10. What do you mean by Balance Sheet?

Answers for Self Assessment Questions

1. (b) 2. (a) 3. (c) 4. (d) 5. (a)
6. (b) 7. (c) 8.(d) 9. (a) 10. (b)
 8
Process Costing
CONTENTS
Objectives
Introduction
8.1 Understand the Process Costing Concept
8.2 Explain the Accounts with Process
8.3 Describe the Losses and Gains
8.4 Summary
8.5 Keywords
8.6 Self Assessment Questions
8.7 Review Questions

Objectives
After studying this chapter, you will be able to:

Understand the Process costing concept

Explain the Accounts with Process
Describe the Losses and Gains

Introduction
Process Costing is a method of costing used to ascertain the cost of a product at each process or
stage of manufacture. In this method, the costs of materials, wages and overheads are accumulated
for each process separately, for a given period, and then ca rried forward comulatively from one
process to the next process till the last process is completed. Records are also maintained to account
for process losses. These losses may be normal or abnormal. Separate accounting is done for normal
and abnormal losses, opening and closing work-in- progress and inter-process profits, if any. This
method of costing is used in those industries where mass production of identical units is undertaken
on a continuous basis and finished products are subjected to a number of p roduction stages called
processes before completion. The system of process costing is suitable for industries involving
continuous production of the same product or products through the same process or set of processes.
It is in use in plant producing paper, rubber products, medicines, chemical products. It is also very
much common in flour mill, bottling companies, canning plants, breweries etc.
8.1 Understand the Process Costing Concept
Process cost systems are used to apply costs to similar products th at are mass produced in a
continuous fashion, such as the production of ice cream, steel or soft drinks. In comparison, costs in
a job order cost system are assigned to a specific job, such as the construction of a customized
home, the making of a motion picture, or the manufacturing of a specialized machine.
Process costing is that aspect of operation costing which is used to ascertain the cost of the product
at each process or stage of manufacture, where processes are carried on having one or more of the
following features
Production is done having a continuous flow of identical products except where plant and
machinery is shut down for repairs, etc.
Clearly defined process cost centers and the accumulation or all costs by the cost centers.
The maintenance of accurate records of units and part units produced and cost incurred by each
process.
The finished product of one process becomes the raw materials of the next process or operation
and so on until the final product is obtained.
Avoidable and unavoidable losses usually arise at different stages of manufacture for various
reasons. Treatment of normal and abnormal losses or gains is to be studied in this method of
costing.
Sometimes goods are transferred from one process to another process not at cost price but at
transfer price just to compare this with the market price and to have a check on the inefficiency
and losses occurring in a particular process. Elimination of profit element from stock is to be
learnt in this method of costing.
Different products with or without by-products are simultaneously produced at one or more
stages or processes of manufacture. The valuation of by -products and apportionment of joint cost
before point of separation is an important aspect of this method of costing. I n certain industries,
by-products may require further processing before they can be sold. A main product of one firm
may be a by product of another firm and in certain circumstances, it may be available in the
market at prices which are lower than the cost to the first mentioned firm. It is essential,
therefore, that this cost be known so that advantages can be taken of these market conditions.
Output is uniform and all units are exactly identical during one or more processes. So the cost
per unit of production can be ascertained only by averaging the expenditure incurred during a
particular period.

8.1.1 Types of Processing

As stated above, process costing is used in case of industries, which involve processing of a product
through different stages. The various types of processing are as follows:

Continuous sequential processing: In case of this processing a product has to pass through different
cost centers or stages of manufacturing continuously and in succession one after the other during a
period. The processing being continuous and identical, the costing units for each centre or stage are
identical during any period. Examples of this type of processing a re cement-making, paper-making,
refining of crude petroleum, etc.
Discontinuous Processing: In case of this processing, a process is independently operated for the
individual product as such at frequent intervals. The costing unit in case of this processin g,
dependent upon the product may vary even for the same cost centre. Examples of this type of
processing are dye manufacturing, fruit preservation, vegetable canning, yam spinning, etc.

Parallel Processing: In case of this processing, the operations or stages through which the product
has to pass run parallel and separately. All these parallel processes ultimately join with the end
process. Examples of this type of processing are manufacturing different components which
ultimately join in the assembly process to make a product, meat packing etc.

Selective Processing: In case of this processing, the combination of the processes or stages of
operation depend upon the end-product to be commercialized. Examples of this type of processing
are cooked meat, chloride compounds like bleaching power of zinc chloride or hydrochloric acid,
etc.

8.1.2 Advantages of Process Costing

The advantages of process costing can be summarized as follows:
The cost of different processes as well as finished product can be computed conveniently at short
intervals, say, daily or weekly.
Control cost and production can be advantageously affected as predetermined and actual data are
available for each department or process.
It involves less clerical work because of the simplicity of co st records.
The average costs of homogeneous products can easily be computed
Expenses can be allocated to different processes on rational basis and accurate cost, thus, can be
ascertained.
It enables the correct valuation of closing inventories.

8.1.3 Disadvantage of Process Costing

The cost ascertained at the end of the process is called historical cost which is of very small use
for managerial control. Since it is based on historical costs, it has all the weaknesses of
historical costing.
The system of costing conceals weakness and inefficiencies in processing.
It does not evaluate the efforts of individual workers or supervisors.
The valuation of Work-in-progress on the basis of degree of completion is merely a guess work.
If production is not homogeneous, as in the case of foundries making castings of different sizes
and shapes, the average cost may give an incorrect picture of cost.

8.1.4 Costing Procedure

The factory or concern is divided into distinct processes or operations and a separate account is
opened for each process (cost centre). The account is debited with the value of material, labor and
overheads relating to the process. The value of by products and scrap, if any, is credited to the
account and the balance of this account, representing t he cost of partially worked out product, is
passed on to the next process becomes the raw material of the next process. In some industries,
depending upon the plant arrangement, the partially worked out product of a process may be
transferred to a process stock account from which it may be issued to the next process as and when
required. The finished out of the last process (i.e. finished product) is transferred to the Finished
Goods Account.

All expenditure of materials, labour, direct expenses and overheads are charged to the process
concerned.
Materials: Materials required for each process are drawn from store against Materials
Requisitions or Bill of Materials and debited to cost. When the materials are issued in bulk, the
person-in charge of the department has to keep the account of materials consumed. When the
finished product of one process becomes the raw material of the next process, the account of the
receiving process should be debited with the cost of transfer, in addition to the cost of ad ditional
materials.
Labour: Wages paid to labourers and workmen who are engaged in particular processes are
directly allocated ‗to the process. If workers are engaged in a number of processes, the wages
paid may be apportioned on the basis of time -booking.
Direct Expense: Direct expenses such as depreciation, insurance, electricity, repairs, etc. are
directly allocated to the respective accounts.
Overheads: Rent, telephone, lighting, gas, water, etc. which are some common expenses of one
or more processes, may be apportioned to the various processes on suitable basis. Generally,
these overheads are recovered at predetermined rates or based on direct wages or prime cost.
From the cost accounting point of view, there could be processes which may or may not hav e
process losses. Similarly, in respect of each process, there may or may not be work -in-progress
at the beginning or at the end.

Did you know?

Process costing is an accounting methodology that traces and accumulates direct costs, and allocates
indirect costs of a manufacturing process.

8.2 Explain the Accounts with Process

The process of accounting involves recording classifying and summarizing of past events and
transactions of financial nature, with a view to enabling the user of accounts to interpret the
resulting summary. The utility of accounting information is greatly increased when it is complied in
a systematic manner and financial statements prepared at periodic intervals.
 Figure 8.1: Accounting process

8.2.1 Check Your Progress

Define the following terms:
Cost Concept
Business entity concept
Going concern concept
Duel aspect concept
Explain the following Accounting conventions:
Disclosure Consistency
Draw the chart showing Accounting Process.

8.2.2 Account
An account is summarised record or statement of all transactions relating to a particular person or to
an Assets or liability or income or expense. According to Koehler‘s Dictionary for accounts, an
account has been defined as a formal record of a particular type of tra nsaction expressed in money.
Each account is divided into two parts by the vertical line drawn in the middle.
In order to keep full record of all the transactions the business has to keep.
An account of each head of expenses or income earned by the busin ess and
An account of each property which belongs to the business and
An account of each party with whom business deal

8.2.3 Non-cost or sales value methods

These methods do not attempt to cost by products or its inventory. The following are the main
methods which are included in this group
Other Income or Miscellaneous Income Method.
 By-product‘s sales added to the main product‘s sales.
By-product‘s value deducted from the total cost.
Credit of sales value less selling and distribution expenses.
Credit of sales value less selling and distribution expenses as well ascost incurred after split off.
Credit of sale value less selling and distribution expenses, cos t incurred after split off and
estimated profit or Reverse Cost Method.

8.2.4 Cost Methods

These methods attempt to apportion some of the joint cost to by -products. The following methods
are including under this category:
Opportunity or replacement cost method.
Standard cost method, and
Apportionment on suitable basis.
These methods will now be discussed one by one.

8.2.5 Non-cost or Sales Value Methods

Other income or miscellaneous income method: Under this method, the sales value of by-
product, which is negligible, is credited to the profit and loss account treating it as other or
miscellaneous income. By-products which are not sold and are in stock are valued at nil value for
balance sheet purposes and thus vitiate the valuation of closing stock. Accoun ting of by-products by
this method is also inaccurate as there is a time lag between the sale and production. There is also a
possibility that by-products may arise in one period but may be accounted in another period and thus
distort the profits of two periods.

By-product’s sales added to the main product’s sales : Under this method, all costs incurred on
main and by-products are deducted from the combined sales of the main product and by -products.
This method is generally adopted in those cases where eith er the value of the by-products is very
small or where the by-products are sold in the market in the state in which they emerge from the
main product. By-products in stock are valued at nil value for balance sheet purposes.

By-product’s sales deducted from total cost: Under this method, the sales value of by-products
―is deducted either from production costs or from the cost of sales. Fluctuating costs of by -products
also affect the costs of the main product and may encourage concealing the inefficienci es therein.
The stock in this case will be valued at total cost or cost of sales basis.
Credit of sales value less selling and distribution expenses : Under this method, the selling and
distribution costs incurred for selling the byproducts are deducted fro m the sales value of by-
products and the net amount is either credited to process account or is deducted from total cost. The
closing stock of by-products is valued at selling price less an estimate of the cost likely to be
incurred in selling the stock of by-products.

Credit of sales value less selling and distribution costs and its incurred on by-products after
split-off point: Under this method, selling and distribution costs and costs incurred on further
processing the by-products are deducted from the sale value of the by-products and net amount is
credited to the process account. The closing stock of by -products is valued at selling price less an
estimate of the cost likely to be incurred in selling and processing the stock of such by -products.
This method suffers from the disadvantage that, if the market value of by -product fluctuates, the
credit to the Process Account of main product will fluctuates accordingly. Owing to the fact that
credit to the fact that credit to the main product Process Accoun t fluctuates, inefficiencies in that
process may be concealed.

Reserve cost method: Under this method an estimated profit from the sale of by -products, selling
and distribution expenses and further processing costs after the split off point are deducted from the
sales value of by-products and the net amount is credit to the -main product.

8.2.6 Cost Methods

The following methods are included in this category:
Opportunity or Replacement Cost Method: This method is adopted where by-products are
utilized in the undertaking itself as input material for some other process. The opportunity cost, i.e.,
the cost which would have been incurred, had the by -product been purchased from outside suppliers
is taken as the cost of the by-product. The process Account is credited with the value of the by -
products so ascertained. For example, in the production of a main product, 200 units of a by -product
A are produced, which are transferred to another product where the y are consumed. If the by-
product were purchased from the market, the price would be Rs. 3 per unit. Thus, the amount to be
credited to the main product in respect of the by-product under this method is 20 units × Rs.3 = Rs.
600.

Standard Cost Method: Under this method, a standard cost is set on the basis of technical
assessment for each by-product and credit is given to the process account on this basis. The standard
may be arrived at on the basis of past average price or may be fixed according to the principles of
standard costing. As credit in respect of the byproduct cost is a stable figure under this method,
effective control can be exercised on the cost of the main product.

Apportionment on Suitable Basis: Where by-products are of major significance, the cost should
be apportioned on the most suitable basis. This method is followed where by -products are processed
to dispose of waste material more profitably to utilize idle plant. In the first case, byproducts after
separation are charged with overheads at full rates, whereas in the second case, by-product costs
after separation will include variable costs only.

8.3 Describe the Losses and Gains

When materials are processed, they lose or gain in volume or weight as a result of the process. It is
common that process loss or scrap or wastage occur in process industries. These process losses may
be of two types, viz. controllable and uncontrollable.
Normal or uncontrollable loss: Because of the nature of the raw materials, some loss is inherent
and is unavoidable. This is known as normal waste or normal loss. And this type of loss is expected
in normal condition for example, stamping process, evaporation, etc. The percentage of such losses
is anticipated from past experience by the management. Loss of this type should be absorbed by
good units produced, i.e. the cost of units lost in charged to the good units output. Any value
realizable on the normal loss will be credited to the process account.

Abnormal Loss or Controllable Loss: In certain cases, it can be seen that the loss exceeds the
predetermined normal loss. Any loss exceeding the normal is called abnormal loss. Abnormal loss
should not affect the normal cost of production. It is caused by accidents, sub -standard materials,
carelessness etc. Therefore, abnormal loss is valued just like good units and transferred to a separate
account called Abnormal Loss Account. Value of Abnormal loss
Units of abnormal loss the loss on account of abnormal loss or wastage is not borne by production,
but by Profit and Loss Account. Abnormal Wastage Account is debited and Process Account is
credited with the cost of abnormal wastage. If the wastage is sold in the market, Abnormal Wastage
Account is credited with the realized price and the balance is transferred t o Profit and Loss Account

Abnormal Gain or Effectiveness

Sometimes, the actual loss in a process may be smaller than what so expected on the basis of
experience. This represents an exceptional or abnormal gain over what is normally anticipated. The
value of abnormal gain is calculated in the same manner as that of abnormal loss and is credited to
Abnormal Gain Account. The amount of scrap which would otherwise have been realized, had there
been normal and no abnormal gain, is debited to the Abnormal Gain A ccount and the balance is
credited to Costing Profit and Loss Account.

Defective
Finished products that are not up to the aimed standard are known as defectives. Spoilage cannot be
repaired, but defectives can be repaired by additional labor and materials into effective units. It
defectives are sodas seconds the amount received is credited to the concerned process account. If the
defective are reprocessed into good units, the extra amount of materials and labour will be treated as
factory overheads. If the defectives cannot be identified, the normal cost is charged to factory
overheads and abnormal cost will be transferred costing profit and loss account

Inter Process Profits

Sometimes the output of one process is transferred to a subsequent process, not at cost, but at a
price, showing a profit to the transferor process. Transfer price may be made at a price
corresponding to current wholesale market price or at cost plus an agreed percentage.
The objects are to whom whether the cost of production competes with the market prices and to
make each process stand on its own efficiency and economies effected, i.e. the transferee process are
not given the benefits of economies effected in the earlier process. This s ystem involves a rather
unnecessary complication of the accounts, as the desired comparison could be prepared on separate
cost reports for each process or by adopting a standard costing system when standards could be set
for each process. The complexity brought into the accounts arises from the fact that the inter -process
profits so introduced remain included in the price of process stocks, finished stocks and work -in-
progress. For the balance sheet purpose, inter -process profits cannot be included in stock, as a firm
cannot make a profit by trading itself.

To avoid these complications a provision must be created to reduce the stock to actual cost price.
This problem arises only in respect of stocks on hand at the end of the period, because goods sold
sill have realized the internal profits. In order to compute the profit element in closing inventories
and to obtain the net realized profit for a period, three columns have been shown on each side of
process accounts and closing stock have been deducted from the debit side of the process accounts
instead of showing it on the credit side. Cost of closing stock can be easily obtained if we compare
the accumulated cost and total in any process. The cost of stock can be obtained by the following
The profit on closing stock can then be easily obtained by deducting the cost of stock thus arrived at
from the value of stock. Sometimes opening stock and production overheads are given. We should
add the opening stock at the beginning along with transfer cost, materials a nd wages. From the total
of these, closing stock should be deducted to calculate prime cost. Then production overheads are
added this becomes the total cost of the process to which is added the desired percentage of profit

Work-in-Progress
The problem of .ascertaining work-in-progress in process industries is very important and generally
difficult. In most firms, production is on a continuous basis and so the problem of work -in-progress
is quite common. This problem can be solved by calculating equivalent production (units) or
equivalent completed (effective) units.

Equivalent Production
Equivalent production means converting the incomplete production into its equivalent completed
units. In each process, an estimate is made of the percentage completion wor k-in-progress with
regard to different elements of cost, viz., material, labor and overhead. It is most important that the
estimate of percentage completion is as accurate as possible. The formula for computing equivalent
completed units is

8.3.1 When There is only closing work-In-progress

Without Process Losses
Under this case, the existence of process losses is ignored. Closing work -in-progress is converted
into equivalent units on the basis of estimates as regards degree or completion of materials, labour
and production overhead. After calculating the equivalent units, it is not difficult to evaluate closing
work-in-progress.
With Process Losses
Generally, losses are inherent in process operations. Normal process losses are ignored in
ascertaining equivalent production. But abnormal losses or gains should be treated as good units
having due regard to the degree of completion. If units scrapped have any realizable value, that
amount should be deducted from the cost of materials in the –cost statement before dividing it by
equivalent production units. As regards abnormal loss, if the degree of completion is separately
given, it has to be duly considered while preparing the Equivalent Production Statement. Otherwise,
it may be assumed that the rejection (in respect of units of abnormal loss ) has taken place at the
stage of final inspection and abnormal loss units may, therefore, be taken to be 100% complete in all
respects. But in case of abnormal gain, the degree of completion should always be taken at 100% as
gain is represented By good production units

When there is Opening As Well as Closing Work-in-Process

Often in a continuous process there will be opening as well as closing work -in-progress which are to
be converted into equivalent of completed units before apportionment of process costs. The
procedure of conversion of opening work-in-process will vary depending upon whether average cost
method or first in first out method of apportionment of costs is followed. Problem of closing work -
in-progress have already been discussed in the previous pages. The following pages will discuss
both methods for valuation of work- in-progress one by one:

Average Cost Method

This method is useful when prices fluctuate from period to period. The closing valuation o f work-
in-progress in the old period is added to the cost of the new period and an average; rate is obtained
which tends to even out price fluctuations. In calculating the equivalent production opening units
will not be shown separately as units of opening work-in-progress are taken to be included in the
units completed and transferred.

FIFO Method
Under this method one assumes that the raw materials issued to work -in-progress pass through the
finished goods in a progressive cycle, i.e. what comes first g oes out first? This method is
satisfactory when prices of raw materials and rates of direct labor and overheads are relatively
stable. Work-in-progress at the end of the period becomes the opening working - progress for the
next period, the closing work-in-progress will be valued at costs ruling during the new period, while
the opening work-in-progress will valued at costs ruling during the old period. Thus, where costs are
more or less the same in each period, this system is adequate. In this method opening incomplete
work-in-progress units are to be converted to equivalent production after taking into consideration
the percentage of work yet to be done and show separately in the statement of equivalent production

Did you know?

Accounts payable, also known as Creditors, is money owed by a business to its suppliers and shown
on its Balance Sheet as a liability. Accounts payable is recorded in the Account Payable sub -ledger
at the time an invoice is vouch red for payment

Caution
In order to obtain accurate average costs, average costing is necessary to measure the production at
various stages of manufacture as all the input units may not be converted into finished goods; some
may be in progress.

Case Study-Case A. Accounting for Spoiled Units:

The House Hold Aids Company assembles clip clothespins in three sections, and uses process
costing. Under normal operating conditions, each section has a spoilage rate of 2%. However,
spoilage can go as high as 5% and is usually discovered when a faulty pi n enters process or on final
completion by a section. The spring mechanism is the only material which can be saved from as
piled unit. The production supervisor assigns a worker once or twice a week to remove the spring‘s
forms piled units. The salvaged springs are placed in bins at the assembly tables in section No1 to be
used again. No accounting entry is made of this salvage operation. In the past, the controller has
made no attempt to account for spoilage separately. Lost unit costs have been absorbed b y the units
transferred out of the section and those remaining in the process. However, because spoilage is
increasing, a different method is needed

Questions
1. What is the spring mechanism of accounting?
2. Write the summary of the following case study

8.4 Summary
Process cost systems are used to apply costs to similar products that are mass produced in a
continuous fashion, such as the production of ice cream, steel or soft drinks. In comparison,
In case of this processing, the combination of the processes or stages of operation depend upon
the end-product to be commercialized.
The process of accounting involves recording classifying and summarizing of past events and
transactions of financial nature
The problem of .ascertaining work-in-progress in process industries is very important and
generally difficult
In certain cases, it can be seen that the loss exceeds the predetermined normal loss. Any loss
exceeding

8.5 Keywords
Costing Procedure: Target costing is a pricing method used by firms. It is defined as "a cost
management tool for reducing the overall cost of a product over its entire life -cycle with the help of
production, engineering, research and design
Inter Process Profits: Process costing is famous topic of cost accounting. It is that method of
costing which is used at that industry where production is done in step by step process
Labour: Growth accounting is a procedure used in economics to measure the contribution of
different factors to economic growth and to indirectly compute the rate of tech nological progress,
measured as a residual, in an economy. This methodology was introduced by Robert Solow in 1957
Overheads: Total absorption costing (TAC) is a method of Accounting cost which entails the full
cost of manufacturing or providing a service.
Process Losses: Certain losses are inherent in the production process and cannot b eliminated.
These losses occur under efficient operating conditions and are referred to as Normal or
uncontrollable losses.
 8.6 Self Assessment Questions
1. The factory or concern is ………………….. into distinct processes or operations and a separate
account
(a)Divided (b) Processes
(c)Operations (d) Account

2. Sometimes the output of one process is transferred to a …………….. process, not at cost, but at a
price, showing a profit to the transferor process
(a)Output (b) Processes
(c)Operations (d) Subsequent

3. The utility of accounting information is greatly increased when it is complied in a systematic

manner …………………and statements prepared at periodic intervals.
(a)Greatly (b) Financial
(c)Operations (d) None of these

4. This method is generally adopted in those cases where either the value of the by……………… is
very small
(a)Method (b) Financial
(c)Products (d) None of these

5. Materials required for each process are drawn from store against Materials Requisitions or
…………. of Materials and debited to cost
(a) Bill (b) Materials
(c) process (d)Subsequent

6. Finished ………. that are not up to the aimed standard are known as defectives
(a)products (b) standard
(c)Operations (d) None of these

7. There is also a possibility that by-products may arise in one period but may be accounted in
another period and thus distort the …………. of two periods.
(a)Profits (b) Period
(c)Products (d) None of these

8. This method is followed where by-products cost………. are processed to dispose of waste
material more
(a)Products cost (b) Financial
(c)Material (d) None of these

9. The standard may be arrived at on the basis of past average ……….. or may be fixed according
to the principles of standard costing
(a)Price (b)financial
(c)Costing (d) None of these

10. The complexity brought into the ………… arises from the fact that the inter -process profits
(a)Method (b) Financial
(c)Accounts (d) None of these

8.7 Review Questions

1. What is the process costing?
2. What do you mean by process costing concept?
3. Explain the accounts with process in detail
4. Describe the losses concept
5. Write the short note on Gains
6. What are the cost methods?
7. What is the closing work-In-progress?
8. Describe the Inter Process Profits
9. Explain the Costing Procedure
10. Write the Accounts with Process?
Answers for Self Assessment Questions
1. (a) 2.(d) 3.(d) 4.(c) 5.(a)
6. (a) 7.(a) 8.(b) 9.(b) 10.(c)
 9
Process Losses and Gains
CONTENTS
Objectives
Introduction
9.1 Process Losses (Normal and Abnormal)
9.2 Process Gains
9.3 Process concepts
9.4 Process Module
9.5 Summary
9.6 Keywords
9.7 Self Assessment Questions
9.8 Review Questions

Objectives
After studying this chapter, you will be able to:

Explain Process Losses

Describe Process Gains
Discuss the Process concepts
Explain Process Module

Introduction
A series of logically related activities or tasks (such as planning, production, or sales) performed
together to produce a defined set of results. A business process is an activity or set of activities that
will accomplish a specific organizational goal. Business process management (BPM) is a system atic
approach to improving those processes. The Business Process Management Initiative (BPMI), a non -
profit organization, exists to promote the standardization of common business processes, as a means
of furthering development of Business Process Execution Language (BPEL) and Business Process
Modelling Notation (BPMN). Both languages were created to facilitate communication between IT
and line-of-business (LOB).In another word a business process or business method is a collection of
related, structured activities or tasks that produce a specific service or product (serve a particular
goal) for a particular customer or customers.

It often can be visualized with a flowchart as a sequence of activities with interleaving decision
points or with a Process Matrix as a sequence of activities with relevance rules based on the data in
the process. Process Costing is a method of costing used to ascertain the cost of a product at each
process or stage of manufacture. In this method, the costs of materials, wages and o verheads are
accumulated for each process separately, for a given period, and then carried forward cumulatively
from one process to the next process till the last process is completed. Records are also maintained
to account for process losses. These losses may be normal or abnormal. Separate accounting is done
for normal and abnormal losses, opening and closing work -in progress and inter-process profits, if
any. This method of costing is used in those industries where mass production of identical units is
undertaken on a continuous basis and finished products are subjected to a number of production
stages called processes before completion.

9.1 Process Losses (Normal and Abnormal)

The loss that occurs in the course of converting an input raw material into finished products is
known as process loss. Such a loss may occur because of the nature of the raw materials. This type
of loss occurs in terms of the difference between the input quantity and the output quantity. The
difference between the input quantity and the output quantity arising on account of production
operation is called process loss.

Process Loss = Normal process loss + Abnormal process loss

When materials are processed; they lose or gain in volume or weight as a result of the process. It is
common that process loss or scrap or wastage occur in process industries. These process losses may
be of two types, viz. controllable and uncontrollable.

9.1.1 Normal or Uncontrollable Loss:

The loss expected or anticipated prior to production is a normal pr ocess loss. It is thus called a
standard loss. A provision for such a loss is made before starting production. Weight losses,
shrinkage, evaporation, rusting etc. are the examples of normal loss. Normal loss increases the cost
of production of the usable goods realized. Because of the nature of the raw materials, some loss is
inherent and is unavoidable. This is known as normal waste or normal loss.
And this type of loss is expected in normal condition for example, stamping process, evaporation,
etc. The percentage of such losses is anticipated from past experience by the management. Loss of
this type should be absorbed by good units produced, i.e. the cost of units lost in charged to the good
units output. Any value realisable on the normal loss will be cr edited to the process account.

Normal Loss Without Scrap Value

The cost of production of 40 units consisting of materials Rs. 1,500;
labor Rs.1,300 and
Overhead Rs.164.
The normal waste is 5% of input. Show the Process Account.
Solution :

Note: The normal wastage reduces the quantity of output. But the cost of normal loss, regarded as
part of the cost of production process, in which it occurs. The amount of loss is borne in the
production cost or good units. The cost per unit of output goes up to that extent. The quantity of
normal wastage is recorded in the Quantity Column and Nil figure is shown in the amount column.

Rs. 2,964
Per Rate 78
40 2
(or) Rs. 78 × 38 = Rs. 2,964
Normal Loss With Scrap Value
The following expenditure is incurred for producing articles, called
Nikhil Motors:
Materials (200 Units) Rs. 4,000
Labor Rs. 3,000
Indirect Expenses Rs. 2,000
Normal wastage is 5% of the input. One unit of wastage is sold at Rs. 16.50 each. Prepare Process
Account.

Solution:
Note: The quantity of Normal wastage is shown in the unit column and the amount, i.e. Rs. 16.50 ×
10 units = Rs. 165 is shown in the amount column. When the normal wastage ha scraps value, good
unit rate is calculated as follows:

Rs. 9,000 – Rs. 165 = Rs. 8,835 >> 190 = 46.50

Note that if the normal wastage is not sold for any price, then, the unit rate is calculated as follows:
Rs. 9,000 >> 190 = Rs. 47.37

9.1.2 Abnormal Loss or Controllable Loss:

In certain cases, it can be seen that the loss exceeds the p redetermined normal loss. Any loss
exceeding the normal is called abnormal loss. Abnormal loss should not affect the normal cost of
production. It is caused by accidents, sub-standard materials, carelessness etc. The loss realized over
the normal loss is called an abnormal loss. Abnormal loss arises because of abnormal working
conditions, bad working condition, carelessness, rough handling, lack of proper knowledge, low
quality raw material, machine breakdown, accident etc. Therefore an abnormal loss is an
unanticipated loss. Abnormal loss is a controllable loss and thus can be avoided if corrective
measures are taken. Therefore, abnormal loss is also called an avoidable loss. The value of an
abnormal loss is assessed on the basis of the production cost with which the profit and loss account
is charged. Therefore, abnormal loss is valued just like good units and transferred to a separate
account called Abnormal Loss Account.

Normal cost of normal production

Units of abnormal loss
Value of Abnormal loss = Normal output

The loss on account of abnormal loss or wastage is not borne by production, but by Profit and Loss
Account.
Abnormal Wastage Account is debited and Process Account is credited with the cost of abnormal
wastage. If the wastage is sold in the market, Abnormal Wastage Account is credited with the
realized price and the balance is transferred to Profit and Loss Account.

Normal loss and abnormal loss with no scrap value.

Prepare Process Account from the following
Materials issued 1,000 kg. @ Rs. 125
Wages Rs. 28,000
Overheads Rs. 8,000
Normal loss 5% of input.
Output 900 kgs.

Solution:
Note: Normal output = 1,000 kgs. 50 kgs = 950 kgs.

Normal cost of Normal output = Rs. 1,61,000

Cost per unit of normal output = Rs. 1,61,000 >> 950 = 169.47

Abnormal Wastage amount = Rs. 169.47 × 50 = Rs. 8,473.50 or Rs. 8,474

Amount of good units = Rs. 169.47 × 900 = Rs. 1,52,526
or 1,61,000/ 950 × 900 = 1,52,526
= 1,52,526

9.2 Process Gains

Gain is a profit or an increase in value of an investment such as a stock or bond. Gain is calculated
by fair market value or the proceeds from the sale of the investment minus the sum of the purchase
price and all costs associated with it. If the investment is not converted into cash or another asset,
the gain is then called an unrealized gain.

a) Abnormal Gains: The margin allowed for normal loss is an estimate (i.e. on the basis of
expectation in process industries in normal conditions) and slight differences are bound to occur
between the actual output of a process and that anticipates. This difference may be positive or
negative. If it is negative it is called ad abnormal Loss and if it is positive it is Abnormal gain i.e. if
the actual loss is less than the normal loss then it is called as abnormal gain. The value of t he
abnormal gain calculated in the similar manner of abnormal loss. The formula used for abnormal
gain is:
Abnormal Gain,

Total Cost incurred - Scrap Value of Normal Loss

Abnormal Gain Unites
Input units - Normal Loss Units

The sales values of abnormal gain units are transferred to Normal Loss Account since it arrive out of
the savings of Normal Loss. The difference is transferred to Costing P & L A/c. as a Real Gain.

Example: In process A, 1000 units of raw materials were introduced at a cost of Rs. 15,000. Direct
wages amounted to Rs. 7,500 and manufacturing overheads to Rs. 5,000. 10% of the units
introduced are normally lost in the course of manufacture and these are sold @ Rs. 5 per unit. The
actual output of the process was 940 units. Prepare Process A Account and Abnormal Gain Account.

Note: Calculation of Value of Abnormal Gain

Normal Output = Units Introduced – Normal Loss
= 100 – 100
= 900 units
Abnormal Gain = 940 - 900
= 40 units
Value of Abnormal Gain =
Total Cost - Scrap Realised
Units of Abnormal Gain
Normal Output
27,500 500
40
900
Rs.1, 200

9.2.1 Defective:
Finished products that are not up to the aimed standard, are known as defectives. Spoilage cannot be
repaired, but defectives can be repaired by additional labour and materials into effective units. It
defectives are sold as seconds the amount received is credited to the concerned process account. If
the defective are reprocessed into good units, the extra amount of materials and labour will be
treated as factory overheads. If the defectives cannot be identified, the normal cost is charged to
factory overheads and abnormal cost will be transferred costing profit and loss account.

Example: The following particulars for the last process are given.
Units Rs.
Transfer to the last process at cost of the 4,000 9,000
previous process
Transfer to finished stock from the process 3,240
Direct wages 2,000
Direct materials used 3,000
The factory overhead in process is absorbed @ 400% of the direct materials.
Allowance for normal loss is 20% of units worked.
The scrap value is Rs. 5 per unit.
You are required to prepare
(a) Last Process Account
(b) Normal Wastage Account and

Solution:
9.2.2 Inter Process Profits
Sometimes the output of one process is transferred to a subsequent process, not at cost, but at a
price, showing a profit to the transfer process. Transfer price may be made at a pr ice corresponding
to current wholesale market price or at cost plus an agreed percentage. The objects are:
(i) to whom whether the cost of production competes with the market prices; and
(ii) to make each process stand on its own efficiency and economies e ffected, i.e. the transferee
process are not given the benefits of economies effected in the earlier process.

This system involves a rather unnecessary complication of the accounts, as the desired comparison
could be prepared on separate cost reports for each process or by adopting a standard costing system
when standards could be set for each process. The complexity brought into the accounts arises from
the fact that the inter-process profits so introduced remain included in the price of process stocks,
finished stocks and work-in-progress. For the balance sheet purpose, inter -process profits cannot be
included in stock, as a firm cannot make a profit by trading itself. To avoid these complications a
provision must be created to reduce the stock to actual cost price. This problem arises only in
respect of stocks on hand at the end of the period, because goods sold sill have realised the internal
profits.
In order to compute the profit element in closing inventories and to obtain the net realised profit for
a period, three columns have been shown on each side of process accounts and closing stock have
been deducted from the debit side of the process accounts instead of showing it on the credit side.
Cost of closing stock can be easily obtained if we compare t he accumulated cost and total in any
process. The cost of stock can be obtained by the following

Formula:
= Cost/Total × Closing Stock
The profit on closing stock can then be easily obtained by deducting the cost of stock thus arrived at
from the value of stock. Sometimes opening stock and production overheads are given.
We should add the opening stock at the beginning along with transfer cost, materials and wages.
From the total of these, closing stock should be deducted to calculate prime cost. Then pro duction
overheads are added this becomes the total cost of the process to which is added the desired
percentage of profit.
9.2.3 Work-in-Progress
The problem of .ascertaining work-in-progress in process industries is very important and generally
difficult. In most firms, production is on a continuous basis and so the problem of work -in-progress
is quite common. This problem can be solved by calculating equivalent production (units) or
equivalent completed (effective) units. Equivalent Production : Equivalen t production means
converting the incomplete production into its equivalent completed units. In each process, an
estimate is made of the percentage completion work -in-progress with regard to different elements of
cost, viz., material, labour and overhead. It is most important that the estimate of percentage
completion is as accurate as possible.
The formula for computing equivalent completed units is:

Actual number of units in Percentage of

Equivalent completed units
process of manfacture work completed

The steps involved in the computation of equivalent production are outlined be low :
(i) Express the opening inventory of work- in-progress in equivalent completed units: This may be
done by multiplying the units of opening work-in progress by the percentage of work required to be
done to complete the unfinished work of the previous period.
(ii) Add to (i) above, the number of units completed out of the units introduced during the period.
(iii) Then add (ii) above, the equivalent completed units of closing work -in progress. This can be
done by multiplying the units of closing work in progress by the percentage of work done on the
unfinished units at the end of the period.
The equivalent units may be required to be computed in respect of each element of cost, viz.,
material, labour and production overhead. The cost of units completed fr om the unfinished units of
the previous period (opening work-in-progress) plus the units completed of the current period‘s
input, and the units still remaining uncompleted (closing work -in progress)
should be shown separately.

Example: Opening stock of work- in-progress 4,000 units 40% complete.

Units put into process: Units completed: 30,000
Units put into process: 32,000
Closing stock of work- in-progress 2,000 units, 60% complete.
Calculate equivalent production.

Solution:
Rs.
Opening stock-work required to be completed
(4,000 × 60%) 2,400
Add: Units introduced and completed during the period
(30,000 – 2,000) 28,000
Add: Closing stock (work done i.e. 60%)
(2,000 × 60% ) 1,200
Completed equivalent production Total- 31,600

9.3 Process concepts

Work product: what is produced
Task: how to perform the work
Role: who performs the work
Process: used to define work breakdown and workflow
Guidance: templates, checklists, examples, guidelines, concepts, and so on

Work Product
Work products may take various shapes or forms, such as:
Documents, such as a Vision, or a Project Plan.
A model, such as a Use-Case Model or a Design Model. These can contain model elements (sub -
artefacts) such as Design Classes, Use Cases, and Design Subsyste ms.
Databases, spreadsheets, and other information repositories.
Source code and executables.
Work products can be classified as "artefacts" if they are concrete things, ―outcomes‖ if they are
not concrete, and "deliverables" if they are a packaging o f artifacts.

Role
A role defines the behaviour and responsibilities of an individual, or a set of individuals working
together as a team, within the context of a software engineering organization. Note that roles are not
individuals; instead, roles describe responsibilities. An individual will typically take on several roles
at one time, and frequently will change roles over the duration of the project.

Some Examples:
Analyst: Represents customers and end users, gathers input from stakeholders and defines
requirements.
Developer: Develops a part of the system, including designing, implementing, unit testing, and
integrating.

Task
A task is work performed by a role. It is usually defined as a series of steps that involve creating or
updating one or more work products.

Some Examples:
Develop a vision: Develop an overall vision for the system, including capturing the problem to be
solved, the key stakeholders, the scope and boundary of the system, the system's key features, and
any constraints.

Plan Iteration: Define the scope and responsibilities of a single iteration.

Process
Processes pull together tasks, work products, and roles, and add structure and sequencing
information. Tasks or work products can be grouped into higher level activities, called a work
breakdown structure (WBS). Activities or tasks can be marked as "planned" to identify work that
you expect to assign and track.

9.4 Process Module

Often in a continuous process there will be opening as well as closing work -in-progress which are to
be converted into equivalent of completed units before apportionment of process costs. Problem of
closing work-in-progress have already been discussed in the previous pages. The following pages
will discuss both methods for valuation of work - in-progress
one by one:

Average Cost Method: This method is useful when prices fluctuate from period to period. The
closing valuation of work- in-progress in the old period is added to the cost of the new period and an
average; rate is obtained which tends to even out price fluctuations. In calculating the equivalent
production opening units will not be shown separately as units of opening work -in-progress are
taken to be included in the units completed and transferred.

FIFO Method : Under this method one assumes that the raw materials issued to work -in-
progress pass through the finished goods in a progressive cycle, i.e. what comes first, goes out first.
This method is satisfactory when prices of raw materials and rates of direct lab our and overheads are
relatively stable. Work-in-progress at the end of the period becomes the opening work -in-progress
for the next period, the closing work-in-progress will be valued at costs ruling during the new
period, while the opening work-in-progress will valued at costs ruling during the old period. Thus,
where costs are more or less the same in each period, this system is adequate. In this method
opening incomplete work-in-progress units are to be converted to equivalent production after taking
into consideration the percentage of work yet to be done and shown separately in the statement of
equivalent production.

9.4.1 Joint Products

Joint products are products which by the very nature of the production process cannot be produced
separately, and which have more or less equal economic importance. They represent ―two or more
products separated in the course of the same processing operation, usually requiring further
processing, each product being in such proportion that no single product can be desi gnated as the
major product.
For example, gasoline, diesel, kerosene, lubricating oil, coal tar, paraffin and asphalt are the joint
products obtained from crude oil in a refinery Sometimes a dissection is made between joint product
and co-products. Coproduces do not always arise from the same operation or raw materials and the
quantity of co-products is within the control of the manufacturer. For example, in the automobile
manufacturing industry, a number of co -products such as cars, jeeps and trucks of va rious types may
be produced in different quantities according to the need of the concern while in the oil industry, the
quantity of various joint products remains almost the same and cannot be changed without changing
the quantity of the rest of the items.

By-Products
By-products refer to secondary or subsidiary products having some saleable or usable value
produced incidentally in the course of manufacturing the main product. According to ICMA
terminology, a by-product is ―a product which is recovered incidentally from the material used in
the manufacture of recognized main products, such a by -product having either a net realisable value
or a usable value which is relatively low in comparison with the saleable value of the main products.
By-products may be further processed to increase their realisable value‖. For example, in sugar
industries, sugar is the main product, and fibres from sugarcane for lining materials, molasses for
the manufacture of alcohol are by products. Similarly in coke ovens, gas and t ar produced along
with the main product ‗coke‘ are by-products.

9.4.2 Distinction Between Joint Products and By -products

The classification of various products from the same process into joint products and by -products
depends upon the relative importance of the products and their value. If the various end products are
almost equal in importance and their value is also more or less the same, they may be identified as
joint products. But, if one end-product has greater importance and higher value and the oth er
products are of less importance and rather of low value, the hitter may be classified as by -products.
It may be noted that the value of some end products may be so insignificant that they may be
classified as waste or scrap. Further joint products are p roduced simultaneously but by-products are
produced incidentally in addition to the main product

(i) Manufacturing Objective

If the objective of a concern is to produce say, product A, other products, say B and C, produced
incidentally, will be treated as by-products because the plant objective is to produce only one
product i.e. product A. On the other hand, if the objective of another concern is to produce products
B and C and if product A emerges incidentally, then products B and C will be treated as jo int
products while Product A will be treated as a by-product. Again, if the objective of a third concern
is to produce products. A, B and C simultaneously, then all the three products will be termed joint
products.

(ii) Value
If the value of one product is. Considerably low as compared with that of another, which is
simultaneously produced, and then the former is liable to be classified as a by -product.

On the other hand, if the value of a product, which is incidentally produced, is of considerable
importance as compared with that of the main product it may be classified as a joint product.

Did you know?

The procedure of conversion of opening work-in-process will vary depending upon whether average
cost method or first in first out method of apporti onment of costs is followed.
Caution
However, cases are not uncommon where the main products of one industry become the by -products
of another. In such a case; the following factors may be taken into consideration in making
distinction between joint products and by-products.

Case Study-Kingfisher Airlines

Kingfisher Airlines started by flamboyant beer baron Vijay Mallya in May 2005 shared the name of
India‘s leading beer brand.Though originally conceived and announced as a ―value‖ carrier,
Kingfisher rapidly morphed into a full‐service airline more in keeping with Mallya‘s style and went
head‐on at Jet Airways. By September 2007, Kingfisher had 34 aircraft in its fleet (4 A ‐319, 12
A‐320, 6 A‐321, 12 ATR‐72) and served 34 destinations. The airline had 51 A‐320 family aircraft on
order for delivery by 2014, 35 ATR aircraft on order for delivery between 2006 and 2010, and 50
wide‐bodied aircraft (including the A‐380) on order for delivery between 2008 and 2018 for a
planned international expansion.

What went wrong? Failed low cost model: It cannot be understood that why airlines (read Kingfisher
and Jet) tried to replicate business models of international LCCs (Low Cost Carriers) RyanAir or
Southwest Airlines (Exhibit 14)? Is low cost the only way to mak e money? If this would have been
the case then Singapore Airlines would have been bankrupt by now. It looks like that Kingfisher
failed to study the models carefully and blindly acquired Air Deccan. The primary way any low cost
carrier makes money is by operating on non‐primary routes using secondary airports which reduces
costs for the airlines and then the benefits are passed on to the customers unlike Kingfisher which
charged low fare for Kingfisher Red but continued operating at prime routes including m etros.
Kingfisher should have avoided flying even a single aircraft to metros and should have taken
advantage of hundreds of uncommon routes and we all know that India is under penetrated market
and much advantage could have been taken by exploring newer r outes. Kingfisher was a five star
airliner then there was no reason to operate on two different business models at the same time.
These were simply the over ambitious plans of the management of Kingfisher Airlines.

Kingfisher Airlines is unofficially bankrupt and officially out of funds. The difference between two
statements? Kingfisher Airlines is operating without any cash. The bank accounts are frozen and
customers are not willing to fly with the carrier. The steps Kingfisher Airlines must take now
With accumulated losses of Rs.6,524 crores, outstanding loans of Rs.7,057 crores, overdue to tax
authorities, airports and fuel suppliers, and less than half of its fleet flying, Kingfisher does not
present a pretty picture for any airline company.
If Kingfisher Airlines wants to fly then the promoters need to induce few thousand millions.
With that money they should first clear due of oil companies, IATA and other regulatory
authorities otherwise Kingfisher would fly into sunset.
Kingfisher Airlines definitely needs to raise fresh capital as well. Banks did give Kingfisher one
last chance last year by infusing capital which was on request converted into shares but due to
landslide fall in share price of Kingfisher Airlines, the investments of Banks have almost eroded.
Consortium of banks in any case will not pour good money after bad. The promoters need to give
personal guarantees in order to raise funds.
Questions
1.Why Kingfisher failed to study the models carefully and blindly acquired Air Deccan?
2. Why the customers unlike Kingfisher which charged low fare?

9.5 Summary
Process is a series of logically related activities or tasks (such as planning, production, or sales)
performed together to produce a defined set of results. A business process is an activity or set of
activities that will accomplish a specific organizational goal.
The loss that occurs in the course of converting an input raw material into finished products is
known as process loss. Such a loss may occur because of the nature of the r aw materials.
The loss expected or anticipated prior to production is a normal process loss. It is thus called a
standard loss. A provision for such a loss is made before starting production. Weight losses,
shrinkage, evaporation, rusting etc. are the examples of normal loss.
Abnormal loss arises because of abnormal working conditions, bad working condition,
carelessness, rough handling, lack of proper knowledge, low quality raw material, machine
breakdown, accident etc.
Process gain is a profit or an increase in value of an investment such as a stock or bond. Gain is
calculated by fair market value or the proceeds from the sale of the investment minus the sum of
the purchase price and all costs associated with it.

9.6 Keywords
BPM: Business process management is a holistic management approach[1] focused on aligning all
aspects of an organization with the wants and needs of clients. It promotes business effectiveness
and efficiency while striving for innovation, flexibility, and integration with technology.
BPMI: The Business Process Management Initiative is a non -profit organization that exists to
promote the standardization of common business processes, as a means of furthering e -business and
B2B development.
BPEL: Business Process Execution Language short for Web Services Business Process Execution
Language (WS-BPEL) is an OASIS standard executable language for specifying actions within
business processes with web services.
LOB: Line-of-business is a general term which often refers to a set of one or more highly related
products which service a particular customer transaction or business need. In some industry sectors,
like insurance, "line of business" also has a regulatory and accounting definition to mean a statutory
set of insurance policies. It may or may not be a strategically relevant business unit.
Inter Process Profits: In some process industries the output of one process is transferred to the next
process not at cost but at market value or cost plus a percentage of profit. The difference betwe en
cost and the transfer price is known as inter -process profits
9.7 Self Assessment Questions
1. The type of spoilage that should not affect the cost of inventories is
(a) Abnormal spoilage (c) Seasonal spoilage
(b) Normal spoilage (d) Indirect spoilage

2. Abnormal loss is charged to

(a) process account (b) costing profit and loss account
(c) Normal loss account (d) process loss

3. Materials may not be put into process

(a) At the beginning of an operation (b) Continuously
(c) At the end of the operation (d) In the shipping department.

4. Process cost method is especially suitable for

(a)Custom production (c) FIFO
(b) Standard costs (d) LIFO

5. In process costing, costs follow

(a) Price rise (c) Product flow
(b) Price declines (d) Finished goods

6. Which of the following method of costing can be used in a large oil refinery?
(a) Process costing (c) Unit costing
(b) Operating costing (d) Job costing

7. Which of the following paid is odd :

(a) Construction-Contract costing (b) Ship-building-Job costing
(c) Brick manufacturing Process costing (d) Transport undertaking – Operating costing

8. A product which has practically no sales or utility value is

(a) Waste (c) Spoilage
(b) Scrap (d) Defectives

9. Trimmings in timber industry should be treated as a:

(a) Waste (c) Spoilage
(b) Scrap (d) Defectives

10. The type of process loss that should not affect the cost of inventory is
(a) Abnormal loss (c) Seasonal loss
(b) normal loss (d) standard loss
9.8 Review Questions
1. What do you mean by normal loss? How is it treated in process cost accounts?
2. What do you mean by abnormal loss? How is it treated in process cost accounts?
3. Distinguish between normal loss and abnormal loss.
4. What do you mean by abnormal effective? How is it treated in process cost accounts?
5. What do you mean by inter process profit? What purpose does it serve?
6. What do you mean be equivalent production?
7. Enumerate any two advantages of process gain.
8. Enumerate any two disadvantages of process loss.
9. What do you meant by equivalent units?
10. State any four features of process modling.

Answers for Self Assessment Questions

1. (a) 2.(b) 3.(d) 4.(b) 5.(c)
6. (a) 7.(c) 8.(a) 9.(b) 10.(a)
 10
Accounting Treatment
CONTENTS
Objectives
Introduction
10.1 Understand the Accounting Treatment Equivalent Production
10.2 Inter Process Profit
10.3 Describe the Joint Product, By-Product are excluded
10.4 Summary
10.5 Keywords
10.6 Self Assessment Questions
10.7 Review Questions

Objectives
After studying this chapter, you will be able to:
Understand the accounting treatment equivalent production
Explain the inter process profit
Describe the joint product
Explain the by-product

Introduction
This paper started out as a survey of the uses of ―Education‖ variables in aggregate production
functions and of the problems associated with the measurement of such variables and with the
specification and estimation of models that use them. It soon becam e clear that some of the issues to
be investigated in usual practice of certain firms. The output of one process is transferred to the
subsequent process at current market price or cost plus agreed percentage of profit. The object is to
show a margin of profit or loss on each process to performing the relative efficiency of each
process. The difference between the costs and the transfer price is known as Inter -Process Profit.
When two or more products are produced simultaneously from the use of a single raw material
which is equally important. Such a product can be a joint product which is more important if
produced from the same raw material. This product is also called as Main Product. On the other
hand, if the products are not of the same importance call ed as ―By-Products.‖ For example, crude oil
is the main product which can be processed in to petrol, kerosene, oil tar etc.

10.1 Understand the Accounting Treatment Equivalent Production

This paper started out as a survey of the uses of "education" variables in aggregate production
functions and of the problems associated with the measurement of such variables and with the
specification and estimation of models that use them. It soon became clear that some of the issues to
be investigated were very complex and possessed a literature of such magnitude that any "quick"
survey of it would be both superficial and inadvisable. This paper, therefore, is in the fond of a
progress report on this survey, containing also a list of questions which this literatur e and future
work may help eventually to elucidate. Not all of the interesting questions will be asked, however,
nor all of the possible problems rose. I have limited myself to those areas which seem to require the
most immediate attention as we proceed beyond the work already accomplished. Surveys several
attempts to "validate" such an index through the estimation of aggregate production functions and
reviews some alternative approaches suggested in the literature. Next, the question of how many
"dimensions" of labour it is useful to distinguish is raised and explored briefly. The puzzle of the
apparent constancy of rates of return to education and of skilled -unskilled wage differentials in the
last two decades provides a unifying thread through the latter parts of this paper as the discussion
turns to the implications of the ability-education-income interrelationships for the assessment of the
contribution of education to growth, the possible sources of the differential growth in the demand
for educated versus uneducated labour, and the possible complementarities between the
accumulation of physical and human capital. While many questions are raised, only a few are
answered.

10.1 Education as a Variable in Aggregate Production Functions

Much of the criticism of the use of such education per man indexes as measures of the quality of the
labour force is summarized by two related education ―really‖ affect productivity. education‖ and its
contribution measured correctly for the purpose at han d. The measures I have presented are not
much more than accounting conventions. Evidence has yet to be presented that "education" explains
productivity differentials and that, moreover, the particular form of this variable suggested above
does it best.
There is, of course, a great deal of evidence that differences in schooling are a major determinant of
differences in wages and income, even holding many other things constant.8 Also, rational
behaviour on the part of employers would lead to the allocation o f the labour force in such a way
that the value of the marginal product of the different types of labour we be roughly proportional to
their relative wages. Still, a more satisfactory way of really nailing down this point, at least for me,
is to examine the role of such variables in econometric aggregate production function studies. Such
studies can provide us with a procedure for ―validating‖ the various suggested quality adjustments,
and possibly also a way of discriminating between alt ernative forms and measures of ―education‖.
Consider a very simple Cobb-Douglas type of aggregate production function:
Y = AKaLs,
Where Y is output, K is a measure of capital services, and L is a measure of labour input in
"constant quality units." Let the correct labour inp ut measure be defined as
L=EN,
Where N is the "un weighted" number of workers and E is an index of the quality of the labour
force. Substituting EN for L in the production function, we have
Y = AKaE$N8,
Providing us with a way of testing the relevance of a ny particular can- dilate for the role of At this
level of approximation, if our index of quality is correct and relevant, when the aggregate
production function is estimated using N and E as separate variables, the coefficient of quality
should both be "significant" in some statistical sense and of the same order of magnitude as the
coefficient of the number of workers It is this type of reasoning which led me, among other things,
to embark

Aggregation Obviously
Constructing such indexes of "quality" (or human capital) we are engaged in a great deal of
aggregation. There are many different types and qualities of "education" and much of the richness
and the mystery of the world are lost when all are lumped into one index or number. Nevertheless,
as long as we are dealing with aggregate data and asking over -all questions, the relevant
consideration is not whether the underlying world is really more complex than we are depicting it,
but rather whether that matters for the purpose of our analysis. And even if we

decide that one index of E hides more than it reveals, our response will surely not be "therefore let's
look at 23 or 119 separate labour or education categories," but rather what kind of two -, three-, or
four-way disaggregation of E will give us the most insight into the problem. From a formal point of
view, we can appeal either to the Hicks composite -good or to the Leontief reparability theorems to
guide us in the quest for correct aggregation. If relative prices (rentals or wages) of labour with
different schooling or skill levels have remained constant, then we lose little in aggregating them
into one composite input measure.
A glance at the "relative prices" for different educational classes reported for the United States in
does not reveal any drastic changes in them.

Thus, it is unlikely that at this level of aggregation much violence is done to the data by putting
them further together into one L or E index. Similar results can be gleaned from a variety of
occupational and skill differential data. In general, they have remained remarkably stable in the face
of very large changes in relative actually, 10 and achievement tests are so intimately intertwined
with education that we may never be successful in disentangling all their separate contribu tions. IQ
tests were originally designed to determine which children could not learn at "normal" rates.
Consequently, children with above average 10 are expected to learn at above normal rates. The
effect of intelligence on learning is presumably two fold Higher IQ children know more to start with
and this "knowing more" makes it easier to learn a given new subject, and higher 10 children are
"quicker." They absorb more for a similar length of exposure, and hence know more at the end of a
given period. Since schools try, in a sense, to maximize the students' "achievement," and since
achievement and JO tests are highly enough correlated for us to treat them interchangeably, one
might venture to define the gross output of the schooling system as ability. That is, schools use the
time of teachers and students and their respective abilities to increase the abilities of the students.

From this point of view, the student's ability is both the raw material that he brings to the schooling
process, which will determine how much he will get out of it, and the final output that he takes away
from it. Hence, at least part of the apparent returns to "ability" should be imputed to the schooling
system.'9 How much depends on what is the bottleneck in the production of educated people the
educational system or the limited number of "able" people that can benefit from it. If, as I believe
may be the case, ability constraints have not been really binding, very little, if any, of the gross
return to education should be imputed to the not very scarce resource of innate ability Examining the
tables from Wolfe‘s studies reproduced in Becker and Denison, one is struck both by the importance
of interaction, and by the very limited effect of 10 on earnings except for those within the upper tail
of the educational distribution.2' In fact, the IQ adjustment constitutes only a very small portion of
Denison's total "ability" adjustment.

One of his major adjustments is based on a cross classification of earnings -by-education by father's
occupation. It is not clear at all why this is an "ability" dimension.22 Higher -income and -status
fathers will provide both more schooling at home and buy better quality schooling in the market. To
the extent that these differences reflect the latter rather than the former, it does not seem reasonable
to adjust for them at all. In most studies that use 10 or achievement tests, th ese tests are taken at the
end of the secondary school period. As we have noted, such Test scores are to some unknown degree
themselves the product of the Such studies can provide us with a procedure for "validating‖ the
various suggested quality adjustments, and possibly also a way of discriminating between alternative
forms and measures of "education

10.2 Inter Process Profit

The output of one process is transferred to the subsequent process at current market price or cost
plus agreed percentage of profit. The object is to show a margin of profit or loss on each process to
performing the relative efficiency of each process. The difference between the costs and the transfer
price is known as Inter-Process Profit. On accounting complication of this techni que is the fact that
work in progress and stock figures at the end of the period will include a profit element. For balance
sheet purposes, inter process profits cannot be included in stocks because a firm cannot make a
profit by trading with itself. Financial accounting requires stock to be valued at the lower cost or
realizably valued. The unrealized profit, therefore, must be calculated and written back

When opening and closing stocks of WIP exist, unit costs cannot be computed by simply dividing
the total cost by total number of units still in process. We must convert the work in progress in to
finished elements called "equivalent unit" so that the unit cost can be obtained. For example, 300
units 60% complete are equal to 180 equivalent units. It con sists of balance of work done on
opening work in progress, current production done fully and part of work done on closing work in
progress. Once credit side entries are valued the equivalent units are ignored. Steps Involved for

Calculation of Equivalent Units

The following procedure to be followed for calculation of equivalent units:
Calculate the number of equivalent units after taking the percentage of degree of completion in
respect of opening stock of work in progress.
To add the units introduced deducting the closing work in progress.
Convert the equivalent units of closing work in progress and add to the above.
Find out net process costs element wise i.e. materials, labour and overheads.
Calculate the cost per unit of equivalent production of e ach element of cost separately.
Find out the cost of finished goods transferred to the next process and stock of work in progress,

The above procedures are to be considered for preparation of the following three statements:
Statement of Equivalent Production.
Statement of Cost.
Statement of Evaluation the success of business is measured in terms of profit and profit is
dependent on three basic factors:
Cost of production;
Selling prices;
Volume of sales.

These three factors are inter-dependent because cost determines selling price to arrive at the desired
level of profit; the selling price affects the volume of sales, the volume sales directly affects the
volume of production and volume of production in turn influences cost . An understanding of the
interrelationship between these factors is extremely useful to management in budgeting and profit
planning. This is because profit planning helps in predicting the probable effect of change in any of
these factors on the remaining factors

Break-Even Analysis
The study of cost-volume profit analysis is often referred to as breakeven analysis. Break -even
analysis is an extension of the marginal costing principles. It is interpreted in narrow as well as
broader sense. In its narrow sense, break even analysis is concerned with finding out the breakeven
point i.e. the point of no profit and no loss. When used in broader sense, it is a system of analysis
that can be used to determine probable profit/loss at any given level of output.

Assumptions Underlying Break-even Analysis

All costs can be separated into .fixed and variable components.
Variable cost per unit remains constant and total variable cost varies in direct proportion to the
volume of production.
Total fixed cost remains constant.
Selling price does not change as volume changes.
There is only one product or in the case multiple products, the sales mix does not change. In
other words, when several products are being sold, the sale of various products will always be in
some predetermined proportion.
There is synchronization between production and sales.
Productivity per worker does not change.
There will be no change in the general price level.

Calculations in Break-even Analysis

The break-even point is the volume of output at which total cost is exactly equal to revenue. It is a
point of no profit and no loss. This is the minimum point of production at which total cost is
recovered arid after this point profit begins.

Additional Calculations
In addition to the calculation of break-even point, the above formulae can also be used in making
certain additional calculations. These are:
Calculation of Profit for different sales volumes.
Calculation of sales for desired profit

10.2.1 The Profit Volume Chart

The profit volume chart or profit graph portrays the profit and loss at different levels of sales and is
an alternative presentation of the facts illustrated in the break -even chart. Such a chart can be
constructed from the same basic data from which a break -even chart can be drawn.
Construction of Profit- Volume Chart
The following steps should be taken to construct a profit – volume chart.
Select a scale on horizontal axis.
The horizontal axis in the profit volume graph represents sales. This horizontal axis in the profit
volume graph represents sales. The horizontal line known as sales line divides the graph into two
parts.
Select a scale on vertical axis.
The vertical axis show fixed cost and profit. The fixed cost is market below the sales line on the left
hand vertical line and profit is shown above the sales on the right hand side vertical line.
Plot fixed cost and profit.
Point is plotted for the given-fixed cost and profit. These points are connected by a diagonal line
which crosses the sales line a breakeven -point

Limitations of Break- Even Analysis

Although break-even analysis is an invaluable tool of management, there are some limitations from
which the technique suffers. These limitations of breakeven analysis arise from certain assumptions
on which the analysis is based and which are, in effect, not true. Thus ―break even analysis is based
on a simplified model of a business which is unrealistic.‖ ―It must be applied an intelligent
discrimination, with an adequate grasp of assumptions underlying the technique sur rounding its
practical applications.‖
The assumption that all cost can be clearly separated into fixed and variable components is not
possible to achieve accurately in practice, thereby resulting in inaccurate break -even analysis.
The assumption that variable cost per unit remains constant and that it gives a straight line chart
is also not always true. In practice, many of the variable costs do not observe this tendency.
Most of the variable costs, no doubt move in sympathy with the volume of production n ot
necessarily in direct proportion to the volume. Similarly, the assumption that fixed costs remains
constants is also unrealistic. Fixed costs are constant only within a limited range of output and
tend to increase by a sudden jump when additional plant and machinery is introduced.
The assumption regarding selling prices remaining unchanged as volume changes is also not
true. In practice, selling prices do not remain fixed and change in prices affects demand. Any
increases in output can be sold only by effecting a reduction in selling price which would affect
the sales line.
The assumption that only one product is being produced or that product mix will remain
unchanged is also not found in practice. The sales of various products manufactured are not
always in a predetermined proportion.
It is assumed that production and sales are synchronized. This is not always so Sales may fall
short of production or may be capable of increase to much production only by effecting a
reduction a reduction in selling prices.
The break even analysis completely ignores the consideration of capital employed which may be
an important factor the study of profit analysis. In spite of these -limitations, break-even analysis
is a very useful management device, provided it is used o nly by those who are fully aware of its
limitations because the alone the technique can be used more effectively.

10.3 Describe the Joint Product, By-Product are excluded

When two or more products are produced simultaneously from the use of a single raw material
which is equally important. Such a product can be a joint product which is more important if
produced from the same raw material. This product is also called as Main Product. On the other
hand, if the products are not of the same importance called as "By-Products." For example, crude oil
is the main product which can be processed in to petrol, kerosene, oil tar etc.
Almost every company produces and sells more than one type of product. Although companies may
engage in multiple production processes to manufacture a variety of products, they may also engage
in a single process to simultaneously generate various different outputs such as those of Bulkhead
Beef and its customers. In a like manner, the refining of crude oil may produce gasoline, motor o il,
heating oil, and kerosene. A single process in which one product cannot be manufactured without
producing others is known as a joint process.
Such processes are common in the extractive, agricultural, food, and chemical industries. The costs
incurred for materials, labour, and overhead during a joint process are referred to as the joint cost of
the production process. This chapter discusses joint processes, their related product outputs, and the
accounting treatment of joint cost. Outputs of a joint pr ocess are classified based on their revenue-
generating ability, and joint cost is allocated only to the primary products of a joint process, using
either a physical or monetary measure. Although joint cost allocations are necessary to determine
financial statement valuations, such allocations should not be used in internal decision making. Joint
costs may also be incurred in service businesses and not -for-profit organizations. Such costs in these
organizations are often for advertisements that publicize dif ferent product lines or locations, or ads
for different purposes, such as public service information and requests for donations. Joint costs of
not-for-profit firms are covered in the last section of this chapter. A joint process simultaneously
produces more than one product line.

The product categories resulting from a joint process that have a sales value are referred to as
Joint products,
By-products
Scrap. Joint
Products are the primary outputs of a joint process; each joint product individually has substantial
revenue generating ability. Joint products are the primary reason management undertakes the
production process yielding them. These products are also called primary products, main products,
or co products. Joint products do not necessarily hav e to be totally different products; the definition
of joint products has been extended to include similar products of differing quality that result from
the same process. For example, when oil refinery processes petroleum into gasoline, the outputs will
all have been derived from petroleum, but different grades will have more octane and other
characteristics based on the extent and types of additional processing. In contrast, by -products and
scrap are incidental outputs of a joint process. Both are salvable , but their sales values alone would
not be sufficient for management to justify undertaking the joint process. For example, donut whole
cut-outs are a by-product of the donut-making process. Scrap may be generated in the setup stage.
Contractors may tear out old fixtures, cupboards, etc., in remodelling a home. Such items are often
resold to other contractors.

By-products are viewed as having a higher sales value than scrap. A final output from a joint
process is waste, which is a residual output that has no sales value. A normal amount of waste may
create a production cost that cannot be avoided in some industries. Alternatively, many companies
have learned either to minimize their production waste by changing their processing techniques or to
reclassify waste as a by-product or scrap through selling it to generate some minimal amount of
revenue. A company may change a product classification over time because of changes in
technology, consumer demand, or ecological factors. Some products originally classif ied as by-
products are reclassified as joint products, whereas some joint products are reduced to the by -
product category. Even products originally viewed as scrap or waste may be upgraded to a joint
product status. Years ago, for example, the sawdust and chips produced in a lumber mill were
considered waste and discarded. These items are now processed further to produce particleboard
used in making inexpensive furniture.
Therefore, depending on the company, sawdust and chips may be considered a joint prod uct or a by-
product. Sometimes a by-product will be accidentally discovered by good fortune. An interesting
example is found in the Internet revolution. Classification of joint process output is based on the
judgment of company managers, normally after con sidering the relative sales values of the outputs.
Classifications are unique to each company engaged in the joint process. For example, Lazy -K
Ranch and Sterling Steers Ltd. each engage in the same joint production process that produces three
outputs: meats, bone, and hide. Lazy-K Ranch Classifies all three outputs as joint products, whereas
Sterling Steers Ltd. Classifies meats and hide as joint products; bone is regarded as a by -product.
These classifications could have resulted from the fact that Lazy -K Ranch has the facilities to
process bone beyond the joint process, but Sterling Steers does not have such facilities. Further
processing endows bone with a substantially higher sales value per unit than selling bone as it exits
the joint process.

10.3.1Features of Joint Products

The following are the important features of joint products:
Joint products are produced from the sample raw materials.
They are produced from the common features of manufacturing process.
Joint products are of equal importance and value.
They may require further processing after their split off or point of separation.
Objectives of Joint Product Costing
The following are the important objectives of joint product costing:
To facilitate product costing of inventory valuation and income determination.
To ascertain the profitability of each product
To facilitate to make or buy decisions.
To provide information to fix the prices of product.
To evaluate the change of product mix and output variations.
To determine cost per unit, cost allocation and cost ascertainment.
To ensure effective cost control.

10.3.2Methods of Apportionment of Joint Products

The following are the important methods commonly used for apportionment of joint costs up to the
point of separation.
Average Unit Cost Method
Physical Unit Method
Survey Method
Contribution Margin Method
Standard Cost Method
Market Value Method
Market Value at Point of Separation
Market Value After Further Processing
 Net realizable Value or Reserve Cost Method

Average Unit Cost Method:

Under this method, average cost per unit of the finished product is calculated by the total joint costs
up to the point of separation is divided by the total production of all the products or outputs. This
method is very simple and conveniently applicable where the resultant products can be expressed in
common units.

Physical Unit Method:

Under this method, the joint costs are allocated or apportioned to joint products on the basis of
relative physical units of output of each joint product till split -off occurs. These physical units refer
to weight or measure such as pounds, tonnes, gallons, bales, volume etc. This method is suitable
where the joint products will be measurable in the same units. This method cannot be applied when
joint products consist of different types of units like liquids and solids.

Survey Method:
Survey Method is also termed as ―Points Value Method." In this method, joint costs are allocated on
the basis of percentage or point‘s value is assigned to each product according to their relative
importance. This method is also taken into various relevant factors such as volume, mixtures, selling
price, technical engineering and marketing processes. The ratio of joint costs can be calculated by
physical quantities of each products use mul tiplied with the weight age points.

Contribution Margin Method: This method is also called as "Gross Margin Method." According to
this method joint costs are allocated or apportioned as fixed cost and variable cost incurred at the
point of separation. Joint fixed costs are apportioned on the basis of contribution of each product
whereas variable portion of joint costs are apportioned according to the volume of units produced.

Standard Cost Method: Under this method, joint costs are apportioned on the ba sis of standard
costs. For this, standard costs are determined in advance for a joint products based on past
experience, technical aspects, operational efficiency and cost factors of each products etc

Market Value Method:

This method is also termed as "Relative Sales Value Method. According to this method, the number
of units of each product manufactured is multiplied by the product's selling price to obtain the sales
value of production. The portion of total joint costs allocated to each product is equal to the ratio of
the sales value of each product's total market value. Here, there are various kinds of market value
methods:
Market Value at the Separation Point
Market Value After Further Processing
Net Realizable Value

Market Value at Separation Point:

Under this method, the market value of the joint products at the split off point is ascertained on the
basis of dividing joint cost. Weight age is also given to the quantities of each product:

Market Value after Further Processing:

In this method, joint cost is apportioned according to the ratio of final selling price of each product.
Net Realizable Value: This method is also called as "Reverse Cost Method." Under this method, the
estimated profit, selling and distribution expenses and post separation costs are reduced from the
sales value of each joint product. A ratio is established on the basis of which the total costs before
separation point is apportioned. Subsequent costs are added to arrive at product costs

10.3.3 By Products
The term by-product is also known as "Minor Product." It refers to any product of comparatively
less value that is incidentally manufactured along with the main products. In other words, if the
products produced are not as of equal importance, then the pro ducts of significantly low value are
known as "by-products." Accordingly, they are jointly produced with other main products and
remain inseparable up to the point of split off or point of separation.

Accounting Treatment or Method of Valuation of By -products

The object of valuation of by-products cost accounting is to assign a portion of the total costs to
each by-product. This is important to calculate the unit product cost and prepare the profit and loss
account and balance sheet. Following are the i mportant methods employed in this connection:
Non-Cost Methods or Sales Value Methods:
Other Income Method.
Adding Sales Value to Total Cost Method.
Crediting to Sales Value Less Selling and Distribution Expenses Method.

Expenses Cost Method.

Replacement Cost Method or Opportunity Cost Method
Standard Cost Method
Apportionment on Suitable Basis
Non-Cost Method

This method is also known as ―Sales Value Method." While in valuation of the by -products only
sales value of by-products is taken in to account in accounting treatment of by-products they use
anyone of the following non-cost methods:
Other income method under this method, when the sales value of the by -products is very low or
negligible, it is treated as other income and same is credited t o the profit and loss account.
Adding sales value to total cost method. Under this method all the cost of joint products
deducted from the combined sales proceeds of both joint products and main products.
Crediting to sale value loss selling and distribu tion expenses under this method, costs incurred
relating to selling and distribution expenses of by -products are deducted from the sales value of
by-product and the net sales value credited to the process account.
Reverse cost method. In this method. Cost of by-product is determined by sales of the by-
product
 Deducted from the estimated profit and all costs incurred on by -products after split off point.
This method also known as "crediting sales value less profit."
Cost methods Cost methods are useful to determine the cost of by -products when the apportion
of the portion of Joint costs incurred to by-products. The following are the important methods
included under these categories.
Replacement cost method this method is also called as opportunity cost method in this
Method by-products are determined where by-products are used as raw material in some other
process. Here the by-products are value at the opportunity cost of purchasing or replacing them
The opportunity cost of by-product refers to the cost which could have been incurred had the by -
product being used as material could have been purchased from the market. The process account
is credited with the value of by product so ascertained.
Apportionment on suitable basis under this method, if the value of by products is considerably
Significant, the actual cost of by-product is ascertained by apportioning the joint costs up to the
point of physical separation by way of suitable basis used for costing of jo int products.

Did you know?

The output of one process is transferred to the subsequent process at current market price or cost
plus agreed percentage of profit. The object is to show a margin of profit or loss on each process

Caution
Apart from legal investment issues, the variations of structured debt securities make it impossible to
generalize about appropriate tax and accounting treatment for an investor. Investors should consult
with their own tax advisors and accountants prior to investment.

Case Study-Healthcare/Pharmaceutical sector:

Financial leadership consultancy at a $ 10 billion global company
As a result of the spin-off of an international conglomerate ($ 80 billion sales company) into three
independent companies, the Corporate Finance department in Luxemburg had to be transitioned
accordingly.
In this interim financial management assignment we reported into the Corporate Finance Controller
in Luxemburg and supervised the Finance & Accounting department. The assignment included:
Assisting the Corporate Financial Controller with:
Switching existing corporate ledgers to a new entity ERP platfor m
Identifying key responsibilities, organizational structure and staffing levels
Reviewing and implementing financial processes and systems
Planning and implementing the resources and knowledge transfer
Transitioning of accounting activities/processes from Dublin to Luxembourg
Advising on financial and economical topics of organizational change management

Setting up an accounting treatment for following Corporate Treasury processes:

Zero balance account and sweeps between Luxembourg and Swiss entities (I/C revolvers)
Market to market reporting and accounting for both Swiss and Luxembourg Corporate entities
Accounting for external debt and public debt
Monitoring exchange rate differences enabling reporting and forecasting P&L impact

Supporting the Finance & Accounting department :

Month and year-end closing preparation and management (US GAAP) reporting
Uploading monthly figures in Hyperion system, ensuring appropriate consolidat ed reports
Preparing deliverables for corporate and external audit and Sox compliant reviews
Preparing annual statutory accounts and corporate tax reporting

Questions
1.How healthcare/pharmaceutical sector assisting the corporate financial controller.
2.What is over view of case study?

10.4 Summary
Products are the primary outputs of a joint process; each joint product individually has
substantial revenue generating ability
When two or more products are produced simultaneously from the use of a single raw material
which is equally important.
In usual practice of certain firms. The output of one process is transferred to the subsequent
process at current market price or cost plus agreed percentage of profit .
This method is also termed as "Relative Sales Value Method. According to this method, the
number of units of each product
Standard cost method in this method, a standard cost is fixed for each by -product and the process
account is credited with this standard cost.

10.5 Keywords
Average Unit Cost Method: Under the average cost method, it is assumed that the cost of inventory
is based on the average cost of the goods available for sale during the period.
Selling prices: Income method under this method, when the sales value of the by -products is very
low or negligible
Inter Process Profit: he profit associated with the transfer of goods from one process to another
process is called inter-process profit
Profit-volume Chart: Cost–volume–profit (CVP), in managerial economics is a form of cost
accounting. It is a simplified model, useful for elementary instruction and for short -run decisions
Expenses Cost Method: A second method used to take a tax deduction for vehicle use is the actual
cost method.

10.6 Self Assessment Questions

(1)The main product is usually produced in greater quantities than the............
(a) Joint Product (b) By-Products
(c) Work in Progress (d) Finished Products

(2)Joint Cost are allocated according to sales value of individual products under.............
(a)Market Value Method (b) Average Unit Cost Method
(c) Survey Method (d) Physical Unit Method

(3) Under the Market Value Method, Joint Costs are allocated according to of individual products
(a)Cost Price (b) Market price or cost price whichever is less
(c) Sales Value (d) Cost and Demand Price

(4)Under the Other Income Method of accounting of by -products, the sales value of the by-products
is ................
(a)Credited to Profit and Loss Account (b) Credited to Process Account
(c) Credited to Process Account (d) Credited to By-Product Account

(5)On accounting treatment of by-products, the sales value of the by-products is credited to profit
and loss account under----
(a) Other Income method (b) Replacement Cost Method
(c) Standard Price Method (d) Cost Method

(6)Under the Average Unit Cost Method of apportionment of joint costs, the cost per unit of each
product is the --
(a) Constant (b) Different
(c) Same (d) Semi-Variable

(7)..................are-of limited sales value produced simultaneously with the products of a greater
value
(a) Joint Products (b) By-Products
(c) Semi-Finished Products (d) Finished Products

(8)The stage of production at which separate products are identified is known as ----
(a) Split Off Point (b) Break-Even Point
(c) Point of Separation (d) A and C

(9)Relate to process and incurred after split off point

(a) Subsequent Costs (b) Joint Costs
(c) By-Product Costs (d) Marginal Costs

(10)The concept of equivalent production is used in case of processes which have at the end of a
period
(a) Completed Units (b) Incompleted Units
(c) Joint Products (d) By-Products
10.7 Review Questions
1. Explain the accounting treatment equivalent production
2. What do you understand by Joint Product?
3. Explain the important features of Joint Product.
4. What are the objectives of Joint Product Costing?
5. Explain the different methods of apportionment of Joint Pr oduct.
6. What is mean by By-Products?
7. What are the important methods of valuation of By -Products?
8. What do you understand by Inter -Process Profits?
9. Explain Equivalent Units.
10. Write short notes on:
(a) Joint Products
(b) By-Products
(c) Net Realizable Value
(d) Physical Unit Method
(e) Inter-Process Profits
(f) Equivalent Units.

Answers for Self Assessment Questions

1. (b) 2.(a) 3.(c) 4.(a) 5.(a)
6. (c) 7.(b) 8.(d) 9.(c) 10.(a)
 11
Concepts of Budget
CONTENTS
Objectives
Introduction
11.1 Budget
11.2 Budgetary Control
11.3 Objectives of Budget
11.4 Advantages and Disadvantages of Budget Control
11.5 Budget Planning
11.6 Budget Factors
11.7 Flexible Budget
11.8 Summary
11.9 Keywords
11.10 Self Assessment Questions
11.11 Review Questions

Objectives
After studying this chapter, you will be able to:
Define the budget
Understand the budgetary control
Explain the objectives of budget
Define the advantages and limitations of budget
Define budgetary control
Discuss the budget factors
Explain the flexible budget

Introduction
The word budget developed from bougette or ‗small bag‘ in middle French. The use of the word
spread to England, where it came to designate the leather bag in which ministers of the crown
carried financial plans to parliament, and eventually it became synonymous with its contents. The
use of the word in the United Kingdom now refers to the spring financial statement, which focuses
on taxation measures. In most countries, the term refers to the annual expenditure and revenue plans
tabled in the legislature.
The first traceable legal definition of the budget is contained in a French decree of 1862: ‗The
budget is a document which forecasts and authorizes the annual receipts and expenditures o f the
State In most countries, the government budget is drafted at regular intervals by the executive and
tabled in the legislature for review and approval before the beginning of the fiscal year to which it
applies.

Sources of income vary substantially between countries. They usually include direct taxes, which are
levied on income or capital, for example income tax. Such taxes are called direct because it is
normally assumed that the real burden of payment falls directly on the person or firm that is
immediately responsible for paying them. By contrast, indirect taxes such as sales taxes or excise
taxes on alcohol and tobacco are so called because it is assumed that the real burden of paying the
tax will not fall on the firm immediately responsible for pa ying it but rather that it will be passed
on to the customer. Other sources of government income might consist of user charges for certain
services, foreign aid, and income from investments or commercial activities. In considering its
revenue raising options, the government has to weigh advantages and disadvantages.
For example, boosting reliance on sales taxes makes taxation more regressive. This means that a
poor person will pay as much tax as a rich person when purchasing an item of clothing or food, as
sales tax does not take account of income differentials. On the other hand, income taxes are
progressive when they apply higher rates to individuals with a higher level of income. But where the
formal economy is small, excessive taxation of a few high i ncome individuals can undercut
investment, which hampers growth and employment creation. Over time, this might erode the tax
base and reduce the ability of government to raise revenues. Raising an adequate amount of
revenues, while at the same time preserving equity and stimulating economic growth, can be a
difficult balancing act. On the expenditure side of the budget, government allocates funds to various
functions such as health care, education, agriculture, justice, defence and so on. This is called the
functional classification of expenditures. The share of total expenditures allocated to each sector is a
key indicator of spending priorities for a given year and of shifts in priorities over a period of time.
In terms of the economic classification of ex penditures a distinction can be made between current
and capital expenditures. Current expenditures are on goods and services that are consumed
immediately, for example wages of civil servants or supplies of learning material for schools.
Capital expenditures comprise money spent on the purchase of goods that can be used to produce
other goods, for example machinery or infrastructure. The balance between current and capital
spending is important. When a clinic is built and equipped to service a community ( a capital
expenditure), then government has to make sure that it sets aside sufficient funds to run the clinic on
a day to day basis, which requires budgeting for wages, medicines and the like (current
expenditures).
11.1 Budget
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period of
time, usually one year. In other words, a budget is a systematic plan for the utilization of manpower
and material resources. In a business organisation a b udget represents an estimate of future costs and
revenues. Budgets may be divided into two basic classes Capital Budgets and Operating Budgets.
Capital budgets are directed towards proposed expenditure for new projects and often require special
financing. The operating budgets are directed towards achieving short term operational goals of the
organisation, for instance, production or profit goals in a business firm. Operating budgets may be
sub-divided into various departmental or functional budgets.
The main characteristics of a budget are:
(a) It is prepared in advance and is derived from the long term strategy of the organisation
(b) It relates to future period for which objectives or goals have already been laid down
(c) It is expressed in quantitative from, physical or monetary units, or both.

Different types of budgets are prepared for different purposes e.g. Sales Budget. Production Budget,
Administrative Expense Budgets, Raw-material Budget, etc. All these sectional budgets are
afterwards integrated into a master budget which represents an overall plan of the organisation.
A budget helps it‘s in the following ways:
It brings about efficiency and improvement in the working of the organisation.
It is a way of communicating the plans to various units of the organisation. By establishing the
divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus minimizes
the possibilities of buck-passing if the budget figures are not met.
It is a way of motivating managers to achieve the goals set for the units.
It serves as a benchmark for controlling on-going operations.
It helps in developing a team spirit where participation in budgeting is encouraged.
It helps in reducing wastage's and losses by revealing them in time for corrective action.
It serves as a basis for evaluating the performance of managers.
It serves as a means of educating the managers.

11.2 Budgetary Control

No system of planning can be successful without having an effective and efficient system of control.
Budgeting is closely connected with control. The exercise of control in the organisation with the
help of budgets is known as budgetary control. The process of budgetary control includes:
1. preparation of various budgets
2. continuous comparison of actual performance with budgetary performance and
3. revision of budgets in the light of changed circumstances

A system of budgetary control should not become rigid. There should be enough scope for flexibility
to provide for individual initiative and drive . Budgetary control is an important device for making
the organisation more efficient on all fronts. It is an important tool for controlling costs and
achieving the overall objectives.
Installing a Budgetary Control System
Having understood the meaning and significance of budgetary control in an organisation, it will be
useful for you to know how a budgetary control system can be installed in the organisation. This
requires first of all, finding answers to the following questions in the context of an organi sation:
What is likely to happen?
What can be made to happen?
What are the objectives to be achieved?
What are the constraints and to what extent their effects can be minimised?
Having found answers to the above questions, the following steps may be tak en for
Installing an effective system of budgetary control in an organisation.

Organisation for Budgeting

The setting up of a definite plan of organisation is the first step towards installing budgetary control
system in an organisation. A, Budget Manual should be prepared giving details of the powers,
duties, responsibilities and areas of operation of each executive in the organisation.

Responsibility for Budgeting

The responsibility for preparation and implementation of the budgets may be fixed as unde r:

Budget Controller
Although the Chief Executive is finally responsible for the budget programme, it is better if a large
part of the supervisory responsibility is delegated to an official designated as Budget Controller or
Budget Director. Such a person should have knowledge of the technical details of the business and
should report directly to the President of the Chief Executive of the organisation.

Budget Committee
The Budget Controller is assisted in his work by the Budget Committee. The Committee m ay consist
of Heads of various departments, viz., Production, Sales Finance, Personnel, Purchase, etc. with the
Budget Controller as its Chairman. It is generally the responsibility of the Budget Committee to
submit, discuss and finally approve the budget figures. Each head of the department should have his
own Subcommittee with executives working under him as its members.

Fixation of the Budget Period

‗Budget period‘ means the period for which a budget is prepared and employed. The budget period
depends upon the nature of the business and the control techniques. For example, a seasonal industry
will budget for each season, while an industry requiring long periods to complete work will budget
for four, five or even larger number of years. However, it is ne cessary for control purposes to
prepare budgets both for long as well as short periods.

Budget Procedures
Having established the budget organisation and fixed the budget period, the actual work or
budgetary control can be taken upon the following pattern:
Key Factor
It is also termed as limiting factor. The extent of influence of this factor must first be assessed in
order to ensure that the budget targets are met. It would be desirable to prepare first the budget
relating to this particular factor, and then prepare the other budgets. We are giving below an
illustrative list of key factors in certain industries.

The key factors should be correctly identified and examined. The key factors need not be of a
permanent nature. In the long run, the management may overcome the key factors by introducing
new products, by changing material mix or by working overtime or extra shifts etc.

Making a Forecast
A forecast is an estimate of the future financial conditions or operating results. Any estimation is
based on consideration of probabilities. An estimate differs from a budget in that the latter embodies
an operating plan of an organisation. A budget envisages a commitment to certain objectives or
targets, which the management seeks to attain on the basis of the f orecasts prepared. A forecast on
the other hand is an estimate based on probabilities of an event. A forecast may be prepared in
financial or physical terms for sales, production cost, or other resources required for business.
Instead of just one forecast a number of alternative forecasts may be considered with a view to
obtaining the most realistic, overall plan.

Preparing Budgets
After the forecasts have been finalised the preparation of budgets follows. The budget activity starts
with the preparation of the sales budget. Then production budget is prepared on the basis of sales
budget and the production capacity available. Financial budget (i.e. cash or working capital budget)
will be prepared on the basis of sales forecast and production budget. All thes e budgets are
combined and coordinated into a master budget. The budgets may be revised in the course of the
financial period if it becomes necessary to do so, in view of the unexpected developments, which
have already taken place or are likely to take pla ce.

Choice between Fixed and Flexible Budgets

A budget may be fixed or flexible. A fixed budget is based on a fixed volume of activity. It may lose
its effectiveness in planning and controlling if the actual capacity utilisation is different from what
was planned for any particular unit or time e.g. a month or a quarter, The flexible budget is more
useful for changing levels of activity as it considers fixed and variable costs separately.
Fixed costs, as you are aware, remain unchanged over a certain rang e of output. Such costs change
when there is a change in capacity level. The variable costs change in direct pro -portion to output. If
'flexible budgeting approach is adopted, the budget controller can analyse the variance between
actual costs and budgeted costs depending upon the actual level of activity attained during a period
of time. This will be explained in detail a little later.

11.3 Objectives of Budget

Many companies go through the budgeting process every year simply because they did it the year
before, but they do not know why they continue to create new budgets.
The objectives of budgeting are given below:

Provide Structure: A budget is especially useful for giving a company guidance regarding the
direction in which it is supposed to be going. Thus, it forms the basis for planning what to do next.
A CEO would be well advised to impose a budget on a company that does not have a good sense of
direction. Of course, a budget will not provide much structure if the CEO promptly files away the
budget and does not review it again until the next year. A budget only provides a significant amount
of structure when management refers to it constantly, and judge‘s employee performance based on
the expectations outlined within it.

Predict Cash Flows: A budget is extremely useful in companies that are growing rapidly, that have
seasonal sales, or which have irregular sales patterns. These companies have a difficult time
estimating how much cash they are likely to have in the near term, which results in periodic cash-
related crises. A budget is useful for predicting cash flows, but yields increasingly unreliable results
further into the future.

Allocate Resources: Some companies use the budgeting process as a tool for deciding where to
allocate funds to various activities, such as fixed asset purchases. Though a valid objective, it should
be combined with capacity constraint analysis (which is more of an industrial engineering function
than a financial function) to determine where resources should really be alloc ated.

Model Scenarios: If a company is faced with a number of possible paths down which it can travel,
and then you can create a set of budgets, each based on different scenarios, to estimate the financial
results of each strategic direction. Though usefu l, this objective can result in highly unlikely results
if management lets itself become overly optimistic in inputting assumptions into the budget model.

Measure Performance: A common objective in creating a budget is to use it as the basis for judging
employee performance, through the use of variances from the budget. This is a treacherous
objective, since employees attempt to modify the budget to make their personal objectives easier to
achieve.

11.4 Advantages and Disadvantages of Budget Control

Advantage and disadvantage of budget are given below:
Advantage
Like other control methods, budgets have the potential to help organizations and their members
reach their goals. Budget control offers several advantages to managers. Some of these are:
The major strength of budgeting is that it coordinates activities across departments.
Budgets translate strategic plans into action. They specify the resources, revenues, and activities
required to carry out the strategic plan for the coming year.
Budgets provide an excellent record of organizational activities.
Budgets improve communication with employees.
Budgets improve resources allocation, because all requests are clarified and justified.
Budgets provide a tool for corrective action through reallocations.

Disadvantage
However, budgets control can also create problems. The disadvantages of budgets are:
The major problem occurs when budgets are applied mechanically and rigidly.
Budgets can demotivate employees because of lack of participation. If the budgets are arbitrarily
imposed top down, employees will not understand the reason for budgeted expenditures, and will
not be committed to them.
Budgets can cause perceptions of unfairness.
Budgets can create competition for resources and politics.
A rigid budget structure reduces initiative and innovation at lower levels, making it impossible
to obtain money for new ideas.

11.4.1 The Benefits and Limitations of Budgets

Budgets are instruments of planning and control. Budgets specify the expenses an employee or an
organizational unit in an establishment is authorized or permitted to incur for different types of
activities or assets. Generally, a budgetary planning and control systems includes some mechanis m
to restrict incurring of expenditure exceeding the budget, and to monitor the actual expenditure
against the budgets. Thus, for example, budget of marketing department of a company may specify
the budgets under various accounts heads such as salaries, ad vertisement and travelling.

The marketing manager will have considerable freedom to take decisions in matter of number of
salesman to be employed, salaries to be paid to them, their travel cost and amount spent on
advertisement and promotion as long as the total expenditure under any head does not exceed the
budget. The manager may need to obtain special sanction for incurring expenditure exceeding the
budget. Also the actual expenditure incurred by the marketing department will be periodically
compared with budgets, and the performance of the marketing manager will be influenced
substantially by the extent to which actual expenditure are equal to or less than the budgets.
The biggest benefit of a budgeting system is that it allows managers the freedom of decision making
as long as they do not exceed the budgets. It also enables a company to lay standards of performance
and levels of activities of different functions and departments within the company.

This ensures that various departments and functions op erate within the framework of a common
overall plan. Budget also serves as a means of evaluating the performance of different functions and
managers within an organization. The biggest limitation of traditional budgeting system is that it
focuses primarily on expenses, paying little attention to the results obtained as a result of the
expenses incurred. Thus in the above example, the marketing manager may fail to cash on an
opportunity to sell more by increasing the travelling of his sales -persons because that will lead to
the travel expenditure exceeding the budget.
The emphasis on input cost to the inclusion of the consideration of results obtained makes budgeting
quite meaningless when the level of operations are very much fluctuating. For example, produc tion
cost in any company is closely linked to the level of production. Therefore, a rigid budget that fails
to take into consideration the level of production can become quite inappropriate as planning or
controlling tool.

Another common problem of budgeting system is related to the way budgets are finalised. In many
organizations the budgets are often prepared on the basis of past performance rather than the future
requirements. This tends to create a false feeling of planned working, when in reality the
organization is only drifting along with the flow of past trends.
There have been many attempts to overcome the limitations of budgeting systems by introducing
many innovations such as flexible budgeting, zero based budgeting, and performance budgeting.

11.5 Budget Planning

Budget planning entails identifying the sources of income and taking into account all current and
future expenses, with an aim to meet an individual‘s financial goals. The primary aim of a budget
planner is to ensure savings after the allocation for spending.

Budget is an important concept of microeconomics and can be understood as an organizational plan

stated in monetary terms. Business start-up budget, corporate budget, event management budget,
government budget and personal or family budget are some variations of this concept.

Budget Planning: Making Ends Meet

In a personal or family budget, the sources of all income (inflows) are identified and the expenses or
outflows are planned for. The final plan seeks to match the outflows t o inflows. The equation that
restricts an individual or a household from spending more than the available resources is known as
budget constraint.

How is Budget Planning Done?

By following good budgeting strategies, one can ensure the successful managemen t of his or her
expenditure and the recording of savings so that investments may be made for securing one‘s future.
Increased life expectancy has raised the amount of money one requires after retirement. This means
that there is a need for increased retirement savings, while most people are living pay check to pay
check or depending on credit card debt (which has a high interest rate) to raise their standard of
living. Thus, there is a growing need for effective personal budget planning.
Calculate Income: This should include income from all sources, including your pay check and
interest from any investment.
Determine Bill for Essentials: List out your essential expenses, which may include rent, grocery,
clothing, telephone and electricity bills and gas and c ar maintenance. Calculate the amount spent on
each.

Determine Debt Elimination: Note down your total debts, including interest payments on the same.

Determine Bill for Non-Essentials: Your list of non essentials may include vacations, gifts and trips
to restaurants. Calculate the amount spent on each.

Calculate Savings: This is done by subtracting the figure obtained by adding steps 2, 3 and 4 from
the figure obtained in calculate income.

11.6 Budget Factors

The principal budget factor is the factor that limits the activities of functional budgets of the
organization. The early identification of this factor is important in the budgetary planning process
because it indicates which budget should be prepared first.
The general sales volume is the principal budget factor. So the sales budget must be prepared first,
based on the available sales forecasts. All other budgets should then be linked to this.
Alternatively, the machine capacity may be limited for the forthcoming period and therefore
machine capacity is the principal budget factor. In this case, the production budget must be followed
first and all the other budgets follow it. Failure to identify the principal budget factor could lead to
delays later on when the managers realize that the targets they have been working with are not
feasible.
We can identify the principal budget factor by the following:
1. In case of single product organization
2. In case of multi-product organization

In Case of Single Product Organization

Identify the capacity of the production departments. Generally the normal capacity is considered
for budget/estimation
ii. Max. production in a department = Normal Capacity / Time per unit
iii. Select the minimum production volume among the above results.
iv. The department producing that result is known as the bottleneck among the production
department.
v. Identify the sale or the demand of the product

In Case of Multi Product Organization

Sale/demand is the principal budget factor
2. Capacity is in short supply or the limiting facto r i.e. capacity requirement according to
demand is more than the supply
a. Only one limiting factor
b. More than one limiting factor
11.7 Flexible Budget
A flexible budget, or ―flex‖ budget, itemizes different expense levels depending upon changes in the
amount of actual revenue. This approach varies from the more common static budget, which contains
nothing but fixed amounts that do not vary with actual revenue levels.
In its simplest form, the flex budget will use percentages of revenue for certain expen ses, rather than
the usual fixed numbers. This allows for an infinite series of changes in budgeted expenses that are
directly tied to revenue volume. However, this approach ignores changes to other costs that do not
change in accordance with small revenue variations. Consequently, a more sophisticated format will
also incorporate changes to many additional expenses when certain larger revenue changes occur,
thereby accounting for step costs. By making these changes to the budget, a company will have a
tool for comparing actual to budgeted performance at many levels of activity.

Advantages of Flexible Budgeting

Since the flexible budget restructures itself based on activity levels, it is a good tool for evaluating
the performance of managers - the budget should closely align to expectations at any number of
activity levels. It is also a useful planning tool for managers, who can use it to model the likely
financial results at a variety of different activity levels.

Disadvantages of Flexible Budgeting

Though the flex budget is a good tool, it can be difficult to formulate and administer. One problem
with its formulation is that many costs are not fully variable, instead having a fixed cost component
that must be included in the flex budget formula. Anot her issue is that a great deal of time can be
spent developing step costs, which is more time than the typical accounting staff has available,
especially when in the midst of creating the standard budget. Consequently, the flex budget tends to
include only a small number of step costs, as well as variable costs whose fixed cost components are
not fully recognized.

Example of a Flexible Budget

ABC Company has a budget of $10 million in revenues and a $4 million cost of goods sold. Of the
$4 million in budgeted cost of goods sold, $1 million is fixed, and $3 million varies directly with
revenue. Thus, the variable portion of the cost of goods sold is 30% of revenues. Once the budget
period has been completed, ABC finds that sales were actually $9 million. If it used a flexible
budget, the fixed portion of the cost of goods sold would still be $1 million, but the variable portion
would drop to $2.7 million, since it is always 30% of revenues. The result is that a flexible budget
yields a budgeted cost of goods sold of $3.7 million at a $9 million revenue level, rather than the $4
million that would be listed in a static budget.

Did you know?

The process of calculating the costs of starting a small business begins with a list of all necessary
purchases including tangible assets (for example, equipment, inventory) and services (for example,
remodelling, insurance), working capital, sources and collateral.
Caution
On the other hand, if the figures diverge wildly from the budget, this sends an ‗out of control‘
signal, and the share price could suffer as a result.

Case Study-Example Restaurant Pty Ltd

Take the example of a small business restaurant with a typical turnover of $750,000, and with profit
and expense ratios which fit within industry averages.
Profitability
A forecast shows that the business will produce a Gross Profit of $465,000 (62%) and an operating
profit before interest, depreciation and tax of around $142,000 for an owner -operator. The budget
and cash flow statements reveal the business factors which give the most leverage for profit
improvement.

Cash Flow
The cash flow forecasts show that the business requires cash to boost its business in quieter seasonal
periods, but has surplus cash during peak trading periods. Knowing this allows th e amount and
timing of borrowings to be predicted with confidence. For an astute manager it should also lead to a
questioning of strategies - to examine ways of offsetting the slow cash flow through sales or expense
management, or a fresh marketing strategy.

Leveraging Improvements
A quick short-list of sensitivity factors shows a potential for 49% profit gains, and this is typical of
most businesses. With a properly constructed budget model, by varying the budget inputs a range of
high-yielding factors can be easily identified. This example shows that a 5% improvement in
customer spend would yield a whopping 26% increase in operating profit. In this case, product -
pricing, and the amount each customer spends are high -leverage factors. Compare this with a 5%
reduction in labour costs, which although significant, would only produce a 6% profit improvement.
At a basic level this suggests that an effort to boost customer spending levels will yield bigger
results than trying to reduce labour costs. But of course a closer examination may suggest that both
improvements (and indeed neither of them) can be readily achieved.

Taking action and Further Analysis

After identifying the high-leverage factors, the next step is to examine each factor in more detail,
and brainstorm ways to achieve the suggested results.For example a 5% reduction in Cost of Goods
Sold, potentially yielding a 10% increase in operating profit, might be achieved by:
changing the sales product mix, or
re-negotiating terms with suppliers, or
re-engineering inventory management,
Or any combination of these and other actions
As part of a deeper analysis it's instructive to break sales into categories, and then fully apportion all
costs including overheads to see what the profit really is, category by category (or even item by
item). The categories used will be specific to the business; for example they might be geographic,
demographic, product-related, by selling channel, or some other segmentation which makes sense.
This can be very revealing; sales items with high gross profit margins are not necessarily the most
profitable overall. Using this information to make strategic or operational changes can lead to big
profit improvements. This kind of information is almost never available from regular financ ial
statements, and therefore is a frequently overlooked opportunity for improvement.

Testing decisions, the "what if?" analysis

Once specific improvement measures have been identified and costed, it's a simple matter to re -run
the budget forecasts to ensure that the proposed changes make sense, and that the cash flows of the
business are safe. Having a budget and cash flow forecast is the essential starting point for planning
and control. The example business budget and cash flow package used here can be produced in less
than a day for almost any business.

Questions
1. What do you understand by cash flow forecast?
2. How can we identify the high-leverage factors?

11.8 Summary
A budget is a plan expressed in quantitative, usually monetary terms, covering a specific period
of time, usually one year.
Budget helps in reducing wastage's and losses by revealing them in time for corrective action.
The exercise of control in the organisation with the help of budgets is known as budgetary
control.
Budget is a way of communicating the plans to various units of the organisation. By establishing
the divisional, departmental, sectional budgets, exact responsibilities are assigned.
A Budget represents an estimate of future costs and revenues.
Budget brings about efficiency and improvement in the working of the organisation.
A flexible budget, or ―flex‖ budget, itemizes different expense levels depending upon changes in
the amount of actual revenue.
Budget planning entails identifying the sources of income and taking into a ccount all current and
future expenses, with an aim to meet an individual‘s financial goals.

11.9 Keywords
Flexible Budget: A budget designed to change in accordance with the level of activity actually
attained.
Budget: A statement in financial terms, prepared prior to a defined period of time, showing the
strategy to be pursued during that period for the purpose of attaining a given objective.
Capital expenditures: Capital expenditures are expenditures creating future benefits.
Tax: A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or
a functional equivalent of a state.
Forecasting: It is the process of making statements about events whose actual outcomes (typically)
have not yet been observed.
Revenue or Turnover: It is income that a company receives from its normal business activities,
usually from the sale of goods and services to customers.

11.10 Self Assessment Questions

1. A budget
(a) is a substitute for management
(b) is an aid to management
(c) can operate or enforce itself
(d) is the responsibility of the accounting department

2. Which one of the following is not a benefit of budgeting?

(a) It facilitates the coordination of activities
(b) It provides definite objectives for evaluating performance
(c) It provides assurance that the company will achieve its objectives
(d) It requires all levels of management to plan ahead on a recurring basis

3. Budgeting is usually most closely associated with which management functions?

(a) Planning (b) Directing
(c) Motivating (d) Controlling

4. A common starting point in the budgeting process is

(a) expected future net income (b) past performance
(c) to motivate the sales force (d) a clean slate, with no expectations

5. budget period should be

(a) monthly
(b) for a year or more
(c) long-term
(d) long enough to provide an obtainable goal under normal business conditions

6. The starting point in preparing a master budget is the preparation of the

(a) production budget (b) sales budget
(c) purchasing budget (d) personnel budget

7. The word budget developed from bougette or ‗small bag‘ in m iddle French.
(a) True (b) False

8. A sales forecast
(a) shows a forecast for the firm only
(b) shows a forecast for the industry only
(c) shows forecasts for the industry and for the firm
(d) plays a minor role in the development of the master budget
9. The process of budgetary control includes:
(a) preparation of various budgets
(b) continuous comparison of actual performance with budgetary performance and
(b) revision of budgets in the light of changed circumstances
(d) All of these

10. Budgets do not specify the expenses an employee or an organizational unit in an establishment is
authorized or permitted to incur for different types of activities or assets.
(a) True (b) False

11.11 Review Questions

1. What do you understand by budget?
2. Define the Responsibility for budgeting.
3. What are the budget procedures? Explain
4. Explain the objectives of budget.
5. How can you explain the budgetary control?
6. What are the advantage and disadvantage of budgetary control?
7. What are the benefits and limitations of budgets?
8. What is the budget planning regarding to government budget and personal or family budget?
9. Define the Factors affecting budget.
10. What is the flexible budget and also define its advantages?

Answers for Self Assessment Questions

1 (b) 2 (c) 3 (a) 4 (b) 5 (d)
6 (b) 7 (a) 8 (c) 9 (d) 10 (b)
 12
Meaning of Standard Cost and
Standard Costing
CONTENTS
Objectives
Introduction
12.1 Standard Costing
12.2 Advantages and limitations of Standard Costing
12.3 Standard Costing vs. Budgetary Control
12.4 Types of Standard
12.5 Analysis of Variances
12.6 Material and Labour
12.7 Summary
12.8 Keywords
12.9 Self Assessment Question
12.10 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain the meaning of standard costing
Explain the advantages and limitations of standard costing
Define standard costing vs. budgetary control
Describe the types of standard
Discuss analysis of variances

Introduction
Management accounting is managing a business through accounting information. In this process,
management accounting is facilitating managerial control. It can also be applied to your own
daily/monthly expenses, if necessary. These measures should be applie d correctly so that
performance takes place according to plans. Planning is the first tool for making the control
effective. The vital aspect of managerial control is cost control. Hence, it is very important to plan
and control costs. Standard costing is a technique which helps you to control costs and business
operations. It aims at eliminating wastes and increasing efficiency in performance through setting up
standards or formulating cost plans.

Meaning of Standard
When you want to measure something, you must take some parameter or yardstick for measuring.
We can call this as standard. What are your daily expenses? An average of INR 250. If you have
been spending this much for so many days, then this is your daily standard expense.
The word standard means a benchmark or yardstick. The standard cost is a predetermined cost which
determines in advance what each product or service should cost under given circumstances.
In the words of Backer and Jacobsen, ―Standard cost‖ is the amount the firm thinks a product or the
operation of the process for a period of time should cost, based upon certain assumed conditions of
efficiency, economic conditions and other factors.‖

Definition
The CIMA, London has defined standard cost as ―a predetermined cost which is calcu lated from
management‘s standards of efficient operations and the relevant necessary expenditure.‖ They are
the predetermined costs on technical estimate of material labour and overhead for a selected period
of time and for a prescribed set of working cond itions. In other words, a standard cost is a planned
cost for a unit of product or service rendered. The technique of using standard costs for the purposes
of cost control is known as standard costing. The actual cost can be ascertained only when
production is undertaken. The predetermined cost is compared to the actual cost and a variance
between the two enables the management to take necessary corrective measures.

What is a standard cost?

A standard cost is a planned or forecast unit cost for a product or service, which is assumed to hold
good given expected efficiency and cost levels within an organisation. It represents a target cost and
is useful for planning, controlling and motivating within an organisation. Variance analysis is a
budgetary control process, which compares standard or budgeted costs and revenues with the actual
results of an organisation, in order to obtain information regarding any exceptions from budget; this
information is also used to improve performance through control action e.g. correcting problems.
Standard costing can be used for
Budget preparation e.g. planning
Control through exception reporting e.g. performance measurement
Stock valuation
Cost bookkeeping
Motivating staff
Under a standard costing system an organisation can value stock at standard cost, incorporating this
within the ledger or cost accounts of the organisation, the budget or forecasts being a memorandum
kept outside the ledger accounts.
12.1 Standard Costing
When costs are determined in advance on certain predetermined standards under a given set of
operating conditions, it is called standard costing. Standard costing is to be compared with the actual
costs periodically to analyze the changes in the cost to revise the standards to avoid any loss due to
outdated costing.

12.1.1 Cost Accounting

Standard costing, marginal costing, opportunity cost analysis, differential costing and other cost
techniques play a useful role in operation and control of the business undertaking

12.1.2 Overview of Standard Costing

Under standard costing, predetermined costs are used for valuing inventory and for charging
material, resource, overhead, period close, and job close and schedule complete transaction s.
Differences between standard costs and actual costs are recorded as variances.
Use standard costing for performance measurement and cost control. Manufacturing industries
typically use standard costing.
Standard costing enables you to:
Establish and maintain standard costs
Define cost elements for product costing
Value inventory and WIP balances
Perform extensive cost simulations using unlimited cost types
Determine profit margin using expected product costs
Update standard costs from any cost type
Revalue on-hand inventories, in transit inventory, and discrete WIP jobs when updating costs
Record variances against expected product costs
Measure your organization's performance based on predefined product costs
If you use Inventory without WIP, you can define your item costs once for each item (in the cost
master organization) and share those costs with other organizations. If you share standard costs
across multiple organizations, all reports, inquiries, and processes use those costs. You are not
required to enter duplicate costs.

12.2 Advantages and limitations of Standard Costing

Standard costing is a management control technique for every activity. It is not only useful for cost
control purposes but is also helpful in production planning and policy formulation. It allows
management by exception. For instance, if the industry changed the technology then the system will
not be suitable. In that case, we will have to change or revise the standards. A frequent revision of
standards will become costly.
12.2.1 Advantages
In the light of various objectives of this system, some of the advantages of this tool are given below:
Efficiency measurement: The comparison of actual costs with standard costs enables the
management to evaluate performance of various cost centres. In the absence of standard costing
system, actual costs of different period may be compared to measure efficiency. It is not proper to
compare costs of different period because circumstance of both the periods may be different. Still, a
decision about base period can be made with which actual performance can be compared.

Finding of variance: The performance variances are determined by comparing actual costs with
standard costs. Management is able to spot out the place of inefficiencies. It ca n fix responsibility
for deviation in performance. It is possible to take corrective measures at the earliest. A regular
check on various expenditures is also ensured by standard cost system.

Management by exception: The targets of different individuals are fixed if the performance is
according to predetermined standards. In this case, there is nothing to worry. The attention of the
management is drawn only when actual performance is less than the budgeted performance.
Management by exception means that everybody is given a target to be achieved and management
need not supervise each and everything. The responsibilities are fixed and everybody tries to achieve
his/her targets.

Cost control: Every costing system aims at cost control and cost reduction. The standards are being
constantly analyzed and an effort is made to improve efficiency. Whenever a variance occurs, the
reasons are studied and immediate corrective measures are undertaken. The action taken in spotting
weak points enables cost control system.

Right decisions: It enables and provides useful information to the management in taking important
decisions. For example, the problem created by inflating, rising prices. It can also be used to provide
incentive plans for employees etc.

Eliminating inefficiencies: The setting of standards for different elements of cost requires a detailed
study of different aspects. The standards are set differently for manufacturing, administrative and
selling expenses. Improved methods are used for setting these stand ards. The determination of
manufacturing expenses will require time and motion study for labour and effective material control
devices for materials. Similar studies will be needed for finding other expenses. All these studies
will make it possible to eliminate inefficiencies at different steps.

12.2.2 Limitations of Standard Costing

It cannot be used in those organizations where non -standard products are produced. If the
production is undertaken according to the customer specifications, then each job will involve
different amount of expenditures.
The process of setting standard is a difficult task, as it requires technical skills. The time and
motion study is required to be undertaken for this purpose. These studies require a lot of time
and money.
 There are no inset circumstances to be considered for fixing standards. The conditions under
which standards are fixed do not remain static. With the change in circumstances, if the
standards are not revised the same become impracticable.
The fixing of responsibility is not an easy task. The variances are to be classified into
controllable and uncontrollable variances. Standard costing is applicable only for controllable
variances.

12.2.3 Setting Standards

Normally, setting up standards is based on the past exper ience. The total standard cost includes
direct materials, direct labour and overheads. Normally, all these are fixed to some extent. The
standards should be set up in a systematic way so that they are used as a tool for cost control.
Various Elements which Influence the Setting of Standards

Setting Standards for Direct Materials

There are several basic principles which ought to be appreciated in setting standards for direct
materials. Generally, when you want to purchase some material what are the factors you consider? If
material is used for a product, it is known as direct material. On the other hand, if the material cost
cannot be assigned to the manufacturing of the product, it will be called indirect material. Therefore,
it involves two things:
Quality of material
Price of the material

The second step in determining direct material cost will be a decision about the standard price.
Material‘s cost will be decided in consultation with the purchase department. The cost of purchasing
and store keeping of materials should also be taken into consideration. The procedure for purchase
of materials, minimum and maximum levels for various materials, discount policy and means of
transport are the other factors which have bearing on the materials cost price. It inc ludes the
following:
Cost of materials
Ordering cost
Carrying cost
The purpose should be to increase efficiency in procuring and store keeping of materials. The type
of standard used ideal standard or expected standard also affects the choice of standard p rice.

12.2.4 Determination of Standard Costs

How should the ideal standards for better controlling be determined?
Determination of Cost Centre
―A cost centre is a department or part of a department or an item of equipment or machinery or a
person or a group of persons in respect of which costs are accumulated, and one where control can
be exercised.‖ Cost centres are necessary for determining the costs. If the whole factory is engaged
in manufacturing a product, the factory will be a cost centre. In fact, a cost centre describes the
product while cost is accumulated.
Current Standards
A current standard is a standard which is established for use over a short period of time and is
related to current condition. It reflects the performance that should be attained during the current
period. The period for current standard is normally one year. It is presumed that conditions of
production will remain unchanged. In case there is any change in price or manufacturing condition,
the standards are also revised. Current standard may be ideal standard and expected standard.
Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is fixed on the
assumption that favourable conditions will prevail and management will be at its best. The price
paid for materials will be lowest and wastes etc. will be minimum possible. The labour time for
making the production will be minimum and rates of wages will also be low. The overheads
expenses are also set with maximum efficiency in mind. All the conditions, both internal and
external, should be favourable and only then ideal standard will be achieved.
Basic Standards
A basic standard may be defined as a standard which is established for use for an indefinite period
which may a long period. Basic standard is established for a long period and is not adjusted to the
preset conations. The same standard remains in force for a long period. Th ese standards are revised
only on the changes in specification of material and technology productions. It is indeed just like a
number against which subsequent process changes can be measured. Basic standard enables the
measurement of changes in costs. For example, if the basic cost for material is INR 20 per unit and
the current price is INR 25 per unit, it will show an increase of 25% in the cost of materials. The
changes in manufacturing costs can be measured by taking basic standard, as a base standard cannot
serve as a tool for cost control purpose because the standard is not revised for a long time. The
deviation between standard cost and actual cost cannot be used as a yardstick for measuring
efficiency.
Normal Standards
As per terminology, normal standard has been defined as a standard which, it is anticipated, can be
attained over a future period of time, preferably long enough to cover one trade cycle. This standard
is based on the conditions which will cover a future period of five years, concernin g one trade cycle.
If a normal cycle of ups and downs in sales and production is 10 years, then standard will be set on
average sales and production which will cover all the years. The standard attempts to cover variance
in the production from one time to another time. An average is taken from the periods of recession
and depression. The normal standard concept is theoretical and cannot be used for cost control
purpose. Normal standard can be properly applied for absorption of overhead cost over a long peri od
of time.
Organization for Standard Costing
The success of standard costing system will depend upon the setting up of proper standards. For the
purpose of setting standards, a person or a committee should be given this job. In a big concern, a
standard costing committee is formed for this purpose. The committee includes production manager,
purchase manager, sales manager, personnel manager, chief engineer and cost accountant. The cost
accountant acts as a co-coordinator of this committee.
Accounting System
Classification of accounts is necessary to meet the required purpose, i.e. function, asset or revenue
item. Codes can be used to have a speedy collection of accounts. A standard is a pre -determined
measure of material, labour and overheads. It may be exp ressed in quality and its monetary
measurements in standard costs.

12.2.5 Controlling Cost

Cost accounting helps in attaining aim of controlling cost by using various techniques such as
Budgetary Control, Standard costing, and inventory control. Each item of cost is budgeted at the
beginning of the period and actual expenses incurred are compared with the budget. This increases
the efficiency of the enterprise.

Advantages of Job Costing

The following are the advantages of job costing.
Accurate information is available regarding the cost of the job completed and the profits
generated from the same.
Proper records are maintained regarding the material, labour and overheads so that a costing
system is built up
Useful cost data is generated from the point of view of management for proper control and
analysis.
Performance analysis with other jobs is possible by comparing the data of various jobs. However
it should be remembered that each job completed may be different from the other.
If standard costing system is in use, the actual cost of job can be compared with the standard to
find out any deviation between the two.
Some jobs are priced on the basis of cost plus basis. In such cases, a profit margin is added in
the cost of the job. In such situation, a customer will be willing to pay the price if the cost data
is reliable. Job costing helps in maintaining this reliability and the data made available becomes
credible.

12.3 Standard Costing vs. Budgetary Control

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

12.3.1 Points of Similarity:

There are certain basic principles which are common to both standard costing and budgetary control.
These are:
The establishment of pre-determined targets of performance
The measurement of actual performance
The comparison of actual performance with the pre -determined targets.
The analysis of variances between the actual and the standard performance
To take corrective measures, where necessary.
12.3.2 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: (see table 12.1)

Table 12.1: Standard Costing and Budgetary Control

Standard Costing Budgetary Control
Scope Standard costs are developed Budgets are compiled functions of the
mainly for the manufacturing business such as sales, purchase,
function and sometimes also for production, cash, capital expenditure,
making and administration research & development, etc.,
functions
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.
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 actual side by side.
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
costs. for output.
Basis Standard cost are usually Budgets may be based on previous
established after considering such year‘s costs without any attention being
vital matters as production capacity, paid to efficiency.
methods employed and other factors
which require attention when
determining an acceptable level of
efficiency.
Projection Standard cost is a projection of cost Budget is a projection of financial
accounts accounts.

12.4 Types of Standard

Standard in simple words is a measure of what is expected to take place under the current or
anticipated circumstances. Another way of defining standard is that it is something that is
predetermined or planned and management wishes that actual results equate to standards.
Standards are one of important quantitative tools in the hand of management to control a nd measure
performance of business operations. However it heavily depends on the type of standards used to
decide about the control actions and to measure the performance.
12.4.1 Types of Standards
Following are different types of standards:
 Basic standards
Normal standards
Current standards
Attainable (expected) standards
Ideal (theoretical) standards

Basic Standards
These are standards established considering those factors that are basic in nature and remain
unchanged over a long period of time and are altered only when the business operations change
significantly affecting the very basic foundations of the entity and nature of business. These
standards help compare business operations over a longer period of time. Basic standards are used
not only to evaluate actual results but also current expected results (current standards). We can say
that basic standards work as a standard for other standards. As basic standards are not updated
according to latest circumstances thus they are not used often as they c annot help in short term
period variance analysis.

Normal Standards
These are such standards which are expected if normal circumstances prevail. Term normal
represents the normal conditions of the business in the absence of any unexpected fluctuations
(either favourable or unfavourable). Even through normal standards is more of a theoretical in nature
as reality cannot be sufficiently predicted with all its fluctuations in advance. Also, circumstances
may change in such a way that factors which were expect ed to be controllable are not so controllable
by the mangers. Thus it has limited application in today‘s business environment. However, normal
standards acts as a good yardstick that represents challenging yet attainable results and can be used
by management in such environment which is simple in nature and is not prone to great fluctuations.

Current Standards
These standards are representative of current business conditions. These are mostly short term in
nature and are widely used as they are the most re levant standards to be used for control purposes.
These standards represent the state that business currently achieving or must achieve.

Attainable Standards/Expected Standards

These standards are based on current conditions and circumstances and represents what can be
attained with the present setup in place and if the current conditions prevail. Current standards may
be set lower or easier than expected standards but good managers always try to achieve what is
attainable so that no resource is left unused. It means that attainable standards are representative of
the potential that business is capable to achieve. For example machinery is expected to run for 4,000
hours where it can run for 5,000. Thus current standard is 4,000 hours where attainabl e is 5,000
hours. These standards are useful as they help management to analyze their performance and to use
the unused potential at the right time.

Ideal Standards/Theoretical Standards:

These standards represent what business operations would be under i deal set of circumstances where
everything is running at the optimum level with an ideal balance. These standards are representative
of long term goals rather than for short term performance measurement. But with the advancement
of technology and inventions even the ideal standards become attainable over the period of time but
with every step taken forward and every question answered, more questions and more complexities
pop up and it‘s in human nature that it always extends the way forward with every miles tone
achieved. Therefore, ideal standards are not meant to be achieved rather to act like a guiding star.

12.4.2 What Type of standard should be selected?

This is not like that one standard is always good and the other always bad. It is all relative. It i s a
matter of situation and involves judgment to decide which standard is suitable for a particular
situation and which can provide relevant and reliable information which is also easily available and
applicable. Therefore, it depends on the requirements o n the basis of which it is determined what
type of standard is suitable for use.
For example, in financial or environmental crisis it will be good if management stick with current
standards rather than using attainable standards as even maintaining current standards is sometime
difficult.
On the other hand if management is of the opinion that circumstances are favourable and also the
resources available are capable of facing a challenge then it may switch to attainable or even normal
standards and a bit to the extreme ideal standards where ideal standards may help to motivate staff
to perform at its peak.

12.5 Analysis of Variances

An important technique for analyzing the effect of categorical factors on a response is to perform an
Analysis of Variance. An ANOVA decomposes the variability in the response variable amongst the
different factors. Depending upon the type of analysis, it may be important to determine:
(a) Which factors have a significant effect on the response?
(b) How much of the variability in the response variable is attributable to each factor?
Stat graphics centurion provides several procedures for performing an anal ysis of variance:

One-Way ANOVA: it is used when there is only a single categorical factor. This is equivalent to
comparing multiple groups of data.
Multifactor ANOVA: it is used when there is more than one categorical factor, arranged in a crossed
pattern. When factors are crossed, the levels of one factor appear at more than one level of the ot her
factors.
Variance Components Analysis: it is used when there are multiple factors, arranged in a hierarchical
manner. In such a design, each factor is nested in the factor above it.
General Linear Models: it is used whenever there are both crossed and nested factors, when some
factors are fixed and some are random, and when both categorical and quant itative factors are
present.

12.5.1 One-Way ANOVA

A one-way analysis of variance is used when the data are divided into groups according to only one
factor. The questions of interest are usually:
(a) Is there a significant difference between the groups?
(b) If so, which groups are significantly different from which others?
Statistical tests are provided to compare group means, group medians, and group standard
deviations. When comparing means, multiple range tests are used, the most popular of which is
Tukey's HSD procedure. For equal size samples, significant group differences can be determined by
examining the means plot and identifying those intervals that do not overlap.

Figure12.2: One-Way ANOVA

12.5.2 Multifactor ANOVA

When more than one factor is present and the factors are crossed, a multifactor ANOVA is
appropriate. Both main effects and interactions between the factors may be estimated. The output
includes an ANOVA table and a new graphical ANOVA from the latest edition of Statistics for
Experimenters by Box, Hunter and Hunter (Wiley, 2005). In a graphical ANOVA, the points are
scaled so that any levels that differ by more than exhibited in the distribution of the residuals are
significantly different.

Figure12.2: Multifactor ANOVA

12.5.3 Variance Components Analysis

A Variance Components Analysis is most commonly used to determine the level at which variability
is being introduced into a product. A typical experiment might select several batches, several
samples from each batch, and then run replicates tests on each sample. The goal is to determine the
relative percentages of the overall process variability that is being introduced at each level.

Figure 12.2: Components Analysis

12.5.4 General Linear Model

The General Linear Models procedure is used whenever the above procedures are not appropriate. It
can be used for models with both crossed and nested factors, models in which one or more of the
variables are random rather than fixed, and when quantitative factors are to be combine d with
categorical ones. Designs that can be analyzed with the GLM procedure include partially nested
designs, repeated measures experiments, split plots, and many others. For example, pages 536 -540
of the book Design and Analysis of Experiments (sixth edi tion) by Douglas Montgomery (Wiley,
2005) contains an example of an experimental design with both crossed and nested factors. For that
data, the GLM procedure produces several important tables, including estimates of the variance
components for the random factors.

Analysis of Variance for Assembly Time

Table 12.2: Analysis of Variance for Assembly Time
Source Sum of Squares Df Mean Square F-Ratio P-Value
Model 243.7 23 10.59 4.54 0.0002
Residual 56.0 24 2.333
Total 299.7 47
(Corr.)

Type III Sums of Squares

Table 12.3: Type III Sums of Squares
Source Sum of Squares Df Mean F-Ratio P-Value
Square
Layout 4.083 1 4.083 0.34 0.5807
Operator(Layout) 71.92 6 11.99 2.18 0.1174
Fixture 82.79 2 41.4 7.55 0.0076
Layout*Fixture 19.04 2 9.521 1.74 0.2178
Fixture*Operator(Layout) 65.83 12 5.486 2.35 0.0360
 Residual 56.0 24 2.333
Total (corrected) 299.7 47

Expected Mean Squares

Table 12.4: Expected Mean Squares
Source EMS
Layout (6)+2.0(5)+6.0(2)+Q1
Operator(Layout) (6)+2.0(5)+6.0(2)
Fixture (6)+2.0(5)+Q2
Layout*Fixture (6)+2.0(5)+Q3
Fixture*Operator(Layout) (6)+2.0(5)
Residual (6)

Variance Components
Table 12.5: Variance Components

Source Estimate
Operator(Layout) 1.083
Fixture*Operator(Layout) 1.576
Residual 2.333

12.6 Material and Labour

As stated in the previous chapter, there can be only two explanations for the flexible budget variance
for variable costs. First, there can be a difference between budgeted input prices and actual input
prices: the company paid more per yard of fabric, or less per pound of steel, than planned. Second,
there can be an efficiency piece: the company used more fabric per pair of pants, or fewer pounds of
steel per widget, than planned. In this chapter, we separate the flexible budget vari ance for direct
materials into these two pieces: the ―price‖ piece, and the ―efficiency‖ piece. At the end of the
chapter, we extend the discussion to other variable costs direct labour and variable overhead.

12.6.1 How to Calculate Material & Labour Variances

Calculating Variances
Material and labour variances allow a comparison between the budgeted amount of material and
labour used compared to the actual amount of material and labour used.
Instructions for Material Variances
Determine the actual quantity of a product produced the price to produce the product, the
budgeted price of the product, the actual material used and the budgeted material used. For
example, Firm A produces widgets. During the year it produced 2,000 widgets at a cost of INR
150 per widget, and INR 175 was budgeted per widget. The company budgeted 1,000 units for
direct materials, but it took 1,300 units to produce the widgets.
 Multiply actual quantity purchased by the difference of actual price and budgeted price. This
equals the direct materials price variance. In the example, direct materials price variance is INR
1, 00,000 X (INR175-INR150) which equals INR 50,000.
Multiply the budgeted price by the difference between actual materials used and budgeted
materials. This equals the direct materials quantity variance. In the example, direct materials
quantity variance

12.6.2 Derivation of the Direct Materials Variances:

Given these definitions, the flexible budget can be expressed as
SQ x SP;
And the flexible budget variance can be expressed as
(AQ x AP) – (SQ x SP) (1)
By introducing the following expression, we can separate the flexible budget variance into two
pieces.
AQ x SP
This expression measures what the company ―should have spent‖ for the actual quantity of inputs
used. We insert this expression into Equation (1) for the flexible budget variance:
(AQ x AP) – (AQ x SP) – (SQ x SP) (2)
The first difference in Equation (2) can be rewritten as follows:
(AQ x AP) – (AQ x SP) = AQ x (AP – SP)
This expression is the price variance. It is the actual inputs used in production (AQ) multiplied by
the difference between the budgeted price (SP) and the actual price (AP) paid per unit of input. The
price variance is abbreviated PV. Hence:
PV = AQ x (AP – SP)

12.6.3 Labour Variances

Determine the actual hours worked, the actual rate charged for labour, the budgeted rate for
labour, the actual hours of worked and the budgeted hours for the period. Firm A has employees
work 400 hours for a planned INR 6 an hour, but it actually cost INR 6.50 due to over time. The
firm budgeted for 350 hours of work.
Multiply actual hours worked by the difference between actual rate and budgeted rate. This is
direct labour rate variance. In the example, direct labour rate variance is 400 X (INR6.50 -INR 6)
which equals INR 200.
Multiply the standard rate by the difference between actual hours worked and standard hours
worked. This is the direct labour efficiency variance. In the example, INR 6 X (400 - 350) which
equals INR 300.

12.6.4 Cost Variances for Direct Labour:

The formulas for splitting the flexible budget variance into a ―price‖ variance and ―quantity‖
variance are the same for direct labour as direct materials. However, the terminology differs
slightly. What is called the price variance for direct materials is called the rate variance or wage rate
variance for direct labour. However, we retain the same abbreviations:
PV = AQ x (AP – SP)
Where AQ is the actual labour hours used in production, AP is the actual wage rate, and SP is the
budgeted wage rate.
What is called the quantity or usage variance for direct materials is called the efficiency variance for
direct labour. We abbreviate this variance as EV:
EV = SP x (AQ – SQ)
Where SP and AQ are the same as above and SQ is the flexible budget quantity of labour hours (the
labour hours the factory should have used for the volume of output units produced).
The issue discussed earlier in this chapter regarding the timing of the recognition of the price
variance for direct materials does not arise for direct labour. Consequently, for direct labour, the
sum of the wage rate variance and efficiency variance always equals the flexible budget variance.

Did you know?

The cost accounting which is designed to find out how much s hould be the cost of a product under
the existing conditions.

Caution
This allows management to tell if there is a favourable or unfavourable variance. Once management
makes these determinations, they can determine proper changes in budgets and planning in the
future.

Case Study: Standard Costing and Variance Analysis

Effect of Assumed Standard Levels
Harden Company has experienced increased production costs. The primary area of concern
identified by management is direct labour. The company is consideri ng adopting a standard cost
system to help control labour and other costs. Useful historical data are not available because
detailed production records have not been maintained.
To establish labour standards, Harden Company has retained an engineering cons ulting firm. After a
complete study of the work process, the consultants recommended a labour standard of one unit of
production every 30 minutes, or 16 units per day for each worker. The consultants further advised
that Harden's wage rates were below the prevailing rate of INR per hour.
Harden's production vice-president thought that this labour standard was too tight, and from
experience with the labour force, believed that a labour standard of 40 minutes per unit or 12 units
per day for each worker would be more reasonable. The president of Harden Company believed the
standard should be set at a high level to motivate the workers and to provide adequate information
for control and reasonable cost comparison. After much discussion, management decided to use a
dual standard.
The labour standard of one unit every 30 minutes, recommended by the consulting firm, would be
employed in the plant as a motivation device, while a cost standard of 40 minutes per unit would be
used in reporting. Management also concluded that the workers would not be informed of the cost
standard used for reporting purposes. The production vice -president conducted several sessions prior
to implementation in the plant, informing the workers of the new standard cost system and
answering questions. The new standards were not related to incentive pay but were introduced when
wages were increased to INR 350 per hour.
Questions
How to increased production cost in standard costing?
Discuss about the Harden Company.

12.7 Summary
Variance means difference while analysis means breakdown.
A standard cost is a planned or forecast unit cost for a product or service, which is assumed to
hold good given expected efficiency and cost levels within an organization.
Efficiency variance results from the use of more or less activity measure which is used as cost
driver than the standard quantity, given the actual output
Standards for raw materials are determined by two elements: the amount of material required and
its price.
Variances are important, because management can use them to identify potential inefficiencies in
the manufacturing process.

12.8 Keywords
Analysis of Variances: An important technique for analyzing the effect of categorical factors on a
response is to perform an Analysis of Vari ance
Analysis: It is the process of breaking a complex topic or substance into smaller parts to gain a
better understanding of it.
Budgetary Control: Budgetary control is extensive in nature and the intensity of analysis tends to be
much less than that in standard costing
Standard Costs: The costs which should be incurred (based on performance standards developed by
the organization) in manufacturing the organization‘s inventory or providing the organization‘s
services.
Types of standard: Standard in simple words is a measure of what is expected to take place under
the current or anticipated circumstances
Variance: The difference between the actual costs of manufacturing inventory or providing services
and the costs that should be incurred based on performance standards (standard costs).

12.9 Self Assessment Question

1. …………………………is the technique of analyzing the process of manufacturing a product to
determine what it should cost
(a) Analysis of Historical Data (b) Task Analysis
(c) Variance Analysis (d) None of these.

2. …………………………. is the difference between a budgeted or standard amount and the actual
amount during a given period.
(a) Variance (b) Cost variance
(c) Variance Analysis (d) None of these.

3. A standard cost is a planned or forecast unit cost for a product or service, which is assumed to
hold good given expected efficiency and cost levels within an organization.
(a) True (b) False

4. Actual costing can be used for budget preparation, control through exception reporting, stock
valuation.
(a) True (b) False

5. ……………………………is determined by examining the actual purchase cost of the finished

purchased part or raw material to determine the variance from the be previously established
standard.
(a) Material Usage Variance (b) Material Variances
(c) Price variance (d) None of these

6. The ……………………....is the difference between the standard and the actual hours extended by
the standard hourly labour rate.
(a) direct labour variances (b) labour efficiency variance
(c) labour rate variance (d) None of these.

7. The factory overhead variances are the difference between the actual overhead drawn and the
budgeted allowance estimated for the capacity utilized.
(a) True (b) False

8. Direct material cost variance is the difference between the standa rd direct wages specified for the
activity achieved and the actual direct wages paid.
(a) True (b) False

9. Actual amount paid or incurred, as opposed to estimated cost or standard cost is known as
…………………………..
(a) actual cost (b) standard costs
(c) cost variance (d) None of these.

10. A flexible budget calculates budgeted costs based on the actual output level in the budget period.
(a) True (b) False

12.10 Review Questions

1. What is standard costing and variance analysis?
2. What are the different types of variance analysis?
3. What is variance and how it is related to budgeting and cost control technique?
4. What are the advantages and limitation of standard costing?
5. What is the difference between material price variance and material usage vari ance?
6. Explain the difference between overhead spending variance and capacity variance.
7. What are the problems encountered in the interpretation of variance?
8. Explains the various reasons for variance.
9. What are the differences between factory overhead varianc e and overhead spending variance?
10. What are the two primary causes of direct materials and direct labour variances?

Answers of Self Assessment Questions

1. (b) 2. (a) 3. (a) 4. (b) 5. (c)
6. (b) 7. (b) 8. (a) 9. (a) 10. (a)
 13
Definition of Marginal Cost and
Marginal Costing
CONTENTS
Objectives
Introduction
13.1 Understand the Assumptions and uses of Marginal Costing
13.2 Differences between Marginal and Absorption Costing
13.3 Absorption Costing and Marginal Costing
13.4 Contribution Margin
13.5 Summary
13.6 Keywords
13.7 Self Assessment Questions
13.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Understand the assumptions and uses of marginal costing
Differences between marginal costing and absorption costing
Explain the marginal cost equation
Discuss the contribution margin

Introduction
In the preceding unit, we familiarised you with the different elements of cost i.e. Materials labour
and expenses. These elements of cost can broadly be put into two categories: Fixed and variable
costs. Fixed costs are those which do not vary but remain c onstant within a given period of time in
spite of fluctuations in production. The examples of fixed costs are: rent, insurance charges,
management salaries, etc. On the other hand, variable costs are those which vary in direct proportion
to any change in the volume of output. The costs of direct material, direct wages etc can be put into
this category. The cost of a product or process can be ascertained (using the different elements of
cost) by any of the following two techniques:

13.1 Understand the Assumptions and uses of Marginal Costing

Marginal costing is not a method of costing on the lines of Job or process costing, but is a special
technique which presents information to management enabling it to measure the Profitability of an
undertaking by considering the behaviour of costs. Marginal costing may be used in conjunction
with other costing methods like job or process costing or with other techniques such as standard
costing or budgetary control. Marginal cost is nothing but variable costs. It is cle arly composed of
all direct costs and variable overheads. The I.C.M.A London has defined marginal costs ‗as the
amount at any given volume of output by which aggregate costs are changed, if volume of output is
increased or decreased by one unit‘. In simple words, marginal cost is the additional cost of
predicting additional units. An important point is that marginal cost per unit remains unchanged
irrespective of the level of activity. The following example would further clarify the concept of
marginal costs. This definition makes it clear that marginal costing goes beyond the ascertainment of
costs. It is a technique concerned with the effect on profit when the volume or type of output
changes. In particular, marginal costing studies the effect which fixed cost has on the running of a
business.

13.1.1. Characteristics of Marginal Costing

The essential characteristic and mechanism of marginal costing technique may be summed up as
follows:
Segregation of costs into fixed and variable elements .
In marginal costing all costs are classified into fixed and variable. Semi -costs are also segregated
into fixed and variable elements.

Marginal costs as products costs.

Only marginal (variable) costs are charged to products costs.

Fixed costs as period costs

Fixed costs are treated as period costs are charged to costing Profit and Loss Account of the period
in which they are incurred.

Valuation of inventory
The work-in progress and finished stocks are valued at marginal costs only.

Contribution.
Contribution is the difference between sales value and marginal costs of sales. The relative
profitability of products or departments is based on a study of ‗contribution‘ made by each of the
products or departments.

Pricing
In marginal costing, prices are based on marginal cost plus contribution.
13.1.2 Marginal costing and profit
In marginal costing, profit is calculated by a two stage approach. First of all contribution is‘
determined for each product or departments. The contributions of various products or departments
are pooled together and such a total contributions from all products is called ‗Fund‘. Then from this
fund is deducted the total fixed cost to arrive at a profit or loss. This is illustrated below:

Figure 13.1: Marginal costing and profit

Marginal Costing may be defined as ―the ascertainment by differentiating between fixed cost and
variable cost, of marginal cost and of the effect on profit of changes in volume or type of output."
With marginal costing procedure costs are separated into fixed and variable cost. Marginal costing is
―a technique of cost accounting pays special attention to the behaviour of costs with changes in the
volume of output." This definition lays emphasis on the ascertainment of marginal costs and als o the
effect of changes in volume or type of output on the company's profit.

Marginal Costing
Features of Marginal Costing
All elements of costs are classified into fixed and variable costs.
Marginal costing is a technique of cost control and decision making.
Variable costs are charged as the cost of production.
Valuation of stock of work in progress and finished goods is done on the basis of variable costs.
Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of sellin g price
over marginal cost of sales.
Profitability of various levels of activity is determined by cost volume profit analysis

13.1.2 Marginal Cost

The ten Marginal Cost refers to the amount at any given volume of output by which the aggregate
costs are charged if the volume of output is changed by one unit. Accordingly, it means that the
added or additional cost of an extra unit of output. Marginal cost may also be defined as the ―cost of
producing one additional unit of product." Thus, the con cept marginal cost indicates wherever there
is a change in the volume of output; certainly there will be some change in the total cost.
It is concerned with the changes in variable costs. Fixed cost is treated as a period cost and is
transferred to Profit and Loss Account. The technique of marginal costing is concerned with
marginal cost. It is, therefore, necessary for you to understand correctly the term ‗Marginal Cost‘.
Management Accountants, Marginal Cost as ―the amount at any given volume of output by which
aggregate costs are changed if the volume of output is increased by one unit ‖. On analysing this
definition we can conclude that the term "Marginal Cost" refers to increase or decrease in the
amount of cost on account of increase or decrease of pro duction by a single unit
.
13.1.3 Break-Even Analysis
The term ‗Break-even Analysis‘ refers to a system of determination of that level of activity where
total cost equals total selling price. However, in the broader sense, it refers to that system of
analysis which determines the probable profit at any level of activity. The relationship between cost
of production, volume of production, profit and sales value is established by break -even analysis.
The analysis is also known as

Cost-volume-profit analysis.
Break-even analysis is useful for a manager in the following ways
It helps him in forecasting the profit fairly accurately.
It is helpful in setting up flexible budgets, since on the basis of Cost -volume
Profit relationship, one can ascertain the costs, sales and profits at different levels of activity.
It assists in performance evaluation for purposes of management control.
It helps in formulating price policy by projecting the effect which different price structures will
have on costs and profits.
It helps in determining the amount of overhead cost to be charged at various levels of operations,
since overhead rates are generally pre-determined on the basis of a selected volume of
production.
Thus, cost-volume-profit analysis is an important medium through which one can have an insight
into effects on profit due to variations in costs (both fixed and variable and sales (both volume
and value). This enables us to take appropriate decisions. This aspect will be discussed in detail
in the next unit of this course.
However, it will be expedient for us to understand at this stage the meaning of and the technique
of determining the break-even point.

Break-even Point
It refers to that level of activity where the income of the business exactly equals its expenditure. In
other words, it is a `no profit, no loss' point. If production is increased beyond this level, profit shall
accrue to the business and if it is decreased below this level, loss shall b e suffered.
Did you know?
In relation to a given volume of output, additional output can normally be obtained at less than
proportionate cost because within limits, the aggregate of certain items of cost will tend to remain
fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in
output.

13.2 Differences between Marginal and Absorption Costing

The difference between Absorption Costing and Marginal Costing is based on the recovery of fixed
overheads. The difference in valuation of inventory under the two techniques is a consequence of
such treatment. However, for the sake of clarity, we are analysing the difference from both angles,
viz. recovery of overheads and valuation of stock.

13.2.1 Recovery of overheads

In case of Absorption Costing, both fixed and variable overheads are charged to production. On the
other hand, in Marginal Costing only variable overheads are charged to production while fixed
overheads are transferred in full to the profit and loss ac count. Thus, in case of marginal Costing,
there is under- recovery of overheads since only variable overheads is charged to production.

13.2.2 Valuation of Stocks

In Absorption Costing stocks of work -in-progress and finished goods are valued at works c ost and
total cost of production respectively. The works cost or cost of production is so defined as to include
the amount of fixed overheads also. In marginal Costing, only variable costs are considered while
computing the value of work-in progress or finished goods. Thus, the closing stock in Marginal
Costing is undervalued as compared to Absorption Costing. But this does not result in carrying over
of fixed overheads of one period to another, as it happens in Absorption Costing.
The above points of difference will become clear with the help of the following
Under Absorption Costing all fixed and variable costs are recovered from production while
under Marginal Costing only variable costs are charged to production.
Under Absorption Costing valuation of stock of work in progress and finished goods is done on
the basis of total costs of both fixed cost and variable cost. While in Marginal Costing valuation
of stalk of work in progress and finished goods at total variable cost only.
Absorption Costing focuses its attention on long -term decision making while under Marginal
Costing guidance for short-term decision making.
Absorption Costing lays emphasis on production, operation or process while Marginal Costing
focuses on selling and pricing aspects.

Differential Costing
Differential Costing is also termed as Relevant Costing or Incremental Analysis. Differential
Costing is a technique useful for cost control and decision making.
According to ICMA London differential costing "is a technique based on preparation of adhoc
information in which only cost and income differences between two alternatives courses of actions
are taken into consideration." Differential Costing Differential C osting is also termed as Relevant
Costing or Incremental Analysis. Differential Costing is a technique useful for cost control and
decision making. According to ICMA London differential costing "is a technique based on
preparation of adhoc information in which only cost and income differences between two
alternatives courses of actions are taken into consideration.

The following are the differences between marginal costing and differential costing.
Differential Costing can be made in the case of both absorption costing as well as marginal
costing
While marginal costing excludes the entire fixed cost, some of the fixed costs may be taken into
account as being relevant for the purpose of differential cost analysis.
Marginal costing may be embodied in the accounting system whereas differential cost is worke d
separately as analysis statements.
In marginal costing, margin of contribution and contribution ratios are the main yardstick for the
performance evaluation and for decision making. In differential cost analysis differential costs
are compared with the incremental or detrimental revenues as the case may be.

13.3 Absorption Costing and Marginal Costing

Absorption costing technique is also termed as Traditional or ―Full Cost Method‖. According to this
method, the cost of a product is determined after considering both fixed and variable costs. The
variable costs, such as those of direct materials, direct l abour, etc. are directly charged to the
products, while the fixed costs are apportioned on a suitable basis over different products
manufactured during a period. Thus, in case of Absorption Costing all costs are identified with the
manufactured products. This will be clear with the help of the following.

Thus, the technique of Absorption Costing may lead to rather odd results particularly for seasonal
businesses in which the stock levels fluctuate widely from one period to another. Their profits for
the two periods will be influenced by the transfer of overheads in and out of stock, showing falling
profits when the sales are high and increasing profits when the sales are low. The technique of
Absorption Costing may also lead to the rejection of profitable business. The total unit cost will tend
to be regarded as the lowest possible selling price.

Advantages of Marginal Costing

The following are the important decision making areas where marginal costing technique is used
Pricing decisions in special circumstances.
Pricing in periods of recession
Use of differential selling prices.

13.4 Contribution Margin

Contribution margin is defined as the extent to which each unit sale contributes to a business‘s fixed
cost base.
In other words, a business‘s contribution margin is equal to: unit price – variable costs per unit. In
cost-volume-profit analysis, a form of management accounting, contribution margin is the marginal
profit per unit sale. It is a useful quantity in carrying out various calculations, and can be used as a
measure of operating leverage. Typically, high contribution margins are prevalent in the labour -
intensive tertiary sector while low contribution margins are prevalent in the capital -intensive
industrial sector. Contribution margin analysis is a measure of operating leverage: it measures how
growth in sales translates to growth in profits. The contribution margin is computed by using a
contribution income statement: a management accounting version of the income statement that has
been reformatted to group together a business‘s fixed and variable costs.

Contribution is different than gross margin in that a contribution calculation seeks to separate out
variable costs from fixed costs on the basis of economic analysis of the nature of the expense
whereas gross margin is determined using accounting standards. Calculating the contribution margin
is an excellent tool for managers to help determine whether to keep or drop certain aspects of the
business. For example, a production line with positive contribution margin should be kept even it
causes negative total profit, when the contribution margin offsets part of the fixed cost. However, it
should be dropped if contribution margin is negative because the c ompany would suffer from every
unit it produces. The contribution margin analysis is also applicable when the tax authority performs
tax investigation, by identifying target interviewee who has unusual high contribution margin ratio
then other companies in the same industry. Contribution margin is also one of the factors to judge
whether a company has monopoly power in competition law, such as use of the Lerner Index test

Case Study
This report presents a case study of how marginal -cost analysis can be used to influence investment
decisions, not only in deciding whether to procure a major weapon system, but also how to invest
R&D dollars for maximum potential leverage in the long run. The case involves the strategic
defence system, following President Reagan's "Star Wars" speech of. The analysis presented here
addresses the relative costs to the defender and the attacker in a race in which attackers added re -
entry vehicles and defenders added interceptors. The initial results, based on the technology
necessary for near-term deploy me, were very unfavourable. Subsequent analysis considered a
variety of plausible technological breakthroughs and highlighted the potential value of what came to
be called "brilliant pebbles," although great uncertainty remained ab out whether a favourable
marginal cost ratio could be obtained.
While not a complete policy analysis, the study is an important example of systems analysis: it
affected policy at the time by tempering the claims of strategic defence enthusiasts and channe lling
R&D and architecture studies in fruitful directions.
Questions
1. Explain the marginal-cost analysis.
2. Explain the channelling of R&D.

13.5 Summary
Marginal costing is regarded as superior to traditional costing so far as managerial decision -
making is concerned. It identifies only such costs with the jobs or products which directly vary
 with the level of output. The uncertainty and irrationality associated.
The technique of marginal costing greatly helps the management in taking appropriate
managerial decisions, viz., dropping a product line, making or buying a component, shut -down
or continuation of operations in periods of trade depression, fixation of minimum selling price of
a product, etc.
Marginal costing involves computation of marginal cost. The term marginal cost is synonymous
with the term `variable cost'. It comprises of direct material, direct labour, variable direct
expenses and variable overheads

13.6 Keywords
Absorption Costing: A technique where all costs, fixed as well as variable, are allotted to cost units.
Break-even Point: It refers to the level of activity where the income of the business exactly equals
its expenditure. It is also termed as no profit, no loss' point.
Contribution: It refers to the excess of selling price over variable cost.
Marginal Cost: The variable cost of one more unit of a product or service, i.e. a cost which would
be avoided if the unit was not produced or service not provided.
Marginal Costing: A technique whereby marginal cost of a product is ascertained. Only variable
costs are charged to production. Fixed costs are charged against the contribution of the period. It is
also termed as `variable costing'.

13.7 Self Assessment Questions

1. The collection and presentation of accounting information come within the area of Cost
accounting.
(a) True (b) False

2. A study of sociology helps to understand the behaviour of man in groups.

(a) True (b) False

3. Cost accounting is.................. to management needs.

(a) low sensitive (b) highly sensitive
(c) Both a and b (d) None of these.

4. Thus, cost......... analysis is an important medium through which one can

(a) cost marginal (b) profit
(c) volume-profit (d) None of these

5. The work-in progress and finished stocks are valued at marginal costs only.
(a) True (b) False

6. The overhead expenses which do not vary with the activity level are called......
(a) variable overheads (b) fixed overheads
(c) semi variable overheads (d) none of these

7. To use of job...........method will be useful for accounting system

(a) labour (b) person
(c) costing (d) accountant

8. This method is followed where by-products cost………. are processed to dispose of waste
material more
(a)products cost (b) financial
(c)material (d) None of these

9. The standard may be arrived at on the basis of past average ……….. Or may be fixed according to
the principles of standard costing
(a) price (b) financial
(c) costing (d) None of these

10. The type of spoilage that should not affect the cost of inventories is
(a) abnormal spoilage (c) seasonal spoilage
(b) normal spoilage (d) indirect spoilage

13.8 Review Questions

1. What do you understand by marginal costing?
2. Explain briefly the features of marginal costing.
3. What are the differences between absorption costing and marginal costing?
4. What is mean by differential costing?
5. Compare and contrast marginal costing and differential costing.
6.Define break-even point.
7. Briefly explain the advantages and limitations of marginal costing.
8. What do you understand by cost volume profit analysis?
9.Define contribution.
10. Explain marginal cost equation
Answers for Self Assessment Questions
1. (a) 2.(a) 3.(b) 4.(c) 5.(a)
6. (b) 7.(c) 8.(b) 9.(b) 10.(a)
 14
Profit-Volume Ratio
CONTENTS
Objectives
Introduction
14.1 Breakeven Point
14.2 Margin of Safety
14.3 Angle of incidence
14.4 Decision Making with the Held of Marginal Costing
14.5 Summary
14.6 Keywords
14.7 Self Assessment Question
14.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Explain about break-even point
Describe margin of safety
Define angle of incidence
Explain the marginal costing

Introduction
The cost functions and cost relations with the production and distribution system of an economic
entity. To assist planning and decision making, management should know n ot only the budgeted
profit, but also:
the output and sales level at which there would neither profit nor loss (break -even point)
the amount by which actual sales can fall below the budgeted sales level, without a loss being
incurred (the margin of safety)
Marginal Costs, Contribution and Profit
A marginal cost is another term for a variable cost. The term ‗marginal cost‘ is usually applied to
the variable cost of a unit of product or service, whereas the term ‗variable cost‘ is more commonly
applied to resource costs, such as the cost of materials and labour hours. Marginal costing is a form
of management accounting based on the distinction between:
The marginal costs of making selling goods or services, and
Fixed costs, which should be the same for a gi ven period of time, regardless of the level of
activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of INR 50 per unit and
that sells for INR 90 per unit. For every additional unit of the product that is mad e and sold, the firm
will incur an extra cost of INR 50 and receive income of INR 90. The net gain will be INR 40 per
additional unit. This net gain per unit, the difference between the sales price per unit and the
marginal cost per unit, is called contribution.
Contribution is a term meaning ‗making a contribution towards covering fixed costs and making a
profit‘. Before a firm can make a profit in any period, it must first of all cover its fixed costs.
Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor
loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the
contribution per unit.
Cost Volume Profit analysis is broadly known as CVP. Specifically speaking, we all are concerned
with in-depth analysis and application of CVP in practical world of industry management.

Profit-volume ratio (P.V.R.)

This indicates the relation between the sales value and its corresponding contribution. This explains
the rate at which sales are contributing towards the recovery of fixed costs and profit. A high ratio
means that breakeven point is achieved soon after which profit is earned at a higher rate and a low
ratio implies the opposite. The following formula calculates this ratio .

From the above discussion, we can understand that the term ―Profit Volume Ratio‖ is rather
misleading, because the term profit where actually means, the contribution of the sales and the term
volume actually means sales value and not the sales volume. Therefore, properly speaking it should
be called Contribution Sales Ratio (C.S.R.). However, since the term P.V.R. is widely used, we also
use the same name in our lessons. Every organisation strives to improve their P.V. ratio ether by
reducing the variable cost per unit or by increasing the selling price per unit whichever is possible.
A high P.V. ratio earns profits at an accelerated rate and vice versa. The P.V. ratio can be depicted
graphically.

Profit Volume Ratio (P/V Ratio)

The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales
and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of
change of profit due to change in volume of sales.
A fundamental property of marginal costing system is that P/V ratio remains constant at different
levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the
following:
Breakeven point
Profit at any volume of sales
Sales volume required to earn a desired quantum of profit
Profitability of products
Processes or departments

The contribution can be increased by increasing the sales price or by reduction of variable costs.
Thus, P/V ratio can be improved by the followin g:
Increasing selling price
Reducing marginal costs by effectively utilizing men, machines, materials and other services
Selling more profitable products, thereby increasing the overall P/V ratio

When the contribution from sales is expressed as a sales value percentage, then it is known as
profit/volume ratio (or P/V ratio). The relationship between the contribution & sales is expressed by
it. Sound ‗financial health‘ of a company‘s product is indicated by better P/V ratio. The change in
profit due to change in volume is reflected by this is reflected by this ratio. If expressed on equal
footing with sales, it will show how large the contribution will appear. If size of sales is INR 100,
then P/V ratio of 60% will mean that contribution is INR 60.
One important characteristic of P/V ratio is that at all levels of output it will remain constant
because at various levels, variable cost as a proportion of sales remains constant.. When P/V ratio is
considered in conjunction with margin of safety, it becomes pa rticularly useful. P/V ratio can be
referred by other terms like:
(a) Marginal income ratio,
(b) Contribution to sales ratio, &
(c) Variable profit ratio.
P/V ratio may be expressed as:
P/V ratio= Contribution / Sales
= Sales – Variable cost
Sales
= 1- Variable cost
Sales
Or, P/V ratio = Fixed Cost + Profit
Sales
It is also possible to express the ratio in terms of percentage by multiplying by 100. Thus a
relationship between the contribution & sales is established by the profit/volume ratio. Hence it
might be better to call it as a Contribution/Sales ratio (or C/S ratio), though the term Profit/Volume
ratio (P/V ratio) is now widely called.
Also, by comparing the change in contribution to change in sales or by change in profit to change in
sales, it is possible to compute the ratio. Because it is assumed that the fixed cost will remain the
same at different levels of output, an increase in contribution will mean increase in profit.
Thereby, P/V ratio =Change in contribution
Change in sales
Or, Change in profit
Change in Sales
Improvement in P/V ratio should always be tried to be bought in by the management. The higher the
rate, the greater will be the contribution towards fixed costs & profit.

Cost-Volume-Profit (C-V-P) Relationship

We have observed that in marginal costing, marginal cost varies directly with the volume of
production or output. On the other hand, fixed cost remains unaltered regardless of the volume of
output within the scale of production already fixed by management. In case if cost behaviour is
related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed,
variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed
remains fixed and then there is a change in profit. Being a manager, you constantly strive to relate
these elements in order to achieve the maximum profit.
Apart from profit projection, the concept of Cost -Volume-Profit (CVP) is relevant to virtually all
decision-making areas, particularly in the short run. The relationship among cost, revenue and profit
at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in
various statement forms. Profit depends on a large number of factors, most i mportant of which are
the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of
sales depends upon the volume of production and market forces which in turn is related to costs.
Management has no control over market. In order to achieve certain level of profitability, it has to
exercise control and management of costs, mainly variable cost. This is because fixed cost is a non -
controllable cost. But then, cost is based on the following factors:
Volume of production
Product mix
Internal efficiency and the productivity of the factors of production
Methods of production and technology
Size of batches
Size of plant

Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit
structure. This enables management to distinguish among the effect of sales, fluctuations in volume
and the results of changes in price of product/services.
In other words, CVP is a management accounting tool that expresses relationship among sale
volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost -volume- profit
analysis can answer a number of analytical questions. Some of the questions are as follows:
What is the breakeven revenue of an organization?
How much revenue does an organization need to achieve a budgeted profit?
What level of price change affects the achievement of budgeted profit?
 What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other ―what if‖ type o f questions. Cost-volume-
profit analysis is one of the important techniques of cost and management accounting. Although it is
a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It
provides an answer to ―what if‖ theme by telling the volume required producing.
Following are the three approaches to a CVP analysis:
Cost and revenue equations
Contribution margin
Profit graph

Did you know?

A profit-volume ratio is one financial calculation used in operating a business to determine
profitability and to make decisions about the future of the business.

Objectives of Cost-Volume-Profit Analysis

In order to forecast profits accurately, it is essential to ascertain the relationship between cost
and profit on one hand and volume on the other.
Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at
various levels of activities.
Cost-volume-profit analysis assists in evaluating performance for the purpose of control.
Such analysis may assist management in formulating pricing policies by projecting the effect of
different price structures on cost and profit.

14.1 Breakeven Point

Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we
can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation,
P/V ratio or contribution per unit.
Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
Using P/V Ratio
Contribution at BEP Fixed cost
Sales S BEP = =
P/ V ratio P/ V ratio
Thus, if sales is INR. 2,000, marginal cost INR. 1,200 and fixed cost INR. 400, then:
400 x 2000
Breakeven point = = INR. 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
 800
So, breakeven sales = INR. 400 / .4 = INR. 1000

Using Contribution per unit

Fixed cost
Breakeven point = = 100 units or INR. 1000
Contribution per unit

14.1.1 Breakeven Analysis Graphical Presentation

Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful
graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and
fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of
change of one factor on other factors and exhibits the rate of profit and margin of safety at different
levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of
intersection called breakeven point. It is popularly called breakeven chart because it shows clearly
breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different
volumes of sales.

14.1.2 Construction of a Breakeven Chart

The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and
sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to
horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points.
This will give total cost line. Alternatively, obtain total cost at different levels; pl ot the points
starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so
obtained.

14.1.3 Uses of Breakeven Chart

A breakeven chart can be used to show the effect of changes in any of the following profit factors:
Volume of sales
Variable expenses
Fixed expenses
Selling price

14.1.4 Limitations and Uses of Breakeven Charts

A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and
sales price remain constant. In practice, all these fact INR may change and the original breakeven
chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the
original combined breakeven chart fails to give a clear picture when the sales mix changes. In this
case, it may be necessary to draw up a breakeven chart for each product or a group of products. A
breakeven chart does not take into account capital employed which is a very important factor to
measure the overall efficiency of business. Fixed costs may increase at some level whereas variable
costs may sometimes start to decline. For example, with the help of quantity discount on materials
purchased, the sales price may be reduced to sell the additional units produced etc. These changes
may result in more than one breakeven point, or may indicate higher profit at lower volumes or
lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e.
in forecasting, decision-making, long term profit planning and maintaining profitability. The margin
of safety shows the soundness of business whereas the fixed cost line shows the degree of
mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the
product or division under consideration. It also helps a monopolist to make price discrimination for
maximization of profit.

14.1.5 Profit Graph

Profit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of
profit to volume of sales. The construction of a profit graph is relatively easy and the procedure
involves the following:
Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or
loss on vertical axis. The area above horizontal axis is called profit area and the one below it is
called loss area.
Plotting the profits of corresponding sales and joining them. This is profit line.

A business Firm usually pursues a profit objective. In a way, it plans for maximizing its profit. Both
the operations plan and the over-all plan of the firm are couched in terms of this `profit objective;
and their primary variables are cost, volume, and p rofit forecast for the planning period. The critical
variable is usually the `volume of sales forecast' around which costs and profit estimates are built.
A question often faced in the planning stage itself is: what will happen to profit if the forecast l evel
of sales changes? Such a question will not always be irrelevant because conditions change so
rapidly. A manager seeking an appropriate answer to this question would obviously want to get some
guidance. The profit graph which shows the relationship bet ween profit and volume (P/V
relationship) helps to provide the questioning manager a possible answer.
We will recall from the calculations presented in the previous section about gauging the impact of
changes in price, volume, etc., on profit that a term called 'marginal income' was calculated.
Marginal income' is the difference between sales and variable expenses and represents total
contribution to fixed expenses and profit. This term may be understood in another way as well. If
variable expenses are expressed as a per cent of sales we get the variable cost ratio. Then, total
contribution or marginal income is equal to "1 -variable cost ratio‖. The variable cost ratio for the
normal volume of sales is 50% or .50. Total contribution or marginal income would , therefore, be 1-
.50 = .50 or 50%. Another term for `marginal income' is P/V ratio or the profit -volume ratio. You
must note that the P/V ratio is not obtained by dividing sales volume by profit but by deducting the
variable cost ratio from unity

Figure 14.1: Profit Graph

Break-Even Analysis is used to
o predict future profits/losses
o predict results e.g. produce Product A or Product B
Break-Even Point is when Sales Revenue equals Total Costs
at this point no profit or loss is incurred
the firm merely covers its total costs
Break-Even Point can be shown in graph form or by use of formulae
When the total costs incurred and the total value of sales made are equal, the organisation attains a
stage of no loss and no profit i.e., the sale proceeds are just enough to cover the total costs (both the
fixed costs and variable costs). This position is called the break -even point. If sales go up beyond
the break-even point, organisation makes a profit; if they come down, a loss is incurred. Thus, sales
at break-even point are the minimum amount of sales that must be effect in order to avoid any loss.
This figure is very useful for accountants in studying the profit factors. In this context acknowledge
of the marginal costing method is essential for the study of break - even analysis. It may be said that
break even analysis is simply an extension of the principles of marginal costing.

14.1.6 Breakeven Analysis Graphical Presentation

Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful
graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and
fixed costs, and profit or loss at different levels of activ ity. Such a chart also shows the effect of
change of one factor on other factors and exhibits the rate of profit and margin of safety at different
levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of
intersection called breakeven point. It is popularly called breakeven chart because it shows clearly
breakeven point (a point where there is no profit or no loss). Profit graph is a development of simple
breakeven chart and shows clearly profit at different volumes of sales.

14.1.7 Break-Even Analysis

In order to calculate how profitable a product will be, we must firstly look at the Costs involved.
There are two basic types of costs a company incurs.
Variable Costs
Fixed Costs

Variable costs are costs that change with changes in production levels or sales. Examples include:
Costs of materials used in the production of the goods.
Fixed costs remain roughly the same regardless of sales/output levels. Examples include: Rent,
Insurance and Wages
Total Costs
Total Costs is simply Fixed Costs and Variable Costs added together.
TC = FC + VC
As Total Costs include some of the Variable Costs then Total Costs will also change with any
changes in output/sales.
If output/sales rise then so will Total Costs.
If output/sales fall then so will Total Costs.

14.1.8 Breakeven Point in Sales Revenue

Here also, numerator is the same fixed costs. The denominator now will be weighted average
contribution margin ratio which is also called weighted average P/V ratio. The modified formula is
as follows:
Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio

Caution
Comparing a firm‘s ratios to average industry ratios requires a degree of importance.

14.2 Margin of Safety

Description: The margin of safety is the amount by which sales can drop before a company‘s
breakeven point is reached, expressed as a percentage. It is particularly useful in situations where
large portions of a company‘s sales are at risk, such as when they are tied up in a single customer
contract that can be cancelled. Knowing the margin of safety gives an analyst a good idea of the
probability that a company may find itself in difficult financial circumstances caused by sales
fluctuations. Conversely, if the margin of safety is a large percentage, then a company can likely
weather a substantial sales decline.
Formula: To calculate the margin of safety, subtract the breakeven point from the current sales level,
and then divide the result by the current sales level. To calculate the breakeven point, divide the
gross margin percentage into total fixed costs. This formula can be broken down into individual
product lines for a better view of risk levels within business units. The formula is as follows:
Current Sales Level – Breakeven Point
Current Sales Level
Here are two alternative versions of the margin of safety:
Budget based. A company may want to project its margin of safety under a budget for a future
period. If so, replace the current sales level in the formula with the bud geted sales level.
Unit based. If you want to translate the margin of safety into the number of units sold, then use
the following formula instead (though note that this version works best if a company only sells
one product):

Current Sales Level - Breakeven Point

Selling Price per Unit

14.3 Angle of incidence

Angle of incidence indicates the rate at which profit is earned in an organisation after crossing the
break-even point. In a break even chart, the angle at which the sales line cuts the total cost line is
called the angle of incidence.
While the point at which the sales and total cost line cut each other is called the break -even point,
the angle at which these lines intersect is called the angle of incidence. Sales after breakeven point
will bring profit; therefore, this angle indicates the profit earning rate of the business. Hence, it is
also called profit angle or profit path1n this sense, the concept of angle of incidence is an important
tool for management in times of expansion of the mar ket for the product.
Every business concern would like to have as large an angle of incidence as possible because a wide
angle represents a higher rate of profit earning and a narrow angle implies relatively a low rate of
return. The consideration of the angle of incidence arises only after meeting the entire amount of
fixed costs; therefore, the nature of the angle depends upon the incidence of variable costs. In other
words, a narrow angle indicates that variable costs form relatively a large part of the cost of the
product and vice versa.

14.3.1 There are two approaches used for representing a break-even point:
The algebraic method, and
The graphical method.
The angle formed by the sales line and the total cost line at the break -even point is known as Angle
of Incidence. The angle of incidence is used to measure the profit earning capacity of a firm. A large
angle of incidence indicates a high rate of profit and on the other hand a small angle of incidence
means that a low rate of profit.

14.3.2 Relationship between Angle of Incidence, Break-Even Sales and Margin of Safety Sales
When the Break-even sales are very low, with large angle of incidence, it indicates that the firm
is enjoying business stability and in that case margin of safety sales will als o be high.
When the break-even sales are low, but not very low with moderate angle of incidence, in that
case though the business is stable, the profit earning rate is not very high as in the earlier case.
Contrary to the above when the break-even sales are high, the angle of incidence will be narrow
with much lower margin of safety sales
14.4 Decision Making with the Held of Marginal Costing
The costs that vary with a decision should only be included in decision analysis. For many decisions
that involve relatively small variations from existing practice and/or are for relatively limited
periods of time, fixed costs are not relevant to the deci sion. This is because either fixed costs tend to
be impossible to alter in the short term or managers are reluctant to alter them in the short term.

14.4.1 Definition
Marginal costing distinguishes between fixed costs and variable costs as convention al ly classified.
The marginal cost of a product is its variable cost. This is normally taken to be; direct labour,
direct material, direct expenses and the variable part of overheads.

Marginal costing is formally defined as ‗the accounting system in which variable costs are charged
to cost units and the fixed costs of the period are written -off in full against the aggregate
contribution. Its special value is in decision making‘.
The term ‗contribution‘ mentioned in the forma l definition is the term given to the difference
between Sales and Marginal cost.

14.4.2 Contribution Sales Marginal Cost

The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total
marginal costs of a department or batch or operation. The meaning is usually clear from the context.
Alternative names for marginal costing are the contributio n approach and direct costing we will
study marginal costing as a technique quite distinct from absorption costing.

14.4.3 Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)
Fixed cost + Profit = Contribution ......(2)

By combining these two equations, we get the fundamental marginal cost equation as follows:

Sales – Marginal cost = Fixed cost + Profit ......(3)

This fundamental marginal cost equation plays a vital role in profit projection and has a wider
application in managerial decision-making problems.
The sales and marginal costs vary directly with the number of units sold or produced. So, the
difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the
ratio of contribution to sales remains constant at all levels.

Did you know?

The contribution margin can also be written as a contribution margin ratio relating profit to volume
expressed as the ratio of contribution margin to sales.
Caution
Cost behaviour can be viewed in terms of total costs or unit costs. Both approaches will be used, but
they are not interchangeable.

Case Study:On-site and Off-site Impact of Watershed Development of Rajasamadhiyala,

Gujarat, India
The world population is expected to touch 9.19 billion by 2050. Most of the population increase is
expected in developing countries in Asia and Africa. Each year an additional 0.25 billion metric tons
of grain must be produced to feed the increased population, which is 21% increase in food
production each year Looming water scarcity over large parts of the world and increased withdrawal
by agriculture from 2500 km3 in 2000 to 3200 km3 by 2025 has attracted the attention of po licy
makers and researchers for achieving food and water security. It is estimated that by 2025, one third
of the world‘s population (especially in the developing countries) would face severe water scarcity.
To achieve food security, minimize the water con flicts and reduce poverty it has become essential to
increase productivity of rainfed systems by harnessing the existing potential. Globally 80% of
agriculture is rainfed and contributes 60% to world‘s food basket. Current productivity levels of
rainfed agriculture are low. However, there are evidences to indicate that productivity of rainfed
systems could be doubled in Asia or even quadrupled in Africa with adoption of appropriate soil,
water and nutrient management options. The comprehensive assessment pr ogram has initiated an
exhaustive study to assess the water needs for food production, which includes a multilevel
assessment.
The main objectives of the rainfed project are:
To quantify potential of rainfed systems for achieving food security;
To quantify constraints, alternative technological, policy, and institutional options for achieving
the potential of rainfed systems; and
To suggest intervention strategies including supplemental irrigation for increasing productivity
through enhanced resource use efficiency.
In order to assess the achievable yields on farmers‘ field at micro -level we have adopted the
approach of detailed case studies in different regions where improved technologies are applied for
increasing productivity of rainfed systems. This case study is part of the larger study under the
comprehensive assessment of rainfed systems in the semi -arid tropics of India, where micro-level
studies at watershed scale will be linked to meso and macro levels using simulation modelling
approach at eco regional and global scales.
Main expected outputs from studies at different scales are to assess the potential contribution of
rainfed systems to global food basket, impact on livelihoods, environment, policy and institutional
guidelines to meet the achievable yields on larger scale and identify the research and development
needs to minimize the gap between potential and achievable yields of important crops in the rainfed
systems. In India watershed management is adopted on a large scale for conserving rainwater and
soil and also for increasing production of rainfed systems. In India various watershed programs have
spent more than INR 2 billion till 2004.

Introduction
Erratic and low rainfall, low fertility soils, poor infrastructure develo pment, along with high
population pressure with low literacy levels are some of the main causes of poverty in the SAT.
High demographic pressure of one billion people in India and additional 519 million people are
expected to be added by 2050. Furthermore 33% of the world‘s population mostly from developing
countries including India will be affected by water scarcity by 2025. Inherent low fertility soils in
the tropics are prone to severe land degradation and 51% of India‘s geographical area is categorized
as degraded, most of which occurs in rainfed agro -eco systems. Water and soil resources are finite,
non-renewable over the human life time frame, and prone to degradation through misuse and
mismanagement.
The Government of India adopted watershed manageme nt as a strategy to address the sustainable
agricultural productivity in the rainfed areas since the last three decades. Further GOI has adopted
watershed management as a national policy since 2003. The case study region of Sourashtra is
characterized by low, erratic and undependable rainfall with low productive soils. Scarcity of water
for agricultural and domestic purpose remains a major problem in the region and has led to low crop
productivity and environmental degradation. Decline in per capita agricul tural production has
seriously affected food security and livelihoods of people. Several studies have highlighted that
appropriate rainwater management and utilization results in enhanced agricultural productivity.
However, systematic assessment of on-site and off-site impact studies of watershed development are
lacking Through this study an attempt is made to study the on -site and off-site impact of
considerable rainwater harvesting measures implemented at Rajasamadhiyala watershed, in Rajkot
district of Gujarat since 1978, and the specific watershed development activities initiated from 1995
onwards. A comprehensive assessment of Rajasamadhiyala watershed was taken up under the
present study to assess the on-site impact of watershed development program as well as off-site
impacts on two downstream watersheds. The overall goal of this case study is to get insights into
watershed management programs as implemented and to identify the avenues for augmenting the
progress and impact of it in India. The specific objectives of the study were to:
To assess the impact of watershed development on crop production, crop and fodder
productivity, improved livelihoods, minimizing land degradation and groundwater availability in
the micro watershed
To assess the off-site impact on the downstream villages in terms of groundwater availability
and crop production, because of rainwater harvesting in the micro -watershed above on a top
sequence
To identify the gaps/constraints for increasing water productivity in the watershed for harnessing
full potential of rainfed systems.

14.5 Summary
Fixed and variable cost classification helps in CVP analysis. Marginal cost is also useful for
such analysis.
Breakeven point is the incidental study of CVP. It is the point of no profit and no loss. At this
specific level of operation, it covers total costs, including variable and fixed overheads.
Breakeven chart is the graphical representation of cost structure of business.
Profit/Volume (P/V) ratio shows the relationship between contribution a nd value/volume of
sales.
 Margin of safety is the difference between sales or units of production and breakeven point.

14.6 Keywords
Variable Costing: It is used in managerial accounting. Costs are classified as either Variable or
Fixed, depending on their Cost Behaviour.
Profit/volume chart: The profit/volume chart is a variation of the breakeven chart which provides a
simple illustration of the relationship of costs and profit to sales.
Margin of Safety: The margin of safety is the difference in units between the budgeted sales volume
and the breakeven sales volume.
Contribution: It is the difference between sales and marginal or variable costs.
Break-Even Analysis: The break-even point is the level of output or sales which must be achieved
for the business to make neither a profit nor a loss.
Angle of incidence: It indicates the rate at which profit is earned in an organisation after crossing
the break-even point.

14.7 Self Assessment Question

1. At Branson Corporation, the selling price per unit is INR800 and variable cost per unit is INR500.
Fixed costs are INR1,000,000 per year. In this case, the contribution margin per unit is:
a. INR300 b. INR0.375
c. 2,500 units. d. None of the above.

2. At Branson Corporation, the selling price per unit is INR800 and variable cost per unit is INR500.
Fixed costs are INR1,000,000 per year. Assuming sales of INR3,000,000, profit will be:
a. INR125,000 b. INR680,000
c. INR750,000 d. None of the above.

3. The contribution margin ratio measures:

a. Profit per unit. b. Contribution margin per dollar of sales.
c. Profit per dollar of sales. d. The ratio of variable to fixed costs.

4. In March, Octavius Company had the following costs related to producing 5,000 units: Direct
materials INR60,000 Direct labor 20,000 Rent 5,000 Depreciation 4,000 Estimate variable cost per
unit using account analysis.
a. INR17.80 b. INR4.00
c. INR5.80 d. INR16.00

5. Using the following production/cost data, estimate variable cost per unit using the high -low
method:
Month Production Cost
January 2,000 INR20,000
February 2,500 INR21,000
March 3,000 INR23,000
April 1,900 INR18,500

a. INR4.00 b. INR3.70
c. INR4.20 d. INR4.09

6. At Branson Corporation, the selling price per unit is INR800 and variable cost per unit is INR500.
Fixed costs are INR1,000,000 per year. In this case, the break -even point is approximately:
a. 3,333 units. b. 6,667 units.
c. 5,500 units. d. None of the above.

7. Consider the sales and variable cost information for the three departments at Fortesque Drug in
May:
Drugs Cosmetics Housewares
Sales INR80,000 INR40,000 INR30,000
Variable cost 40,000 15,000 25,000
Contribution margin INR40,000 INR25,000 INR 5,000 Based on this information, estimate the
increase in profit for a INR10,000 increase in sales (assuming the sales mix stays the same).
a. INR4,667 b. INR5,667
c. INR3,334 d.None of the above.

8. Consider the sales and variable cost information in Question 7. Assuming that total fixed costs at
Fortesque Drug are INR30,000 per month, what is the break -even level of sales in dollars?
a. INR86,326 b. INR45,876
c. INR72,284 d. INR64,286.

9. If a firm has relatively high operating leverage, it has:

a. Relatively high variable costs. b. Relatively high fixed costs.
c. Relatively low operating expenses. d. Relatively high operating expenses.

10. Product A has a contribution margin per unit of INR500 and requires 2 hours of machine time.
Product B has a contribution margin per unit of INR1,000 and requires 5 hours of machine time.
How much of each product should be produced given there are 100 hours of available machine time?
a. 50 units of A. b. 25 units of B.
c. 50 units of A and 25 units of B. d. None of the above.

14.8 Review Questions

1. Discuss the concept of fixed and variable cost.
2. Discuss Cost-Volume-Profit analysis is a useful technique for managerial decision -making.
3. Discuss Cost-Volume-Profit analysis has no limitation.
4. What is a breakeven chart?
5. What questions can a breakeven chart answer to?
6. Provide a formula to determine the breakeven point of a single product, multi -product and
different divisions and subdivisions of an organization.
7. What are the disadvantages of using breakeven analysis?
8. Define contribution margin.
9. What is Angle of Incidence?
10. Explain Margin of safety shows the financial strength of a business.

Answers to Self Assessment

1. (a); 2. (a); 3. (b); 4. (d); 5. (d);
6. (a); 7. (a); 8. (d); 9. (b); 10. (a).
 15
Fund flow statement
CONTENTS
Objectives
Introduction
15.1 Meaning of Fund Flow Statement
15.2 Concept and Preparation
15.3 Limitations of Fund-flow Statement
15.4 Comparison between fund flow and cash flow statement
15.5 Summary
15.6 Keywords
15.7 Self Assessment Questions
15.8 Review Questions

Objectives
After studying this chapter, you will be able to:
Describe the meaning fund flow statement
Explain the concept and preparation
Describe comparison between fund flow and cash flow statement

Introduction
The purpose of measuring trading performance, operational efficiency, profitability and financial
position of a concern revealed by Trading, Profit and Loss Account and Balance Sheet. These
financial statements are prepared to find out the Gross Profit or Gross Loss, Net Profit or Net Loss
and financial soundness of a firm, a whole for a particular period of time. From the management
point of view, the usefulness of information provided by these income statements, functions
effectively and efficiently. In the true sense they do not disclose the nature of all transactions.
Management, Creditors and Investors etc. want to determine or evaluate the sources and application
of funds employed by the firm for the future course of action. Based on these backgrounds, it is
essential to analyze the movement of assets, liabilities, funds from operations and capital between
the components of two year financial statements. The analysis of financial statements helps to the
management by providing additional information in a meaningful manner.
 Funds flow statement is based on the concept of working capital while cash flow statement is
based on cash which is only one of the elements of working capital. Thus cash flow statement
provides the details of funds movements.
Funds flow statement tallies the funds generated from various sources with various uses to which
they are put. Cash flow statement records inflows or outflows of cash; the difference of total
inflows and outflows is the net increase or decrease in cash and cash equivalents.
Funds Flow statement does not contain any opening and closing balance whereas in cash flow
statement opening as well as closing balances of cash and cash equivalents are given.

15.1 Meaning of Fund Flow Statement

Fund flow statement is a statement which shows the infl ow and out flow of funds between two dates
of balance sheet. So, it is known as the statement of changes in financial position. We all know that
balance sheet shows our financial position and inflow and outflow of fund affects it. So, in company
level business, it is very necessary to prepare fund flow statement to know what the sources are and
what applications of fund between two dates of balance sheet are. Generally, it is prepare after
getting two year balance sheet.
According to Prof. Anthony, ―The funds flow statement describes the sources from which additional
funds were derived and the use of which these funds were put.‖ Fund flow statements are known
with different names, statement of source and uses of funds.
Summary of financial operations.
Movement of working capital statement.
Fund received and distributed statement.
Fund generated and expended statement.

It is a statement summarizing the significant financial changes in items of financial position which
have occurred between the two different balance sheet dates. This statement is prepared on the basis
of ―Working Capital‖ concept of funds. Fund flow Statement helps to measure the different sources
of funds and application of funds from transactions involved during the course of business. The f und
flow statement also termed as statement of sources and application of fund, where got and where
gone out statement, inflow of fund or outflow of fund statement.

15.1.1 Importance or Uses of Fund Flow Statement

Fund Flow Statements are prepared for financial analysis in order to meet the needs of people
serving the following purposes:
It highlights the different sources and applications or uses of funds between the two accounting
period.
It brings into light about financial strength and weakness of a concern.
It acts as an effective tool to measure the causes of changes in working capital.
It helps the management to take corrective actions while deviations between two balances sheet
figures.
It is an instrument used by the investors for effective deci sions at the time of their investment
proposals.
 It also presents detailed information about profitability, operational efficiency and financial
affairs of a concern.
It serves as a guide to the management to formulate its dividend policy, retention policy and
investment policy etc.
It helps to evaluate the financial consequences of business transactions involved in operational
finance and investment.
It gives the detailed explanation about movement of funds from different sources or uses of
funds during a particular accounting period.

15.1.2 Flow of Funds

The term ―Flow of Funds‖ refers to changes or movement of funds or changes in working capital in
the normal course of business transactions. The changes in working capital may be in the form of
inflow of working capital or outflow of working capital. In other words, any increase or decrease in
working capital when the transactions take place is called as ―Flow of Funds.‖ If the components of
working capital results in increase of the fund, it is known as Inflow of Fund or Sources of Fund.
Similarly, if the components of working capital effects in decreasing the financial position it is
treated as Outflow of Fund.

For example, if the fund rose by way of issue of shares will be taken as a source of fund or inflow of
fund. This transaction results in increase of the financial position. Like this, the fund used for the
purchase of machinery will be taken as application or use of fund or outflow of fund. Because it
stands to reduce the fund position.
The following Figure 15.1 shows the movement of funds:

Figure 15.1: Movement of funds.

15.1.3 No Flow of Funds

Some transactions may not make any movement or changes in the fund position. Such transactions
are involved within the business concern. Like the transa ction which involves either between current
assets and current liabilities or between non-current assets and non-current liabilities and hence do
not result in the flow of funds. For example, conversion of shares in to debenture. Such transaction
involves between non-current accounts only and this activity does not effect in increase or decrease
of the working capital position.
15.1.4 Statement of Changes in Financial Position
It is a statement prepared on the basis of all financial resources, i.e., assets, liabilities and capital.
This statement is attempt to measure changes in both current and non -current accounts.
The changes in financial position may occur in deal with foll owing transactions:
Involves between current assets and non-current assets (fixed assets or permanent assets).
Involves between current liabilities and non-current assets.
Involves between current assets and non-current liabilities (long-term liabilities and capital).
Involves between current liabilities and non-current liabilities.
The following Figure 15.2 explains the flow of funds when transaction involves between current and
non-current accounts:

Figure 15.2: Flow of funds chart.

When the transaction involves between non-current account and current account, it is not movement
of funds. The following Figure 15.3 shows the no flow of funds:

Figure 15.3: No flow of funds chart.

15.1.5 Examples of Flow of Funds and No Flow of Funds

The following are the few examples of flow of funds and no flow of funds:
 Table 15.1: Examples of flow of funds and no flow of funds

15.1.6 Application or Uses of Funds

The other side of the funds flow statement is application of funds that side shows how the funds
procured from different sources are allocated or used.
There may be following uses or applications of the funds:
(1) Funds lost in Operations: Sometimes the result of trading in a certain year is a loss and some
funds are lost during that trading period. Such loss of funds means outflow of funds so that item if
treated as an application of funds.
(2) Redemption of the Preference Share Capital: A company cannot redeem its equity share within
its life time but can redeem their preference share as the result of re demption of preference share an
outflow of funds takes place. So the redemption of the shares is written in the application side of the
funds flow statement. One thing should be remembered is that the premium provided on the
redemption will also considered as an application.
(3) Repayment of Loans and Redemption of Debentures : As share the repayment of loans and
redemption of debenture also leads a outflow of cash so these items are also treated as application of
the funds.
(4) Purchase of any Non-current or Fixed Asset: If the businessman purchases any fixed asset or
making investment for the long time period that will also generate a outflow of funds and treated as
an application of funds. If the fixed asset is purchased in exchange of any other considerat ion rather
than cash that will not treated as application of funds.
(5) Payment of Dividend and Tax: Payment of dividend and tax are also applications if funds. It is
the actual payment of dividend and tax, which should be taken as an outflow of funds and not the
mere declaration of the dividend or creation of a provision for taxation.
(6) Any other Non-trading Payment: Any payment or expenses not related to the trading operations
of the business amounts to outflow and is taken as an application of funds. T he examples could be
drawing in case of sole trader or partnership firm, loss of cash.

15.1.7 Components of Sources of Funds

1. Fresh Issue of Equity Share Capital.
2. Fresh Issue of Preference Share Capital.
3. Issue of Debentures and Bonds.
4. Long-term Loans rose from bank, financial institutions and public.
5. Long-term Loans on Mortgage.
6. Sale of Fixed Assets.
7. Sale of Long-term Investments.
8. Non-trading Incomes.
9. Fund from Operations.
10.Net Decrease in Working Capital (as per schedule of changes in working capital).

15.1.8 Components of Applications of Funds

Generated funds from various sources may be utilized in the following ways for meeting the future
productive programmes of the business:
1. Redemption of shares and debentures.
2. Repayment of loans rose from bank, financial institutions and public.
3. Purchase of Fixed Assets.
4. Purchase of Long-Term Investments.
5. Non-trading Expenditure; Payment of Tax; Payment of Dividend.
6. Fund Lost in Operations.
7. Net Increase in Working Capital (as per schedule of changing in working capital).

Specimen Form of Fund Flow Statement

The following are the two usual formats for preparation of Sources and Application of Fund is
presented below:
1. Statement Form.
2. Account Form.
Statement Form (See Table 15.2)
 Table 15.2: Statement form

Account Form (See Table 15.3)

Table 15.3: Account form

Illustration: 1
From the following Balance sheet of William & Co. Ltd., you are required to prepare a Schedule of
Changes in Working Capital and Statement of Sources and Application of Funds.
Solution:

15.2 Concept and Preparation

In order to analyse the sources and application of funds, it is essential to know the meaning and
components of flow of funds given below:
1. Current Assets
2. Non-current Assets (Fixed or Permanent Assets)
3. Current Liabilities
4. Non-current Liabilities (Capital and Long-Term Liabilities)
5. Provision for Tax
6. Proposed Dividend

(1) Current Assets: The term ―Current Assets‖ refer to the assets of a business of a transitory nature
which are intended for resale or conversion into different form during the course of business
operations. For example, raw materials are purchased and the amount unused at the end of the
trading period forms part of the current as stock on hand. Materials•in process at the end of the
trading period and the labour incurred in processing them also form part of current assets.
(2) Non-current Assets: (Permanent Assets): Non-current Assets also refer to as Permanent Assets
or Fixed Assets. This class of asset include those of tangible and intangible nature having a specific
value and which are not consumed during the course of business and trade but provide the means for
producing saleable goods or providing services. Land and Building, Plant and Machinery, Goodwill
and Patents etc. are the few examples of Non -current assets.
(3) Current Liabilities: The term current liabilities refer to amount owing by the business which are
currently due for payment. They consist of amount owing to creditors, bank loans due for
repayment, proposed dividend and proposed tax for payment and expenses accrued due.
(4) Non-current Liabilities: The term Non-current Liabilities refer to Capital and Long-term Debts.
It is also called as Permanent Liabilities. Any amount owing by the business which are payable over
a longer period time, i.e., after a year are referred as Non -current Liabilities. Debenture, long-term
loans and loans on mortgage etc., are t he few examples of non-current liabilities.
(5) Provision for Taxation: Provision for taxation may be treated as a current liability or an
appropriation of profit. When it is made during the year it is not used for adjusting the net profit, it
is advisable to treat the same as current liability. Any amount of tax paid during the year is to be
treated as application of funds or non -current liability. Because it is used for adjusting the net profit
made during the year.
(6) Proposed Dividend: Like provision for taxation, it is also treated as a current liability and
noncurrent liability, when dividend may be considered as being declared. And thus, it will not be
used for adjusting the net profit made during the year. If it is treated as an appropriation, i.e., a non-
current liability when the dividend paid during the year.
(7) Provisions Against Current Assets and Current Liabilities : Provision for bad and doubtful
debts, provision for loss on inventories, provision for discount on creditors and provision made
against investment etc. are made during the year, they may be treated separately as current assets or
current liabilities or reduce the same from the respective gross value of the assets or liabilities.
The list of Current Accounts and Non -current Accounts are given in Table 15.4:

Table 15.4: Current accounts and non-current accounts

15.2.1 Preparation
Fund flow analysis involves the following important three statements such as:
1. Fund From Operations
2. Statement of Changes in Working Capital
3. Fund Flow Statement.

1. Fund from Operations

Fund from Operation is to be determined on the basis of Profit and Loss Account. The operating
profit revealed by Profit and Loss Account represents the excess of sales revenue over cost of goods
sold. In the true sense, it does not reflect the exact flow of funds caused by business operations.
Because the revenue earned and expenses incurred are not in conformity with the flow of funds.
For example, depreciation charges on fixed assets, write up of fixed assets or fict ions assets, any
appropriations etc. Do not cause actual flow of funds. Because they have already been charged to
such profits. Hence, fund from operation is prepared to find out exact inflow or outflow of funds
from the regular operations on the basis of items which have readjusted to the current profit or loss.
The balancing amount of adjusted profit and loss account is described as fund from operations.

Calculation of Fund from Operations

Fund from operations can calculate with the help of the following adjustments. The adjustments may
be shown in the specimen Performa of profit and loss account. (See Table 15.5)

Table 15.5: Specimen Performa of profit and loss account

2 Statements of Changes in Working Capital

It is also termed as Statement of Changes in Working Capital. Before preparation of fund flow
statement, it is essential to prepare first the schedule of changes in working capital and fund from
operations. Statement of changes in working capital is prepa red on the basis of items in current
assets and current liabilities of between two balance sheets. This statement helps to measure the
movement or changes of working capital during a particular period. The term working capital refers
to excess of current assets over current liabilities. The working capital may be ―Increase in working
capital‖ or ―Decrease in working capital.‖ An increase in the amount represents decrease in working
capital. In the same way, over all changes in working capital is calculated and presented in the
schedule of changes in working capital. The final result of Net Decrease in Working Capital refers
to Source of Funds or Inflow of Funds. Like this, Net Increase in Working Capital represents
Application of Fund or Uses of Funds. Of an item of current assets in the current year as compared
to the previous year represents to an increase in working capital. Similarly, a decrease in the amount
of an item of current assets in the current year as compared to the previous year would

15.3 Limitations of Fund-flow Statement

The fund flow statement suffers from the following limitations:
The fund flow statement is prepared with the help of balance sheet and profit and loss account of
the current period and these statements are based on histo rical cost. So a realistic comparison of
profitability and the funds position is not possible as the current cost is not considered for the
purpose of preparation of fund flow statement.
The cash position of the firm is not revealed by fund flow statement . To know the cash position
a cash flow statement has to be prepared.
The various activities are not classified as operating activities, investing activities and financing
activities while preparing fund flow statement.

15.4 Comparison between fund flow and cash flow statement

Cash flow statement is. In fact, a modified version of fund flow statement. However two statements
are not identical. Differences between the two are presented in Table 15.6.
Table 15.6: Difference between cash flow statement and fund flow statement
Did You Know?
Management accounting was first used in 1950 by a team of accountants visiting U. S.

Caution
Be aware while preparing a fund flow statement any wrong information can affect the economic
flow of the organization.

Case Study-Financial Sector Reforms in India

India has presently entered a high-growth phase of 8–9% per annum, from an intermediate phase of
6% since the early 1990s. The growth rate of real GDP averaged 8.6% for the 4 year period ending
2006–07; if one considers the last 2 years, the growth rates are even higher at over 9 per cent. There
are strong signs that the growth rates will remain at elevated levels for several years to come. This
strengthening of economic activity has been supported by higher rate s of savings and investment.
While the financial sector reforms helped strengthening institutions, developing markets and
promoting greater integration with the rest of the world, the recent growth phase suggests that if the
present growth rates are to be sustained, the financial sector will have to intermediate larger and
increasing volume of funds than is presently the case. It must acquire further sophistication to
address the new dimensions of risks.
It is widely recognized that financial intermediatio n is essential to the promotion of both extensive
and intensive growth. Efficient intermediation of funds from savers to users enables the productive
application of available resources. The greater the efficiency of the financial system in such
resource generation and allocation, the higher is its likely contribution to economic growth.
Improved allocated efficiency creates a virtuous cycle of higher real rates of return and increasing
savings, resulting, in turn, in higher resource generation. Thus, develo pment of the financial system
is essential to sustaining higher economic growth.
Questions
1. Write the summary of the above case study.
2. Discuss the advantages and disadvantages of financial and banking sector reforms in India.

15.5 Summary
Fund flow analysis is done by studying past fund flows and projecting future fund flows.
The term ―Fund‖ refers to Cash, to Cash Equivalents or to Working Capital and all financial
resources which are used in business.
If the components of working capital results in increase of the fund, it is known as Inflow of
Fund or Sources of Fund.
Fund flow analysis is accomplished by preparing a fund flow statement for evaluating the uses of
funds and determining the sources of funds to finance those users.
In pro forma financial statement, the pro forma balance sheet and profit and loss account are
prepared to enable the management to evaluate the performance of the enterprise future financial
conditions.

15.6 Keywords
Cash Budget: It is used to determine short-term cash needs.
Current Assets: It refers to the assets of a business of a transitory nature which are intended for
resale or conversion into different form during the course of business operations.
Current Liabilities: It refers to amount owing by the business whi ch are currently due for payment.
Flow of Funds: The changes in working capital in the normal course of business transactions.
Net Working Capital: Excess of Current Assets over Current Liabilities.

15.7 Self Assessment Questions

1. A fund flow statement is a summary of a firm‘s inflow and outflow of funds.
(a) True (b) False

2. The ……………………..is a report on financial operations changes.

(a) cash-flow-statement (b) funds-flow-statement
(c) Both a and b (d) None of these.

3. Funds Flow Statement is an income statement

(a) True (b) False

4. ………………………shows the items of income and expenditure of a particular period

(a) Cash-flow-statement (b) Funds-flow-statement
(c) Income statement (d) None of these.

5. ………………………. is used to determine short-term cash needs.

(a) Cash-flow-statement (b) Cash Budget
(c) Income statement (d) None of these.

6. The term ―Fund‖ refers to:

(a) Cash (b) Working Capital (c) Both a and b (d) None of these.

7. ……………………… represents total of all Current Assets

(a) Gross Working Capital (b) Gross Working Capital
(c) Net Working Capital (d) None of these.

8. ……………………………………..refers to excess of current assets over current liabilities.

(a) Gross Working Capital (b) Gross Working Capital
(c) Net Working Capital (d) None of these.

9. The term ………………. refer to the assets of a business of a transitory nature which are intended
for resale or conversion into different form during the course of business operations
(a) Cash budgeting (b) Gross Working Capital (c) Current liabilities (d) current Assets

10. The term Current Liabilities refer to amount owing by the business which are currently due for
payment.
(a) True (b) False

15.8 Review Questions

1. What do you mean by fund flow statement?
2. Explain the changes of financial position.
3. Briefly explain the flow of funds and no flow of funds. Illustrate with numerical examples.
4. What are the components of flow of fund?
5. What do you understand by fund flow statement? How i s it prepared?
6. Explain the importance of fund flow statement.
7. Distinguish between:
Fund flow statement and income statement
Fund flow statement and balance sheet
8. Explain the limitations of fund flow statement.
9. Explain the procedure for preparat ion of fund flow statement.
10. What do you understand by fund from operations?
Answers for Self Assessment Questions
1. (a) 2. (b) 3. (a) 4. (c) 5. (b)
6. (c) 7. (b) 8. (c) 9. (d) 10. (a)