INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.

MATERIAL COST 2.1

EMPLOYEE COST & DIRECT EXPENSES 3.1

OVERHEADS – ABSORPTION COSTING METHOD 4.1

ACTIVITY BASED COSTING 5.1

COST SHEET 6.1

COST ACCOUNTING SYSTEM 7.1

UNIT & BATCH COSTING 8.1

JOB COSTING 9.1

PROCESS & OPERATION COSTING 10.1

JOINT PRODUCTS & BY PRODUCTS 11.1

SERVICE COSTING 12.1

STANDARD COSTING 13.1

MARGINAL COSTING 14.1

BUDGET & BUDGETARY CONTROL 15.1

 Introduc on to Cost and Management Accoun ng

Chapter INTRODUCTION TO COST AND

1 MANAGEMENT ACCOUNTING

Important Questions-
1. State the types of cost in the following cases:
a. Interest paid on own capital not involving any cash outflow.
b. Withdrawing money from bank deposit for the purpose of purchasing new machine for expansion purpose.
c. Rent paid for the factory building which is temporarily closed.
d. Cost associated with the acquisition and conversion of material into finished product.
2. Mention the cost unit of following industries:
a. Electricity
b. Automobile
c. Cement
d. Steel
e. Gas
f. Brick Making
g. Coal Mining
h. Engineering
i. Professional Services
j. Hospital
3. Identify the methods of costing for the following:
a. Where all costs are directly charged to a specific job.
b. Where all costs are directly charged to a group of products.
c. Where cost is ascertained for a single product.
d. Where the nature of the product is complex and method cannot be ascertained.
e. Costs are charged to operations and averaged over units produced.
4. State the method of costing to be used in the following industries:
i. Real Estate
ii. Motor Repairing Workshop
iii. Chemical Industry
iv. Transport Service
v. Assembly of Bicycles
vi. Biscuits manufacturing Industry
vii. Power Supply Companies
viii. Car manufacturing Industry
ix. Cement Industry
x. Printing Press
xi. Oil Refinery
xii. Interior Decoration
xiii. Airlines Company
xiv. Advertising
xv. Car Assembly
5. Specify the types of Responsibility centres under the following situations:
i. Purchase of bonds, stocks, or real estate property.
ii. Ticket counter in a Railway station.
iii. Decentralized branches of an organization.
iv. Maharana, Navratna and Miniratna public sector undertaking (PSU) of Central Government.
v. Sales Department of an organization
6. What is Cost accounting? Enumerate its important objectives
7. Define the terms Imputed cost and Capitalised cost
8. Distinguish between Fixed overheads and Variable overheads.
9. Write note on Essential factors for installing a Cost Accounting system.
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10. Distinguish between cost units and cost centres.

11. Briefly explain the essential features of a good cost accounting system.
12. Distinguish between cost control and cost reduction.
13. Explain the following:
a. Explicit costs
b. Engineered costs
14. Explain 'Sunk Cost' and 'Opportunity Cost".
15. Define 'Cost Centre' and state its types.
16. Narrate the objectives of cost accounting.
17. Explain what do you mean by Profit Centres.
18. Write short notes on:
a. Sunk Cost
b. Opportunity Cost
19. Explain the Conversion cost.
20. What are the essential factors for installing a cost accounting system? Explain.
21. State the difference between Cost Accounting & Management Accounting.
22. Why are cost and management accounting information are required by the staff at operational level? Describe.
23. Explain Opportunity Cost.
24. Mention and explain types of responsibility centres,
25. Briefly explain the ‘techniques of costing’.
26. Define cost objects and give examples of any four cost objects,

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1. Meaning and Definitions-

(i) Cost- Cost is the amount of resource given up in exchange of some goods or services.
(ii) Costing- Costing is defined as “the technique and process of ascertaining costs”.
(iii) Cost Accounting- It is defined as the process of accounting for cost which begins with the recording of income and
expenditure or the bases on which they are calculated and ends with the preparation of periodical statements and reports
for ascertaining and controlling costs.
(iv) Cost Accountancy- It is defined as the application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment of profitability.
It includes the presentation of information derived there from for the purpose of managerial decision making.
(v) Management Accounting- It is the application of the principles of accounting and financial management to
create, protect, preserve and increase value for the stakeholders of for-profit and not-for-profit enterprises in the
public and private sectors.”
(vi) Cost Management- It is an application of management accounting concepts, methods of collections, analysis and
presentation of data to provide the information needed to plan, monitor and control costs.

2. OBJECTIVES OF COST ACCOUNTING

The main objectives of Cost and Management Accounting are explained as below:
(i) Ascertainment of Cost: Costs are accumulated, assigned and ascertained for each cost object. This cost object may
be a unit, job, operation, process, department or service.
(ii) Determination of Selling Price and Profitability: The Cost Accounting System helps in determination of selling price
and thus profitability of a cost object. Cost accounting system provides a basis for price fixation and rate negotiation.
(iii) Assisting Management in Decision Making: It provides relevant information which assist management in planning,
implementing, measuring, controlling and evaluating of various activities. A robust cost and management accounting
system provides internal and external information to the industry which will be relevant for decision making.
(iv) Cost Control
(v) Cost Reduction

Difference between Cost Control and Cost Reduction

Cost Control Cost Reduction

1. Cost control aims at maintaining the costs in 1. Cost reduction is concerned with reducing costs. It
accordance with the established standards. challenges all standards and endeavors to improvise them
continuously
2. Cost control seeks to attain lowest possible cost 2. Cost reduction recognises no condition as permanent, since
under existing conditions. a change will result in lower cost.
3. In case of cost control, emphasisis on past and 3. In case of cost reduction, it is on presentand future.
present
4. Cost control is a preventive Function 4. Cost reduction is a corrective function. It operates even
when an efficient cost control system exists.

5. Cost control ends when targetsare achieved. 5. Cost reduction has no visible end and is a continuous
process.

3. SCOPE OF COST ACCOUNTING

Scope of Cost Accounting consists of the following functions:
(i) Costing: Costing is the technique and process of ascertaining costs of products or services. Generally, cost is
ascertained using historical costs, standard costs, process cost, operation cost etc.

(ii) Cost Accounting: This is a process of accounting for cost which begins with the recording of expenditure and ends
with the preparation of periodical statement and reports for ascertaining and controlling cost.

(iii) Cost Analysis: It involves the process of finding out the factors responsible for variance in actual costs from the
budgeted costs and accordingly fixation of responsibility for cost differences.

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(iv) Cost Comparisons: It also includes comparisons of cost involved in alternative courses of action such as use of
differenttechnology for production, cost of making different products and activities, and cost of same product/ service
over a period of time.

(v) Cost Control: It involves a detailed examination of each cost in the lightof advantage received from the incurrence
of the cost. Thus, we can state that cost is analyzed to know whether cost is not exceeding its budgeted cost and
whether further cost reduction is possible or not.

(vi) Cost Reports: These reports are primarily prepared for use by the management at different levels. Cost Reports helps
in planning and control, performance appraisal and managerial decision making

(vii) Statutory Compliances: Maintaining cost accounting records as per the rules prescribed by the statute to maintain
cost records relating to utilization of materials, labour and other items of cost as applicable to the production of goods
or provision of services as provided in the Act and these rules.

4. Difference between Cost Accounting and Management Accounting

Sr. No. Basis Cost Accounting Management Accounting
(i) Nature It records the quantitative aspect only. It records both qualitative andquantitative aspect.

(ii) Objective It records the cost ofproducing a product It provides information to management for
and providing a service. planning and co-ordination.

(iii) Area It only deals with cost ascertainment. It is wider in scope as it includes financial accounting,
budgeting, taxation, planning etc.

(iv) Recording of It uses both past and present figures. It is focused with the projection of figures for
data future.
(v) Development Its development is related to industrial Its development is related to the need of modern
revolution. business world.

(vi) Rules and It follows certain principles and It does not follow any specific rules and
Regulation procedures for recording costs of regulations.
different products.

5. Difference between Financial Accounting and Cost Accounting

Sr. No. Basis Financial Accounting Cost Accounting
(i) Objective It provides information about the financial Ascertainment of cost for the purpose of cost
performance of an entity. control and decision making.

(ii) Nature It classifies records, presentand interprets It classifies, costs records, present, and interprets it
transactions in monetary terms. in a significant manner.

(iii) Recordingof It records Historical data. It makes use of both historical and pre- determined
data costs.
(iv) Users of The users of financial accounting The cost accounting information is generally used by
information statements are shareholders, creditors, internal management. But sometimes regulatory
financial analysts and government and its authorities also.
agencies, etc.
(v) Analysis of cost It shows profit or loss of the organization It provides the cost detailsfor each cost object i.e.
andprofit either segmentwise or as a whole. product, process, job,operation, contracts etc.

(vi) Time period Financial Statements are Reports and statements are prepared as and when
prepared usually for a year. required.

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(vii) Presentationof A set format is used for presenting In general, no set formats for presenting cost
information financial information. information are followed.

6. ROLE & FUNCTIONS OF COST AND MANAGEMENT ACCOUNTING

The role of a cost and management accounting system is to:
 Provide relevant information to management for decision making,
 Assist management for planning, measurement, evaluation and controlling of business activities,
 Help in allocation of cost to products and inventories for both external and internal users.

The functions of Cost and Management Accounting include:

(i) Collection and accumulation of cost for each element of cost.
(ii) Assigning costs to cost objects to ascertain cost.
(iii) Cost and Management Accounting Department sets budget and standards for a particular period or activity beforehand
and these are compared with theassigned and ascertained cost. All this exercise is done to control costs.
(iv) The main function of Cost and Management Accounting is provision of relevant information to the management for
decision making. An Information system environment is set up which is popularly known as Management
Information System (MIS).
(v) The performance of a responsibility centre is measured and evaluated against the set standards. The function of
Cost and Management Accounting is to gather data like time taken, wastages, process idleness etc., analyse the data,
prepare reports and take necessary actions.

7. USERS OF COST AND MANAGEMENT ACCOUNTING

Internal Users
Internal users, who use the Cost and Management Accounting information mayinclude the followings:
(a) Policy Makers- The policy makers are those who formulate strategies
- to achieve the goals (short & long term both)
- to fulfil the objectives of the organization,
- to position the organisation into the competitive market environment
- to design the organisational structure to get the policy and strategies implemented.

(b) Managers- The managers use the information

- to know the cost of a cost object and cost centre
- to know the price for the product or service
- to measure and evaluate performance of responsibility centres
- to the know the profitability-product-wise, department-wise, customer-wise etc.
- to evaluate the strategic options and to make decisions

(c) Operational level staff- The operational level staff like supervisors,foreman, team leaders require information
- to know the objectives and performance goals for them
- to know product and service specifications like volume, quality and process etc.
- to know the performance parameters against which their performanceis measured and evaluated.
- to know divisional (responsibility centre) profitability etc.

(d) Employees- Employees are concerned with the information related with time and attendance, incentives for work,
performance standards etc.

External Users
External users, who use the Cost and Management Accounting information may include the followings:
(a) Regulatory Authorities- Regulatory Authorities are concerned with cost accounting data and information for different
purpose which includes tariff determination, providing subsidies, rate fixation etc. To do this the regulatory bodies require
information on the basis of some standards and format in this regard.
(b) Auditors- The auditors while conducting audit of financial accounts or forsome other special purpose audit like
cost audit etc. require information related with costing and reports reviewed by management etc.
(c)
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(d) Shareholders- Shareholders are concerned with information that effect their investment in the entity. Management
communicates to the shareholders through periodic communique, annual reports etc. regarding new orders received,
product expansion, market share for products etc.
(e) Creditors and Lenders- Creditors and lenders are concerned with data and information which affects an entity’s ability
to serve lenders or creditors. For example, any financial institutions which provides loan to an entity against book debts
and inventories are more concerned with regular reporting onnet debt position and stock balances.

8. ESSENTIALS OF A GOOD COST ACCOUNTING SYSTEM

The essential features, which a good Cost Accounting System should possess, are as follows:
(a) Informative and simple: Cost accounting system should be tailor-made, practical, simple and capable of meeting the
requirements of a business concern. The system of costing should not sacrifice the utility by introducing inaccurate and
unnecessary details.
(b) Accurate and authentic: The data to be used by the cost accounting system should be accurate and authenticated;
otherwise it may distort the output of the system and a wrong decision may be taken.
(c) Uniformity and consistency: There should be uniformity and consistencyin classification, treatment and reporting
of cost data and related information. This is required for benchmarking and comparability of the results of the
system for both horizontal and vertical analysis.
(d) Integrated and inclusive: The cost accounting system should be integrated with other systems like financial accounting,
taxation, statistics and operational research etc. to have a complete overview and clarity in results.
(e) Flexible and adaptive: The cost accounting system should be flexible enough to make necessary amendment and
modifications in the system to incorporate changes in technological, reporting, regulatory and other requirements.
(f) Trust on the system: Management should have trust on the system and its output. For this, an active role of management
is required for the development of such a system that reflects a strong conviction in using information for decision
making.

9. INSTALLATION OF COSTING SYSTEM

Before setting up a system of cost accounting the factors mentioned below should bestudied:
(a) Objective: The objective of setting up the costing system, for example whether it is being introduced for fixing
prices or for establishing a systemof cost control.
(b) Nature of Business or Industry: The industry in which the business is operating. Every business or industry has its own
uniqueness and objectives. According to its cost information requirement, cost accounting methods are followed.
(c) Organisational Hierarchy: Costing system should fulfil the information requirements of different levels of management.
Top management is concerned with the corporate strategy, strategic level management is concerned with marketing
strategy, product diversification, product pricing etc. Operational level management needs the information on
standardquantity to be consumed, report on idle time etc.
(d) Knowing the product: Nature of the product determines the type of costing system to be implemented. The product
which has by-products requires costing system which accounts for by-products as well. In case of perishable or short
self- life products, marginal costing is appropriate to know the contribution and minimum price at which products
could be sold.
(e) Knowing the production process: A good costing system can never be established without the complete knowledge of
the production process. Cost apportionment can be done on the most appropriate and scientific basis if a cost
accountant can identify degree of effort or resources consumed in a particular process. This also includes some basic
technicalknow-how and process peculiarity.
(f) Information synchronisation: Establishment of a department or a system requires substantial amount of organisational
resources. While drafting a costing system, information needs of various other departments should be taken into account.
For example, in a typical business organisation accounts department needs to submit monthly stock statement to its lender
bank, quantity wise stock details at the time of filing returns to tax authorities etc.
(g) Method of maintenance of cost records: The organization must determine beforehand the manner in which Cost
and Financial Accounts could be inter-locked into a single integral accounting system and how the results of separate
sets of accounts i.e. cost and financial, could be reconciled by means of control accounts.
(h) Statutory compliances and audit: Records are to be maintained to comply with statutory requirements and applicable
cost accounting standards should be followed.

(i) Information Attributes: Information generated from the Costing system should possess all the attributes of useful
information i.e. it should be complete, accurate, timely, relevant. to have an effective management information system
(MIS).
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10. COST ACCOUNTING WITH THE USE OF INFORMATION TECHNOLOGY (IT)

The impact of IT in Cost Accounting may include the following:
(i) After the introduction of ERPs, different functional activities get integrated and as a consequence, a single entry
into the accounting system provides custom made reports for every purpose and saves an organisation from preparing
different sets of documents. Reconciliation process of results of both cost and financial accounting systems becomes
simpler and less cumbersome.
(ii) A move towards paperless environment can be seen where documents likeBill of Material, Material Requisition Note,
Goods Received Note, labour utilisation report etc. are no longer required to be prepared in multiple copies, the related
department can get e-copy from the system.
(iii) Information Technology with the help of internet (including intranet and extranet) are helping in resource procurement
and mobilisation. For example, production department can get materials from the stores without issuing material
requisition note physically. Similarly, purchase orders can be initiated to the suppliers with the help of extranet. This
enables an entity to shift towards Just-in-Time (JIT) approach of inventory management and production.
(iv) Cost information for a cost centre or cost object is ascertained with accuracy in timely manner. Each cost centre a cost
object is codified and all related costs are assigned to the cost objects or cost centres using assigned codes.This
automates the cost accumulation and ascertainment process. The cost information can be customised as per the
requirement. For example, when an entity manufactures or provides services, managers are able to receive information
job-wise, batch-wise, process-wise, cost centre wise etc.
(v) Uniformity in preparation of report, budgets and standards can be achieved with the help of IT. ERP software plays an
important role in bringing uniformity irrespective of location, currency, language and regulations.
(vi) Cost and revenue variance reports are generated in real time basis whichenables the management to take control measures
immediately.
(vii) IT enables an entity to monitor and analyse each process of manufacturingor service activity closely to eliminate
non value-added activities.

10.1 Digital Costing System

Digital costing system links different business functions such as production, procurement, inventory management with
the digital costing system of its suppliers, customers and the market through data sharing and network interaction.
Digital Costing System provides data to get the following information:
(i) Cost incurred on a cost object.
(ii) Data on time spent.
(iii) Data on resource consumption.
(iv) Data on current market price of final product and raw materials.
(v) Data on lead time and availability of materials.
(vi) Data on product demand and trend.

10.2 Benefits of Digital Costing System

With the help of Artificial Intelligence (AI) and Machine learnings (ML) which helpsin analysis of the Big data and
apprehend the consumption and demand pattern,the following benefits can be achieved:
(i) Ascertainment of cost with certainty on a cost object (the cost object is discussed in later paragraph). This helps to
analyse the activities for cost allocation and apportionment.
(ii) Analysis of data on time spent on each activity to study and formulate incentive plans.
(iii) Helps in material requirement planning and scheduling the material procurement. Data on resource consumption can
be analysed for resource optimisation and finding the possibilities for zero wastage and Just-in Time (JIT).
(iv) Helps to identify and eliminate the non-value-added activities.
(v) Data on resource consumption is helpful in setting the standards andmeasurement of variances on real time basis.
(vi) Data on current market prices of material and consumables helps to estimate cost and setting standards
on Marked to Market (M2M) basis.
(vii) Extrapolation of data on customer behaviour towards the products to predict the market demand. It is helpful is
preparation of budgets and planning of production.
(viii) A better analysis of cost behaviour improves the cost benefit analysis and equipping the management in informed
decision making.

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11. COST OBJECTS

Cost object is anything for which a separate measurement of cost is required. Cost object may be a product, a service,
a project, a customer, a brand category,an activity, a department or a programme etc.

Examples of cost objects are:

Product Smart phone, Tablet computer, SUV Car, Book etc.
Service An airline flight from Delhi to Mumbai, Concurrent auditassignment, Utility bill
payment facility etc.
Project Metro Rail project, Road projects etc.

Activity Quality inspection of materials, Placing of orders etc.

Process Refinement of crudes in oil refineries, melting of billets or ingotsin rolling mills etc.

Department Production department, Finance & Accounts, Safety etc.

Cost object remains in nucleus of cost classification and analysis of the cost behaviour. Classification of a cost element as
direct, indirect, fixed or variable, all depends on cost object.

11.1 Cost Units

It is a unit of product, service or time (or combination of these) in relation to which costs may be ascertained or
expressed.
Cost units are usually the units of physical measurement like number, weight, area, volume, length, time and value.
A few typical examples of cost units are as follows:
Industry or Product Cost Unit Basis

Automobile Number

Cement Ton/ per bag etc.

Chemicals Litre, gallon, kilogram, ton etc.

Power Kilo-watt hour (kWh)

Steel Ton

Transport Passenger- kilometer

Gas Cubic feet

Some examples from the CIMA terminology are as follows:

Industry Sector Cost unit
Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Engineering Contract, job
Oil Barrel, tonne, litre
Hotel/Catering Room/meal
Professional services Chargeable hour, job, contract
Education Course, enrolled student, successful student
Hospitals Patient day

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Activity Cost unit

Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials Requisition unit issued/received, materialmovement, value issued/received
storage/handling

Personnel Personnel record

administration

11.2 Cost Driver

 A Cost driver is a factor or variable which effect level of cost. Generally, it is an activity which is responsible for cost
incurrence. Level of activity or volume of production is the example of a cost driver. An activity may be an event,
task, or unit of work etc.
 CIMA Official terminology defines cost driver as “Factor influencing the level ofcost” Often used in the context of
Activity Based Costing to denote the factor whichlinks activity resource consumption to product outputs, for example
the number of purchase orders would be a cost driver for procurement cost.”
 Examples of cost drivers are number of machine set ups, number of purchase orders, hours spent on product inspection,
number of tests performed etc.

12. TYPES OF RESPONSIBILITY CENTRES

(i) Cost Centres: The responsibility centre which is held accountable for incurrence of costs which are under its control.
The performance of this responsibility centre is measured against pre-determined standards or budgets. The cost centres
are of two types:
(a) Standard Cost Centre and (b) Discretionary Cost Centre
(a) Standard Cost Centre: Cost Centre where output is measurable andinput required for the output can be specified.
Based on a well-established study, an estimate of standard units of input to produce a unit of output is set. The
actual cost for inputs is compared with the standard cost. Any deviation (variance) in cost is measured and
analysed into controllable
and uncontrollable cost. The manager of the cost centre is expected to comply with the standard and held
responsible for adverse cost variances. The input-output ratio for a standard cost centre is clearly identifiable.
(b) Discretionary Cost Centre: The cost centre whose output cannot bemeasured in financial terms, thus input-
output ratio cannot be defined.The cost of input is compared with allocated budget for the activity. Examples of
discretionary cost centres are Research & Development department, Advertisement department where output of
these department cannot be measured with certainty and co-related with cost incurred on inputs.
(ii) Revenue Centres: The responsibility centres which are accountable for generation of revenue for the entity. Sales
Department for example, is responsible for achievement of sales target and revenue generation. Though, revenue
centres do not have control on expenditures it incurs but sometimes expenditures related with selling activities like
commission to sales person etc. are incurred by revenue centres.
(iii) Profit Centres: These are the responsibility centres which have both responsibility of generation of revenue and
incurrence of expenditures. Since, managers of profit centres are accountable for both costs as well as revenue,
profitability is the basis for measurement of performance of these responsibility centres. Examples of profit centres are
decentralised branchesof an organisation.
(iv) Investment Centres: These are the responsibility centres which are not only responsible for profitability but also have
the authority to make capital investment decisions. The performance of these responsibility centres is measured on the
basis of Return on Investment (ROI) besides profit. Examples of investment centres are Maharatna, Navratna and
Miniratna companies of Public Sector Undertakings of Central Government.

13. LIMITATIONS OF COST ACCOUNTING

Like other branches of accounting, cost accounting also has certain limitations.The limitations of cost accounting are
as follows:
1. Expensive: It is expensive because analysis, allocation and absorption of overheads requires considerable amount of
additional work, and hence additional money.
2. Requirement of reconciliation: The results shown by cost accounts differ from those shown by financial accounts. Thus
preparation of reconciliation statements is necessary to verify their accuracy.

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3. Duplication of work: It involves duplication of work as organization has to maintain two sets of accounts i.e. Financial
Accounts and Cost Accounts.

14. CLASSIFICATION OF COSTS

It means the grouping of costs according to their common characteristics. Theimportant ways of classification of costs
are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making

14.1 By Nature or Element

This type of classification is useful to determine the total cost.
The elements of cost described as under:
(i) Direct Materials: Materials which are present in the finished product (cost object) or can be economically identified
in the product are termed as direct materials. For example, cloth in dress making; materials purchased for a specific
job etc. However, in some cases a material may be direct but it is treated as indirect; because it is used in small
quantities, it is not economically feasible to identify that quantity. Those materials which are used for purposes
ancillary to the business are also treated as Indirect Materials.
(ii) Direct Labour: Labour which can be economically identified or attributed wholly to a cost object is termed as direct
labour. For example, employee engaged on the actual production of the product or in carrying out the necessary
operations for converting the raw materials into finished product.
(iii) Direct Expenses: All expenses other than direct material or direct labour which are specially incurred for a
particular cost object and can be identifiedin an economically feasible way are termed as Direct Expenses. For
example, hire charges for some special machinery, cost of defective work etc.
(iv) Indirect Materials: Materials which do not normally form part of the finished product (cost object) are known
as indirect materials. These are —
 Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.)
 Stores used by service departments like power house, boiler house, canteen etc.
(v) Indirect Labour: Labour cost which cannot be allocated but can be apportioned to or absorbed by cost units or
cost centres is known as indirect labour. Examples of indirect labour includes salary paid to foreman and
supervisors; maintenance workers; etc.
(vi) Indirect Expenses: Expenses other than direct expenses are known as indirect expenses. These cannot be
directly, conveniently and wholly allocated to cost centres. Factory rent and rates, insurance of plant and
machinery, power, light, heating, repairing, telephone etc., are some examples of indirect expenses.
(vii) Overheads: The aggregate of indirect material costs, indirect labour costs and indirect expenses is termed as
Overheads. The main groups into which overheads may be subdivided are as follows:
 Production or Works Overheads: Indirect expenses which are incurred in the factory and for the
running of the factory. E.g.: rent, power etc.
 Administration Overheads: Indirect expenses related to management and administration of business. E.g.:
office rent, lighting, telephone etc.
 Selling Overheads: Indirect expenses incurred for marketing of a commodity. E.g.: Advertisement
expenses, commission to sales persons etc.
 Distribution Overheads: Indirect expenses incurred for dispatch of the goods E.g.: warehouse charges,
packing(secondary) and loading charges.

14.2 By Functions
Under this classification, costs are divided according to the function for whichthey have been incurred. It includes
the following:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads

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(vi) Selling Overheads

(vii) Distribution Overheads
(viii) Research and Development costs etc.

14.3 By Variability or Behaviour

Based on this classification, costs are classified into three groups viz., fixed, variable and semi-variable.
(a) Fixed costs– These are the costs which are incurred for a period, and which, within certain output and turnover
limits, tend to be unaffected by fluctuations in the levels of activity (output or turnover). They do not tend to
increase or decrease with the changes in output. For example, rent, insurance of factory building etc., remain
the same for different levels of production.

(b) Variable Costs– These costs tend to vary with the volume of activity. Any increase in the activity results in an
increase in the variable cost and vice- versa. For example, cost of direct material, cost of direct labour, etc.

(c) Semi-variable costs– These costs contain both fixed and variable components and are thus partly affected by
fluctuations in the level of activity. Examples of semi variable costs are telephone bills, gas and electricity etc.

14.3.1 -Methods of segregating Semi-variable costs into fixed andvariable costs

The segregation of semi-variable costs into fixed and variable costs can be carried out by using the following
methods:
(a) Graphical method
(b) High-Low method
(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method

(a) Graphical Method: Under this method, the following steps are followed:
(i) A large number of observations regarding the total costs at differentlevels of output are plotted on a graph.
(ii) The output is plotted on the X-axis and the total cost is plotted on the Y-axis.
(iii) Then, by judgment, a line of “best-fit”, which passes through all or most of the points, is drawn.
(iv) The point at which this line cuts the Y-axis indicates the total fixed costcomponent in the total cost.
(v) If a line is drawn at this point parallel to the X-axis, this indicates the fixedcost.
(vi) The variable cost, at any level of output, is derived by deducting this fixedcost element from the total cost.

(b) High- Low Method: Under this method, difference between the total costat highest and lowest volume is
divided by the difference between the sales value at the highest and lowest volume. The quotient thus obtained
gives us the rate of variable cost in relation to sales value.

(c) Analytical Method: Under this method an experienced cost accountant tries to judge empirically what
proportion of the semi-variable cost would be variable and what would be fixed. The degree of variability is
ascertained for each item of semi-variable expenses.

(d) Comparison by period or level of activity method: Under this method, the variable overhead may be
determined by comparing two levels of output with the amount of expenses at those levels. Since the fixed
element does not change, the variable element may be ascertained with the help of the following formula.
Change in the amount of expense
Change in the quantity of output

(e) Least Square Method: This is the best method to segregate semi-variable costs into its fixed and variable
components. This is a statistical method and is based on finding out a line of best fit for a number of observations.
The method uses the linear equation y = mx + c, where
‘m’ represents the variable element of cost per unit,
‘c’ represents the total fixed cost,‘y’ represents the total cost,
‘x’ represents the volume of output.
The total cost is thus split into its fixed and variable elements by solving thisequation.

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 Introduc on to Cost and Management Accoun ng

14.4 By Controllability
Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: -
 Cost that can be controlled, typically by a cost, profit or investment centre manager is called controllable cost.
 Controllable costs incurred in a particular responsibility centre can be influenced by the actionof the manager
heading that responsibility centre.
 For example, direct costs comprising direct labour, direct material, direct expenses and some of the overheads are
generally controllable by the shop floor supervisor or the factory manager.

(b) Uncontrollable Costs –

 Costs which cannot be influenced by the action of a specified member of an undertaking are known as uncontrollable
costs.
 For example, expenditure incurred by say, the tool room is controllable by the foreman in-charge of that section but
the share of the tool-room expenditure which is apportioned to a machine shop is not controlled by the
machine shop foreman.

Distinction between Controllable Cost and Uncontrollable Cost: The distinction between controllable and
uncontrollable costs is not very prominentand is sometimes left to individual judgement. In fact, no cost is
uncontrollable; itis only in relation to a particular individual that we may specify a particular cost to be either controllable
or uncontrollable.

14.5 By Normality
According to this basis, cost may be categorised as follows:
(a) Normal Cost - It is the cost which is normally incurred at a given level of output under the conditions in which that
level of output is normally attained.
(b) Abnormal Cost - It is the cost which is not normally incurred at a givenlevel of output in the conditions
in which that level of output is normally attained. It is charged to Costing Profit and loss Account.

14.6 By Costs used in Managerial Decision Making

According to this basis, cost may be categorised as follows:
(a) Pre-determined Cost - A cost which is computed in advance before production or operations start, on the basis of
specification of all the factors affecting cost, is known as a pre-determined cost.
(b) Standard Cost - A pre-determined cost, which is calculated from managements ‘expected standard of efficient
operation’ and the relevant necessary expenditure. It may be used as a basis for price fixation and forcost
control through variance analysis.
(c) Marginal Cost - The amount at any given volume of output by which aggregate costs increases if the volume of
output is increased or decreased by one unit.
(d) Estimated Cost - Kohler defines estimated cost as “the expected cost ofmanufacture, or acquisition, often in
terms of a unit of product computedon the basis of information available in advance of actual production or
purchase”. Estimated costs are prospective costs since they refer toprediction of costs.
(e) Differential Cost - (Incremental and decremental costs). It represents thechange (increase or decrease) in total cost
(variable as well as fixed) due to change in activity level, technology, process or method of production, etc.
For example, if any change is proposed in the existing level or in the existing method of production, the increase
or decrease in total cost or in specific elements of cost as a result of this decision will be known as incremental cost
or decremental cost.
(f) Imputed Costs - These costs are notional costs which do not involve any cash outlay. Interest on capital, the
payment for which is not actually made,is an example of imputed cost. These costs are similar to opportunity
costs.
(g) Capitalized Costs -These are costs which are initially recorded as assets and subsequently treated as expenses.
Example, installation expenses on the erection of a machine are added to the cost of a machine.
(h) Product Costs - These are the costs which are associated with the purchase and sale of goods (in the case of
merchandise inventory). In the production scenario, such costs are associated with the acquisition and conversion
of materials and all other manufacturing inputs into finished product for sale. Hence, under marginal costing,
variable manufacturing costs and under absorption costing, total manufacturing costs (variable and fixed) constitute
inventoriable or product costs.

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 Introduc on to Cost and Management Accoun ng

(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefitof opportunity foregone in accepting
an alternative course of action. For example, a firm financing its expansion plan by withdrawing money from its
bank deposits. In such a case the loss of interest on the bank deposit is the opportunity cost for carrying out the
expansion plan.
(j) Out-of-pocket Cost - It is that portion of total cost, which involves cash outflow. This cost concept is a short-run
concept and is used in decisions relating to fixation of selling price in recession, make or buy, etc. Out–of– pocket
costs can be avoided or saved if a particular proposal under consideration is not accepted.
(k) Shut down Costs - Those costs, which continue to be, incurred even when a plant is temporarily shut-down e.g.
rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of the plant. In other words, all fixed
costs, which cannot be avoided during the temporary closure of a plant, will be known as shut down costs.
(l) Sunk Costs - Historical costs incurred in the past are known as sunk costs. They play no role in decision
making in the current period. For example, inthe case of a decision relating to the replacement of a machine, the
written down value of the existing machine is a sunk cost and therefore, not considered.
(m) Absolute Cost - These costs refer to the cost of any product, process or unit in its totality. When costs are presented
in a statement form, various cost components may be shown in absolute amount or as a percentage of total cost
or as per unit cost or all together. Here the costs depicted in absolute amount may be called absolute costs and are
base costs on which further analysis and decisions are made.
(n) Discretionary Costs – Such costs are not tied to a clear cause and effectrelationship between inputs and outputs.
They usually arise from periodic decisions regarding the maximum outlay to be incurred. Examples include
advertising, public relations, executive training etc.
(o) Period Costs - These are the costs, which are not assigned to the productsbut are charged as expenses against
the revenue of the period in which theyare incurred. All non-manufacturing costs such as general & administrative
expenses, selling and distribution expenses are recognised as period costs.
(p) Engineered Costs - These are costs that result specifically from a clear cause and effect relationship between
inputs and outputs. The relationship is usually personally observable. Examples of inputs are direct material costs,
direct labour costs etc. Examples of output are cars, computers etc.
(q) Explicit Costs - These costs are also known as out-of-pocket costs and refer to costs involving immediate payment
of cash. salaries, wages, postage and telegram, printing and stationery, interest on loan etc. are some examples of
explicit costs involving immediate cash payment.
(r) Implicit Costs - These costs do not involve any immediate cash payment. They are not recorded in the books of
account. They are also known as economic costs.

15. METHODS OF COSTING

Different industries follow different methods of costing because of the differencesin the nature of their work. The various
methods of costing are as follows:
Methods Description
Single or OutputCosting Under this method, the cost of a product is ascertained, theproduct being
the only one produced like bricks, coals, etc.
Batch Costing This method is the extension of job costing. A batch may represent a number
of small orders passed through the factory in batch. Each batch here is
treated as a unit of cost and thus separately costed. Here cost per unit is
determined by dividing the cost of the batch by the number of units
produced in the batch.
Job Costing Under this method of costing, cost of each job is ascertained separately.
It is suitable in all cases where work is undertaken on receiving a
customer’s order like a printing press, motor workshop, etc.

Contract Costing Under this method, the cost of each contract is ascertained separately. It is
suitable for firms engaged in the construction of bridges, roads, buildings
etc.
Process Costing Under this method, the cost of completing each stage ofwork is ascertained,
like cost of making pulp and cost ofmaking paper from pulp. In mechanical
operations, the costof each operation may be ascertained separately; the
name given is operation costing.

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 Introduc on to Cost and Management Accoun ng

Operating Costing It is used in the case of concerns rendering services liketransport, supply of
water, retail trade etc.
Multiple Costing It is a combination of two or more methods of costing outlined above.
Suppose a firm manufactures bicycles including its components; the parts
will be costed by the system of job or batch costing but the cost of
assembling the bicycle will be computed by the single or output costing
method. The whole system of costing is known as multiple costing.

The following table summarises the various methods of costing applied indifferent industries:
Nature of Output Method Cost Examples of
Industries

A Series of Processes Process costing or For each process Sugar

Operation Costing
Construction of building Contract Costing For each contract Real estate

Similar units of a Single Unit or output or Single For the entire Cold Drinks
Product, produced by Costing activity, but
Single Process averaged for the
output

Rendering of Services Operating Costing For all services Hospitals

Customer Specifications: Job Costing For each order/ Advertising
single Unit assignment/job

Consisting of multiple MultipleCosting Combination of any Car Assembly

varieties of activities and method
processes

16. TECHNIQUES OF COSTING

For ascertaining cost, following types of costing are usually used.
Techniques Description
Uniform Costing When a number of firms in an industry agree among themselves to follow
the same system of costing in details, adopting common terminology for
various items and proc- esses they are said to follow a system of uniform
costing.
Advantages of such a system are:
- A comparison of the performance of each of the firmscan be
made with that of another, or with the average performance in the industry.
- Under such a system, it is also possible to determinethe cost of
production of goods which is true for the industry as a whole. It is found
useful when tax-relief or protection is sought from the Government.

Marginal Costing It is defined as the ascertainment of marginal cost by differentiating

between fixed and variable costs. It is used toascertain effect of changes in
volume or type of output on profit.
Standard Costing It is the name given to the technique whereby standard costs are pre-
and Variance determined and subsequently compared with the recorded actual costs. It
Analysis is thus a technique of cost ascertainment and cost control. This technique
may be used in conjunction with any method of costing. However, it is
especially suitable where the manufacturing method involves production
of standardised goods of repetitive nature.

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 Introduc on to Cost and Management Accoun ng

Historical Costing It is the ascertainment of costs after they have beenincurred. This type
of costing has limited utility.
 Post Costing: It means ascertainment of cost after production is
completed.
 Continuous costing: Cost is ascertained as soon as the job is
completed or even when the job is in progress.
Absorption Costing It is the practice of charging all costs, both variable and fixed to
operations, processes or products. This differs from marginal costing where
fixed costs are excluded.

1.15
 Material Cost

Chapter MATERIAL COST

2

Important Question
1. Write treatment of items associated with purchase of material:
a. Cash discount
b. Subsidy/ Grant/ Incentives
c. VAT or State Sales Tax
d. Commission/brokerage paid Explain ABC Analysis.
e. Detention Charges/Fines
f. Demurrage
g. Cost of Returnable containers
h. Central Goods and Service Tax (CGST)
i. Shortage due to abnormal reasons.
2. Which system of inventory management is known as 'Demand pull' or 'Pull through' system of production? Explain. Also,
specify the two principles on which this system is based.
3. Explain 'Just In Time' (JIT) approach of inventory management.
4. Discuss ABC analysis as a system of inventory control.
5. Distinguish between bill of material and material requisition note.
6. "Perpetual inventory system comprises Bin Card and Stores Ledger, but the efficacy of the system depends on continuous
stock taking." Comment.
7. Distinguish between 'Scraps' and 'Defectives' in costing.
8. Distinguish between 'Bin Card' and 'Stores Ledger'.
9. Explain FIFO and LIFO method of stores issue.
10. Explain obsolescence and circumstances under which materials become obsolete. State the steps to be taken for its treatment.
11. Define Inventory Control and give its objectives. List down the basis to be adopted for Inventory Control.
12. Write a short note on VED analysis of Inventory Control.

1. MATERIAL
1.1 Meaning of Material
The general meaning of material is allcommodities/ physical objects used to make the final product. It may be direct
or indirect.
(i) Direct Materials: Materials, cost of which can be directly attributable to the end product for which it is being used,
in an economically feasible way.
(ii) Indirect Materials: Those materials which are not directly attributable to aparticular final product.

1.2 Importance of proper recording and control of material are as follows:

(a) Quality of final product: The quality of output depends on the quality of inputs.
(b) Price of the final product: Material constitutes a significant part of any product and the cost of final product is directly
related with cost of materials used to produce the product.
(c) Production continuity: In order to avoid production interruptions, an adequate level of stock of materials should
be maintained.
(d) Cost of Stock holding and stock-out: An entity has to incur stock holding costs in the form of interest and/or
opportunity cost for the fund used, stock handling losses like evaporation, obsolescence etc.
Under-stocking causes in loss of revenue due to stock-out and breach of commitment.
(e) Wastage and other losses: While handling and processing of materials, some wastage and loss arise. Based on the
nature of material and process, these are classified as normal and abnormal for efficient utilisation and control.
(f) Regular information about resources: Regular and updated information on availability and utilisation of materials
are necessary for the entity for timely and informed decision making.

2.1
 Material Cost

2. MATERIAL CONTROL
2.1 Objectives of System of Material Control
(i) Minimising interruption in production process: Material Control system ensures that no activity, particularly
production, suffers from interruption for want of materials and stores.
(ii) Optimisation of Material Cost: All the materials and stores are acquired at the lowest possible price considering the
required quality and other relevant factors like reliability in respect of delivery, etc., holding cost too needs to be
minimized.
(iii) Reduction in Wastages: It has an objective of avoidance of unnecessary losses and wastages that may arise from
deterioration in quality due to defective or long storage or from obsolescence.
It may be noted that losses and wastages in the process of manufacture are a concern of the production department.
(iv) Adequate Information: The system of material control maintains proper records to ensure that reliable information is
available for all items of materials and stores.
(v) Completion of order in time: Proper material management is very necessary for fulfilling orders of the firm. This
adds to the goodwill of thefirm.

2.2 Requirements of Material Control

Material control requirements can be summarised as follows:
1. Proper co-ordination of all departments involved viz., finance, purchasing,receiving, inspection, storage, accounting
and payment.
2. Determining purchase procedure to see that purchases are made, after making suitable enquiries, at the most
favourable terms to the firm.
3. Use of standard forms for placing the order, noting receipt of goods, authorising issue of the materials etc.
4. Preparation of budgets concerning materials, supplies and equipment to ensure economy in purchasing and use of
materials.
5. Operation of a system of internal check so that all transactions involving materials, supplies and equipment purchases
are properly approved and automatically checked.
6. Storage of all materials and supplies in a well designated location with proper safeguards.
7. Operation of a system of perpetual inventory together with continuous stock checking so that it is possible to
determine, at any time, the amount and the value of each kind of material in stock.
8. Operation of a system of stores control and issue so that there will be deliveryof materials upon requisition to
departments in the right amount at the time they are needed.
9. Development of system of controlling accounts and subsidiary records which exhibit summary and detailed
material costs at the stage of material receiptand consumption.
10. Regular reports of materials purchased issue from stock, inventory balances, obsolete stock, goods returned to
vendors, and spoiled or defective units are required.

2.3 Elements of Material Control

Material Control

Material
Material Storage Material Usage
Procurement
Control Control
Control

3. MATERIALS PROCUREMENT PROCEDURE

3.1 Bill of Materials
 It is also known as Materials Specification List or Materials List. It is a detailedlist specifying the standard quantities
and qualities of materials and components required for producing a product or carrying out of any job.
 Format and content of a Bill of Materials vary on the basis of industrial peculiarities, management information system
(MIS) and accounting system in place.

2.2
 Material Cost

Uses of Bill of Material

1. Production Dept. - Production is planned according to the nature, volume of the materials required to be used.
Accordingly, material requisition lists are prepared.
2. Purchase Dept. – Materials are procured (purchased) on the basis of specifications mentioned in it.
3. Stores Dept. – It is used as a reference document while issuing materials to the requisitioning department.
4. Cost/ Accounting Dept. - It is used to estimate cost and profit. Any purchase, issue and usage are compared/verified
against this document.

3.2 Material Requisition Note

 It is also known as material requisition slip. It is a voucher of authority used to get materials issued from store.
 It is prepared by the production department and materials are withdrawn on the basis of material requisition list or bill of
materials.
 Format of a Material requisition note may vary on the basis of Industrial Peculiarities, Management Information System
(MIS) and Accounting System in place.

Difference between Bill of Materials and Material Requisition Note

Bill of Materials Material Requisition Note
1. It is the document prepared by theengineering or planning 1. It is prepared by the production or other consuming
dept. department.
2. It is a complete schedule of component parts and raw 2. It is a document asking Store-keeper to issue
materials required for a particular job or work order. materials to the consuming department.

3. It often serves the purpose of a material requisition as it 3. It cannot replace a bill of materials
shows the complete schedule of materials required for a
particular job i.e. it can replace material requisition.

4. It can be used for the purpose of quotations. 4. It is useful in arriving historical cost only.
5. It helps in keeping a quantitative control on materials drawn 5. It shows the material actually drawn from stores.
through material requisition.

3.3 Purchase Requisition

 This document authorises the purchase department to order for the materials specified in the note.
 Since the materials purchased will be used by the production departments, there should be constant co-ordination between
the purchase and production departments.
 A purchase requisition is a form used for making a formal request to the purchasing department to purchase
materials.

3.4 Inviting Quotation/ Request for Proposal (RFP)/Notification Inviting Tender (NIT)
Materials purchase department has to answer the following question beforeinitiating purchasing of materials:
(i) What to purchase?
(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase?
(v) At what price to purchase?

The following are the few suggestive steps to answer to the questions:
(i) What to purchase?
Materials are purchased as per the requisition received from the stores oruser departments. In case of materials
used regularly, the materials are purchased as per the standard operating procedures (SOP).

(ii) When to purchase?

Materials are purchased considering the need for the materials for production and safety, however, the timing of
placing the order is very important to get the materials replenished before the requirement arise and without affecting
the production schedule.
Supply of materials i.e., how easily the materials are available in the market,

2.3
 Material Cost

Lead time i.e., time requiredto get the order from supplier’s place to production place,
Consumption pattern of materials are the important factors which affects the timing ofpurchase. Related to the
question, later in this chapter Re-order Stock Level will be learnt. Further the concept of just-in-time (JIT), which
is briefly discussed in this chapter is also associated with the question ‘when’ to purchase.

(iii) How much to purchase?

The quantity of materials to be ordered depends on the factors like material consumption pattern, minimum order size
as offered by the supplier, quantity discount, storage cost and capacity and working capitalrequirement etc. The
concept of Economic Order Quantity (EOQ) will be discussed later in this chapter.

(iv) Where to purchase?

This is the process of selecting supplier of materials to be purchased. This isa very sensitive and crucial process,
though for every organization but specifically for the organizations where public money is involved i.e., public sector
undertakings (PSUs).
Selection process of supplier could be a grey area which attracts special attention of regulators like CVC (Central
Vigilance Commission), CAG (Comptroller and Auditor General of India), Auditors and others. The supplier selection
process be such transparent and fair that all suppliers are treated equal to get opportunity in participation in Tender
process.
The selection process starts with Enquiry/Request for Proposals (RFP)/ Notification Inviting Tender (NIT).
The RFP or NIT can be floated offline i.e., manual process or online by publishing on website or designated electronic
market places.
One of the examples of electronic market place is GeM (Government e Marketplace).
Government e Marketplace (GeM): A dedicated e-market for different goods & services procured by Government
Organisations / Departments / PSUs. It aims to enhance transparency, efficiency and speed in public procurement. It
provides the tools of e-bidding, reverse e-auction and demand aggregation to facilitate the government users, achieve
the best value for their money. The purchases through GeM by Government usershave been authorised and made
mandatory by Ministry of Finance.

(v) At what price to purchase?

The answer to the question is discussed in the following paragraph where the Lowest bidder (also called L1
bidder) for the material is selected.

3.5 Selection of Quotation/ Proposal

 After invitation of tender from the vendors, interested vendors who are fulfillingall the criteria mentioned in the tender
notice send their price quotations/ proposals to the purchase department. On the receipt of quotations, a comparative
statement is prepared.
 For selecting material suppliers, the factors which the purchase department keeps in its mind are—price, quantity, quality
offered, time of delivery, mode of transportation, terms of payment, reputation of supplier etc.
 In addition to the above listed factors purchase manager obtains other necessary information for final selection of material
suppliers.

3.6 Preparation and Execution of Purchase Orders

Once the best quotation is decided, the purchase manager or concerned officer proceeds to issue the formal purchase order.
It is a written request to the supplier to supply specified materials at specified rates and within a specified period. Generally,

copies of purchase order are given to Store or order indenting department, receiving department and cost accounting
department. A copy of the purchase order with relevant purchase requisitions, is held in the file of the department to
facilitate the follow-up of the delivery andalso for approval of the invoice for payment.

3.7 Receipt and Inspection of Materials

After execution of purchase order and advance payment (if terms of quotation so specify), necessary arrangement is made to
receive the delivery of materials After receipt of materials along with relevant documents or/ and invoice, receiving
department (store dept.) arrange to inspect the materials for its conformity with purchase order. After satisfactory inspection,
materials are received and Goods Received Note is issued. If some materials are not found in good condition or are not in
conformity with the purchase order are returned back to the vendor alongwith a Material Returned Note.

2.4
 Material Cost

3.1.1 Goods Received Note

If everything is in order and the supply is considered suitable for acceptance, the Receiving department prepares a
Receiving Report or Material Inward Note or Goods Received Note. Generally, it is prepared in quadruplicate, the
copies being distributed to purchase department, store or order indenting department, receiving department and
accounting department.

3.1.2 Material Returned Note

Sometimes materials have to be returned to suppliers after these have been received in the factory. Such returns may
occur before or after the preparation of the receiving report.
If the return takes place before the preparation of the receiving report, such material obviously would not be
included in the report and hence not shown in the stores ledgers. In that case, no adjustment in the account books would
be necessary.
But if the material is returned after its entry in the receiving report, a suitable document must be drawn up in
support of the issue so as to exclude from the Stores of Material Account the value of the materials returned
back. This document usually takes the form of a Material Returned Note or Material outward return note.

3.8 Checking and Passing of Bills for Payment

The invoice received from the supplier is sent to the accounts section to check authenticity and mathematical accuracy. The
quantity and price are also checkedwith reference to goods received note and the purchase order respectively. The accounts
section after checking its accuracy finally certifies and passes the invoice for payment.

4. VALUATION OF MATERIAL RECEIPTS

After the procurement of materials from the supplier actual material cost is calculated. Ascertainment of cost of material
purchased is called valuation of materials receipts. Cost of material includes cost of purchase net of trade discounts,
rebates, duty draw-back, input credit availed, etc. and other costs incurred in bringing the inventories to their present
location and condition.

Treatment of items associated with purchase of materials is tabulated as below

Sl No. Items Treatment
Discounts and Subsidy

(i) Trade Discount Trade discount is deducted from the purchaseprice if it is not shown as
deduction in the invoice.

(ii) QuantityDiscount Like trade discount quantity discount is also shown as deduction from the
invoice. It is deducted from the purchase price if not shown as deduction.

(iii) Cash Discount Cash discount is not deducted from the purchase price. It is treated as interest
and finance charges. Itis ignored.

(iv) Subsidy/ Grant/ Any subsidy/ grant/ incentive received from the Government or from other
Incentives sources deducted from the cost of purchase.

Duties and Taxes

(v) Road Tax/ TollTax Road tax/ Toll tax, if paid by the buyer, is included
with the cost of purchase.

(vi) Goods and Goods and Service Tax (GST) is paid on supply of goods and provision of
Service Tax services and collected from the buyers. It is excluded from the cost of purchase
(GST) if credit for the same is available. Unless mentioned specifically it should not
form part of cost of purchase.

(vii) Custom Duty Custom duty is paid on import of goods fromoutside India. It is added with
the purchase cost.

2.5
 Material Cost

Penalty and Charges

(viii) Demurrage Demurrage is a penalty imposed by the transporter for delay in uploading or
offloading of materials. It is an abnormal cost and not included with cost of
purchase
(ix) Detention charges/ Detention charges/ fines imposed for non-compliance of rule or law by any
Fine statutory authority. It is an abnormal cost and not included with cost of purchase

(x) Penalty Penalty of any type is not included with the cost ofpurchase

Other expenditures

(xi) Insurancecharges Insurance charges are paid for protecting goodsduring transit. It is added with
the cost of purchase.

(xii) Commission or Commission or brokerage paid is added with thecost of purchase.

brokerage paid.

(xiii) Freight inwards It is added with the cost of purchase as it is directlyattributable to procurement
of material.

(xiv) Cost of Treatment of cost of containers are as follows:

containers  Non-returnable containers: The cost ofcontainers is added with the cost
of purchaseof materials.
 Returnable Containers: If the containers are returned and their costs are
refunded, then cost of containers should not be considered in the cost of
purchase.
 If the amount of refund on returning the container is less than the amount
paid, then,only the short fall is added with the cost of
purchase.

(xv) Shortage Shortage in materials is treated as follows:

Shortage due to normal reasons: Good units absorb the cost of shortage
due to normal reasons. Losses due to breaking of bulk, evaporation, or due to
any unavoidable conditions etc. are the reasons of normal loss.
Shortage due to abnormal reasons: Shortage arises due to abnormal reasons
such as material mishandling, pilferage, or due to any avoidable reasons are not
absorbed by the good units. Losses due to abnormal reasons are debited to
costing profit and loss account.

5. MATERIAL STORAGE & RECORDS

Proper storing of materials is of primary importance. Apart from preservation of quality, the store-keeper also ensures safe
custody of the material. It should bethe function of store-keeper that the right quantity of materials always should be
available in stock.

5.1 Duties of Store Keeper

These can be briefly set out as follows:
(i) General control over store: Store keeper should keep control over all activities in Stores department. He should check
the quantities as mentionedin Goods received note and with the purchased materials forwarded by the receiving department
and to arrange for the storage in appropriate places.
(ii) Safe custody of materials: Store keeper should ensure that all the materials are stored in a safe condition and environment
required to preserve the quality of the materials.
(iii) Maintaining records: Store keeper should maintain proper record of quantity received, issued, balance in hand and
transferred to/ from otherstores.
(iv) Initiate purchase requisition: Store keeper should initiate purchase requisitions for the replacement of stock of all regular

2.6
 Material Cost

stores items whenever the stock level of any item of store approaches the re-order level fixed.
(v) Maintaining adequate level of stock: Store keeper should maintain adequate level of stock at all time. He/ she should
take all the necessaryaction so that production could not be interrupted due to lack of stock. Further he/ she should take
immediate action for stoppage of further purchasing when the stock level approaches the maximum limit. He also needs
to reserve a particular material for a specific job when so required.
(vi) Issue of materials: Store keeper should issue materials only against the material requisition slip approved by the appropriate
authority. He/ she should also refer to bill of materials while issuing materials to requisitioning department.
(vii) Stock verification and reconciliation: Store keeper should verify the book balances with the actual physical stock at
frequent intervals by way of internal control and check the any irregular or abnormal issues, pilferage,etc.

5.2 Store Records

The record of stores may be maintained in three forms:
 Bin Cards
 Stock Control Cards
 Store Ledger
1. Bin Cards: It is a quantitative record of inventory which shows the quantity of inventory available in a particular bin. Bin
refers to a box/ container/ space where materials are kept. Card is placed with each of the bin (space) to record the details
of material like receipt, issue and return. It is maintained by store department.

2. Stock Control Cards: It is also a quantitative record of inventory maintained by stores department for every item of
material. In other words, it is a record which shows the overall inventory position in store. Recording includes receipt, issue,
return, in hand and order given.

Advantages and Disadvantages of Bin Cards

Advantages:
(i) There would be fewer chances of mistakes being made as entries are madeat the same time as goods received or issued
by the person actually handling the materials.
(ii) Control over stock can be more effective, as comparison of the actual quantity in hand at any time with the book balance
is possible.
(iii) Identification of the different items of materials is facilitated by reference to the Bin Card, the bin or storage receptacle.

Disadvantages
(i) Store records are dispersed over a wide area.
(ii) The cards are liable to be smeared with dirt and grease because of proximityto material and also because of handling
materials.
(iii) People handling materials are not ordinarily suitable for the clerical workinvolved in writing Bin Cards.

Advantages and Disadvantages of Stock Control Cards

Advantages:
(i) Records are kept in a more compact manner so that reference to them is facilitated.
(ii) Records can be kept in a neat and clean way by men solely engaged in clerical work so that a division of workers between
record keeping and actual material handling is possible.
(iii) As the records are at one place, it is possible to get an overall idea of the stock position without the necessity of going
round the stores.

Disadvantages:
(i) On the spot comparison of the physical stock of an item with its bookbalance is not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the caseof bin cards, as the Stock Control Cards are
housed in cabinets or trays.

3. Stores Ledger: A Stores Ledger is maintained to record both quantity and cost of materials received, issued and those
in stock. It is a subsidiary ledger to the main cost ledger; it is maintained by the Cost/ Accounts Department. The source
documents for posting the ledger are Goods received notes, Materials requisition notes etc.

The first two forms are records of quantities received, issued and those in balance, but in the third record i.e. store ledger,
value of receipts, issues and closing balance is also maintained. Usually, records of quantities i.e. Bin cards and Store

2.7
 Material Cost

Control Cards are kept by the store keeper in store department while record of both quantity and value is maintained by
cost accounting department.

Difference between Bin Card & Stores Ledger

Bin Card Stores Ledger
It is maintained by the storekeeper in the store. It is maintained in cost accounting department.

It contains only quantitative details of material received, It contains information both in quantity and value.
issued and returned to stores.

Entries are made when transactiontakes place. It is always posted after the transaction.
Each transaction is individually posted. Transactions may be summarized andthen posted.

Inter-department transfers do not appear in Bin Card. Material transfers from one job toanother job are recorded
for costing purposes.

6. INVENTORY CONTROL
 The Chartered Institute of Management Accountants (CIMA) defines Inventory Control as “The function of ensuring that
sufficient goods are retained in stock to meet all requirements without carrying unnecessarily large stocks.”
 The objective of inventory control is to make a balance between sufficient stock and over-stock.
 The main objective of inventory control is to maintain a trade-off between stock-out and over-stocking.

Inventory
Control

By Setting On the basis of

Using Ratio
Quantitative Relative Physical Control
Analysis
Levels Classification

6.1 Inventory Control- By Setting Quantitative Levels

Re-order Stock Level  When to Order
Re-order Quantity/ EOQ  How Much to Order
Maximum Stock Level  Upto how much to stock
Minimum Stock Level  At least How much to stock
Average Stock Level  Stock normally kept
Danger Stock Level  Kept for emergency requirement
Buffer Stock  To meet sudden demand

(i) Re-order Stock Level (ROL): This level lies between minimum and the maximum levels in such a way that before the
material ordered is received into the stores, there is sufficient quantity in hand to cover both normal and abnormal
consumption situations. In other words, it is the level at which fresh order should be placed for replenishment of stock.
It is calculated as:
ROL = Maximum Consumption x Maximum Re-order Period

Maximum Consumption = The maximum rate of material consumption in production activity

Maximum Re-order period= The maximum time to get order from supplier to the stores

This can also be calculated alternatively as below:

ROL = Minimum Stock Level + (Average Rate of Consumption × AverageRe-order period)

Minimum Stock Level = Minimum Stock level that must be maintained all the time.

2.8
 Material Cost

Average Rate of Consumption = Average rate of material consumption in production activity.

It is also known as normal consumption/ usage
Average Re-order period = Average time to get an order from supplier to the stores.
It is also known asnormal period.

(Re-order period is also known as Lead time)

(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which purchase requisition is made by the store
department. While setting the quantity to be re-ordered, consideration is given to the maintenance of minimum level of
stock, re-order level, minimum delivery time and the most important the cost. Hence, the quantity should be where, the
total of carrying cost and ordering cost is at minimum. For this purpose, an economic order quantity should be
calculated.
Economic Order Quantity (EOQ): The size of an order for which total of ordering and carrying cost are minimum.
Ordering Cost: Ordering costs are the costs which are associated with the purchase or order of materials such as cost to
invite quotations, documentation works like preparation of purchase orders, employee cost directly attributable to the
procurement of material, transportation and inspection cost etc.
Carrying Cost: Carrying costs are the costs for holding/ carrying of inventories in store such as the cost of fund invested
in inventories, cost of storage, insurance cost, obsolescence etc.

The Economic Order Quantity (EOQ) is calculated as below:

( ) ( )
EOQ =
( )

Annual Requirement (A)- It represents demand for raw material or Input for ayear.
Cost per Order (O) - It represents cost of placing an order for purchase.
Carrying Cost (C) – It represents cost of carrying average inventory on annualbasis.
Assumptions underlying E.O.Q.: The calculation of economic order of material to be purchased is subject to the
following assumptions:
(i) Ordering cost per order and carrying cost per unit per annum areknown and they are fixed.
(ii) Anticipated usage of material in units is known.
(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the leadtime is zero.

(iii) Minimum Stock Level: It is lowest level of material stock, which must be maintained in hand at all times, so that there
is no stoppage of production due to non-availability of inventory.
It is calculated as below:
Minimum Stock Level = Re-order Stock Level - (Average Consumption Rate
× Average Re-order Period)

(iv) Maximum Stock Level: It is the highest level of quantity for any material which can be held in stock at any time. Any
quantity beyond this level cause extra amount of expenditure due to engagement of fund, cost of storage, obsolescence etc.
It can be calculated as below:
Maximum Stock Level = Re-order Level + Re-order Quantity - (Minimum
Consumption Rate × Minimum Re-order Period)

Here, Re-order Quantity may be EOQ

(v) Average Inventory Level: This is the quantity of material that is normallyheld in stock over a period. It is also
known as normal stock level.
It can be calculated as below:
Average Stock Level = Minimum Stock Level + 1/2 Re-order Quantity Alternatively, it can be
calculated as below:
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑆𝑡𝑜𝑐𝑘 𝐿𝑒𝑣𝑒𝑙 + 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑆𝑡𝑜𝑐𝑘 𝐿𝑒𝑣𝑒𝑙
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘 𝐿𝑒𝑣𝑒𝑙 =
2

2.9
 Material Cost

(vi) Danger level: It is the level at which normal issues of the raw materialinventory are stopped and emergency issues are
only made.
It can be calculated as below:
Danger Level = Average Consumption* × Lead time for emergency purchase

*Some time minimum consumption is also used.

(vii) Buffer Stock: Some quantity of stock may be kept for contingency to beused in case of sudden order, such stock
is known as buffer stock.

6.2 Inventory Stock-Out

 Stock out is said to be occurred when an inventory item could not be supplied due to insufficient stock in the store.
 Due to stock out an entity not only loses overheads costs and profit but reputation (goodwill) also due to non-fulfilment
of commitment.
 While deciding on the level of inventory, a trade-off between the stock out cost and carrying cost is made so that overall
inventory cost can be minimized.

6.3 Just In Time (JIT) Inventory Management

 JIT is a system of inventory management with an approach to have zero inventories in stores. According to this approach
material should only be purchased when it is actually required for production.
 JIT is based on two principles
(i) Produce goods only when it is required and
(ii) the products should be delivered to customers at the time only when they want.
 It is also known as ‘Demand pull’ or ‘Pull through’ system of production. In this system, production process actually
starts after the order for the products is received. Based on the demand, production process starts and the requirement for raw
materials is sent to the purchase department for purchase.

6.4 Inventory Control- On the basis of Relative Classification

ABC Analysis  On the basis of value and frequency of inventory
Fast, Slow and Non-Moving (FSN)  On the basis of inventory turnover
Vital, Essential and Desirable (VED)  On the basis of importance of inventory
High, Medium and Low (HML)  On the basis of price of an item of inventory

(1) ABC Analysis: This system exercises discriminating control over different items of inventory on the basis of the investment
involved. Usually the items are classified into three categories according to their relative importance, namely, their value
and frequency of replenishment during a period.
(i) ‘A’ Category: This category of items consists of only a small percentage i.e., about 10% of the total items handled
by the stores but require heavy investment about 70% of inventory value, because of their high prices or heavy
requirement or both. Items under this category can be controlled effectively by using a regular system which
ensures neither over-stocking nor shortage of materials for production.
(ii) ‘B’ Category: This category of items is relatively less important; they may be 20% of the total items of material
handled by stores. The percentage of investment required is about 20% of the total investment in inventories. In the
case of these items, as the sum involved is moderate, the same degree of control as applied in ‘A’ category of
items is not warranted.
(iii) ‘C’ Category: This category of items does not require much investment; itmay be about 10% of total
inventory value but they are nearly 70% of thetotal items handled by store. For these categories of items,
there is no needof exercising constant control.

Advantages of ABC analysis: The advantages of ABC analysis are the following:
(i) Continuity in production: It ensures that, without there being any danger of interruption of production for want
of materials or stores, minimum investment will be made in inventories of stocks of materials or stocks to be
carried.
(ii) Lower cost: The cost of placing orders, receiving goods and maintaining stocks is minimised specially if the
system is coupled with the determination of proper economic order quantities.
(iii) Less attention required: Management time is saved since attention need to be paid only to some of the items
rather than all the items, as would be the case if the ABC system was not in operation.
(iv) Systematic working: With the introduction of the ABC system, much of the work connected with purchases
2.10
 Material Cost

can be systematized on a routine basis, tobe handled by subordinate staff.

(2) Fast Moving, Slow Moving and Non-Moving (FSN) Inventory: It is also known as FNS (Fast, Normal and Slow moving)
classification of inventory analysis. Under this system, inventories are controlled by classifying them on the basis of
frequency of usage. The classification of items into these three categories depends on the nature and managerial
discretion. A threshold range on the basisof inventory turnover is decided and classified accordingly.
(i) Fast Moving- This category of items is placed nearer to store issue pointand the stock is reviewed frequently
for making of fresh orders.
(ii) Slow Moving- This category of items is stored little far and stock is reviewed periodically for any obsolescence,
and may be shifted to Non-moving category.
(iii) Non-Moving- This category of items is kept for disposal. This category of items is reported to the management and
an appropriate provision for loss may be created.

Some of the reasons for slow moving and non-moving inventories are stated below:
(i) Failure of production management to communicate the updatedrequirement to the stores management
(ii) Technological upgradation in terms of new machine requiring new kind ofmaterial or existing material
becoming obsolete.
(iii) Lack of periodic review of inventories.

(3) Vital, Essential and Desirable (VED): Under this system of inventory analysis, inventories are classified on the basis
of its criticality for the production function and final product. Generally, this classification is done for spare parts
which are used for production.
(i) Vital- Items are classified as vital when its unavailability can interrupt the production process and cause a
production loss. Items under this category are strictly controlled by setting re-order level.
(ii) Essential- Items under this category are essential but not vital. Theunavailability may cause sub standardisation and
loss of efficiency in production process. Items under this category are reviewed periodically and get the second
priority.
(iii) Desirable- Items under this category are optional in nature, unavailabilitydoes not cause any production or
efficiency loss.

(4) High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system, inventory is classified on the basis of the
cost of an individual item, A range of cost is used to classify the inventory items into the three categories. High-Cost
inventories are given more priority for control, whereas Medium-cost and Low-cost items are comparatively given
lesser priority.

6.5 Using Ratio Analysis

(i) Input-Output Ratio: Inventory control can also be exercised by the use of input- output ratio analysis. Input-output ratio
is the ratio of the quantity of input of material to production and the standard material content of the actual
output.
This type of ratio analysis enables comparison of actual consumption and standard consumption, thus indicating whether
the usage of material is favourable or adverse.

(ii) Inventory Turnover Ratio: High inventory turnover ratio indicates that the material in the question is a fast moving
one.A low turnover ratio indicates over-investment and locking up of the working capital in inventories. Inventory
turnover ratio may be calculated by using the following formulae: -

Inventory Turnover Ratio =

Average stock = 1/2 (opening stock + closing stock)

/
Average no. of days of Inventory holding =

By comparing the number of days in the case of two different materials, it is possible to know which is fast moving and
which is slow moving. On this basis, attempt should be made to reduce the amount of capital locked up, and prevent over-
stocking of the slow-moving items.

2.11
 Material Cost

6.6 Physical Control

(i) Two Bin System: Under this system, each bin is divided into two parts –
(I) smaller part to stock the quantity equal to the minimum stock or even the re-ordering level, and
(II) the other part to keep the remaining quantity.
Issues are made out of the larger part; but as soon as it becomes necessaryto use quantity out of the
smaller part of the bin, fresh order is placed. “Two Bin System” is supplemental to the record of respective
quantities on the bin card and the stores ledger card.

(ii) Establishment of system of budgets: To control investment in the inventories, it is necessary to know in advance about
the inventories requirement during a specific period (usually a year). The exact quantity of various types of inventories
and the time when they would be required canbe known by studying carefully production plans and production schedules.
Based on this, inventories requirement budget can be prepared. Such a budget will discourage the unnecessary investment
in inventories.

(iii) Perpetual inventory records and continuous stock verification: Perpetual inventory represents a system of records
maintained by the stores department. It, in fact, comprises of: (i) Bin Cards, and (ii) Stores Ledger.
The success of perpetual inventory depends upon the following:
(a) The Stores Ledger showing quantities and amount of each item.
(b) Stock Control cards (or Bin Cards).
(c) Reconciling the quantity balances shown by (a) & (b) above.
(d) Checking the physical balances of a number of items every daysystematically and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, betweenphysical balances and the book
figures.
(f) Making corrective entries wherever required after step (e) and
(g) Removing the causes of the discrepancies referred to in step (e)

Advantages of perpetual inventory: The main advantages of perpetual inventory are as follows:
(1) Physical stocks can be counted and book balances adjusted as andwhen desired without waiting for the
entire stock-taking to be done.

(2) Quick compilation of Profit and Loss Account (for interim period) dueto prompt availability of stock
figures.
(3) Discrepancies are easily located and thus corrective action can be promptly taken to avoid their recurrence.
(4) A systematic review of the perpetual inventory reveals the existence of surplus, dormant, obsolete and
slow-moving materials, so that remedial measures may be taken in time.
(5) Fixation of the various stock levels and checking of actual balances in hand with these levels assist the store
keeper in maintaining stockswithin limits and in initiating purchase requisitions for correct quantityat
the appropriate time.

(iv) Continuous Stock Verification: The checking of physical inventory is an essential feature of every sound system of
material control. The system of continuous stock-taking consists of physical verification of items of inventory. The
stock verification may be done by internal audit department but are independent of the store and production staff. Stock
verification is done at appropriate interval of time without prior notice. The element of surprise is essential for effective
control of the system.

Disadvantages of Annual/ Periodic Stock Taking: Annual stock-taking, however, has certain inherent shortcomings
which tend to detract from the usefulness of such physical verification.
For instance, since all the items have to be covered in a given number of days, either the production department has to
be shut down during those days to enable thorough checking of stock or else the verification must be of limited
character.
On the contrary, continuous stock taking is holding more advantages. Some of them are discussed below:

Advantages of continuous stock-taking:

1. Closure of normal functioning is not necessary.
2. Stock discrepancies are likely to be brought to the notice andcorrected much earlier than under
the annual stock-taking system.

2.12
 Material Cost

3. The system generally has a sobering influence on the stores staffbecause of the element of surprise
present therein.
4. The movement of stores items can be watched more closely by the stores auditor so that chances
of obsolescence buying are reduced.
5. Final Accounts can be ready quickly. Interim accounts are possiblequite conveniently.

7. MATERIAL ISSUE PROCEDURE

(i) Issue against Material Requisition Note: It is the voucher of the authority as regards to the issue of materials
for use in the factory or in any of its departments. After receipt of material requisition slip, store keeper ensures that
requisition is properly authorized and requisitioned quantity is within the quantity specified in bill of materials. After
satisfied with the documents, store keeper issue materials and keeps one copy of the MRN to maintain the necessary
records.

(ii) Transfer of Material: The surplus material arising on a job or other units of production may sometime be
unsuitable for transfer to store because of its bulk, heavy weight, brittleness or some other reason. It may, however,
be possible to find some alternative use for such materials by transferring them to some other job instead of returning
them to the store.

It must be stressed that generally transfer of material from one job to another is irregular, if not improper; in so far,
it is not conducive to correct allocation and control of material, cost of jobs or other units of production.It is only
in the circumstances envisaged above, that such direct transfer should be made. At the time of material transfer, a
material transfer note should be made in duplicate.

No copy is required for the store, as no entry in the stores records would be called for. The Cost Accounting Department
would use its copy for the purpose of making the necessary entries in the cost ledger accounts for the jobs affected.
Format of a material requisition note may vary on the basis of industrialpeculiarities, management information system
(MIS) and accounting systemin place.

(iii) Return of Material: Sometimes, it is not possible before hand to make any precise estimate of the material
requirements or units of production. Besides, at times, due to some technical issues or other difficulties, it is not
practicable to measure the exact quantity of material required by adepartment. In either case, material may have to
be issued from stores inbulk, often in excess of the actual quantity required. Where such a condition exists, it is of
the utmost importance from the point of view of materials control that any surplus material left over on the
completion of a job should be promptly hand over to the storekeeper for safe and proper custody.
Unless this is done, the surplus material may be misappropriated or misapplied to some purpose, other than that for
which it was intended. The material cost of the job against which the excess material was originally drawn in that
case, would be overstated, unless the job is given credit for the surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be accompanied by a document known as a Shop
Credit Note or alternatively as a Stores Debit Note. This document should be made out; by the department returning
the surplus material and it should be in triplicate to be used as follows:
Format of a shop credit note may vary on the basis of industrial peculiarities, management information system (MIS)
and accounting system in place.

8. VALUATION OF MATERIAL ISSUES

These methods may be grouped and explainedas follows:
8.1 Cost Price Methods
(i) Specific Price Method: This method is useful, especially when materials are purchased for a specific job
or work order, as such materials are issued subsequently to that specific job or work order at the price at
which they were purchased.
To use this method, it is necessary to store each lot of material separatelyand maintain its separate account.

Advantages and Disadvantages

Advantages Disadvantages
 The cost of materials issued for  This method is difficult to operate,
production purposes to specific jobs especially when purchases and issues are
2.13
 Material Cost

represent actual and correct costs. numerous.

 This method is best suited for non-

standard and specificproducts.

(ii) First-in First-out (FIFO) Method: It is a method of pricing the issues of materials, in the order in which they
are purchased. In other words, the materials are issued in the order in which they arrive in the store or the items
longest in stock are issued first.

Advantages and disadvantages

Advantages Disadvantages
 It is simple to understand andeasy to  If the prices fluctuate frequently, this method may
operate. lead to clerical error.
 Material cost charged to production  Since each issue of material to production is
represents actual cost with which the related to a specific purchase price, the costs
cost of production should have been charged to the same job are likely to show a
charged. variation from period to period.

 In the case of falling prices, the use of  In the case of rising prices, the real profits of the
this method gives better results. concern being low,while the profits in the books
will appear high. This may lead toinability of the
firm to meet the materials purchase demand at the
current market price.

 Closing stock of material will be

represented very closely at current
market price.

(iii) Last-in-First-out (LIFO) Method: It is a method of pricing the issues of materials on the basis of assumption
that the items of the last batch (lot) purchased are the first to be issued. Therefore, under this method the
prices of the last batch (lot) are used for pricing the issues, until it is exhausted, and so on. If however, the
quantity of issue is more than thequantity of the latest lot, then earlier (lot) and its price will also be taken into
consideration.

Advantages and Disadvantages

Advantages Disadvantages

 The cost of materials issued will be either  Calculation under LIFO system
nearer to and or will reflect the current becomes complicated and cumbersome
market price. Thus, the cost of goods when frequent purchases are made at
produced will be related to the trend of the highly fluctuating rates.
market price of materials. Such a trend in
price of materials enables the matching of
cost of production with current sales
revenues.
 The use of the method during the period of  Costs of different similar batches of
rising prices does not reflect undue high production carried on at the same time
profit in the income statement as it was may differa great deal.
under the first-in-first-out or average
method. In fact, the profit shown here is
relatively lower because the cost of
production takes into account the rising
trend of material prices.

2.14
 Material Cost

 In the case of falling prices profit tends to  In time of falling prices, there will be
rise due to lower material cost, yet the need for writing off stock value
finished products appear to be more considerably to stick to the principle of
competitive and are at market price. stock valuation, i.e., the cost or the
market price whichever is lower.

 Over a period, the use of LIFO helps to  This method of valuation ofmaterial is
iron out the fluctuationsin profits. not acceptable to the income tax
authorities.

 In the period of inflation LIFO will tend to

show the correct profit and thus avoid
paying undue taxes to some extent.

(iv) Base Stock Method: Minimum quantity of stock under this method is always held at a fixed price as reserve
in the stock, to meet the state of emergency, if it arises.
This method of valuing inventory is different from other methods of valuing issues, as the base stock of materials
are valued at the original cost, whereas, materials other than the base are valued using other methods like FIFO,
LIFO etc. This method is not an independent method as it uses FIFO or LIFO.
Advantages and disadvantages of this method depend upon the use of the other method viz., FIFO or LIFO.

8.2 Average Price Methods

(i) Simple Average Price Method: Under this method, materials issued are valued at average price, which is
calculated by dividing the total of rates at which different lot of materials are purchased by total number of lots. In
this method quantity purchased in each lot is ignored. This method is suitable when the materials are received
in uniform lots ofsimilar quantity, and prices do not fluctuate considerably.

Advantages and Disadvantages:

Advantages Disadvantages
 This method is simple to use foran entity  This method does not provide right stock valuation
which orders materialsin a lot of standard when standard quantity for purchase in a lot is not
quantity, asonly price per lot is taken to specified.
calculate average price

 In a stable price environment, this  When price of materials fluctuates and the entity
method gives a price whichapproximates chooses to customise the order quantity, the price
to the current market price. under this method may differ substantially from the
current market price.

(ii) Weighted Average Price Method: Unlike Simple Average Price method, this method gives due weightage to
quantities also. Under this method, issue price is calculated by dividing sum of products of price and quantity
by total number quantities.
This method is useful in case when quantity purchased under each lot isdifferent and price fluctuates frequently.

Advantages and Disadvantages:

Advantages Disadvantages

 It smoothens the price fluctuations, if at  Material cost does not represent actual cost price and
all it is there, due to material purchases. therefore, a different profit or loss will arise out of
such a pricing method.

2.15
 Material Cost

 Issue prices need not be calculated for  It may be difficult to compute, since every time lot
each issue unless new lot of materials is is received,it would require re-computation of issue
received. prices.

8.3 Market Price Methods

(i) Replacement Price Method: Replacement price is defined as the price at which it is possible to purchase an
item, identical to that which is being replaced or revalued. Under this method, materials issued are valued at
the replacement cost of the items. This method pre-supposes the determination of the replacement cost of materials
at the time of each issue; viz., the cost at which identical materials could be currently purchased. The product cost
under this method is at current market price, which is the main objective of the replacement price method.

(ii) Realisable Price Method: Realisable price means a price at which the material to be issued can be sold in
the market. This price may be moreor may be less than the cost price at which it was originally purchased. Like
replacement price method, the stores ledger would show profit or loss inthis method too.

8.4 Notional Price Methods

(i) Standard Price Method: Under this method, materials are priced at some predetermined rate or standard
price irrespective of the actual purchase cost of the materials. Standard cost is usually fixed after taking into
consideration the following factors:
(i) Current prices,
(ii) Anticipated market trends, and
(iii) Discount available and transport charges etc.

Advantages Disadvantages

 The use of the standard price method  The use of standard price does not reflect
simplifies the task ofvaluing issues of the market price and thus results in a
materials. different or
incorrect profit or loss.

 It facilitates the control of material cost  The fixation of standard price becomes
and the task ofjudging the efficiency of difficult when pricesfluctuate frequently
purchase department.

 It reduces the clerical work.

(ii) Inflated Price Method: In case material suffers loss in weight due to natural or climatic factors, e.g.,
evaporation, the issue price of the material is inflated to cover up the losses.

(iii) Re-use Price Method: When materials are rejected and returned to the stores or a processed material is put to
some other use, other than for the purpose it is meant, then such materials are priced at a rate quite different
from the price paid for them originally. There is no final procedure for valuing use of material.

9. VALUATION OF RETURNS & SHORTAGES

9.1 Valuation of Materials Returned to the Vendor
 The price of the materials to be returned to the vendor should include its invoice price plus freight, receiving and handling
charges etc.
 Strictly speaking, the materials returned to the vendor should be returned at the stores ledger price and not at invoice
price. But in practice, only invoice price is considered and the gap between the invoice price and stores ledger price is charged
as overhead.

9.2 Valuation of Materials Returned to Stores

When materials requisitioned for a specific job or work-in progress are found tobe in excess of the requirement or are
unsuitable for the purpose, they are returned to the stores. There are two ways of treating such returns.
2.16
 Material Cost

(1) Such returns are entered in the receipt column at the price at which theywere originally issued, and the
materials are kept in suspense account, to be issued at the same price, against the next requisition.
(2) Include the materials in stock, as if they were fresh purchases at the original issue price.

9.3 Valuation of Shortages during Physical Verification

Materials found short during physical verification should be entered in the issue column and valued at the rate as per the
method adopted, i.e., FIFO or any other.

10. TREATMENT OF NORMAL AND ABNORMALLOSS OF MATERIALS

Loss of materials during handling, storage, process may occur any of the followingforms:

Loss of Material

Waste Scrap Spoilage Defec ves Obsolescence

(i) Waste: The portion of raw material which is lost during storage or production and discarded. The waste may or may not
have any value.
Treatment of Waste
- Normal- Cost of normal waste is absorbed by good production units.
- Abnormal- The cost of abnormal loss is transferred to Costing Profit andloss account.

(ii) Scrap: The materials which are discarded and disposed-off without further treatment. Generally, scrap has either no value or
insignificant value. Sometimes, it may be reintroduced into the process as raw material.

Treatment of Scrap
- Normal- The cost of scrap is borne by good units and income arises on account of realisable value is deducted from the
cost.
- Abnormal- The scrap account should be charged with full cost. The credit is given to the job or process concerned. The
profit or loss in the scrap account, on realisation, will be transferred to the Costing Profit and Loss Account.

(iii) Spoilage: It is the term used for materials which are badly damaged in manufacturing operations, and they cannot be rectified
economically and hence taken out of the process to be disposed off in some manner without further processing.

Treatment of Spoilage
- Normal- Normal spoilage (i.e., which is inherent in the operation) costs are included in costs, either by charging the loss
due to spoilage to the production order or by charging it to the production overhead so that it is spread over all the
products.
Any value realised from spoilage is credited to production order orproduction overhead account, as the case may be.
- Abnormal- The cost of abnormal spoilage (i.e., arising out of causes notinherent in manufacturing process) is charged to
the Costing Profit and Loss Account. When spoiled work is the result of rigid specification, the cost of spoiled work is
absorbed by good production while the cost of disposal is charged to production overhead.

(iv) Defectives: It signifies those units or portions of production which do not meet the quality standards. Defectives arise due
to sub-standard materials, bad-supervision, bad-planning, poor workmanship, inadequate-equipment and careless
inspection.
The defectives which can be re-made as per the quality standard by using additional materials are known as reworks. Reworks
include repairs, reconditioning and refurbishing.
Defectives which cannot be brought up to the quality standards are knownas rejects. The rejects may either be disposed-
off or re-cycled for production process.

Treatment of Defectives:
- Normal- An amount equal to the cost less realisable value on sale of defectives are charged to material cost of good
production.
- Abnormal- Material cost of abnormal defectives is not included in material cost but treated as loss after giving credit to
the realisable value of such defectives. The material cost of abnormal loss is transferred to costing profit and loss account.

2.17
 Material Cost

Difference between Waste and Scrap

Waste Scrap

1. It is connected with raw material or inputs to 1. It is the loss connected with the output
production process

2. Waste of materials mayvisible or be invisible. 2. Scraps are generally identifiable and has
physical substance.
3. Generally, waste has no recoverable value. 3. Scraps are termed as by-products and
has small recoverable value.

Difference between Scrap and Defectives

Scrap Defectives
1. It is the loss connected with the output 1. This type of loss is connectedwith the
output as well as the input.

2. Scraps are not intended but cannot be eliminated 2. Defectives also are not intended but
due to the nature of material or process itself. can be eliminated through a proper
control system.
3. Generally, scraps are not usedor rectified. 3. Defectives can be used after
rectification.

4. Scraps have recoverable insignificant 4. Defectives are sold at a lower value

value. from that of the good one.

Distinction between Spoilage and Defectives: The difference between spoilage and defectives is that while
spoilage cannot be repaired or reconditioned, defectives can be rectified and transferred, either back to the standard
production or to the seconds.
The problem of accounting for defective work is in relation to the costs of rectification or rework.

(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value ofan asset due to its supersession”. In simple
words, obsolescence refers to the loss in the value of an asset due to technological advancements.

Treatment: Materials may become obsolete under any of the following circumstances:
(i) where it is a spare part or a component of a machinery that is used inmanufacturing and is now obsolete;
(ii) where it is used in the manufacturing of a product which has nowbecome obsolete;
(iii) where the material itself is replaced by another material due to eitherimproved quality or fall in price.
In all the three cases, the value of the obsolete material held in stock is a total loss and immediate steps should be taken
to dispose it off at the best available price. The loss arising out of obsolete materials is an abnormal loss and it does not form
part of the cost of manufacture.

2.18
 Employee Cost and Direct Expenses

Chapter EMPLOYEE COST AND DIRECT

3 EXPENSES

Important Question
1. Rowan Premium Bonus system does not motivate a highly efficient worker as a less efficient worker and a highly
efficient worker can obtain same bonus under this system. Discuss with an example.
2. Explain the treatment of Overtime Premium in following situations:
a. SV & Co. wants to grab some special orders, and overtime is required to meet the same.
b. Dept. X has to work overtime to make up a shortfall in production due to some fault of management in dept. Y.
c. S Ltd. has to work overtime regularly throughout the year as a policy due to the workers' shortage.
d. Due to flood in Odisha, RS Ltd. has to work overtime to complete the job.
e. A customer requested the company MN Ltd. to expedite the job because of his urgency of work.
3. Discuss the three different methods of calculating labour turnover.
4. Enumerate the causes of labour turnover.
5. Define 'Labour Turnover'. How is it measured? Explain.
6. Discuss any four objectives of "Time Keeping" in relation to attendance and payroll procedures.
7. Explain Direct Expenses and how these are measured and their treatment in cost accounting

1. Employee (Labour) Cost

 Benefits paid or payable to the employees of an entity,
 whether permanent, or temporary for the services rendered by them
 includes payments made in cash or kind.

Employee cost includes the following:

 Wages and salary;
 Allowances and incentives;
 Payment for overtimes;
 Employer’s contribution to Provident fund and other welfare funds;
 Other benefits (leave with pay, free or subsidised food, leave travelconcession etc.) etc.

Classification of Employee (Labour) Cost

(i) Direct Employee (Labour) Cost
Benefits paid or payable to the employees which can be attributed to a cost object in an economically
feasible manner.

(ii) Indirect Employee (Labour) Cost

Benefits paid or payable to the employees, which cannot be directly attributable to a particular cost object in
an economically feasible manner.

Distinction between Direct and Indirect Employee Cost

Direct employee cost Indirect employee cost

It is the cost incurred in payment of Cost incurred for payment of employees who are
employees who are directly engaged in the not directly engaged in the production process.
production process.
Direct employee cost can be easily identified Indirect employee cost is apportioned on some
and allocated to cost unit. appropriate basis.
Direct employee cost varies with the volume Indirect employee cost may not vary with the
of production and has positive relationship volume of production
with the volume.

3.1
 Employee Cost and Direct Expenses

2. EMPLOYEE (LABOUR) COST CONTROL

 Employee cost control means control over the cost incurred on employees.
 The aim should be to keep the wages per unit of output as low as possible.
 This can only be achieved by giving employees appropriate compensation to encourage efficiency so that optimum
output can be achieved in effective manner.
Role of different departments in Employee Cost Control-
Department Functions

Personnel Recruitment
Department  On receipt of employee requisition from the various departments it searches for the required
skills and qualification.
 It ensures that the persons recruited possess the requisite qualification and skills required for the
job.
Training
 Arranges proper training for the newly recruited employees and workshops for existing
employees.
Records and evaluation
 Maintains all personal and job-related records of the employees.
 Evaluation of performance from time to time
Engineering and  Prepares plans and specifications for each job.
Work Study  Providing training and guidance to the employees.
Department  Supervises production activities.
 Conducts time and motion studies.
 Undertakes job analysis.
 Conducts job evaluation.

Time Keeping  Concerned with the maintenance of attendance records i.e., time keeping
Department  Time spent by an employee on various jobs i.e., time booking etc.

Payroll  The preparation of payroll of the employees.

Department  It disburses salary and wage payments.

Cost Accounting  Accumulation and classification of employee costs.

Department  Analysis and allocation of costs to various cost centers or cost objects

2.1 Important Factors for the Control of Employee Cost

The main points which need consideration for controlling employee costs are the following:
(i) Assessment of manpower requirements.
(ii) Control over time-keeping and time-booking.
(iii) Time & Motion Study.
(iv) Control over idle time and overtime.
(v) Control over employee turnover.
(vi) Wage and Incentive systems.
(vii) Job Evaluation and Merit Rating.
(viii) Employee productivity.

2.2 Collection of Employee Costs

It is the duty of Cost Accounting department to ascertain the effective wages paid per hour in each department and
to analyse the total payment of wages of each department into:
(i) the amount included in the direct cost of goods produced or jobscompleted;
(ii) the amount treated as indirect employee cost and thus included inoverheads; and
(iii) the amount treated as the cost of idle time and hence loss.
(iv) the amount treated as abnormal loss/ gain and to be transferred to profitand loss account.

3.2
 Employee Cost and Direct Expenses

3. ATTENDENCE PROCEDURES
3.1 Attendance Procedure / Time-keeping
Meaning
 It refers to correct recording of the employees’ attendance time.
 There is a difference between “time keeping” and “time booking”. The latter refersto break up of time on various
jobs while the former implies a record of total time spent by the employees in a factory.

Objectives of Time-keeping:
The objectives of time-keeping are as follows:
(i) For the preparation of payrolls.
(ii) For calculating overtime.
(iii) For ascertaining and controlling employee cost.
(iv) For ascertaining idle time.
(v) For disciplinary purposes.
(vi) For overhead distribution.

Methods of Time-keeping:
The examples of time keeping methods are follows:
1. Manual Methods
(a) Attendance Register Method- Under this method, an attendance register is kept to record the arrival and
departure time of an employee.

(b) Metal Disc/ Token Method- Under this method, each employee is allotted a metal disc or a token with a
hole bearing his identification number. The token is kept or handed to the time keeper who record the token
number in his register.

2. Mechanical/ Automated Methods

(a) Punch Card Attendance- Under this method, each employee is provided a card for marking attendance. A
punch card contains data related with the employee in digital form.
In punch card attendance system, an employee needs to either insert or wave his card to a card reader which
then ensures whether the correct person is logging inand/or out.

(b) Bio-Metric Attendance system- Under bio-metric attendance system attendance is marked by recognizing
an employee on the basis of physical and behavioural traits.
An employee’s unique identity like finger print, face and retina image etc. are kept in a database which is
matched at the time of marking of attendance before the attendance device for this purpose.

Requisites of a Good Time-Keeping System:

A good time-keeping system should have following requisites:
 should not allow proxy for another employee under any circumstances.
 should have a provision of recording of time of piece employees so that regular attendance and discipline may
be maintained. This is necessary to maintain uniformity of flow of production.
 should record time of arrival as well as departure of employees, so that total time of employees may be recorded
and wages may be calculated accordingly.
 should be mechanical so that chances of disputes regarding time may not arise between employees and the
time-keeper.
 The system should be simple, smooth and quick. Unnecessary queuing for marking attendance should be
avoided.
 The system should be reviewed and maintained periodically to prevent any error. Late-comers should record
late arrivals.
 Any relaxation by the time-keeper in this regard will encourage indiscipline

3.3
 Employee Cost and Direct Expenses

3.2 Time-Booking
Meaning
Time booking refers to a method wherein each activity of an employee is recorded.

Objectives of Time-Booking
1. Time booking for costing: The time spent on a particular job or activity is used to compute the cost of the job or
activity.

2. Time booking to measure efficiency: The efficiency of the employees is measures by comparing the actual time
taken by an employee with the standard time that should have been taken.

3. Time booking for fixation of responsibility:

- The time booked data is used to analyse the variance in time taken by an employee on a particular job or process
with respect to standard time to see the reasons for the variance.
- The reasons for variance are further classified as controllable and uncontrollable. The controllable reasons are those
which can be avoided by due care and efficiency.
- The uncontrollable reasons cannot be avoided under the normal circumstances. Employees or any other concerned
person or departments are made accountable for variance under controllable reasons.

Time/Job Card
The time/job card can be of two types:
 One containing analysis of time with reference to each job: A separate job card is employed in respect of a
job undertaken; where a job involves several operations, a separate entry is made in respect of each
operation.

 The other with reference to each employee: Under this system, a separate card would be used for each employee
for each day or for each week and the time which he spends on different jobs (and also any idle time) would be
recorded in the same card

4. Payroll Procedure
Steps included in this process are as under:
1. Time and Attendance details: A detailed sheet of number of days or hours worked by each employee (in
case of time-based payment) and units or percentage of work (in case of piece rate) as reflected by the time
keeping methods are sent to the payroll department by the time keeping department.

2. List of employees and other details: A list of employees on roll and the rate at which they will be paid
is sent by the personnel/ HR department. Payroll department should ensure that no unauthorised or
bogus employeeis paid.

3. Computation of wages and other incentives: Payroll department based on the details provided by the
time keeping department and personnel department calculate wages/ salary to be paid to the employees.
Payroll department prepares pay slip for all employees authorized by the personnel department and
forward the same to the cost/ accounting department for further deductions and payment.

4. Payment to the employees: Cost/ accounting department deduct all statutory deduction such as
employee’s contribution to provident fund and employee state insurance (ESI) scheme, TDS on salary etc.
After all deductions wages/ salary is paid to the employees.

5. Deposit of all statutory liabilities: All statutory deduction made from wages/ salary of the employees
alongwith employer’s contributions such as provident fund and employee state insurance scheme are paid to
the respective statutory bodies.

3.4
 Employee Cost and Direct Expenses

The followings are generally deducted from the payroll

Type of deductions Description

Statutory Deductions

1. Provident fund Employee’s contribution to the Provident fund is

deducted from the salary/ wages of the concerned
employee.

2. Employee State Insurance Employee’s contribution to the ESI is

Scheme (ESI) deducted from the salary/ wages.

3. Tax Deduction at Source(TDS) Employer is obliged to deduct tax at source if it will be

paying to the employee net salary exceeding maximum
exemption limit, in equal monthly instalments to the
income tax department.

4. Professional Tax Professional tax is a state level tax imposed for carrying
on business, profession or service.

Other Deductions

1. Voluntary contribution to If any employee so desires may contribute over and

Provident fund above the contribution payable by the employer.
2. Contribution to any benevolent An employee may contribute to any benevolent fund
fund voluntarily by putting a request to the payroll
department.
3. Loan deductions Instalments of any loan taken by the employee.

4. Other advances and dues Other advances like festival advance andunadjusted
advances taken.

5. IDLE TIME
Meaning
The time during which no production is carried-out because the worker remains idle but are paid.

Classification
It can further be classified into below two categories
Particulars Normal Idle time Abnormal Idle time
Meaning It is the time which cannot be avoided or Apart from normal idle time,
reduced in the normal course of business. there may be factors which give
rise to abnormal idle time.
Cause - The time lost between factory gate - lack of coordination
and the place of work - Power failure, Breakdown of
- The interval between one job and machines
another - Non-availability of raw materials,
- The setting up time for the machine, strikes, lockouts, poor supervision,
- Normal rest time, break for lunch flood, etc.
etc. These can be further analysed into
controllable and uncontrollable
Treatment It is treated as a part of cost of It is not included as a part of
production. production cost and is shown as a
separate item in the Costing Profit and
Loss Account.

3.5
 Employee Cost and Direct Expenses

6. OVERTIME
Meaning:
Work done beyond normal working hours is known as ‘overtime work’.
Overtime Payment = Wages paid for overtime at normal rate + Premium (extra) payment for overtime work

Overtime premium: The rate for overtime work is higher than the normal time rate. The extra amount so paid over the
normal rateis called overtime premium.

Note: As per the Factories Act 1948 “Where a worker works in a factory for more than nine hours in any day or for more
than forty eight hours in any week, he shall, in respect of overtime work, be entitled to wages at the rate of twice his
ordinary rate of wages.”

Causes of Overtime and Treatment of Overtime premium in cost accounting

Causes Treatment

The customer may agree to bear the entire charge of If overtime is resorted to at the desire of the customer,
overtime because urgency of work. then overtime premium may be charged to the job
directly.
Overtime may be called for to make up any shortfall in the overtime premium should be treated as overhead
production due to some unexpected development. cost of the particular department or cost centre which
works overtime.
Overtime work may be necessary to make up a shortfall If overtime is worked in a department due to the fault of
in production due tosome fault of management. another department, the overtime premium should be
charged to thelatter department.
Overtime work may be resorted to, to secure an out-turn in Overtime worked on account of abnormal conditions
excess of the normal output to take advantage of an such as flood, earthquake etc., should not be charged to
expanding market or of rising demand cost, but to Costing Profit and Loss Account.

7. LABOUR UTILISATION
For identifying utilisation of labour a statement is prepared (generally weekly) for each department / cost centre which
show
- the actual time paid for
- the standard time (including normal idle time) allowed for production and
- the abnormal idle time analysed for causes thereof.

7.1 Identification of Utilisation of labours with Cost Centres

For the identification of utilisation of labour with the cost centre, a wage analysis sheet is prepared.

Wage analysis sheet is a statement in which total wages paid are analysed according to cost centre, jobs, work
orders etc . The data for analysis is provided by wage sheet, time card, piece work cards and job cards.

The preparation of such sheet serves the following purposes:

(i) It analyse the labour time into direct and indirect labour by cost centres,jobs, work orders.
(ii) It provides details of direct labour cost comprises of wages, overtime to be charged as production cost
of cost centre, jobs or work orders.
(iii) It provides information for treatment of indirect labour cost as overheadexpenses.

7.2 Identification of labour hours with work order orbatches or capital job
For identification of labour hours with work order or batches or capital jobs or overhead work orders the
following points are to be noted:
(i) The direct labour hours can be identified with the particular work order or batches or capital job or
overhead work orders on the basis of details recorded on source document such as time sheet or job
cards.

3.6
 Employee Cost and Direct Expenses

(ii) The indirect labour hours cannot be directly identified with the particular work order or batches or
capital jobs or overhead work orders. Therefore, they are traced to cost centre and then assigned to
work order or batchesor capital jobs or overhead work orders by using overhead absorption rate.

8. SYSTEMS OF WAGE PAYMENT AND INCENTIVES

There exist several systems of employee wage payment and incentives, which can be classified under the following
heads:

8.1 Time Based (Time rate System)

Straight Time Rate System: Under this system, the workers are paid on time basis i.e. hour, day, week, or month.
The amount of wages due to a worker are arrived at by multiplying the time worked (including normal idle period)
by rate for the time.
Wages = Time Worked (Hours/ Days/ Months) × Rate for the time

8.2 Output Based (Piece rate System)

Straight Piece Rate System: Under this system, each operation, job or unit of production is termed as piece. A rate of
payment, known as the piece rate or piece work rate is fixed for each piece. The wages of the worker depend upon his
output and rate of each unit of output; it is in fact independent of the time taken by him. The wages paid to a worker
are calculated as:
Wages = Number of units produced × Rate per unit

8.3 Premium Bonus Method

Under these methods, standard time is established for performing a job. The worker is guaranteed his daily wages
(except in Barth System), if his output is below and upto standard. In case the task is completed in less than the
standard time, the saved time is shared between the employee and the employer.
(i) Halsey Premium Plan: Under Halsey premium plan a standard time is fixed for each job or process. If
there is no saving on this standard time allowance,the worker is paid only his day rate. He gets his time
rate even if he exceeds standard time limit, since his day rate is guaranteed.
If, however, he does the job in less than the standard time, he gets a bonus equal to 50 percent of the wages of
time saved; the employer benefits by the other 50 percent. The scheme also is sometimes referred to as the
Halsey fifty percent plan.

Earnings under Halsey Premium plan is calculated as under:

Wages = Time taken × Time rate + 50% of time saved × Time rate

Advantages and Disadvantages of Halsey Premium Plan

Advantages Disadvantages

1. Time rate is guaranteed while there is 1. Incentive is not so strong as with piece
opportunity for increasing earnings by rate system. In fact the harder the
increasing production. worker works, the lesser he gets per
piece.

2. The system is equitable in as much as the 2. The sharing principle may not be liked
employer gets a direct return for his by employees.
efforts in improving production methods
and providing better equipment.

(ii) Rowan Premium Plan: According to this system a standard time allowanceis fixed for the performance
of a job and bonus is paid if time is saved.

3.7
 Employee Cost and Direct Expenses

Under Rowan System the bonus is that proportion of the time wages astime saved bears to the standard
time.
𝑻𝒊𝒎𝒆 𝑺𝒆𝒗𝒆𝒅
Time taken x Rate per hour + 𝒙 𝑻𝒊𝒎𝒆 𝒕𝒂𝒌𝒆𝒏 𝑿 𝑹𝒂𝒕𝒆 𝒑𝒆𝒓 𝒉𝒐𝒖𝒓
𝑻𝒊𝒎𝒆 𝑨𝒍𝒍𝒐𝒘𝒆𝒅

Advantages and Disadvantages of Rowan Premium Plan

Advantages Disadvantages

1. It is claimed to be a fool-proof system in as 1. The system is a bit

much as a worker can never double his complicated.
earnings even if there is bad rate setting.

2. It is admirably suitable for encouraging 2. The incentive is weak at a high

moderately efficient workers as it production level where the time
provides a better return for moderate saved is more than 50% of the
efficiency thanunder the Halsey Plan. time allowed.
3. The sharing principle appeals tothe 3. The sharing principle is not generally
employer as being equitable. welcomed by employees.

9. ABSORPTION OF WAGES
9.1 Elements of Wages
There are two elements of wages- Monetary and non-monetary.
Non-monetary benefits may include:
(i) Medical facilities;
(ii) Educational and training facilities;
(iii) Recreational and sports facilities;
(iv) Housing and social welfare; and
(v) Cost of subsidised canteen and co-operative societies.

The monetary part of a worker’s remuneration includes the basic wages, dearness allowance, overtime wages,
other special allowance, if any, production bonus, employer’s contribution to the provident fund, Employees
State Insurance scheme premium, contribution to pension fund, leave pay, etc.

The basic wage is the payment for work done, measured in terms of hours attended or the units produced, as the
case may be. The basic wage rate is not normally altered unless there is a fundamental change in the working
conditionsor methods of manufacture.

Dearness allowance is an allowance provided to cover the increase in cost ofliving from one period to another.
This allowance is calculated either aspercentage of the basic wage or as a fixed amount for the days worked.

Overtime allowance is an allowance paid for the extra hours worked at the rates laid down in the Factories Act.
In certain industries, where special allowance for the working conditions, tool maintenance, etc., are paid they
are also considered as part of wages.

Production Bonus is an incentive payment made to workers for efficiency that results in production above the
standard. There are different methods of computing incentives. Under the Payment of Bonus Act, a worker is
entitled to compulsory bonus of 8.33% wages earned in the relevant year or `100 (whichever is greater). The
bonus may be upto 20% of wages depending upon the quantumof profits calculated as per the Act.

3.8
 Employee Cost and Direct Expenses

9.2 Component of Wages Cost or Wages for Costing Purposes

o In the case of indirect Employee, all such payments as also the wages paid to them, must be treated as part of
overheads.
o But in the case of direct workers, two alternatives are possible. The additional charges may be treated as
overheads. Alternatively, the wage rates being chargedto job may be computed by including such payments.

9.3 Holiday and Leave Wages

o One alternative to account for wages paid on account of paid holiday and leavec can be to include them
as departmental overheads.

o In such a case, it is necessaryto record such wages separately from “worked for wages”. Such a segregation
canbe made possible by providing a separate column in the payroll for holiday andleave wages
o If, however, a separate or additional column cannot be provided for this purpose it would be necessary to
analyse the payroll periodically to ascertain how much of the total payment pertains to “worked for wages” and
how much is attributed to leave and holiday wages.
o Another way could be to inflate the wage rate for costing purposes to include holiday and leave wages. This
can be done only in the case of direct workers.

9.4 Night Shift Allowance

In some cases, workers get extra payment if they work at night. Since the extra payment is not for any particular job,
therefore such a payment should be treated as part of overheads.

9.5 Absorption Rates of Employee Cost

o Employee cost include monetary compensation and non-monetary benefits to workers.The total benefits are
treated as overhead and absorbed on the basis of rate per direct employee hour, if overheads are
predominantly employee oriented.
o For direct workers, the ideal method is to charge jobs or units produced by supplying per hour rate calculated
as below:
Rate per hour =

o Another alternative method is to treat the monetary benefits other than basic wages and dearness
allowance as well as cost of non-monetary benefits as overheads.

10. EFFICIENCY RATING PROCEDURES

Efficiency is usually related with performance and may be computed by comparing the time taken with the standard
time allotted to perform the given job/task.
If the time taken by a worker on a job equals or less than the standard time, then he is rated efficient.
In case he takes more time than the standard time he is rated as inefficient.
Efficiency in % = 𝑥 100

For efficiency rating of employees the following procedures may be followed:

1. Determining standard time/performance standards: The first step is to determine the standard time taken by a
worker for performing a particular job/task. The standard time can be determined by using Time & Motion study
or Work study techniques.
While determining the standard time for a job/task a heterogeneous group of workers is taken and contingency
allowances are added for determining standard time.

2. Measuring Actual Performance of workers: For computing efficiency rating it is necessary to develop a
procedure for recording the actual performance of workers. The system developed should record the output of each
worker along with the time taken by him.

3.9
 Employee Cost and Direct Expenses

3. Computation of efficiency rating: The efficiency rating of each worker can be computed by using the above
mentioned Formula.

Need for Efficiency Rating

1. When a firm follows a system of payment by results, the payment has a direct relationship with the output
given by a worker. The firm for making payment to worker is required to ascertain his efficiencylevel.
2. The efficiency rating also helps the management in preparing employee requirement budget or for preparing
manpower requirements.

Employee Productivity: Productivity is generally determined by the input/output ratio. In case of employees, it is
calculated as below:

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑇𝑖𝑚𝑒 𝑓𝑜𝑟 𝑑𝑜𝑖𝑛𝑔 𝑎𝑐𝑡𝑢𝑎𝑙 𝑤𝑜𝑟𝑘

𝐴𝑐𝑡𝑢𝑎𝑙 𝑇𝑖𝑚𝑒 𝑡𝑎𝑘𝑒𝑛

Employee productivity is used for measuring the efficiency of individual workers. It is an index of efficiency in the
utilisation of human resources, materials, capital, power and all kinds of services and facilities.
It is measured by the output in relation to input. Productivity can be improved by reducing the input for a certain quantity
or value of output or by increasing the output from the same given quantity or value of input.

Factors for increasing Employee Productivity: The important factors which must be taken into consideration for
increasing employee productivity are as follows:
1. Employing only those workers who possess the right type of skill.
2. Placing a right type of person to a right job.
3. Training young and old workers by providing them the right types of opportunities.
4. Taking appropriate measures to avoid the situation of excess or shortage ofemployees.
5. Carrying out work study for fixation of wages and for the simplification andstandardisation of work.

11. EMPLOYEE (LABOUR) TURNOVER

a. Employee (Labour) Turnover
Employee turnover or labour turnover in an organisation is the rate of change in the composition of
employee force during a specified period measured against a suitable index.

There are three methods of calculating Employee turnover which are given below:
(i) Replacement Method: This method takes into consideration actual replacement of employees irrespective of
number of persons leaving the organisation. Employee Turnover under this method is calculated as under:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑛 𝑟𝑜𝑙𝑙

New employees appointed on account of expansion plan of the organisation are not included in number
of replacements.

(ii) Separation Method: In this method employee turnover is measured by dividing the total number of
employees separated during the period by the average total number of employees on payroll during the same
period. Employee Turnover under this method is calculated as under:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑛 𝑟𝑜𝑙𝑙

(iii) Flux Method: This method takes both the number of replacements as well as the number of separations
during the period into account for calculation of employee turnover. Employee Turnover under this method is
calculated as under:

3.10
 Employee Cost and Direct Expenses

(𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑠𝑠 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑒𝑑 + 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑛 𝑟𝑜𝑙𝑙

The total number of workers joining, including replacements, is called accessions.

When number of accessions are considered for measuring employee turnover, the employee turnover rate by
Flux method may be computed by using any one ofthe following expressions:
𝑁𝑜. 𝑜𝑓 𝑆𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑜𝑛𝑠 + 𝑁𝑜. 𝑜𝑓 𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡𝑠 + 𝑁𝑜. 𝑜𝑓 𝑁𝑒𝑤 𝐽𝑜𝑖𝑛𝑖𝑛𝑔𝑠
𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑛 𝑟𝑜𝑙𝑙
Or
𝑁𝑜. 𝑜𝑓 𝑆𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑜𝑛𝑠 + 𝑁𝑜. 𝑜𝑓 𝐴𝑐𝑐𝑒𝑠𝑠𝑖𝑜𝑛𝑠
𝑥 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑛 𝑟𝑜𝑙𝑙

Average number of employees during the period is calculated as follows:

No.of employees at begining +No. of employees at end of the period
=
2

Equivalent Employee (Labour) Turnover rate:

If in the above computations, the data given is for a period other than a year, the employee turnover rate so
computed may be converted into equivalent annualemployee turnover rate by using the following formula:
𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
𝑥 365
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

b. Causes of Employee (Labour) Turnover

The reasons for employee turnover in an organisation can be classified under thefollowing three heads:
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.
(a) Personal causes: All the personal reasons which induce or compel an employee to leave his job;
such causes include the following:
(i) Change of jobs for betterment.
(ii) Premature retirement due to ill health or old age.
(iii) Domestic problems and family responsibilities.
(iv) Discontent over the jobs and working environment.

(b) Unavoidable Causes: Unavoidable causes are those under which it becomes obligatory on the part
of management to ask one or more of their employees to leave the organisation; such causes are
summed up as listed below:
(i) Seasonal nature of the business;
(ii) Shortage of raw material, power, slack market for the product etc.;
(iii) Change in the plant location;
(iv) Disability, making a worker unfit for work;
(v) Disciplinary measures;

(c) Avoidable Causes: Avoidable causes are those which require the attention of management on a
continuous basis so as to keep employee turnover ratio as low as possible. The main causes under
this case are indicated below:
(i) Dissatisfaction with job, remuneration, hours of work, working conditions,etc.,
(ii) Strained relationship with management, supervisors or fellow workers;
(iii) Lack of training facilities and promotional avenues;
(iv) Lack of recreational and medical facilities;
(v) Low wages and allowances.

3.11
 Employee Cost and Direct Expenses

Proper and timely management action can reduce the employee turnoverappreciably so far as avoidable
causes are concerned.

c. Effects of Employee (Labour) Turnover

High employee turnover increases the cost of production in the following ways:
(i) Even flow of production is disturbed;
(ii) Efficiency of new workers is low; productivity of new but experienced workers islow in the beginning;
(iii) There is increased cost of training and induction;
(iv) New workers cause increased breakage of tools, wastage of materials, etc.
(v) Cost of recruitment and training increases.

Cost of Employees (Labour) Turnover: Two types of costs which are associated with employee turnover are:
(a) Preventive Costs: The cost incurred to prevent employee turnover or keepit as lowest as possible. Cost
incurred for prevention of employee turnover includes the following:
(i) Cost of medical benefit provided to the employees;
(ii) Cost incurred on employees’ welfare like pension etc.
(iii) Cost on other benefits with an objective to retain employees.

(b) Replacement Costs: These are the costs which arise due to employee turnover. If employees leave soon
after they acquire the necessary training and experience of good work, additional costs will have to
be incurred onnew workers, i.e., cost of recruitment, training and induction, abnormal breakage and scrap
and extra wages and overheads due to the inefficiencyof new workers.
A company will incur very high replacement costs if the rate of employee turnover is high. Similarly, only
adequate preventive costs can keep Employee turnover at a low level.

12. DIRECT EXPENSES

a. Direct Expenses
Expenses other than direct material cost and direct employee cost, which are incurred to manufacture a product or
for provision of service and can be directly traced in an economically feasible manner to a cost object.
The following costs are examples for direct expenses:
(i) Royalty paid/ payable for production or provision of service;
(ii) Hire charges paid for hiring specific equipment;
(iii) Cost for product/ service specific design or drawing;
(iv) Cost of product/ service specific software;
(v) Other expenses which are directly related with the production of goods orprovision of service.

b. Measurement of Direct Expenses

 The direct expenses are measured at invoice or agreed price net of rebate or discount but includes duties and taxes
(for which input credit not available), commission and other directly attributable costs.
 In case of sub-contracting, where goods are get manufactured by job workers independent of the principal entity,
are measured at agreed price.
 Where the principal supplies some materials to the job workers, the value of such materials and other
incidental expenses are added with the job charges paid to the jobworkers.

c. Treatment of Direct Expenses

 Direct Expenses form part of the prime cost for the product or service to which it can be directly traceable
and attributable.
 In case of lump-sum payment or one- time payment, the cost is amortised over the estimated production
volume or benefit derived.
 If the expenses incurred are of insignificant amount i.e. not material, it can be treated as part of overheads.

3.12
 Overheads – Absorp on Cos ng Method

Chapter
OVERHEADS – ABSORPTION COSTING
4 METHOD

Question
1. State the bases of apportionment of following overhead costs:
a. Air Conditioning
b. Time Keeping
c. Depreciation of Plant & Machinery
d. Power/ Steam Consumption
e. Electric Power (Machine Operation)

2. Suggest any one basis of re-apportionment of service department overheads over production departments in the following
instances:

Cost of Service Department Basis

(i) Maintenance and Repair Shop
(ii) Hospital and Dispensary
(iii) Fire Protection
(iv) Stores Department
(v) Transport Department
(vi) Computer Section
(vii) Power House (Electric Power Cost)
(viii) Inspection
(ix) Tool Room
(x) Time- keeping

3. Explain the treatment of over and under absorption of Overheads in Cost accounting.
4. What are the methods of re-apportionment of service department expenses over the production departments? Discuss.
5. How do you deal with the following in cost account?
a. Packing Expenses
b. Fringe benefits
6. Distinguish between cost allocation and cost absorption.
7. Distinguish between allocation and apportionment of cost.
8. How would you account for idle capacity cost in Cost Accounting?
9. Explain Blanket Overhead Rate and Departmental Overhead Rate. How they are calculated? State the conditions required
for the application of Blanket Overhead Rate.
10. Explain what is meant by Practical capacity and Normal capacity. How is normal capacity determined?

4.1
 Overheads – Absorp on Cos ng Method

1. Overheads
Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit. Such
expenses are incurred for output generally and not for a particular work order
Overheads are incurred not only in the factory of production but also on administration, selling and distribution.

2. CLASSIFICATION OF OVERHEADS
Description Example

By Function
Factory or Indirect cost incurred for Stock keeping expenses, repairs and
Manufacturing or manufacturing or production activity maintenance of plant, depreciation of
Production in a factory. factory building, Indirect labour, cost
Overhead Includes all expenditures incurred of primary packing, Insurance of plant
from theprocurement of materials to andmachinery, etc.
the completion of finished product
Office and It incurred on all activities relating to Salary paid to office staffs, repairs &
Administrative general maintenance and depreciation of office
Overheads management and building, postage and stationery, lease
administration of an organisation. rental in case of operating lease,
accounts and auditexpenses etc.
Selling and (i) Selling overhead: Salesmen commission, Advertisement
Distribution expenses related to sale of cost, Sales office expenses etc.
Overheads products and includeall indirect
expenses in sales management
forthe organisation.
Delivery van expenses, Transit
(ii) Distribution overhead: cost
insurance, warehouse and cold
incurred on making product
storage expenses, secondary packing
available for sale in the market.
expenses etc.

By Nature
Fixed Overhead They do not tend to increase or de- Salary paid to permanentemployees,
crease with the changes in Depreciation of building and plant
output. and equipment, Insurance.
Variable These costs tend to vary with the Indirect materials, Power and fuel,
Overhead volume of activity. lubricants, tools and spares etc.

Semi-Variable These costs contain both fixed and Electricity cost, water cost, telephone
Overheads variable components and are thus and internetexpenses etc.
partly affected by fluctuations in the
level of
activity.

By Element

Indirect materials Materials which do not normally form Stores used for maintaining machines
part of the finished product (cost and buildings, stores used by service
object) are known as indirect departments like power house, boiler
materials. house,
canteen etc.

4.2
 Overheads – Absorp on Cos ng Method

Indirect employee Employee costs which cannot be Salary paid to foreman and supervisor,
cost allocated but can be apportioned to salary paid toadministration staff etc.
or absorbed by cost units or cost
centres is known as indirect
employee.
Indirect expenses Expenses other than direct expenses Rates & taxes, insurance, depreciation,
are known asindirect expenses, that advertisement expenses etc.
cannot be directly,
conveniently and wholly
allocated to cost centres.
By Control
Controllablecosts These are those costs which can be Materials cost, wages and salary,
controlled by the implementation of power and fuel etc.
appropriate managerial influence and
proper policies.

Uncontrollable Overhead costs which cannot be Rates and taxes, Depreciation, etc.
costs controlled by the management even
after the implementation of
appropriate managerial influence and
proper polices are known as
uncontrollable costs.

2.1 Advantages of Classification of Overheads into Fixed and Variable

(a) Controlling Expenses: The classification of expenses into fixed and variable components helps in controlling
expenses. Fixed costs are generally policy costs, which cannot be easily reduced.
Variable expenses vary with the volume of activity and the responsibility for incurring such expenditure is
determined in relation to the output.

(b) Preparation of Budget Estimates: The segregation of overheads into fixedand variable part helps in the
preparation of flexible budget.

(c) Decision Making: The segregation of semi variable cost between fixed and variable overhead also helps the
management to take many important decisions.
Likewise, decisions on make or buy, shut down or continue, etc., are also taken after separating fixed costs
from variable costs.

3. ACCOUNTING AND CONTROL OF MANUFACTURING OVERHEADS

The steps given below shows how factory overhead rates are estimated and overheads absorbed on that basis and
the last one show how actual are compared with the absorbed amount.
1. Estimation and Collection of Manufacturing Overheads: The first stage is to estimate the amount of overheads,
keeping in view the past figures and adjusting them for known future changes. The sources available for the collection
of factory overheads may include (a) Invoices, (b) Stores requisition, (c) Wage analysis book (d) Journal entries.
etc.

2. Assignment of Manufacturing Overheads: The guiding principle for assignment of manufacturing overheads to
a cost object is the traceabilityof the overheads in an economically feasible manner.
(a) Cost Allocation: The term ‘allocation’ refers to the direct assignment of cost to a cost object which can
be traced directly. It implies relating overheads directly to the various departments.
The estimated amount of various items of manufacturing overheads should be allocated to various cost
centres or departments.
(b) Cost Apportionment: There are some items of estimated overheads which cannot be directly allocated to
the various departments and cost centres. Such non allocable expenses are to be spread over the various
4.3
 Overheads – Absorp on Cos ng Method

departments or cost centres on the basis of two principles. This is called apportionment.
(c) Re-apportionment: Upto the last stage all overheads are allocated and apportioned to all the departments-
both production and service departments. Service departments are those departments which do not directly
take part in the production of goods or providing services.
The process of assigning service department overheads to production departments is called
reassignment or re-apportionment. At this stage, all the factory overheads are collected under production
departments.

3. Absorption: After completing the distribution as stated above the overheads charged to department are to be recovered
from the output produced inrespective departments. This process of recovering overheads of a department or any
other cost center from its output is called recovery or absorption.

4. Treatment of over and under absorption of overheads: After the year end the total amount of actual factory
overheads is known. There is boundto be some difference between the actual amount of overheads and the absorbed
amount of overheads. So, the overheads are generally either under-absorbed or over-absorbed.

4. STEPS FOR THE DISTRIBUTION OF OVERHEADS

4.1 Estimation and Collection of Overheads
The overhead expenses are usually collected through a system of standing orders.
The term “Standing Order” denotes sanction for indirect expenses under various heads of expenditure. It is a
system under which a number is allotted to each item of expense for the purpose of identification, and the same
is continued from year to year.

4.2 Allocation of Overheads over Various Departments or Departmentalization of Overheads

Factory overheads which are related to any of the production or service departments are allocated to these
departments.
A department may be sub-divided into various cost centres for better cost control and performance evaluation. When
costs are collected by setting up cost centres, several items can be ascertained definitely and the element of
estimation is reduced considerably.

Advantages of Departmentalisation:
(a) Better Estimation of Expenses: Some expenses which relate to the departments will be estimated almost
on an exact basis and, to that extent,the accuracy of estimation of overheads will be higher.
(b) Better Control: For the purpose of controlling expenses in a department, it is obviously necessary that the
figures in relation to each department should be separately available.
(c) Ascertainment of Cost for each department: It is not necessary that a job must pass through all the
departments or that the work required in each department should be the same for all jobs. It is, therefore,
necessary thatonly appropriate charge in respect of the work done in the department is made. This can be
done only if overheads for each department are known separately.
(d) Suitable Method of Costing: A suitable method of costing can be followed differently for each department e.g.,
batch costing when a part is manufactured, but single or output costing when the product is assembled.

4.3 Apportioning Overhead Expenses over VariousDepartments

To apportioning these overheads over different departments benefiting thereby, it is necessary at first to determine the
proportion of benefit received by each department and then distribute the total expenditure proportionately on that
basis. But the same basis of apportionment cannot be followed for different items of overheads since the benefit of
service to a department in each case has to be measured differently. Some of the bases thatmay be adopted for
the apportionment of expenses are stated below:

4.4
 Overheads – Absorp on Cos ng Method

Overhead Cost Bases of Apportionment

1. (i) Rent and other building Floor area, or volume of department

expenses
(ii) Lighting and heating
(conditioning)
(iii) Fire precaution service
(iv) Air- conditioning

2. (i) Perquisites Number of workers

(ii) Labour welfare expenses
(iii) Time keeping
(iv) Personnel office
(v) Supervision
3. (i) Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Perquisites
4. General overhead Direct labour hour, or Direct wages, or
Machine hours.

5. (i) Depreciation of plant and Capital values

machinery
(ii) Repairs and maintenanceof
plant and machinery
(iii) Insurance of stock

6. (i) Power/steam Technical estimates

consumption
(ii) Internal transport
(iii) Managerial salaries
7. Lighting expenses (light) No. of light points, or Area or Meteredunits

8. Electric power (machine Horse power of machines, or Number

operation) of machine hour, or value of machinesor units
consumed.

9. (i) Material handling Weight of materials, or volume of materials, or

(ii) Stores overhead value of materials or unit of materials.

Difference between Allocation and Apportionment

Allocation Apportionment

Allocation deals with the whole items of cost, Apportionment deals with the
which are identifiable with any one proportions of an item of cost for example;
department. For example, indirect wages of the cost of the benefit of a service department
three departments are separately obtained and will be divided between those departments
hence each department will be charged by which has availed those benefits.
respective number of wages individually
Allocation is a direct process of Apportionment is an indirect process because
charging expenses to different cost centres there is a need for the identification of the
appropriate portion of an expense to be borne by
the difference department benefited

4.5
 Overheads – Absorp on Cos ng Method

4.4 Re-apportionment of Service Department Overheadsover Production Departments

The re-apportionment of the service department cost to the production department is known as secondary
distribution. The suggestive bases that may be adopted for re-apportionment are given below:
Cost of the Service Departments: Basis
1. Maintenance and Repair shop Direct labour hours, Machine hours, Direct
labour wages, Asset value x Hours worked
2. Planning and progress
3. Tool room
4. Canteen and Welfare No of direct workers No.
of employees etc.
5. Hospital and Dispensary
6. Personnel Department
7. Time-keeping No. of card punched, No. of employees
8. Computer Section Computer hours, Specific allocation to
departments

9. Power House (Electric lighting Floor area, Cubic content, No. of

cost) electric Points, Wattage.
10. Power House (electric power cost) Horse power, Kwh, Horse power ×
Machine hours, Kwh × Machine hours

11. Stores Department No. of requisitions, Weight or value of

Materials issued.

12. Transport Department Crane hours, Truck hours, Truck mileage, Truck
tonnage, Truck ton-hours, Tonnage handled. No.
of packages of Standard size
13. Fire Protection Capital values
14. Inspection Inspection hours

Methods for Re-apportionment: The re-apportionment of service department expenses over the production
departments may be carried out by using any oneof the following methods:
(i) Direct re-distribution method.
(ii) Step method of secondary distribution or non-reciprocal method.
(iii) Reciprocal Service method.

Direct re- Simultaneous

distribution method Equation method

Step method or
Methods for Re-
non- reciprocal
apportionment
method.
Trial and error
method
Reciprocal Service
method. Repeated
distribution
method

4.6
 Overheads – Absorp on Cos ng Method

(i) Direct Re-Distribution Method: Service department costs under this method are apportioned over the
production departments only, ignoring the services rendered by one service department to the other.

(ii) Step Method or Non-Reciprocal Method: This method gives cognizance to the services rendered by service
department to another service department. The sequence here begins with the department that renders
maximum number of services to the other service department(s).
This process continues till the cost of last service department is apportioned. The cost of last service
department is apportioned among production departments only.

(iii) Reciprocal Service Method: This method recognises the fact that where there are two or more service
departments they may render services to each other and, therefore, these inter-departmental services are to
be given due weight while re-distributing the expenses of the service departments.
The methods available for dealing with reciprocal services are:
(a) Simultaneous equation method;
(b) Trial and error method;
(c) Repeated distribution method.

Reciprocal
Service Method

Simultaneous Repeated
Trial and Error
Distribution
Equation Method Method
Method

(a) Simultaneous Equation Method:

According to this method, the costs of service departments are ascertained. These costs are then re-distributed to
production departmentson the basis of given percentages.

(b) Trial and Error Method:

Repeated distribution method is followed to the extent ofservice departments only.
All apportioned amounts for each service cost centre are added to get the total apportioned cost.
These total service cost centre costs are redistributed to the production departments. Trial and error method and
Simultaneous equation method gives the same result.

(c) Repeated Distribution Method:

Under this method, service departments’ costs are distributed to other service and production departments on
agreed percentages and this process continues to be repeated, till the figures of service departments are either exhausted
or reduced to too small a figure.

5. METHODS OF ABSORBING OVERHEADS TOVARIOUS PRODUCTS OR JOBS

Several methods are commonly employed either individually or jointly for computing the appropriate overhead rate. The
more common of these are:
(1) Percentage of direct materials,
(2) Percentage of prime cost,
(3) Percentage of direct labour cost,
(4) Labour hour rate,
(5) Machine hour rate and
(6) Rate per unit of Output

4.7
 Overheads – Absorp on Cos ng Method

5.1 Percentage of Direct Material Cost

Under this method, the cost of direct material consumed is the base for calculating theamount of overhead absorbed. This
overhead rate is computed by the following formula:
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑐𝑡𝑖𝑜𝑛 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑜𝑓 𝐷𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 = 𝑥 100
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐷𝑖𝑟𝑒𝑐𝑡 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑙𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑠

5.2 Percentage of Prime Cost Method

This method is based on the fact that both materials as well as labour contribute in raising factory overheads. Hence,
the total of the two i.e. Prime cost should be taken as base for absorbing the factory overhead. The overhead rate in
this method is computed by the following formals:
Overhead Rate = 𝑥 100

5.3 Percentage of Direct Labour Cost

Formula to be used under this method is:
Direct Labour Cost Percentage Rate
Overhead rate = 𝑥 100

Advantages Disadvantages
(i) The method is simple andeconomical (i) It gives rise to certain inaccuraciesdue to
to apply. the time factor not being
given full importance.

(ii) The time factor is given (ii) Where machinery is used to some extent in the
recognition even if indirectly. process of manufacture, an allowance for
such a factor is not made.

(iii) Total expenses recovered will not differ (iii) It does not provide for varying skillsof
much from the estimated figure since workers
total wages paid are not likely to
fluctuate much.

5.4 Labour Hour Rate Method

This method is an improvement on the percentage of direct wage basis, as it fully recognises the significance of the
element of time in the incurring and absorption of manufacturing overhead expenses. This method is admirably suited
to operations which do not involve any large use of machinery. To calculate labour hour rate, the amount of
factory overheads is divided by the total number of direct labour hours.
Formula to be used under this method is:
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑜𝑓 𝑎 𝐷𝑒𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡
𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟 𝑅𝑎𝑡𝑒 = 𝑥 100
𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟

5.5 Machine Hour Rate Method

Machine hour rate implies, cost of running a machine for an hour to producegoods. There are two methods of
computing machine hour rates:
(i) Direct Machine hour rate: Only the expenses directly or immediately connected with the operation of the
machine are taken into account e.g., power, depreciation, repairs and maintenance, insurance, etc.
The rate is calculated by dividing the estimated total of these expenses for a period by the estimated number of
operational hours of the machines during the period.

(ii) Comprehensive Machine hour rate: In addition to the expenses stated above there may still be other
manufacturing expenses such as supervision charges, shop cleaning and lighting, consumable stores and shop
supplies, shop general labour, rent and rates, etc. incurred for the department as a whole and, hence, not
charged to any particular machine or group of machines.

4.8
 Overheads – Absorp on Cos ng Method

By the machine hour rate method, manufacturing overhead expenses are charged to production on the
basis of number of hour machines are used on jobs or work orders. Here each machine or group of machines
is treated as a cost centre.

Advantages and disadvantages of Machine hour rate:

Advantages Disadvantages
(1) Where machines are the main factor of (1) Additional data concerning the operation
production, it is usually the best method time of machines, not otherwise
of charging machine operating expenses necessary, must be recorded and
to production. maintained.
(2) The under-absorption of machine (2) As general department rates for all the
overheads would indicate the extent to machines in a department may be
which the machines have been idle. suitable, the computation of a separate
machine hour rate for each machine or
group of machines would mean further
additional work.
(3) It is particularly advantageous where one
operator attends to several machines (e.g.
automatic screw manufacturing
machine),or where several operators are
engaged on the machine e.g. the belt
press used in making conveyer belts.

5.6 Rate Per Unit of Output Method

This is the simplest of all the methods. In this method overhead rate is determined bythe following formula:
Overheads Rate =

6. TYPES OF OVERHEAD RATES

The overhead rates may be of the following types:

Types of Overhead Rate

1. Normal Rate 2. Pre-determined Rate 3. Blanket Rate 4. Departmental Rate

1. Normal Rate: This rate is calculated by dividing the actual overheads byactual base. It is also known as actual
rate.
It is calculated by the following formula:
Normal overhead Rate =

2. Pre-determined Overhead Rate: This rate is determined in advance by estimating the amount of the overhead for
the period in which it is to be used. It is computed by the following formula:
Pre – determined Rate =

The amount of overhead rate of expenses for absorbing them to production may be estimated on the following
three bases.
(1) The figure of the previous year or period may be adopted as the overhead rate to be charged to production
in the current year.
(2) The overhead rate for the year may be determined on the basis of estimated expenses and anticipated
volume of production activity.
(3) The overhead rate for a year may be fixed on the basis of the normal volume of the business.

4.9
 Overheads – Absorp on Cos ng Method

3. Blanket Overhead Rate: Blanket overhead rate refers to the computation of one single overhead rate for the
whole factory. It is to be distinguished from the departmental overhead rate which refers to a separate rate
for each individual cost centre or department. The use of blanket rate may be proper in certain factories producing
only one major product in a continuous process or where the work performed in every department is fairly uniform
or standardised.
This overhead rate is computed as follows:
Blanket Rate =

A blanket rate should be applied in the following cases:

(1) Where only one major product is being produced.
(2) Where several products are produced, but
(a) All products pass through all departments; and
(b) All products are processed for the same length of time in each department.
Where these conditions do not exist, departmental rates should be used.

4. Departmental Overhead Rate: It refers to the computation of one single overhead rate for a particular production
unit or department. Where the product lines are varied or machinery is used to a varying degree in the different
departments, that is, where conditions throughout the factory are not uniform, the use of departmental rates is
to be preferred.
This overhead rate is determined by the following formula:
Department overhead Rate =

7. TREATMENT OF UNDER-ABSORBED AND OVER–ABSORBED OVERHEADS IN COST

ACCOUNTING
Overhead expenses are usually applied to production on the basis of pre-determined rates. Production overheads are
to be determined in advance for fixing selling price, quote tender price and to formulate budgets etc.
/
Pre-determined overhead rate =

The actual overhead rate will rarely coincide with the pre-determined overhead rate, due to variation in pre-determined
overhead rate and actual overhead rate.
Such over or under-absorption as arrived at under different situations may alsobe termed as overhead variance. The
amount of over-absorption being represented by a credit balance in the accounts and the amount of under- absorption as
a debit balance.

Treatment of under/ over absorption of overheads in cost accounting:

Treatment of such under/ over absorption of overheads can be understood withthe help of the following flow chart:

4.10
 Overheads – Absorp on Cos ng Method

Cos ng
P&L A/c

It is desirable to adjust the cost of products manufactured, as otherwise the cost figures would convey a misleading
impression. Such adjustments usually take the form of supplementary rates. Supplementary rate is calculated as below:
/
Supplementary Rate =

Supplementary overhead rate as calculated above is applied to finished goods,semi-finished goods (WIP) and goods finished
and sold. Therefore, under/ overabsorbed overheads are distributed among the unsold stock of finished goods, semi-finished
goods (WIP) and cost of sales (goods produced and sold).

The accounting is done as follows:

Accounts Dr/Cr Calculation of amount
1. Stock of Finished goods A/c Debit/C Units of Finished stock ×
redit Supplementary rate per unit

2. Stock of Semi-finished goods Debit/C Equivalent completed units ×

(WIP) A/c redit Supplementary rate per unit

3. Cost of Sales A/c Debit/C Units sold × Supplementaryrate

redit per unit

However, over or under recovery of overheads due to abnormal reasons (such as abnormal over or under capacity
utilisation) should be transferred to the CostingProfit and Loss Account.

8. ACCOUNTING AND CONTROL OF ADMINISTRATIVE OVERHEADS

According to CIMA Terminology, Administrative overhead is defined as “The sum of those costs of general management
and of secretarial accountingand administrative services, which cannot be directly related to the production, marketing,
research or development functions of the enterprise.”

8.1 Accounting of Administrative Overheads

(a) Apportioning Administrative Overheads between Production and Sales Departments:

4.11
 Overheads – Absorp on Cos ng Method

The reason for the apportionment of overhead expenses over these departments, recognises the fact that
administrative overheads are incurred for the benefit of both of these departments. When this method is adopted,
administrative overheads lose their identity and get merged with production and selling and distribution
overheads.

Disadvantages:
(1) It is difficult to find suitable bases of administrative overheadapportionment over production and sales
departments.
(2) Lot of clerical work is involved in apportioning overheads.
(3) It is not justified to apportion total administrative overheads only over production and sales departments
when other equally importantdepartment like finance is also there.

(b) Charging to Profit and Loss Account: According to this method administrative overheads are charged to
Costing Profit & Loss Account. Below are the reasons
1) the administrative overheads are concerned with the formulation of policies and thus are not directly
concerned with either the production or the selling and distribution functions.
2) it is difficult to determine a suitable basis for apportioning administrative overheads over production and
sales departments.
3) these overheads are the fixed costs. In view of these arguments, administrative overheads should be
charged to Profit and Loss Account.

Disadvantages:
(1) Cost of products is understated as administrative overheads are notcharged to costs.
(2) The exclusion of administrative overheads from cost of products is against sound accounting principle.

(c) Treating Administrative Overheads as a separate addition to Cost of Production/ Sales: This method
considers administration as a separate function like production and sales and, as such costs relating to
formulatingthe policy, directing the organisation and controlling the operations are taken as a separate charge
to the cost of the jobs or a product, sold alongwith the cost of other functions. The bases which are generally
used for apportionment are:
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.

8.2 Control of Administrative Overheads

Mostly administrative overheads are of fixed nature, and they arise as a result of management policies. These fixed
overheads are generally non-controllable. Butat the same time these overheads should not be allowed to grow
disproportionately. Some degree of control has to be exercised over them. The methods usually adopted for
controlling administrative overheads are as follows:
(i) Classification and analysis of overheads by administrative departments according to their functions, and
a comparison with the accomplished results: The expenses incurred by each administrative department are
collected under a standing order for each class of expenditure. These are compared with similar figures
of the previous period in relation to accomplishment. Such a comparison will reveal efficiency or
inefficiency of the concerned department.
(ii) Control through Budgets: Administration budgets (monthly or annually) are prepared for each department.
The budgeted figures are compared with actual ones to determine variances. The variances are analysed
and responsibility assigned to the concerned department to control these variances.
(iii) Control through Standard: Under this method, standards of performance are fixed for each administrative
activity, and the actual performance is compared with the standards set. In this way, standards serve not only
as yardstick of performance but also facilitate control of costs.

4.12
 Overheads – Absorp on Cos ng Method

9. ACCOUNTING AND CONTROL OF SELLINGAND DISTRIBUTION OVERHEADS

Selling cost or overhead expenses are the expenses incurred for the purpose of promoting the marketing and sales of
different products. Distribution expenses, on the other hand, are expenses relating to delivery and dispatch of goods sold.

9.1 Accounting of Selling and Distribution Overheads

The bases usually adopted are:
(a) Sales value of goods;
(b) Cost of goods sold;
(c) Gross Profit on sales; and
(d) Number of orders or units sold.

An estimated amount per unit - The best method for absorbing selling and distributing expenses over various products
is to separate fixed expenses from variable expenses.
Apportion the fixed expenses according to the benefit derivedby each product and thus ascertaining the fixed
expenses per unit.
We give below some of the fixed expenses and the basis of apportionment:
Expenses Basis
Salaries in the Sales Departmentand of the Estimated time devoted to the sale ofvarious
sales men. products.

Advertisement Actual amount incurred for each product since these

days it is usual to advertise each product separately;
common expenses, such as in an exhibition,
should be apportioned on the basis ofadvertisement
expenditure on each product.

Show Room expenses Average space occupied by each

product.

Rent of finished goods god own sand Average quantities delivered during aperiod.
Expenses on own delivery vans

9.2 Control of Selling and Distribution Overheads

Control of selling and distribution expenses is a difficult task because:
1. The incidence of selling and distribution overheads depends mainly on external factors, such as distance of
market, extent and nature of competition, terms of sales, etc. which are beyond the control of management.
2. These overheads are dependent upon the customers, behaviour, their likingand disliking, tastes etc. Therefore,
as such control over the overheads may result in loss of customers.
3. These expenses being of the nature of policy costs are not amenable tocontrol.

In spite of the above difficulties, the following methods may be used for controlling them.
(a) Comparison with past performance - According to this method, selling and distribution overheads are
compared with the figures of the previous period. Alternatively, the expenses may be expressed as a
percentage of sales, and the percentages may be compared with those of the past period. This method is
suitable for small concerns.
(b) Budgetary Control - A budget is set up for selling and distribution expenses. The expenses are classified
into fixed and variable. If necessary, a flexible budget may be prepared indicating the expenses at
different levels of sales. The actual expenses are compared with the budgeted figures and in the case of
variances suitable actions are taken.
(c) Standard Costing - Under this method standards are set up in relation to the standard sales volume.
Standards may be set up for salesmen, territories,products etc. Once the standards are set up, comparison
is made between the actuals and standards: variances are enquired into and suitable action taken.

4.13
 Overheads – Absorp on Cos ng Method

10. CONCEPTS RELATED TO CAPACITY

(i) Installed/ Rated capacity: It refers to the maximum capacity of producing goods or providing services. It is also
known as theoretical capacity and is could not be achieved in normal operating circumstances.
(ii) Practical capacity: It is defined as actually utilised capacity of a plant. Itis also known as operating
capacity. Generally, practical capacity is taken between 80 to 90% of the rated capacity.
(iii) Normal capacity: Normal capacity is the volume of production orservices achieved or achievable on an
average over a period under normal circumstances taking into account the reduction in capacity resulting from planned
maintenance.

Normal capacity is determined as under:

Installed capacity xxx

Adjustments for:

(i) Time lost due to scheduled preventive or plannedmaintenance xxx

(ii) Number of shifts or machine hours or man hours

(iii) Holidays, normal shut down days, normal idle time xxx

(iv) Normal time lost in batch change over xxx xxx

Normal Capacity xxx

(iv) Actual capacity: It is the capacity actually achieved during a given period. Itis presented as a percentage of
installed capacity.
(v) Idle capacity: It is that part of the capacity of a plant, machine or equipment which cannot be effectively utilised
in production.

(a) Normal Idle Capacity: It is the difference between Installed capacity andNormal capacity.
(b) Abnormal Idle Capacity: It is the difference between Normal capacity and Actual capacity utilization where
the actual capacity is lower than thenormal capacity.

Treatment of Idle capacity costs: Idle capacity costs can be treated in product costing, in the following ways:
(a) If the idle capacity cost is due to unavoidable reasons such as repairs, maintenance, changeover of job etc. a
supplementary overhead rate may be used to recover the idle capacity cost. In this case, the costs are charged to the
production capacity utilised.
(b) If the idle capacity cost is due to avoidable reasons such as faulty planning, power failure etc.; the cost should be
charged to costing profit and loss account.
(c) If the idle capacity cost is due to seasonal factors, then, the cost should be charged to the cost of production by
inflating overhead rates.

11. TREATMENT OF CERTAIN ITEMS IN COSTING

(i) Interest and financing charges:
Interest and financing charges shall be presented in the cost statement as a separate item of cost of sales.

(ii) Depreciation: It shall be traced to the cost object to the extent economically feasible. Where it is not directly
traceable it should be assigned using either or two principles i.e. (i) Cause and Effect and (ii) Benefit received.

(iii) Packing expenses:

Cost of primary packing necessary for protecting the product or for convenient handling, should become a part
of the production cost.
The cost of packing to facilitate the transportation ofthe product from the factory to the customer should
become a part of the distribution cost.

4.14
 Overheads – Absorp on Cos ng Method

(iv) Fringe benefits: If the amount of fringe benefit is considerably large, it may be recovered as direct charge by
means of a supplementary wage or labour rate; otherwise these may be collected as part of production overheads.

(v) Expenses on removal and re-erection of machines: All such expenses are treated as production overheads.
When amount of such expenses is large, it may be spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor, then they may be charged
to costing Profit and Loss Account.

(vi) Bad debts: Bad debts should be treated in cost accounting in the same way as any other selling and distribution
cost. However extra ordinarily large bad debts should not be included in cost accounts and charged to profit &
loss account.

(vii) Training expenses: Training expenses of factory workers are treated as part of the cost of production. The training
expenses of office; sales or distribution workersshould be treated as office; sales or distribution overhead as the case may
be.

(viii) Canteen expenses: The subsidy provided or expenses borne by the firm in running the canteen should be regarded
as a production overhead.
If thecanteen is meant only for factory workers therefore these expenses should be apportioned on the basis of the
number of workers employed in each department.

(ix) Carriage and cartage expenses: Transportation expenses related to direct material may be included in the cost
of direct material and those relating to indirect material (stores) may be treated as factory overheads.
Expenses related to the transportation of finished goods may be treated as distribution overhead.

(x) Expenses for welfare activities: All expenses incurred on the welfare activities of employees in a company are
part of general overheads. Such expenses should be apportioned between factory, office, selling and distribution
overheads on the basis of number of persons involved.

(xi) Night shift allowance: The night shift allowance is generally incurred due to the general pressure of work beyond
normal capacity level and is treated as production overhead and recovered as such.
If additional expenditure on night shift is incurred to meetsome specific customer order, such expenditure may
be charged directly to the order concerned.
If night shifts are run due to abnormal circumstances, the additional expenditure should be charged to the costing
profit and loss account.

(xii) Research and Development Expenses:

If research is conducted in the methods of production, the research expenses should be charged to the production
overhead;
The expenditure becomes a part of the administration overhead if research relates to administration.
Market research expenses are charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product shouldbe charged directly to that product.
General research expenses of a routine nature incurred on new or improved methods of manufacture or the
improvement of the existing products should be charged to the general overhead.

4.15
 Ac vity Based Cos ng

Chapter ACTIVITY BASED COSTING

5

Important Question-
1. PP Limited is in the process of implementation of Activity Based Costing System in the organisation. For this purpose, it has
identified the following Business Functions in its organisation:
a. Research and Development
b. Design of Products, Services and Procedures
c. Customer Service
d. Marketing
e. Distribution
You are required to specify two cost drivers for each Business Function Identified above.
2. Explain Activity Based Budgeting.
3. Describe the various level of activities under ABC methodology
4. What is meant by Activity Based Management (ABM) and discuss how Activity Based Management can be used in the
business?

1. MEANING AND DEFINITION

Activity Based Costing:
 Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or services.
 This enables resources & overhead costs to be more accurately assigned to products & services that consume them.
 ABC is a technique which involves identification of cost with each cost driving activity and making it as the basis for
apportionment of costs over different cost objects/ jobs/ products/customers or services.
 ABC assigns cost to activities based on their use of resources. It then assigns costto cost objects based on their use of
activities.
 CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of activities which involves tracing
resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based
on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.”
Meaning of terms used in ABC
Activity: Activity, here, refers to an event that incurs cost.
Cost Object: It is an item for which cost measurement is required e.g. aproduct or a customer.
Cost Driver: It is a factor that causes a change in the cost of an activity.
There are two categories of cost driver.
 Resource Cost Driver: It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a
resource to an activity or cost pool.
 Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used
to assign activity costs to cost objects.
Cost Pool: It represents a group of various individual cost items. It consistsof costs that have same cause and effect
relationship. Example machine set-up.

Examples of Cost Drivers:

Business Functions Cost Driver

Research and Development  Number of research projects

 Personnel hours on a project
Design of products, servicesand  Number of products in design
procedures  Number of parts per product
 Number of engineering hours

5.1
 Ac vity Based Cos ng

Customer Service  Number of service calls

 Number of products serviced
 Hours spent on servicing products
Marketing  Number of advertisements
 Number of sales personnel
 Sales revenue
Distribution  Number of units distributed
 Number of customers

2. Factors prompting the development of ABC

(i) Growing overhead costs because of increasingly automated production
(ii) Increasing market competition, which necessitated more accurate productcosts.
(iii) Increasing product diversity to secure economies of scope & increasedmarket share.
(iv) Decreasing costs of information processing because of continualimprovements and increasing application of information
technology.

3. Usefulness/ Suitability of ABC

1. High amount of overhead: When production overheads are high and form significant costs, ABC is more useful than
traditional costing system.
2. Wide range of products: ABC is most suitable, when, there is diversity in the product range or there are multiple
products.
3. Presence of non-volume related activities: When non-volume related activities e.g. material handling, inspection set-up,
are present significantly and traditional system cannot be applied. ABC will identify non-value-adding activities in the
production process that might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and there is an urgent requirement to compute cost
accurately and to fix the selling price according to the market situation. ABC can also facilitate in reducing cost by
identifying non-value-adding activities in the production process that might be a suitable focus for attention or elimination.

4. TRADITIONAL ABSORPTION COSTING VS ABC

Activity Based Costing Traditional Absorption Costing

Overheads are related to activities and grouped into Overheads are related to cost
activity cost pools. centers/departments.

Costs are related to activities and hence are more Costs are related to cost centers and hence not realistic of cost
realistic. behaviour.

Activity–wise cost drivers are determined. Time (Hours) are assumed to be the only cost driver
governing costs in all departments.

Activity–wise recovery rates are determined and there is Either multiple overhead recovery rates (for each department) or
no concept of a single overheadrecovery rate. a single overhead recovery rate may be determined for absorbing
overheads.
Costs are assigned to cost objects, e.g. customers, Costs are assigned to Cost Units i.e. to products, or jobs or
products, services, departments, etc. hours.

Essential activities can be simplified and unnecessary Cost Centers/ departments cannotbe eliminated. Hence, not
activities can be eliminated. Thus, the corresponding suitable for cost control.
costsare also reduced/ minimized. Hence ABC aids cost
control.

5.2
 Ac vity Based Cos ng

5. LEVEL OF ACTIVITIES UNDER ABC METHO-DOLOGY/COST HIERARCHY

Level of Activities Meaning
Unit level activities The consumption of resourcescan be identified with thenumber of units
produced.
Example - Indirect Material, Inspection, etc.
Batch level activities The activities such as setting up of a machine or processing a purchase
order are performed eachtime a batch of goods is produced. The cost of
batch related activities varies with number ofbatches made, but is common
(or fixed) for all units within the batch.
Example – Material Ordering, Machine set-up, etc.
Product level activities These are the activitieswhich are performed tosupport differentproducts in
product line
Example – Designing of product, production parts, technical drawings,
etc.
Facilities level activities These are the activities which cannot be directly attributed to individual
products. These activities are necessary to sustainthe manufacturingprocess
and are commonand joint to all products manufactured
Example – Maintenance of building, security of factory, etc.

6. STAGES IN ACTIVITY BASED COSTING (ABC)

(1) Identify the different activities within the organisation: It is possible to break the organisation down into many very
small activities. Some activities may be listed as follows:-
 Production schedule changes
 Customer liaison
 Purchasing
 Production process set up
 Quality control
 Material handling
 Maintenance
(2) Relate the overheads to the activities, both support and primary, that caused them. This creates ‘cost pools’ or ‘cost
buckets’. This will be done using resource cost drivers that reflect causality.
(3) Support activities are then spread across the primary activities on some suitable base, which reflects the use of the
support activity. The base is the cost driver that is the measure of how the support activities are used.
(4) Determine the activity cost drivers that will be used to relate the overheads collected in the cost pools to the cost
objects/products. This is based on the factor that drives the consumption of the activity.
(5) Calculate activity cost driver rates for each activity, just as an overhead absorption rate would be calculated in the
traditional system.
Activity Cost Driver Rate = Total cost of Activity
Activity Driver
The activity driver rate can be used not only to identify cost of products, asin traditional absorption costing, but it can also
be used for costing other cost objects such as customers/customer segments and distribution channels. The possibility of
costing objects other than products is part ofthe benefit of ABC.

7. ADVANTAGES OF ACTIVITY BASED COSTING

The main advantages of using Activity Based Costing are:
(i) More accurate costing of products/services.
(ii) Overhead allocation is done on logical basis.
(iii) It enables better pricing policies by supplying accurate cost information.
(iv) Utilizes unit cost rather than just total cost
(v) Help to identify non-value added activities which facilitates cost reduction.

5.3
 Ac vity Based Cos ng

(vi) It is helpful to the organizations with multiple products.

(vii) It highlights problem areas which require attention of the management.

8. LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive, particularly in comparison with traditional costingsystem.
(ii) It is not helpful to the small organizations.
(iii) It may not be applied to organizations with limited products.
(iv) Selection of the most suitable cost driver may not be easy/ may be difficultor complicated.

9. REQUIREMENTS IN ABC IMPLEMENTATION

• Staff Training: Staff training should be done to createan awareness on the purpose of ABC.
• Process Specification: Informal, but structured interviews with key membersof personnel will identify the different
stages of the production process, the commitment of resources to each, processing times and bottlenecks.
• Activity Definition: The activities must be defined clearly in the early stage in order to manage the problems, if any,
effectively. There might be overloadingof information from the new data, but the same is needed in codification.
• Activity Driver Selection: Cost driver for each activity shall be selected.
• Assigning Cost: A single representative activity driver can be used to assign costs from the activity pools to the cost objects.

10. PRACTICAL APPLICATIONS OF ACTIVITY BASED COSTING

10.1 As a Decision-Making Tool
ABC can act as a decision making tool in the following ways:
 ABC along with some other cost management technique can be utilized to improve performance and profitability of an
organization.
 Wholesale distributors can gain significant advantage in the decision-making process through implementation of ABC
concepts by correlating costs to various activities. Introduction of new product or vendor can be better decided through
ABC.
 ABC can assist in decisions related to facility and resource expansion. Oftenthe basis for relocation or opening of a
new distribution center is based oncost associations. Reduction in freight or other logistic costs can offset the expense of
the new facility, staff or equipment. The ABC model can identifythe specific cost elements being targeted, providing a
much clearer picture which aids in management actions.
 ABC augments decision support for human resources. Since the activity can be associated to an individual, new levels
of financial performance can be determined. This might be evident in the case of branch management or sales.
 Companies who wish to determine price based on cost plus markup basisfind ABC method of costing very relevant and
are able to determine competitive prices for their products.

10.2 As Activity Based Management

Meaning of Activity Based Management
- The term Activity Based Management (ABM) is used to describe the cost management application of ABC.
- The use of ABC as a costing tool to manage costs at activity level is known as Activity Based Management
(ABM).
- ABM is a discipline that focuses on the efficient and effective management of activities as the route to continuously
improving the value received by customers. ABM utilizes cost information gathered through ABC.

Various analysis in Activity Based Management

(1) Cost Driver Analysis: The factors that cause activities to be performed needto be identified in order to manage activity
costs. Cost driver analysis identifies the causal factors.

(2) Activity Analysis.

(a) Value-Added Activities (VA): The value-added activities are those activities which are indispensable in order to
complete the process. The customers are usually willing to pay (in some way) for these services. For example,
polishing furniture by a manufacturer dealing in furniture is a value added activity.
(b) Non-Value-Added Activities (NVA): The NVA activity represents work that is not valued by the external or
internal customer. NVA activities do not improve the quality or function of a product or service, but they can
adversely affect costs and prices. Example Moving materials and machine set up for a production run.

5.4
 Ac vity Based Cos ng

(3) Performance Analysis: Performance analysis involves the identification of appropriate measures to report the
performance of activity centres or other organisational units, consistent with each unit’s goals and objectives.

Activity Based Management in Business

Activity Based Management can be used in the following ways-
(i) Cost Reduction: ABM helps the organisation to identify costs against activities and to find opportunities to streamline or
reduce the costs or eliminate the entire activity, especially if there is no value added.
(ii) Business Process Re-engineering: Business process re-engineering involves examining business processes and making
substantial changes to how organisation currently operates. ABM is a powerful tool for measuring business performance,
determining the cost of business outputand is used as a means of identifying opportunities to improve process efficiency
and effectiveness.
(iii) Benchmarking: Benchmarking is a process of comparing of ABC-derived activity costs of one segment of company
with those of other segments. It requires uniformity in the definition of activities and measurement of their costs.
(iv) Performance Measurement: Many organisations are now focusing on activity performance as a means of facing
competitors and managing costsby monitoring the efficiency and effectiveness of activities.

10.3 Facilitate Activity Based Budgeting

Meaning of Activity Based Budgeting (ABB)
 Activity based budgeting analyse the resource input or cost for each activity.
 It provides a framework for estimating the amount of resources required inaccordance with the budgeted level of activity.
Actual results can be compared with budgeted results to highlight both, in financial and non-financial terms, those
activities with major discrepancies from budget for potential reduction in supply of resources.
 It is a planning and control system which seeks to support the objectives of continuous improvement.
 It means planning and controlling the expected activities of the organization to derive a cost-effective budget that meet forecast
workload and agreed strategic goals.
 ABB is the reversing of the ABC process to produce financial plans and budgets.

Key Elements of ABB

The three key elements of activity based budgeting are as follows:-
 Type of work to be done
 Quantity of work to be done
 Cost of work to be done

Benefits of ABB
Few benefits of activity based budgeting are as follows:-
(i) Activity Based Budgeting (ABB) can enhance accuracy of financial forecastsand increasing management
understanding.
(ii) When automated, ABB can rapidly and accurately produce financial plansand models based on varying levels of volume
assumptions.
(iii) ABB eliminates much of the needless rework created by traditionalbudgeting techniques.

5.5
 Cost Sheet

Chapter
6 COST SHEET

1. Cost Sheet
Meaning of Cost Sheet
A Cost Sheet or Cost Statement is a document which provides a detailed cost information of a cost centre or unit.

Format of Cost Sheet-

Particulars Total Cost ( ) Cost perunit ( )

1. Direct materials consumed xxx

2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx
5. Works/ Factory Overheads xxx
6. Gross Works Cost (4+5) xxx
7. Add: Opening Work in Process xxx
8. Less: Closing Work in Process (xxx)
9. Net Works/ Factory Cost (6+7-8) xxx
10. Add: Quality Control Cost xxx
11. Add: Research and Development Cost xxx
12. Add: Administrative Overheads(relating to production activity) xxx
13. Less: Credit for Recoveries/Scrap/By-Products/ misc. income (xxx)
14. Add: Packing cost (primary) xxx
15. Cost of Production (9+10+11+12-13+14) xxx
16. Add: Opening stock of finished goods xxx
17. Less: Closing stock of finished goods (xxx)
18. Cost of Goods Sold (15+16-17) xxx
19. Add: Administrative Overheads (General) xxx
20. Add: Marketing Overheads:
- Selling Overheads xxx
- Distribution Overheads xxx
21. Cost of Sales (18+19+20) xxx
22. Profit xxx
23 Sales (21+22) xxx

2. COST HEADS IN A COST SHEET

The costs are grouped into the following cost heads in a cost sheet:
(i) Prime Cost
(ii) Cost of Production
(iii) Cost of Goods Sold
(iv) Cost of Sales

3. FUNCTIONAL CLASSIFICATION OF ELEMENTS OF COST

For the purpose of cost sheet preparation, costs are classified onthe basis of Functions for which they have been incurred.
Functional Elements of Costs:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost

6.1
 Cost Sheet

(iii) Direct Expenses

(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.

Detailed description of each Cost heads and elements of cost :

1. Prime Cost= direct materials costs + direct employee (labour) costs +direct expenses
[Total of cost for each element has to be calculated separately]

(i) Direct Material Cost: It is the cost of direct material consumed. The cost of direct material consumed is
calculated as follows:
Opening Stock of Material xxx
Add: Additions/ Purchases xxx

Less: Closing stock of Material (xxx)

Direct materials consumed xxxx

Examples-
(a) Cost of material;
(b) Freight inwards;
(c) Insurance;
(d) Trade discounts or rebates (to be deducted);
(e) Duties & Taxes (if input tax credit is not available/ availed) etc.

(ii) Direct Employee (labour) Cost: The total of payment made to the employees engaged in the production of goods
and provision of services.
Examples-
(a) Wages and salary;
(b) Allowances and incentives;
(c) Payment for overtimes;
(d) Bonus/ ex-gratia;
(e) Employer’s contribution to welfare funds such as Provident fund and other similar funds;
(f) Other benefits (medical, leave with pay, free or subsidised food, leave travel concession and provisions for
retirement benefits) etc.

(iii) Direct Expenses: Expenses other than direct material cost and direct employee cost, which are incurred to
manufacture a product or for provision of service and can be directly traced in an economically feasible manner
to a costobject.
Examples-
(a) Power & fuel, steam etc.;
(b) Royalty paid/ payable for production or provision of service;
(c) Hire charges paid for hiring specific equipment;
(d) Fee for technical assistance and know-how;
(e) Amortised cost of moulds, patterns, patents etc.;
(f) Cost for specific design or drawing;
(g) Cost of specific software;
(h) Other expenses which are directly related with the production of goods or provision of service.

2. Cost of Production = Prime cost + factory related costs and overheads.

6.2
 Cost Sheet

Prime Cost xxx

Add : Factory Overheads xxx
xxxx
Gross Works Costs
Add: Opening stock of Work-in-process xxx
Less: Closing stock of Work-in-process (xxx)
Factory or Works Costs xxx
Add: Quality Control Cost xxx
Add: Research & Development cost (Process related) xxx
Add: Administrative Overheads related with production xxx

(i) Factory Overheads: It is also known as works/production/ manufacturing overheads. It includes the following
indirect costs:
(a) Consumable stores and spares;
(b) Depreciation of plant and machinery, factory building etc.
(c) Lease rent of production assets;
(d) Repair and maintenance of plant and machinery, factory building etc.
(e) Indirect employees cost related with production activities;
(f) Drawing and Designing department cost;
(g) Insurance of plant and machinery, factory building, stock of raw material &WIP etc.
(h) Amortized cost of jigs, fixtures, tooling etc.
(i) Service department cost such as Tool Room, Engineering & Maintenance,Pollution Control etc.

(ii) Stock of Work-in-process: The cost of opening and closing stock of work-in-process (WIP) is adjusted to arrive
at factory/ works cost. The WIP stock is valued on the basis of percentage of completion in respect of each
element ofcost.

(iii) Quality Control Cost: This is the cost of resources consumed towards quality control procedures.

(iv) Research & Development cost: It includes only those research and development related cost which is incurred
for the improvement of process, system, product or services.

(v) Administrative Overheads: It includes only those administration overheads which are related to
production. The general administration overheadis not included in production cost.

(vi) Credit for recoveries: The realised or realisable value of scrap or waste is deducted as it reduces the cost of
production.

3. Cost of Goods Sold

It is the cost of production for goods sold.
Cost of Production xxx

Add: Cost of Opening stock of finished goods xxx

Less: Cost of Closing stock of finished goods (xxx)

Cost of Goods Sold xxxx

4. Cost of Sales
It is the total cost of a product incurred to make the product available to the customer or consumer. It includes Cost
of goods sold, administration and marketing expenses.

6.3
 Cost Sheet

Cost of Goods Sold xxx

Add: Administrative Overheads (General) xxx
Add: Selling Overheads xxx
Add: Packing Cost (secondary) xxx
Add: Distribution Overheads xxx
Cost of Sales xxxx
(i) Administrative Overheads: It is the cost related with general administration of the entity.
Example:
(a) Depreciation and maintenance of, building, furniture etc. of corporateor general management.
(b) Salary of administrative employees, accountants, directors, secretariesetc.
(c) Rent, rates & taxes, insurance, lighting, office expenses etc.
(d) Indirect materials- printing and stationery, office supplies etc.
(e) Legal charges, audit fees, corporate office expenses like directors’ sitting fees, remuneration and commission,
meeting expenses etc.

(ii) Selling Overheads: It is the cost related with sale of products or services.
Example:
(a) Salary and wages related with sales department and employeesdirectly related with selling of goods.
(b) Rent, depreciation, maintenance and other cost related with salesdepartment.
(c) Cost of advertisement, maintenance of website for online sales,market research etc.

(iii) Packing cost (secondary): Packing material that enables to store, transport, inform the customer, promote and
otherwise make the product marketable.

(iv) Distribution Overheads: It includes the cost related with making thegoods available to the customers.
Example:
(a) Salary and wages of employees engaged in distribution of goods.
(b) Transportation and insurance costs related with distribution.
(c) Depreciation, hire charges, maintenance and other operating costsrelated with distribution vehicles etc.

4. Treatment of various items of cost in Cost sheet/statement

(i) Abnormal costs- Not form part of cost of production or acquisition or supply of goods or provision of service.
Examples of abnormal costs are:
(a) Cost pertaining to or arising out of a pandemic e.g. COVID-19
(b) Cost associated with employees due to sudden lockdown.

(ii) Subsidy/ Grant/ Incentives- Any such type of payment received/ receivable are reduced from the cost objects to
which such amount pertains.

(iii) Penalty, fine, damages, and demurrage : Not form part of cost.

(iv) Interest and other finance costs- Interest and finance charges are not included in cost of production
Example-
-Interest, including any payment in the nature of interest for use of non- equity funds and
- incidental cost that an entity incurs in arranging those funds.

5. Advantages of Cost sheet or Cost Statements

(i) It provides the total cost figure as well as cost per unit of production.
(ii) It helps in cost comparison.
(iii) It facilitates the preparation of cost estimates required for submittingtenders.
(iv) It provides sufficient help in arriving at the figure of selling price.
(v) It facilitates cost control by disclosing operational efficiency.

6.4
 Cost Accoun ng Systems

Chapter COST ACCOUNTING SYSTEMS

7

Important Question-

1. Indicate, for following items, whether to be shown in the Cost Accounts or Financial Accounts:
a. Preliminary expenses written off during the year
b. Interest received on bank deposits
c. Dividend, interest received on investments
d. Salary for the proprietor at notional figure though not incurred
e. Charges in lieu of rent where premises are owned
f. Rent receivables
g. Loss on sale of Fixed Assets
h. Interest on capital at notional figure though not incurred
i. Goodwill written off
j. Notional Depreciation on the assets fully depreciated for which book value is Nil.
2. List the Financial expenses which are not included in cost.
3. When is the reconciliation statement of Cost and Financial accounts not required?
4. "Is reconciliation of cost accounts and financial accounts necessary in case of integrated accounting system?"
5. What are the motivational factors for adopting a reconciliation process? Explain.
6. What is an Integrated Accounting System? State its advantages.
7. Explain what are the pre-requisites of integrated accounting

1. NON-INTEGRATED ACCOUNTING SYSTEM

1.1 Meaning
 It is a system of accounting under which separate ledgers are maintained for both cost and financial accounts. This system is
also known as cost ledger accounting system.
 Under this system the cost accounts restrict itself to recording only those transactions which relate to the product or service
being supplied.
 Items of expenses which are related to sales, production or other matters of factory management are the ones dealt with in
such accounts. This leads to the exclusion of certain expenses like interest, bad debts and revenue/income from ‘other
than the sale of product or service’.
 Non-Integrated accounting systems contain fewer accounts as compared to financial accounting system due to the exclusion
of purchases, expenses and also Balance Sheet items like fixed assets, debtors and creditors.

1.2 Principal Accounts

The main accounts which are usually prepared when a separate Cost Ledger is maintained are as follows:

(1) Cost Ledger Control Account

 This account is also known as General Ledger Adjustment Account. This account is made to complete double
entry.
 All items of expenditure are credited to this account.
 Sales are debited to this account and net profit/loss from Costing Profit & Loss Account is transferred to this
account.
 The balance in this account at the end of the particular period represents the net total of all the balances of
the impersonal accounts.

(2) Stores Ledger Control Account

 This account is debited for the purchaseof material and credited for issue of materials from the stores.
 The balance in this account indicates the total balance of all the individual stores accounts.

7.1
 Cost Accoun ng Systems

 Abnormal losses or gains if any in this account are transferred to Costing Profit & Loss Account. Entries are made on
the basis of goods received notes and stores requisitions etc.

(3) Wages Control Account

 This account is debited with total wages paid (direct and indirect).
 Direct wages are further transferred to Work-in- Process Control Account and indirect wages to Production Overhead;
Administration Overhead or Selling & Distribution Overhead Control Accounts, as the case may be.
 Wages paid for abnormal idle time are transferred to Costing Profit & Loss Account either directly or through Abnormal
Loss Account.

(4) Manufacturing/Production/Works/ Factory Overhead Control Account

 This account is debited with indirect costs of production such as indirect material, indirect employee, indirect
expenses (carriage inward etc.)
 Overhead recovered (absorbed) is credited to this Account.
 The difference between overhead incurred and overhead recovered (i.e. Under Absorption or Over Absorption of
Overheads) is transferred to OverheadsAdjustment Account.

(5) Work-in-Process Control Account

 This account is debited with the total cost of production, which includes direct materials, direct employee, direct
expenses, production overhead recovered.
 This account is credited with the amount of finished goods completed and transferred.
 The balance in this account represents total balances of jobs/works-in-process, as shown by several job accounts.

(6) Administrative Overhead Control Account

 This account is debited with overheads incurred and credited with overhead recovered.
 The overhead recovered are debited to Finished Goods Control Account, if administrative overhead is related with
production activities otherwise to Cost of Sales A/c.
 The difference between administrative overheads incurred and recovered is transferred to Overhead Adjustment
Account.

(7) Finished Goods Control Accounts

 This account is debited with the value of goods transferred from Work-in-process Control Account and
administration costs recovered (if relates to production activities).
 This account is credited with Cost of Sales Account.
 The balance of this account represents the value of goods unsold at the end of the period.

(8) Selling and Distribution Overhead Control Account

 This account is debited with selling and distribution overheads incurred and credited with the selling and distribution
overheads recovered.
 The difference between overheads incurred andrecovered is transferred usually to Overhead Adjustment Account.

(9) Cost of Sales Accounts

 This account is debited with the cost of finished goods transferred from Finished Goods Control Account for
sale, General Administrative overhead recovered, Selling and distribution overhead recovered.
 The balance of this account is ultimately transferred to Sales Account or Costing Profit & Loss Account.

(10) Costing Profit & Loss Account

 This account is debited with cost of sales, under-absorbed overheads and abnormal losses and is credited with sales
value, over-absorbed overhead and abnormal gains.
 The net profit or loss in this account is transferred to Cost Ledger Control Account.

(11) Overhead Adjustment Account –

 This account is to be debited for under- recovery of overhead and credited with over-recovery of overhead
amount.
 The net balance in this account is transferred to Costing Profit & Loss Account.

7.2
 Cost Accoun ng Systems

1.3 Non-Integrated Accounting System-flowchart

*In the diagram administrative overhead is assumed to be related with production activity. In case of general administration
expenses, it is treated as a part of Cost of Sales.

2. INTEGRATED (OR INTEGRAL) ACCOUNTINGSYSTEM

2.1 Meaning
 Integrated Accounts is the system of accounting, whereby cost and financial accounts are kept in the same set of books.
 There will be no separate sets of books for Costing and Financial records.
 Integrated accounts provide or meet out fully the information requirement for Costing as well as for Financial Accounts.
 For Costing it provides information useful for ascertaining the cost of each product, job, process and operation of any other
identifiable activity and for carrying necessary analysis.
 Integrated accounts provide relevant information which is necessary for preparing profit and loss account and
the balance sheet as per the requirement of law and also helps in exercising effective control over the liabilities and
assets of its business.

2.2 Advantages
The main advantages of Integrated Accounts are as follows:
(a) No need for Reconciliation- The question of reconciling costing profit andfinancial profit does not arise, as there is
only one figure of profit.
(b) Less efforts- Due to use of one set of books, there is a significant saving inefforts made.
(c) Less time consuming- No delay is caused in obtaining information as it isprovided from books of original entry.
(d) Economical process- It is economical also as it is based on the concept of “Centralisation of Accounting
function”.

2.3 Essential pre-requisites for Integrated Accounts

The essential pre-requisites for integrated accounts include the following steps:
1. The management’s decision about the extent of integration of the two setsof books. Some concerns find it useful to
integrate up to the stage of prime cost or factory cost while other prefers full integration of the entire accounting
records.
2. A suitable coding system must be made available so as to serve the accounting purposes of financial and cost accounts.
3. An agreed routine, with regard to the treatment of provision for accruals, prepaid expenses, other adjustment necessary
for preparation of interim accounts.

7.3
 Cost Accoun ng Systems

4. Perfect coordination should exist between the staff responsible for the financial and cost aspects of the accounts and an
efficient processing of accounting documents should be ensured.
Under this system there is no need for a separate cost ledger. Of course, there willbe a number of subsidiary ledgers; in
addition to the useful Customers’ Ledgerand the Purchase Ledger, there will be: (a) Stores Ledger; (b) Stock Ledger and
(c) Job Ledger.

2.4 Features of Integrated Accounting System

Following are the main points of integrated accounting:
(a) Complete analysis of cost and sales are kept.
(b) Complete details of all payments in cash are kept
(c) Complete details of all assets and liabilities are kept and this system doesnot use a notional account to represent
all impersonal accounts
In non-integrated system, a cost ledger control account or general ledger adjustment account is used in cost ledger. But in
the integrated accounting system, general ledger adjustment account is eliminated and detailed accounts for assets and
liabilities are maintained. In other words, following accounts areused for “General Ledger Adjustment Account/ Cost Ledger
Control Account” of non-integrated system:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account etc.
(e) Fixed assets
(f) Share Capital Account

3. RECONCILIATION OF COST AND FINANCIAL ACCOUNTS

 When the cost and financial accounts are kept separately, it is imperative that these should be reconciled to make the cost
accounts reliable.
 It is necessary for reconciliation of the two sets of accounts that sufficient details are available to locate the differences and
the reasons for the same.
 It is, therefore, important thatin the financial accounts, the expenses should be analysed in the same way as in the cost
accounts.
 The reconciliation of the balances of two sets of accounts is possible by preparing a Memorandum Reconciliation
Account.
 In this account, the items charged in one set of accounts but not in the other orthose charged in excess as compared
to the other are identified and collected. These items of differences are either added or subtracted from the profit as
shown by one of the accounts. Finally the profits from two sets of accounts are reconciled. The procedure is similar to
those which are followed for reconciling bank balance as per bank ledger with the balance as shown in bank statement.

3.1 Causes of differences in Financial and Cost Accounts

1. Items included in Financial Accounts only-
(a) Purely Financial Expenses:
(i) Interest on loans or bank mortgages.
(ii) Expenses and discounts on issue of shares, debentures etc.
(iii) Other capital losses i.e., loss by fire not covered by insurance etc.
(iv) Losses on the sales of fixed assets and investments
(v) Income tax, donations, subscriptions
(vi) Expenses of the company’s share transfer office, if any.

(b) Purely Financial Income

(i) Interest received on bank deposits, loans and investments
(ii) Dividends received
(iii) Profits on the sale of fixed assets and investments
(iv) Transfer fee received.
(v) Rent receivables

7.4
 Cost Accoun ng Systems

2. Item included in Cost Accounts only (notional expenses):

(i) Charges in lieu of rent where premises are owned
(ii) Interest on capital at notional figure though not incurred
(iii) Salary for the proprietor at notional figure though not incurred
(iv) Notional Depreciation on the assets fully depreciated for which book value is nil.

3. Items whose treatment is different in the two sets of accounts:

 There are chances that certain items are treated differently in the two sets of accounts. For example, LIFO method
for inventory valuation is not recommended by Accounting Standards for Financial Reporting purpose but this
method may be adopted for cost accounting purpose if management feels it suitable for making any decision.
 Similarly cost accounting may use a different method of depreciation than what is allowed under financial accounting.

4. Varying basis of valuation: It is another factor which sometimes is responsible for the difference. It is well known
that in financial accounts stock are valued either at cost or market price, whichever is lower. But in Cost Accounts,
stocks are only valued at cost.

3.2 Procedure for Reconciliation

There are 3 steps involved in the procedure for reconciliation-
1. Ascertainment of profits as per Financial Accounts
2. Ascertainment of profits as per Cost Account
3. Reconciliation of both the profits.

7.5
 Unit & Batch Cos ng

Chapter UNIT & BATCH COSTING

8

Important Question-

1. What is meant by Job Costing? Give examples of (any four) industries where it is used.
2. Explain Job Costing' and 'Batch Costing'.

1. UNIT COSTING
Meaning:
 Unit costing is that method of costing where the output produced is identical and each unit of output requires identical
cost.
 This method of costing is followed by industries which produce single output or few variants of a single output.
 Under this method costs, are collected and analysed element wise and then total cost per unit is ascertained by dividing
the total cost with the number of units produced.
 This method of costing, therefore finds its application in industries like paper, cement, steel works, mining, breweries
etc. These types of industries produce identical products and therefore have identical costs.
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 =
𝑁𝑜. 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

2. COST COLLECTION PROCEDURE IN UNITCOSTING

Collection of Materials Cost –
Cost of materials issued for production are collected from Material Requisition notes and accumulated for a certain period or
volume of activity

Collection of Employees (Labour) Cost

All direct employee (labour) cost is collected from job time cards or sheets and accumulated for a certain period or volume of
activity.

Collection of Overheads
 Overheads are collected under suitable standing orders numbers, and selling and distribution overheads against cost accounts
numbers.
 Total overhead expenses so collected are apportioned to service and production departments on some suitable basis.
 The expenses of service departments are finally transferred to production departments.
 The total overhead of production departments is then applied to products on some realistic basis, e.g. machine hour; labour
hour; percentage of direct wages; percentage of direct materials; etc.

Treatment of spoiled and defective work

Circumstances Treatment

(1) Loss due to normal reasons When a normal rate of defectives has already been established and actual number of
defectives is within the normal limit, the cost of rectification or loss will be
charged to the entire output.
If, on the other hand, the number of defective units substantially exceeds the normal
limits, the cost of rectification or loss beyond normal limits are written off in Costing
Profit and Loss Account.

8.1
 Unit & Batch Cos ng

(2) Loss due to In this case cost of rectification and loss is treated as abnormal cost and the cost of
abnormal reasons rectification or lossis written off as loss in Costing Profit and Loss Account.

3. BATCH COSTING
Meaning
 Batch Costing is a type of specific order costing where articles are manufactured in predetermined lots, known as
batch.
 Under this costing method, the cost object for cost determination is a batch for production rather output as seen in
unit costing method.
 A batch consists of certain number of units which are processed simultaneously to be for manufacturing operation.
 To initiate production process, an entity has to incur expenditures on engaging workers for production and supervision,
setting-up of machine to run forproduction etc. These are the minimum level of expenditures which have to be incurred
each time a batch is run irrespective of number of units produced.

4. ECONOMIC BATCH QUANTITY (EBQ)

Meaning
Economic batch quantity is the size of a batch where total cost of set-up and holding costs are at minimum.
This relationship is explained with the help of following diagram

The economic batch size or Economic Batch Quantity may be determined by calculating the total cost for a series of possible batch
sizes and checking whichbatch size gives the minimum cost.
Alternatively, a formula can be derived which is similar to determination of Economic Order Quantity (EOQ). The mathematical
formula usually used for its determination is as follows:

EBQ =

Where, D = Annual demand for the product

S = Setting up cost per batch
C = Carrying cost per unit of production

5. DIFFERENCE BETWEEN JOB AND BATCH COSTING

Sr. No Job Costing Batch Costing
1 Method of costing used for non- standard and non- Homogeneous products produced ina continuous
repetitive products produced as per customer production flow in lots.
specificationsand against specific orders.

2 Cost determined for each Job Cost determined in aggregate for the entire Batch and
then arrived at onper unit basis.

3 Jobs are different from each other and independent Products produced in a batch are homogeneous and
of each other. Each Job is unique. lack of individuality

8.2
 Job Cos ng

Chapter JOB COSTING

9

1. JOB COSTING
1.1 Meaning of Job Costing
 CIMA London defines Job Costing as “the category of basic costing methods which is applicable where the work
consists of separate contracts, jobs or batches, each of which is authorised by specific order or contract.”
 Accordingto this method, costs are collected and accumulated according to jobs, contracts, products or work orders.
 Each job or unit of production is treated as a separate entity for the purpose of costing.
 Job Costing is carried out for the purpose of ascertaining cost of each job and takes into account the cost of materials,
employees and overhead etc.

1.2 Principles of Job Costing

The job costing method may be regarded as the principal method of costing sincethe basic object and purpose of all costing
is to:
 Analysis and ascertainment of cost of each unit of production
 Control and regulate cost
 Determine the profitability

1.3 Process of Job Costing

 Prepare a separate cost sheet for each job
 Disclose cost of materials issued for the job
 Employee costs incurred (on the basis of bill of material and time cardsrespectively)
 When job is completed, overhead charges are added for ascertaining totalexpenditure

1.4 Suitability of Job Costing

 When jobs are executed for different customers according to theirspecifications.
 when no two orders are alike and each order/job needs special treatment.
 Where the work-in-progress differs from period to period on the basis of thenumber of jobs in hand.

2. JOB COST CARD/ SHEET

 Each job order is asymmetrical to other due to specific and customised requirements.
 To ascertain cost of a particular job, it is necessary to record all the expenditure related with a job separately. For this
purpose, Job Cost card is used.
 Job cost card is a cost sheet, where the quantity of materials issued, hours spent by different class of employees, amount of
other expenses and share of overheads are recorded.
 This is helpful in knowing the total cost, profitability etc. of a job. The following is an illustrative format of Job Cost card/
sheet.

9.1
 Job Cos ng

Format of Job Cost Sheet:

JOB COST SHEET

Description: _______________________ Job No.: ________________________

Blue Print No.: ______________________ Quantity: _______________________
Material No.: _______________________ Date of delivery: __________________
Reference No.: ______________________ Date commenced: _________________
Date finished: _____________________

Date Reference Details Material Labour Overhead

Total

Summary of costs Estimated(`) Actual(`)

For the job __________________

Direct material cost Units produced ______________

Direct wages Cost/unit ___________________
Production overhead Remarks ____________________
PRODUCTION COST Prepared by: ________________

Administration and Selling Checked by: _________________

& Distribution Overheads

TOTAL COST

PROFIT/LOSS
SELLING PRICE

3. COLLECTION OF COSTS FOR A JOB

3.1 Collection of Materials Cost
 An essential requirement of job cost accounting is that direct materials and their cost must be traced to and identified
with specific job or work order.
 This segregation of materials cost by jobs or work order is brought by the use of separate stores requisitions for each
job or work order.
 The summary of materials cost of each job is posted to individual job cost sheets or cards in the Work-in-
Progress ledger.
 If the surplus material is utilised on some other job, instead of being returned to the stores first, a material
transfer note is prepared.

9.2
 Job Cos ng

3.2 Collection of Labour Cost

 All direct labour is booked against specific jobs in the job time cards or sheets.
 All the idle time also is booked against appropriate standing order expense code number either in the job time card for
each job or on a separate idle time card for each worker
 The total or the periodical total of each job or work order is then posted to the appropriatejob cost card or
sheet in Work-in-Progress ledger. The postings are usually made at the end of each week or month.

3.3. Collection of Overheads

 Total overhead expenses so collected are apportioned to service and production departments on some suitable basis.
 The expenses of service departments are finally transferred to production departments.
 The total overhead of production departments is thenapplied to products on some realistic basis, e.g. machine hour; labour
hour; percentage of direct wages; percentage of direct materials; etc.
 It should be remembered that the use of different methods will lead to a different amount being computed for the works
overhead charged to a job hence to different total cost.

3.4 Treatment of spoiled and defective work

 Spoiled work is the quantity of production that has been totally rejected and cannot be rectified.
 Defective work refers to production that is not as perfect as the saleable product but is capable of being rectified
and brought to the required degree of perfection provided some additional expenditure is incurred.
 Defects arises in following circumstances-

Circumstances Treatment
Where a percentage of defective work is allowed in When a normal rate of defectives has already been
a particular batch as it cannot be avoided. established, if the actual number of defectives is within
the normal limit or is near thereto the cost of
rectification will be charged to the whole job and
spread over the entire output of the batch.

Where defect is due to bad workmanship. In this case cost of rectification will be abnormal cost,
i.e., not a legitimate element of the cost. Therefore, the cost
of rectification shall be written off as a loss
Where defect is due to the Inspection Department In this case the cost of rectification will be charged to
wrongly accepting incoming material of poor the department and will not be considered as cost of
quality. manufacture of the batch. Being an abnormal cost, it
will be written off to theCosting Profit and Loss Account.

4. Advantages and Disadvantages of Job Costing

Advantages Disadvantages

1. The details of Cost of material, labour and overhead for all job 1. Job Costing is costly and laborious method.
is available to control.
2. Profitability of each job can be derived. 2. As lot of clerical process is involved the chances
of error is more.

3. It facilitates production planning. 3. This method is not suitable ininflationary condition.

4. Budgetary control and StandardCosting can be applied in job 4. Previous records of costs will be meaningless if there
costing. is any change in market condition.

5. Spoilage and detective can be identified and responsibilities

can be fixed accordingly.

9.3
 Job Cos ng

5. Difference between Job Costing and Process Costing

Job Costing Process Costing

(i) A Job is carried out or a product is produced by specific The process of producing the product has a continuous
orders. flow and the product produced is homogeneous.

(ii) Costs are determined for eachjob. Costs are compiled on time basis i.e., for production of a
given accounting period for each process or department.

(iii) Each job is separate and independent of other jobs. Products lose their individual identity as they are
manufactured in a continuousflow.
(iv) Each job or order has a numberand costs are collected The unit cost of process is an average costfor the period.
against thesame job number.

(v) Costs are computed when a job is completed. The cost Costs are calculated at the end of the costperiod. The unit
of a job may be determined by adding all costs against the cost of a process may becomputed by dividing the total
job. cost for theperiod by the output of the process duringthat
period.
(vi) As production is not continuous and each job may be Process of production is usually standardized and is
different, somore managerial attention is required for therefore, quite stable. Hence control here is
effective control. comparatively easier.

9.4
 Process & Opera on Cos ng

Chapter PROCESS & OPERATION COSTING

10

Important Question-
1. What is inter-process profit? State its advantages and disadvantages.
2. Explain the following terms in relation to process costing:
a. Equivalent Production
b. Inter-process profit
3. How will you treat normal loss, abnormal loss and abnormal gain in process costing? Explain

1. PROCESS COSTING
Meaning
 Process Costing is a method of costing used in industries where the material has to pass through two or more
processes for being converted into a final product.
 It is defined as “a method of Cost Accounting whereby costs are charged to processes or operations and averaged over units
produced”.
 A separate account for each process is opened and all expenditure pertaining to a process is charged to that process account.
 Such type of costing method is useful in the manufacturing of products like steel, paper, medicines, soaps, chemicals,
rubber, vegetable oil, paints, varnish etc. where the production process is continuous and the output of one process
becomes the input of the following process till completion.

Basic Features
Industries, where process costing can be applied, have normally one or more of the following features:
1. Each plant or factory is divided into a number of processes, cost centres or departments, and each such division is a stage
of production or a process.
2. Manufacturing activity is carried on continuously by means of one or more process run sequentially, selectively or
simultaneously.
3. The output of one process becomes the input of another process.
4. The end product usually is of like units not distinguishable from one another.
5. It is not possible to trace the identity of any particular lot of output to any lot of input materials. For example, in the
sugar industry, it is impossible to trace any lot of sugar bags to a particular lot of sugarcane fed or vice versa.
6. Production of a product may give rise to Joint and/or By-Products.

2. COSTING PROCEDURE IN PROCESS COSTING

The Cost of each process comprises the cost of:
Materials –
 Materials and supplies which are required for each process are drawn against Material Requisitions Notes from the stores.
 Each process for which the materials are used, are debited with the cost of materials consumed on the basis of the
information received from the Cost Accounting department.
 The finished product of first process generally become the raw materials of second process; under such a situation the
account of second process is debited with the cost of transfer from the first process and also with the cost of any additional
material used in process.
Employee Cost (Labour) –
 Each process account should be debited with the labour cost or wages paid to labour for carrying out the processing
activities. Sometimes the wages paid are apportioned over the different processes after selecting appropriate basis.
Direct expenses –
 Each process account should be debited with direct expenses like depreciation, repairs, maintenance, insurance etc.
associated with it.

10.1
 Process & Opera on Cos ng

Production Overheads-
 Expenses like rent, power expenses, lighting bills, gas and water bills etc. are known as production overheads.
 These expenses cannot be allocated to a process. The suitable way out to recover them is to apportion them over different
processes by using suitable basis.
 Usually, these expenses are estimated in advance and the processes debited with these expenses on a pre- determined
basis.

3. TREATMENT OF NORMAL, ABNORMAL LOSS AND ABNORMAL GAIN

 Loss of material is inherent during processing operation.
 The loss of material under different processes arises due to reasons like evaporation or a change in the moisture content
etc.
 Process loss is defined as the loss of material arising during the course of a processing operation and is equal to the
difference between the input quantity of the material and its output.
 There are two types of material losses viz. (i) Normal loss and (ii) Abnormal loss.
(i) Normal Process Loss:
 It is also known as normal wastage.
 It is defined as the loss of material which is inherent in the nature of work.
 Such a loss can be reasonably anticipated from the nature of the material, nature of operation, the experience and technical
data.
 It is unavoidable because of nature of the material or the process.
 It also includes units withdrawn from the process for test or sampling.
Treatment in Cost Accounts:
 The cost of normal process loss in practice is absorbed by good units produced under the process.
 The amount realised by the sale of normal process loss units should be credited to the process account.

(ii) Abnormal Process Loss:

 It is also known as abnormal wastage.
 It is defined as the loss in excess of the pre-determined loss (Normal process loss).
 This type of loss may occur due to the carelessness of workers, a bad plant design or operation, sabotage etc.
 Such a loss cannot obviously be estimated in advance. But it can be kept under control by taking suitable measures.
Treatment in Cost Accounts:
 The cost of an abnormal process loss unit is equal to the cost of a good unit.
 The total cost of abnormal process loss is credited to the process account from which it arises.
 Cost of abnormal process loss is not treated as a part of the cost of the product.
 The total cost of abnormal process loss is debited to costing profit and loss account.

(iii) Abnormal Process Gain/Yield:

 Sometimes, loss under a process is less than the anticipated normal figure.
 In other words, the actual production exceeds the expected figures.
 Under such a situation the difference between actual and expected loss or actual and expected production is known as
abnormal gain or yield.
 So, abnormal gain may be defined as an unexpected gain in production under the normal conditions.
 This arises due to over- estimation of process loss, improvements in work efficiency of workers, use od better technology
in production etc.
Treatment in Cost Accounts:
 The process account under which abnormal gain arises is debited with the abnormal gain and credited to abnormal gain
account which will be closed by transferring to the Costing Profit and Loss account.
 The cost of abnormal gain is computed on the basis of normal production.

4. VALUATION OF WORK-IN-PROCESS
 Work-in-process can be valued on actual basis, i.e., materials used on the unfinished units and the actual amount of labour
expenses involved.
 However, the degree of accuracy in such a case cannot be satisfactory.
 An alternative method is based on converting partly finished units into equivalent finished units.

10.2
 Process & Opera on Cos ng

Equivalent Units
 Equivalent units or equivalent production units, means converting the incomplete production units into their equivalent
completed units.
 Under each process, an estimate is made of the percentage completion of work-in-process with regard to different elements
of costs, viz., material, labour and overheads.
 It is important that the estimate of percentage of completion should be as accurate as possible.

5. STEPS IN PROCESS COSTING

Step-1: Analysis of physical flow of production units
The first step is to determine and analyse the number of physical units in the form of
- inputs (introduced fresh or transferred from previous process, beginning work- in-process) and
- outputs (completed and work-in-process).

Step-2: Calculation of equivalent units for each cost elements

The second step is to calculate equivalent units of production for each cost element i.e. for material, labour and overheads.
It is calculated by taking the extent of work done in respect of each element.

Step-3: Determination of total cost for each cost element

Total cost for each cost element is collected and accumulated for the period. The process of cost collection has already been discussed
above.

Step-4: Computation of cost per equivalent unit for each cost element
In this step, the cost per equivalent unit for each cost element is calculated. The total cost as calculated in Step-3 is divided by the
equivalent units as determined in Step-2.

Step-5: Assignment of total costs to units completed and ending WIP

In this step, the total cost for units completed, units transferred to next process, ending work in process, abnormal loss etc. are
calculated and posted in the process account and production cost report.

6. PROCESS COSTING METHODS

Mainly two methods for valuation of work-in-process are followed:
(i) First-in-first-out (FIFO) method
 Under this method the units completed and transferred are taken from both opening work-in-process (WIP) and freshly
introduced materials/inputs.
 The cost to complete the opening WIP and other completed units are calculated separately.
 The cost of opening WIP is added to cost incurred on completing the incomplete (WIP) units into complete one.
 The total cost of units completed and transferred is calculated by adding opening WIP cost to cost on freshly introduced
inputs.
 In this method the closing stock of work in process is valued at current cost.

(ii) Weighted Average (Average) Method:

 Under this method, the cost of opening work-in-process and cost of the current period are aggregated and the aggregate
cost is divided by output in terms of completed units.
 The equivalent production in this case consists of work-load already contained in opening work-in-process and work-load of
current period.
 The main difference between FIFO method and average method is that units of opening work in process and their cost are
taken in full under average method while under FIFO method only the remaining work done now is considered.

7. INTER-PROCESS PROFITS
 To control cost and to measure performance, different processes within an organization are designated as separate profit
centres.
 In this type of organizational structure, 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.

10.3
 Process & Opera on Cos ng

 The difference between cost and the transfer price is known as inter-process profits.

The advantages and disadvantages of using inter-process profit, in the case of process type industries are as follows:
Advantages:
1. Comparison between the cost of output and its market price at the stage of completion is facilitated.
2. Each process is made to stand by itself as to the profitability.

Disadvantages:
1. The use of inter-process profits involves complication.
2. The system shows profits which are not realised because of stock not sold out.

8. OPERATION COSTING
 This product costing system is used when an entity produces more than one variant of final product using different materials
but with similar conversion activities.
 Which means conversion activities are similar for all the product variants but materials differ significantly.
 Operation Costing method is also known as Hybrid product costing system as materials costs are accumulated by job order
or batch wise but conversion costs i.e. labour and overheads costs are accumulated by department, and process costing
methods are used to assign these costs to products.
 Moreover, under operation costing, conversion costs are applied to products using a predetermined application rate. This
predetermined rate is based on budgeted conversion costs.

10.4
 Joint Products & By Products

Chapter JOINT PRODUCTS & BY PRODUCTS

11

Important Question
1. How apportionment of joint costs upto the point of separation amongst the joint products using market value at the
point of separation and net realizable value method is done? Discuss.
2. How are By-products treated in Costing?
3. Narrate the terms ‘Joint Products’ and ‘By-Products’ with an example of each term.

1. MEANING OF JOINT PRODUCTS AND BY PRODUCTS

 Joint Products - Joint products 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 designated as a major product”.
 For example, in the oil industry, gasoline,fuel oil, lubricants, paraffin, coal tar, asphalt and kerosene are all
produced from crude petroleum. These are known as joint products.

 By-Products - These are defined as “products recovered from material discarded in a main process, or from the
production of some major products, where the material value is to be considered at the time of severance from the
main product.”
 By-product is a secondary or subsidiary product which emanates as a result of manufacture of the main product.
 Examples of by-products are molasses in the manufacture of sugar, tar, ammonia and benzole obtained on
carbonisation of coal and glycerin obtainedin the manufacture of soap.

 Co-Products - Co-products may be defined as two or more products which arecontemporary but do not
emerge necessarily from the same material in the same process.
 For instance, wheat and gram produced in two separate farms with separate processing of cultivation are the
co-products. Similarly, timber boards made from different trees are co-products.

 Split of Point – this is a point in a production process where joint products emerging from the process gets separately
identifiable.
 Split of Point has its importance in the joint product costing as joint costincurred up to this point only and needs to be
borne jointly by the products emerging from the common process.
 Any cost incurred after Split of Point is a product specific cost and to be borne by the product concerned.

Distinction between Joint-Product and By-Product - The main points of distinction as apparent from the definitions of
Joint Products and By-Products are:
(a) Joint products are of equal importance whereas by-products are of small economic value.
(b) Joint products are produced simultaneously but the by-products are produced incidentally in addition
to the main products.

2. APPORTIONMENT OF JOINT COSTS

 Joint costs are the expenditures incurred upto the point of separation i.e. split-off point.
 Importance of Proper apportionment of joint cost over the joint products-
(a) Valuation of closing inventory;
(b) Pricing of products; and
(c) Profit or loss on the sale of different products

11.1
 Joint Products & By Products

3. METHODS OF APPORTIONMENT OF JOINT COST TO JOINT PRODUCTS

The commonly used methods for apportioning total process costs upto the point of separation over the joint products are as
follows:
(i) Physical Units Method
(ii) Net Realisable Value at split-off point
(iii) Using Technical Estimates

Some other methods, which managers may also use for making decisions are:
(i) Market value at the point of separation
(ii) Market value after further processing
(iii) Average unit cost method
(iv) Contribution margin method

(i) Physical Unit Method:

 This method is based on the assumption that the joint products are capable of being measured in the
same units.
 The basis used for apportioning jointcost over the joint products is the physical volume of the joint
products at the point of separation suchas weight, numbers etc.
 Any loss arises during the joint production process is alsoapportioned over the products on the same basis.
 In situation where physical units are different, the joint products must be converted to a common
unitof measurement. In case, the same cannot be converted to a common unitof measurement,
this method cannot be applied. The main defect of this method is that it gives equal importance and
value to all the joint products.
 This method of apportioning is mostly followed when sale price of all the products is uniform.

(ii) Net Realisable Value at Split-off Point Method:

To arrive at the sales value at the split-off point, following are deducted from the sales value ofjoint
products at final stage i.e. after processing:

(i) Directly attributable Selling and distribution expenses like freight,royalty, commission, etc. and

(ii) Post split- off processing cost.

 When selling prices for all products exist at split off, the sales value at split off method is the preferred
technique.
 The resultant figure so obtained is known as net realisable value of joint products. Joint costs are
apportioned in the ratio of net realisable value.
 The net realisable value at split-off point method is widely used in the industries. This method is used
when the realisable value of joint products at split-off is not known.

(iii) Using Technical Estimates:

 This method uses technical estimates to apportion the joint costs over the joint products.
 This method is used when the result obtained by the above methods does not match with the resources
consumed by joint products or the realisable value of the joint products are not readily available.

Other Methods
The followings are the methods which are used by management for taking managerial decisions:
(i) Market value at the point of separation: This method is used for the apportionment of joint costs to joint
products upto the split off point.
 It is difficult to apply this method if the market value of the products at the point of separation is not available.
 It is a useful method when the realisable value of joint products at split-off (point of separation) is known
and where further processing costs are incurred disproportionately.

11.2
 Joint Products & By Products

To determine the apportionment of joint costs over joint products, a factor known as multiplying factor is
determined.
𝑗𝑜𝑖𝑛𝑡 𝑐𝑜𝑠𝑡
𝑀𝑢𝑙𝑡𝑖𝑝𝑦 𝑖𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 ∶ 100
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Total Sales Revenue is sum of production quantity multiplied by the market price for each of the joint
products.

(ii) Market value after further processing: Here the basis of apportionmentof joint cost is the total sales value
of finished products and involves the same principle as above.
 The use of this method is unfair where further processing costs after the point of separation are
disproportionate or when all the joint products arenot subjected to further processing.
 The net realisable value method which is discussed as above overcomes the shortcoming of this method.

(iii) Average Unit Cost Method: Under this method, total process cost (upto the point of separation) is divided
by total units of joint products produced. On division average cost per unit of production is obtained.

Average unit cost = Total process cost (upto the point of separation) ÷ Totalunits of
joint product produced.

 This is a simple method. The effect of application of this method is that all joint products will have uniform
cost per unit.
 If this method is used as the basisfor price fixation, then all the products may have more or less the
same price.
 Under this method customers of high quality items are benefitted as they haveto pay less price on their
purchase.

(iv) Contribution Margin Method: According to this method, joint costs are segregated into two parts - variable
and fixed.
 The variable costs are apportioned over the joint products on the basis of units produced (average method) or
physical quantities.
 The fixed costs are then apportioned over the joint products on the basis of the contribution ratios.

4. METHODS OF APPORTIONMENT OF JOINT COST TO BY PRODUCTS

The following methods may be adopted for the accounting of by-products and arriving at the cost of production of the main
product:
(i) Net Realisable Value method: The realisation on the disposal of the by- product may be deducted from the total
cost of production so as to arrive at the cost of the main product.
For example, the amount realised by the sale of molasses in a sugar factory goes to reduce the cost of sugar produced
in the factory.
When the by-product requires some additional processing and expenses are incurred in making it saleable to the
best advantage of the concern, the expenses so incurred should be deducted from the total value realised from
the sale of the by-product and only the net realisations should be deducted from the total cost of production to
arrive at the cost of production of the main product. Separate accounts should be maintained for collecting
additional expenses incurred on:
(a) further processing of the by-product, and
(b) selling, distribution and administration expenses attributable to the by- product.

(ii) Standard cost in Technical Estimates: By-products may be valued at standard costs. The standard may be
determined by averaging costs recorded in the past and making technical estimates of the number of units of
original raw material going into the main product and the number forming the by- product or by adopting some
other consistent basis.
This method may be adopted where the by-product is not saleable in the condition in which it emerges or
comparative prices of similar products are not available.

11.3
 Joint Products & By Products

(iii) Comparative price:

Under this method, the value of the by-product is ascertained with reference to the price of a similar or an
alternative material.
Suppose in a large automobile plant, a blast furnace not only produces the steel required for the car bodies but also
produces gas which is utilised in the factory.This gas can be valued at the price which would have been paid
to a gas company if the factory were to buy it from outside sources.

(iv) Re-use basis:

 In some cases, the by-product may be of such a nature thatit can be reprocessed in the same process as part of
the input of the process.
 In that case the value put on the by-product should be same as that of the materials introduced into the process.
 If, however, the by-product can be put into an earlier process only, the value should be the same as for the
materials introduced into the process.

5. TREATMENT OF BY-PRODUCT COST IN COST ACCOUNTING

By-product cost can be dealt in cost accounting in the following ways:
(a) When they are of small total value: When the by-products are of smalltotal value, the amount realised from
their sale may be dealt in any one the following two ways:
1. The sales value of the by-products may be credited to the Costing Profit and Loss Account and no credit
be given in the Cost Accounts. The credit to the Costing Profit and Loss Account here is treated either as
miscellaneous income or as additional sales revenue.
2. The sale proceeds of the by-product may be treated as deductions from the total costs. The sale proceeds
in fact should be deducted either fromthe production cost or from the cost of sales.

(b) When the by-products are of considerable total value: Where by-products are of considerable total value, they
may be regarded as joint products ratherthan as by-products.
 To determine exact cost of by-products the costs incurred upto the point of separation, should be apportioned over
by-products and joint products by using a logical basis.
 In this case, the joint costs may be divided overjoint products and by-products by using relative market values;
physical output method (at the point of split off) or ultimate selling prices (if sold).

(c) Where they require further processing: In this case, the net realisable value of the by-product at the split-off
point may be arrived at by subtractingthe further processing cost from the realisable value of by-products.
 If total sales value of by-products at split-off point is small, it may be treated asper the provisions discussed
above under (a).
 In the contrary case, the amount realised from the sale of by-products will beconsiderable and thus it may be
treated as discussed under (b).

11.4
 Service Cos ng

Chapter SERVICE COSTING

12

Important Question-
1. Explain briefly, what do you understand by Operating Costing. How are composite units computed?
2. What do you understand by operating costing? How are composite units computed?
3. Describe Composite Cost Unit as used in Service Costing and discuss the ways of computing it.
4. What do you understand by Build-Operate-Transfer (BOT) approach in Service Costing? How is the Toll rate
computed?

1. INTRODUCTION
 Service Costing is a method of ascertaining costs of providing or operating a service.
 Service costing is also known as operating costing.
 This method is generally use by transport companies, electricity supply companies, canteens, hospitals, theatres,
schools etc

1.1 Application of Service Costing

 Internal: The service costing is required for in-house services provided by a service cost centre to other
responsibility centres as support services.
Examples: Canteen and hospital for staff, Boiler house for supplying steam to production departments, Captive Power
generation unit, operation of fleet of vehicles for transport of raw material to factory or distribution of finished goods
to the market outlets, IT department services used by other departments, research & development, quality assurance,
laboratory etc.

 External: When services are offered to outside customers as a profit centre in consonance with
organisational objectives as an output.
Example: Goods or passenger transport service provided by a transporter, hospitality services provided by a hotel,
provision of services by financial institutions, insurance and IT companies etc.
In both the situation, all costs incurred are collected, accumulated for a certain period or volume, recorded in the cost
accounting system and then expressed in terms of a cost unit of service.

1.2 Service Costing vs Product Costing

Service costing differs from product costing (such as job or process costing) in the following ways due to some basic
and peculiar nature.
(i) Tangibility: Unlike products, services are intangible and cannot be stored, hence, there is no inventory for the
services.
(ii) Cost units: Use of Composite cost units for cost measurement and to express the volume of outputs.
(iii) Material vs Employee cost: Unlike a product manufacturing, employee (labour) cost constitutes a major cost
element than material cost.
(iv) Traceability of costs: Indirect costs like administration overheads are generally have a significant proportion
in total cost of a service as unlike manufacturing sector, service sector heavily depends on support services and
traceability of costs to a service may not economically feasible.

2. SERVICE COST UNIT AND KPI

 All the costs incurred during a period are collected and analyzed and then expressed in terms of a cost per unit of
service.
 The costing should be comprehensive enough to show the effects like off-seasonand peak-season demand, full time,
part time, etc.

12.1
 Service Cos ng

Typical cost unit that may be used include:

Service industry Unit of cost (examples)
Transport Services Passenger- km., (In public transportation) Quintal- km., or Tonne- km.
(In goods carriage)

Electricity Supply service Kilowatt- hour (kWh)

Hospital Patient per day, room per day or per bed, per operation etc.

Canteen Per item, per meal etc.

Cinema Per ticket.
Hotels Guest Days or Room Days
Bank or FinancialInstitutions Per transaction, per services (e.g. per letter of credit,per application, per
project etc.)

Educational Institutes Per course, per student, per batch, per lecture etc.
IT & ITES Cost per project, per module etc.
Insurance Per policy, Per claim, Per TPA etc.

Key Performance Indicator (KPI)

 Key Performance Indicators (KPIs) are the quantitative and qualitative factors which are commonly used to assess the
performance of an organization which are important to achieve its goal.
 For example, in case of Telecom industry Average Return per User (ARPU) is a key indicator, shows average revenue
generated from a user of its services.
 The list below shows few important KPIs for some Service Industries:

Industry KPI Meaning

Number of Shipments, This logistics metric monitors the number of orders that
are shipped outof the warehouse.

Truck Turnaround Rate The time from when a delivery truck enters the warehouse
Transportation (Truck Turning), to collect or deliver products to when it exits the facility.

Lead Time (Order Cycle The amount of time in between order placement by
Time) customer and receipt of order.

On-Time and In-Full The number of orders delivered according to the schedule
(OTIF) and quantityspecified.

Cost per Occupied The average cost per occupied room.

Room (CPOR)
Hotel Industry
Occupancy Rate The ratio of rented or used rooms tothe total amount of
available rooms.

Revenue per availableroom The average revenue per availableroom days.

(RevPAR)

Bed Occupancy Rate The proportion of hospital beds in useat any one time.

Hospitals/
Staff-To-Patient Ratio The number of staff resources present to attend to the
Health care
patients in a hospital over a certain period of time.
Industry

12.2
 Service Cos ng

Average Treatment The average amount that a facilitycharges a patient for a

Charge treatment.

Gross Burn Rate The rate at which the company uses upits available cash to
cover operating expenses.

Customer Acquisition The amount it takes to attract newcustomers.

Cost (CAC)

Customer Lifetime The typical net profit a companygenerates over the entire
Value (CLV) life cycle of asingle customer.
IT & ITES sector
Monthly Recurring The amount earned each month through subscription
Revenue (MRR) renewals, new sales, upsells, and fluctuations on a
monthly basis.

Churn Rate The percentage of customers that cancel their recurring

subscriptions over a given time period.

Cost Per Feature How much a specific feature costs yourbusiness, based on
usage and cloud costs.

Average return per user How much money a company ismaking for each person
(ARPU) using its service.

Subscriber acquisition Costs involved with gaining new

Telecom cost (SAC) subscribers.

Network Operating Cost Expenditure incurred on continualupkeep to

telecom’s network.

Gross Revenue How well a company is retaining its customers based on

Retention (GRR) factors such as sales price increases, organic customer
growth, and more.

Instructional Costs The cost of part-time and full-timefaculty members

Administrative Costs Per How much an institution is spending on administrative

Education Student. services on a per-student basis.
Sector
Tuition Costs Costs accrued by students on asemester
or annual basis.

Student-to-Faculty The number of students per facultymember, on a campus-

Ratio wide basis or bydepartment.

Average Cost Per Claim The average cost of each claim made.
Components of ClaimCosts Costs which are associated with a claimlike legal fees, time
(CCC) to settle, administration costs, and report delays.

Cost Per Quote The costs that the company incurs in order to get a quote
Insurance Sector in front of a potential client.

Administrative Costs Per The cost of the policy administration tonumber of policies
Policy outstanding.

Average Policy Size The total amount of premium collectedby the number of
policies issued for a given time period.

12.3
 Service Cos ng

2.1 Methods for ascertaining Service Cost Unit

Composite Cost Unit
Sometime two measurement units are combined together to know the cost of service or operation. These are called
composite cost units.
Examples of Composite units are Tonne- km., Quintal- km, Passenger-km., Patient- day etc.
Composite unit may be computed in two ways.
(i) Absolute (Weighted Average) basis.
(ii) Commercial (Simple Average) basis.
In both bases of computation of service cost unit, weightage is also given to qualitative factors rather quantitative
(which are directly related with variable cost elements) factors alone.

(i) Weighted Average or Absolute basis – It is a summation of the productsof qualitative and quantitative
factors. Like: In case of Cinema theatres, price for various classes of seats is fixed differently. For example–
First class seat may be provided with higher quality service and hence charged at a higher rate, whereas Second
Class seat may be priced less. In this case, appropriate weight to be given effect for First Class seat and Second
Class seat – to ensure proper cost per composite unit.

(ii) Simple Average or Commercial Basis – It is the product of average qualitative and total quantitative factors.
For example, in case of goods transport, Commercial Tonne-Km is arrived at by multiplying total distance
km., by averageload quantity.

2.2 Equivalent Cost Unit/ Equivalent Service Unit:

To calculate cost or pricing of two more different grade of services which uses common resources, each grade of
service is assigned a weight and converted into equivalent units. Converting services into equivalent units make
different grade of services equivalent and comparable.

3. STATEMENT OF COSTS FOR SERVICE SECTORS

 For preparing a statement of cost or a cost sheet for service sector, costs are usually collected and accumulated for
a specified period viz. A month, quarter or a year,etc.
 The cost statement for services may be prepared either on the basis of functional classification as done for product
costing or on the basis of variability.
 Cost sheet on the basis of variability is prepared classifying all the costs into three different heads:
- Fixed costs or Standing charges
- Variable costs or Operating expenses
- Semi-variable costs or Maintenance expenses

4. APPLICATIONS OF COSTING METHODS IN SERVICE COSTING

Costing techniques vis-a vis Service sector:
 In general, the service sectors are either labour or capital intensive or both, that isthe reason the proportion of costs of
cost elements differs from manufacturing sectors.
 A manufacturing sector may have higher material cost than the labour, butin case of service sector the situation reverses.

Method of costing vis-à-vis Service sector:

 The choice of method of costingdepends on nature of service provided. For example, Job costing method may be suitable
for a business which is engaged in development of customized software, healthcare etc.
 Process costing may be suitable for utility business like power, water supplies etc., Joint products costing may be suitable
for businesses which are providing bundled service like telecom, event management, educational institutes etc.

5. Build-Operate-Transfer (BOT) Approach

 BOT is an option for the Government to outsource public projects to the private sector.
 With BOT, the private sector designs, finances, constructs and operate the facility and eventually, after specified
concession period, the ownership is transferred tothe Government. Therefore, BOT can be seen as a developing
technique for infrastructure projects by making them amenable to private sector participation.

12.4
 Standard Cos ng

Chapter STANDARD COSTING

13

Important Question-
1. Describe the various steps involved in adopting standard costing system in an organization
2. Discuss the steps involved in setting labour time standards.
3. Discuss briefly some of the criticism which may be levelled against the Standard Costing System.

1. What is a Standard or Standard Cost?

Standard costs can be said as
 Planned cost
 Determined on a base or number of bases.

2. Why Standard Costing is Needed?

 Standards or Standard costs are established to evaluate performance of a responsibility centre.
 Standard costs are also used to value inventory where actual figures are not reliably available and to determine selling
prices particularly while preparing quotations.
 The standard costing is preferred for the following reasons:
(a) Prediction of future cost for decision making: Standard costs are set after taking all present conditions and future
possibilities into consideration.
Hence, standard cost is future cost for the purpose of cost estimation and profitability from a proposed project/ order/
activity.

(b) Provide target to be achieved: Standard costs are the target cost which should not be crossed by the responsibility centres.
Performance of a responsibility centre is continuously monitored and measured against the set standards. Any variance
from the standard is noted and reported for appropriate action.

(c) Used in budgeting and performance evaluation: Standard costs are usedto set budgets and based on these budgets
managerial performance is evaluated.
This is of two benefits, one managers of a responsibility centre will not compromise with the quality to fulfill the budgeted
quantity and second, variances can be traced with the responsible department or person.

(d) Interim profit measurement and inventory valuation: Actual profit can only be known after the closure of the accounts.
But an organisation may need to prepare profitability statement for interim periods for managerial reportingand
decision making.

To arrive at profit figure, standard costs are deducted from the revenue.

3. TYPES OF STANDARDS
Types of standards are as below:
(i) Ideal Standards: These represent the level of performance attainable when prices for material and labour are most
favourable, when the highest output is achieved with the best equipment and layout and when the maximum efficiency in
utilisation of resources results in maximum output with minimum cost.
Shortcomings of Ideal Standards:
(a) Since such standards would be unattainable, no one would take these seriously.
(b) The variances disclosed would be variances from the ideal standards. These would not, therefore, indicate the
extent to which they could have been reasonably and practically avoided.
(c) There would be no logical method of disposing of these variances.

13.1
 Standard Cos ng

(ii) Normal Standards: These are standards that may be achieved under normal operating conditions.
 The normal activity has been defined as “the number of standard hours which will produce at normal efficiency sufficient
good to meet the average sales demand over a term of years”.
 These standards are difficult to set because they require a degree of forecasting. The variances thrown out under this
system are deviations from normal efficiency, normal sales volume, or normal production volume.
 If the actual performance is found to be abnormal, large variances may result and necessitate revision of standards.

(iii) Basic or Bogey Standards:

According to this standard, a base year is chosen for comparison purposes in the same way as statisticians use price
indices.
Features of Basic Standard
1. Since basic standards do not represent what should be attained in the present period, current standards should also
be prepared if basic standards are used.
2. Basic standards are, however, well suited to businesses having a small range of products and long production runs.
3. Basic standards are set, on a long-term basis and are seldom revised.
4. When basic standards are in use, variances are not calculated. Instead, the actual cost is expressed as a percentage
of basic cost.

(iv) Current Standards:

 These standards reflect the management’s anticipation of what actual costs will be for the current period.
 These are the costs which the business will incur if the anticipated prices are paid for the goodsand services and the
usage corresponds to that believed to be necessary to produce the planned output.
 The variances arising from expected standards represent the degree of efficiencyin usage of the factors of
production, variation in prices paid for materials and services and difference in the volume of production.

4. THE PROCESS OF STANDARD COSTING

The process of standard cost is as below:
(i) Setting of Standards: The first step is to set standards which are to beachieved, the process of standard setting is
explained below.
(ii) Ascertainment of actual costs: Actual cost for each component of cost is ascertained. Actual costs are ascertained from
books of account, material invoices, wage sheet, charge slip etc.
(iii) Comparison of actual cost with standard cost: Actual costs are compared with the standards costs and variances are
determined.
(iv) Investigate the reasons for variances: Variances arises are investigated for further action. Based on this, performance is
evaluated and appropriate actions are taken.
(v) Disposition of variances: Variances arise are disposed-off by transferring it the relevant accounts (costing profit and loss
account) as per the accounting method (plan) adopted.

5. TYPES OF VARIANCES
Controllable and un-controllable variances:
 Controllable variances are those which can be controlled under the normal operating conditions if a responsibility
centre takes preventive measures and acts prudently.
 Uncontrollable variances are those which occurs due to conditions which are beyond the control of a
responsibility centre and cannot be controlled even though all preventive measures are in place.

Favourable and Adverse variance:

 Favourable variances are those which are profitable for the company and adverse variances are those which
causes loss to the company. While computing cost variances favourable variance means actual cost is less than standard
cost.
 Adverse variance means actual cost is exceeding standard cost.
Favourable variance in short denoted by capital ‘F’ and adverse variances by capital ‘A’.

13.2
 Standard Cos ng

6. Advantages of Standard Costing

(i) It serves as a basis for measuring operating performance and cost control. It serves as a signal for prompt
corrective action.It helps to report exceptional variances i.e. the only matters which are not proceeding according
to plan are reported. This enables the managers to concentrate on essential matters only.
(ii) It aids price fixing. Standard costing can be used to predict costs.
(iii) Introduction of standard costing facilitates evaluation of jobs and introduction of incentives.
(iv) Standard costing facilitates the estimation of the cost of new products
with greater accuracy.
(v) It serves as a basis for inventory valuation. A further advantage of this procedure is that material stock can be recorded
in terms of quantities only.
(vi) Standard costing is also used for the measurement of profit. Standard costing eliminates any variations in profit due
to changes in stock values from one period to another thus provides a basis for the measurement of profit.
(vii) Standard costing is used in planning, budgeting and decision making. Standard costs being the pre-determined costs,
are particularly useful in planning and budgeting.
(viii) Standard costing is used in standardisation of products, operations and processes, it improves the overall production
efficiency and reduces costs.
(ix) The system serves as an incentive to the departmental head to achieve the targets set by the company.
(x) Standard costing sets a uniform basis for comparison of all elements of costs.
(xi) The maximum use of working capital, plant facilities and current assets is assured because wastage of materials and loss
due to idle time are closely controlled.

7. Criticism of Standard Costing

1. Variation in price
 One of the main problem faced in the operation of the standard costing system is the precise estimation of likely
prices or rate to be paid.
 The variability of prices is so great that even actual prices are not necessarily adequately representative of cost.
But the use of sophisticated forecasting techniques should be able to cover the price fluctuation to some
extent.
 Besides this, the system provides for isolating uncontrollable variances arising from variations to be dealt with
separately.

2. Varying levels of output:

 If the standard level of output set for pre- determination of standard costs is not achieved, the standard costs
are said to be not realised.
 However, the statement that the capacity utilisation cannot be precisely estimated for absorption of overheads
may be true only in some industries of jobbing type.
 In vast majority of industries, use of forecasting techniques, market research, etc., help to estimate the output
with reasonable accuracy and thus the variation is unlikely to be very large. Prime cost will not be affected by
such variation and, moreover, variance analysis helps to measure the effects of idle time.

3. Changing standard of technology

 In case of industries that have frequent technological changes affecting the conditions of production, standard
costing may not be suitable.

4. Attitude of technical people

 Technical people are accustomed to think of standards as physical standards and, therefore, they will be
misled by standard costs.

5. Mix of products:
 Standard costing presupposes a pre-determinedcombination of products both in variety and quantity.
 The mixture of materials used to manufacture the products may vary in the long run but since standard costs
are set normally for a short period, such changes can be taken care of by revision of standards.

13.3
 Standard Cos ng

6. Level of Performance: Standards may be either too strict or too liberal because they may be based on
(a) theoretical maximum efficiency,
(b) attainable good performance or
(c) average past performance.
To overcome this difficulty, the management should give thought to the selection of a suitable type of standard.The
type of standard most effective in the control of costs is one which represents an attainable level of good performance.

7. Standard costs cannot possibly reflect the true value in exchange.

 If previous historical costs are amended roughly to arrive at estimates for ad hoc purposes, they are not standard
costs in the strict sense of the term and hence they cannot also reflect true value in exchange.
 In arriving at standard costs the economic and technical factors, internal and external, are brought together and
analysed to arrive at quantities and prices which reflect optimum operations. The resulting costs, therefore,
become realistic measures of the sacrifices involved.

8. Fixation of standards may be costly:

 It may require high order of skill and competency. Small concerns, therefore, feel difficulty in the operation of
such system.

13.4
 Marginal Cos ng

Chapter MARGINAL COSTING

14

Important Question-
1. What do you understand by Key factor? Give two examples of it.
2. Write short note on Angle of Incidence.
3. Discuss basic assumptions of Cost Volume Profit analysis.
4. Elaborate the practical application of Marginal Costing.
5. What is the meaning of Margin of Safety (MOS)? State the relationship between Operating Leverage & Margin of Safety
Ratio.
6. What are the limitations of Marginal Costing?
7. Differentiate between Marginal and Absorption Costing.
8. What is Margin of Safety? What does a large Margin of Safety indicate? How can you calculate Margin of Safety?

1. Definitions
Marginal Cost:
 Marginal cost as understood in economics is the incremental cost of production for producing one additional unit
of product.
 Variable costs have direct relationship with volume of output and fixed costs remains constant irrespective of volume of
production.
 Marginal cost is measured by the total variable cost attributable to one additional unit. For Marginal cost can precisely be
the sum of prime cost and variable overhead.

Marginal Costing:
 It is a costing system where products or services and inventories are valued at variable costs only.
 It does not take consideration of fixed costs.
 This system of costing is also known as direct costing as only direct costs forms the part of product and inventory
cost.
 Costsare classified on the basis of behavior of cost (i.e. fixed and variable) rather functions as done in absorption costing
method.

Direct Costing: Direct costing and Marginal Costing is used synonymously at various places. But the relation of
costs with respect to activity level must be understood. Some costs are variable at batch level but fixed for unit
level whereas others are variable at production line level but fixed for batches and units.

Differential and Incremental Cost:

 Differential cost is difference between the costs of two different production levels.
 It is a relative representation of costs for two different levels that results in the increase or decrease in cost. Incremental
cost, on the other hand, is the increase in the costsdue to change in the volume or process of production activities.
 Incremental costs are sometime compared with marginal cost but in reality, there is a thin line difference between the
two.
 Marginal cost is the change in the total cost due to production of one extra unit while incremental cost can be both
for increase in one unit or in total volume.

2. CHARACTERISTICS OF MARGINAL COSTING

1. All elements of cost are classified into fixed and variable components. Semi-variable costs are also analyzed into
fixed and variable elements.
2. The marginal or variable costs (as direct material, direct labour and variable factory overheads) are treated as the
cost of product.
3. Under marginal costing, the value of finished goods and work–in–progressis also comprised only of marginal
costs. Variable selling and distributionare excluded for valuing these inventories. Fixed costs are not considered for

14.1
 Marginal Cos ng

valuation of closing stock of finished goods and closing WIP.

4. Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are
incurred.
5. Prices are determined with reference to marginal costs and contribution margin.
6. Profitability of departments and products is determined with reference totheir contribution margin.

Cost and Profit Statement under Marginal Costing

Amount ( ) Amount ( )
Revenue (A) xxx
Product Cost:
- Direct Materials xxx
xxx
- Direct employee (labour)
xxx
- Direct expenses
xxx
- Variable manufacturing overheads xxx xxx
Product (Inventoriable) Costs: (B)
Product Contribution Margin {A – B}
- Variable Administration overheads
- Variable Selling & Distribution overheads xxx
Contribution Margin: (C) xxx
xxx xxx
Period Cost:
(D) xxx
Fixed Manufacturing expenses Fixed non-manufacturing
expenses xxx
xxx xxx

Profit/ (loss) {C – D} xxx

(i) Product (Inventoriable) Costs:

 In the case of merchandise inventory, these are the costs which are associated with the purchase and sale
of goods.
 In the production scenario, such costs are associated with the acquisition and conversion of materials and all
other manufacturing inputs into finished product for sale.
 Hence, under marginal costing, variable manufacturing costs constitute inventoriable or product costs.
 Finished goods are measured at product cost. Work-in-process (WIP) inventories are also measured at product
cost on the basis of percentage of completion

(ii) Contribution:
 Contribution or contribution margin is the difference between sales revenue and total variable costs irrespective
of manufacturing or non-manufacturing.
 It is obtained by subtracting variable costs from sales revenue.
 It can also be defined as excess of sales revenue over the variable costs.

(iii) Period Cost:

 These are the costs, which are not assigned to the products but are charged as expenses against the revenue
of the period in which theyare incurred.
All fixed costs either manufacturing or non-manufacturing are recognised as period costs in marginal costing.

3. ADVANTAGES OF MARGINAL COSTING

1. Simplified Pricing Policy:
 The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total.
 Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing
policy can be taken.

14.2
 Marginal Cos ng

 If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will
make decision making task difficult.

2. Proper recovery of Overheads:

 Overheads are recovered in costing on the basis of pre-determined rates.
 If fixed overheads are included on the basisof pre-determined rates, there will be under- recovery of overheads
if production is less or if overheads are more.
 There will be over- recovery of overheads if production is more than the budget or actual expenses are less than the
estimate.
 This creates the problem of treatment of such under or over-recovery of overheads.
 Marginal costing avoids such under or over recovery of overheads.

3. Shows Realistic Profit:

 Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-
in-progress are carried on marginal cost basis and the fixed expenses are written off to profit and loss account as
period cost. This shows the true profit of the period.

4. How much to produce: Marginal costing helps in the preparation of break- even analysis which shows the effect of
increasing or decreasing production activity on the profitability of the company.

5. More control over expenditure:

 Segregation of expenses as fixed and variable helps the management to exercise control over expenditure.
 The management can compare the actual variable expenses with the budgeted variable expenses and take corrective
action through analysis of variances.

6. Helps in Decision Making: Marginal costing helps the management in takinga number of business decisions like
make or buy, discontinuance of a particular product, replacement of machines, etc.

7. Short term profit planning: It helps in short term profit planning by B.E.P charts.

4. LIMITATIONS OF MARGINAL COSTING

1. Difficulty in classifying fixed and variable elements: It is difficult to classify exactly the expenses into fixed and
variable category.
Most of the expenses are neither totally variable nor wholly fixed.
2. Dependence on key factors: Contribution of a product itself is not a guide for optimum profitability unless it is
linked with the key factor.
3. Scope for Low Profitability: Sales staff may mistake marginal cost for total cost and sell at a price; which will result
in loss or low profits. Hence, salesstaff should be cautioned while giving marginal cost.
4. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while
valuing the work-in- progress. In order to show the correct position, fixed overheads have to be included in work-
in- progress.
5. Unpredictable nature of Cost:
 Some of the assumptions regarding the behaviour of various costs are not necessarily true in a realistic situation.
 For example, the assumption that fixed cost will remain static throughout is not correct.
 Fixed cost may change from one period to another. For example, salaries bill may go up because of annual
increments or due to change in pay rate etc.
 The variable costs do not remain constant per unit of output. There may be changes in the prices of raw materials,
wage rates etc. after a certain level of output has been reached due to shortage of material, shortage of skilled
labour, concessions of bulk purchases etc.
6. Marginal costing ignores time factor and investment: The marginal cost of two jobs may be the same but the
time taken for their completion and the cost of machines used may differ.
The true cost of a job which takes longertime and uses costlier machine would be higher. This fact is not
disclosed by marginal costing.
7. Understating of W-I-P: Under marginal costing stocks and work in progress are understated.

14.3
 Marginal Cos ng

5. COST-VOLUME-PROFIT (CVP) ANALYSIS

Meaning:
 It is a managerial tool showing the relationship between various ingredientsof profit planning viz., cost, selling price and
volume of activity.
 As the name suggests,cost volume profit (CVP) analysis is the analysis of three variables, cost, volume and profit.
 It explores the relationship between costs, revenue, activity levelsand the resulting profit. It aims at measuring variations in
cost and volume.

Assumptions:
1. Changes in the levels of revenues and costs arise only because of changes in the number of product (or service)
units produced and sold
2. Total costs can be separated into two components
3. When represented graphically, the behaviours of total revenues and total costs are linear (meaning they can be
represented as a straight line) in relation to output level within a relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period) are known
and constant.
5. The analysis either covers a single product or assumes that the proportion of different products when multiple
products are sold will remain constant as the level of total units sold changes.
6. All revenues and costs can be added, subtracted, and compared withouttaking into account the time value of money.

Importance
It provides the information about the following matters:
1. The behavior of cost in relation to volume.
2. Volume of production or sales, where the business will break-even.
3. Sensitivity of profits due to variation in output.
4. Amount of profit for a projected sales volume.
5. Quantity of production and sales for a target profit level.

Impact of various changes on profit:

An understanding of CVP analysis is extremely useful to management in budgetingand profit planning. It elucidates the
impact of the following on the net profit:
(i) Changes in selling prices,
(ii) Changes in volume of sales,
(iii) Changes in variable cost,
(iv) Changes in fixed cost.

6. Break-Even Analysis
Break-even analysis is a generally used method to study the CVP analysis. This technique can be explained in two ways:
(i) In narrow sense it is concerned with computing the break-even point. At this point of production level and sales there
will be no profit and loss i.e. total cost is equal to total sales revenue.
(ii) In broad sense this technique is used to determine the possible profit/loss at any given level of production or sales.

7. METHODS OF BREAK-EVEN ANALYSIS

Break even analysis may be conducted by the following two methods:

(A) ALGEBRAIC CALCULATIONS

7.1 Break-even Point
 This is the point where neither profits nor losses have been made is known as a break-even point.
 This implies that in order to break even the amount of contribution generated should be exactly equal to the fixed
costs incurred.
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡𝑠

14.4
 Marginal Cos ng

7.2 Cash Break-even Point

 When break-even point is calculated only with those fixed costs which are payablein cash, such a break-even
point is known as cash break-even point.
 This means that depreciation and other non-cash fixed costs are excluded from the fixed costs in computing cash
break-even point. Its formula is –
𝑪𝒂𝒔𝒉 𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕𝒔
𝑪𝒂𝒔𝒉 𝑩𝒓𝒆𝒂𝒌 − 𝒆𝒗𝒆𝒏 𝒑𝒐𝒊𝒏𝒕 =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕𝒔

7.3 Multi-Product Break-Even Analysis

 In a multi-product environment, where more than one product is manufactured by using a common fixed cost, the
break-even point formula needs some adjustments.
 The contribution is calculated by taking weights for the products. The weights may be of sales mix quantity or sales
mix values.

(B) GRAPHICAL PRESENTATION OF BREAK-EVEN CHART

7.4 Break-even Chart
- A breakeven chart records costs and revenues on the vertical axis and the level of activity on the horizontal axis.
- The making of the breakeven chart would requireto select appropriate axes. Subsequently, you will need to mark
costs/revenues on the Y axis whereas the level of activity shall be traced on the X axis.
- Lines representing
(i) Fixed costs
(ii) Total costs at maximum level of activity
(iii) Revenue at maximum level of activity (joined to the origin) shallbe drawn next.
The breakeven point is that point where the sales revenue line intersects the total cost line. Other measures like the
margin of safety and profit can also be measured from the chart.

7.5 Contribution Breakeven Chart

- It is based on the same principles as a conventional breakeven chart except for that it shows the variable cost line
instead of the fixed cost line. Lines for Total cost and Sales revenue remain the same.
- The breakeven point and profit can be read offin the same way as with a conventional chart.
- The contribution can be read as the difference between the sales revenue line andthe variable cost line.

7.6 Profit-Volume Chart

- This is also very similar to a breakeven chart. In this chart the vertical axis represents profits and losses, and the
horizontal axis is drawn at zero profit or loss.
- In this chart each level of activity is taken into account and profits marked accordingly. The breakeven point is where
this line interacts the horizontal axis.
Advantages of the profit-volume chart
The biggest advantage of the profit-volume chart is its capability of depicting clearly the effect on profit and breakeven
point of any changes in the variables. The following example illustrates this characteristic

8. LIMITATIONS OF BREAK-EVEN ANALYSIS

 The limitations of the practical applicability of breakeven analysis and breakeven charts stem mostly from the
assumptions underlying CVP.
 Assumptions like costs behaving in a linear fashionor sales revenue remain constant at different sales levels or the stocks
shall remain constant period after period are unrealistic.
 Similarly, the assumption that the only factor which influences costs is the ‘activity level achieved’ is erroneous because
other factors like inflation also have a bearing on costs.

14.5
 Marginal Cos ng

9. MARGIN OF SAFETY
 The margin of safety can be defined as the difference between the expected level of sale and the breakeven sales. The
larger the margin of safety, the higher is the chances of making profits.
 The Margin of Safety can also be calculated by identifying the difference betweenthe projected sales and breakeven sales
in units multiplied by the contribution per unit. This is possible because, at the breakeven point all the fixed costs are
recovered and any further contribution goes into the making of profits.

10. ANGLE OF INCIDENCE

 This angle is formed by the intersection of sales line and total cost line at the break- even point. This angle shows the rate
at which profit is earned once the break- even point is reached. The wider the angle the greater is the rate of earning
profits. A large angle of incidence with a high margin of safety indicates extremely favourable position.
 The shaded area in the graph given below is representing the angle of incidence.The angle above and below the break-
even point shows the rate of earning
 profitability (loss). Wider angle denotes higher rate of earnings and vice-versa.
Cost and Sales (Rs. ‘ 000)
Cost and Sales (` '000)

11. APPLICATION OF CVP ANALYSIS IN DECISION MAKING

11.1 Framework for Decision Making
Step-1: Identification of Problem
If a manufacturer of certain products, has identified that it can be leader in the industry if it can produce those
products at lower cost than its rival. Here the goal should be (problem area) low-cost production.

Step- 2: Identification of Options

After identification of problem(s), the next step is identification of options to achieve the goal (to answer the
problem).
All possible options need to be explored.Following options for low-cost production:
(a) Purchase of inputs from specialised market- Local vs Import
(b) Make the input in its own factory- Make or Buy
(c) Bulk purchase to avail discount offer- How much to purchase
(d) Make in-house- Make vs Outsource
(e) Bulk processing- How much to produce

14.6
 Marginal Cos ng

(f) Using efficient machine for manufacturing- Old machine vs New machine
(g) Optimisation of key resources- Product mix decisions etc.

Step- 3: Evaluation of the Options

After identification of options, each option is to be evaluated against the objective criteria.
An entity with objective of making profit may evaluate options on the basisof financial measures like impact of
profit or loss, market share, overall impact on profitability, return on investment etc.
Non-financial factors like customer satisfaction, impact on existing market/ customer, ethics of decision are also
evaluated.
This step is a very important and may be grouped into two tasks
(i) Identification of Cost and Benefits of each option
(ii) Estimation of amount of each option

Step-4: Selection of option:

After evaluation of the options, the best option is selected and implemented.

11.2 Principles for Identification of Cost and Benefits for Measurement

(i) Controllability:
 Those cost and benefits which arise due to choice of an option.
 In other words, benefits received, and cost incurred are directly related with the choice of the option.
 Thus, the costs and benefits which are controllable are considered for measurement for making decision.

(ii) Relevance:
 The costs which are controllable need to be relevant for decision making.
 This means all controllable costs are not relevant for decision making unless it differs under the two
options.
 Thus, a cost is treated is relevant only if (a) it is a future cost and (b) it differs under two options under
consideration.

Below is an analysis of few costs for its relevance:

Cost Relevance Reason

(i) Historical Cost Irrelevant The cost has already been incurred and do not affect the decision.
Example: Book value of machinery etc.
(ii) Sunk Cost Irrelevant The cost which are already paid either forgoods or services availed or to be
availed.
Example: Raw material purchased and held in store without having
replacement cost, Cost of drawing, blueprint etc.
(iii) Committed Cost Irrelevant The committed costs are the pre-agreed cost which cannot be revoked under
the normal circumstances. This is also a sunk cost.
Examples: Cost of materials as per rate agreement, Salary cost to employees
etc.
(iv) Opportunity Cost Relevant The opportunity cost is represented by the forgone potential benefit from the best
rejected course of action. Had the option under consideration not chosen, the
benefit would come to the organisation.
(v) Notional or Relevant Notional costs are relevant for the decision making only if company is actually
Imputed Cost forgoing benefits by employing its resources to alternative course of action.
For example, notional interest on internally generated fund is treated as relevant
notional cost onlyif company could earn interest from it.
(vi) Shut-down Cost Relevant By closing down the manufacturing, the organization will save variable
cost of production as well as some discretionary fixed costs. This
particular discretionary cost is known as shut-down cost.

14.7
 Marginal Cos ng

11.3 Principles of Estimation of Costs and Benefits

After identification of the costs and benefits, it is now required to be quantified i.e., the cost and benefit should be
measured and estimated. The estimation is done by following the two principles as discusses below:
(i) Variability: Variability means by how much a cost or benefit increased or decreased due to the choice of the
option.
Variable costs are the cost which differs under the different volume or activities. On the other hand, fixed costs
remain same irrespective of volume and activities.

(ii) Traceability: Traceability of cost means degree of relationship between thecost and the choice of the option.
Direct costs are directly assigned to the optionon the other hand indirect costs needs to be apportioned to the
option on some reasonable basis.

11.4 Short-term Decision-Making using concepts of CVP Analysis

Management uses marginal costing and CVP concepts for making various decisions.
(i) Decisions related with excess supply, such as:
(a) Processing of Special Order
(b) Determination of price for stimulating demand
(c) Local vs Export sale
(d) Determination of minimum price for price quotations
(e) Shut-down or continue decision etc.

(ii) Decisions related with excess demand, such as:

(a) Make or Buy/ In-house-processing vs Outsourcing
(b) Product mix decision under resource constraints (limiting factors)
(c) Sales mix decisions
(d) Sale or further processing etc.

What is a Limiting Factor?

 Limiting factor is anything which limits the activity of an entity.
 The factor is a key to determine the level of sale and production, thus itis also known as Key factor.
 From the supply side the limiting factor may either be Men (employees), Materials (raw material or supplies),
Machine (capacity), or Money (availability of fund or budget) and from demand side it may be demandfor
the product, other factors like nature of product, regulatory and environmental requirement etc.
 The management, while making decisions, has objective to optimise the key resources upto maximum possible
extent.

12. MARGINAL COSTING V/s ABSORPTION COSTING

Marginal costing Absorption costing

1. Only variable costs are considered for product Both fixed and variable costs are considered for product
costing and inventory valuation. costing and inventory valuation.

2. Fixed costs are regarded asperiod costs. The Fixed costs are charged to the cost of production. Each
Profitability of different products is judgedby product bears a reasonable share of fixed cost and thus the
their P/V ratio. profitability of a product is influenced by theapportionment of
fixed costs.
3. Cost data presented highlightthe total contribution Cost data are presented in conventional pattern. Net profit of
of eachproduct. each product is determined after subtracting fixed cost along
with their variable costs.
4. The difference in the magnitudeof opening stock The difference in the magnitude of opening stock and closing
and closing stock does not affect the unit cost of stock affectsthe unit cost of production due to theimpact of
production. related fixed cost.

14.8
 Marginal Cos ng

5. In case of marginal costing the cost per unit In case of absorption costing the cost per unit reduces, as the
remains the same, irrespective of the productionas production increases as it is fixed cost which reduces,
it is valued at variable cost whereas, the variable cost remains the same perunit.

13. Reason for difference in Profit under Marginal and Absorption costing
The above two approaches will compute the different profit because of the differencein the stock valuation. This difference is
explained as follows in different circumstances.
1. No opening and closing stock: In this case, profit / loss under absorptionand marginal costing will be equal.

2. When opening stock is equal to closing stock: In this case, profit / loss under two approaches will be equal
provided the fixed cost element in boththe stocks is same amount.

3. When closing stock is more than opening stock: In other words, when production during a period is more than
sales, then profit as per absorption approach will be more than that by marginal approach. The reason behind this
difference is that a part of fixed overhead included in closing stock valueis carried forward to next accounting
period.

4. When opening stock is more than the closing stock: In other words, when production is less than the sales, profit
shown by marginal costing will be more than that shown by absorption costing. This is because a part of fixed cost
from the preceding period is added to the current year’s cost of goodssold in the form of opening stock.

14.9
 Budget & Budgetary Control

Chapter BUDGET AND BUDGETARY CONTROL

15

Important Question

1. List the eight functional budgets prepared by a business.

2. Distinguish between Fixed and flexible budget.
3. Explain the Essentials of budget.
4. State the considerations on which capital expenditure budget is prepared.
5. Describe the steps involved in the budgetary control technique.
6. Describe the salient features of budget manual.
7. Why is 'Zero Base Budgeting' (ZBB) considered superior to 'Traditional Budgeting'? Explain.
8. What are the cases when a flexible budget is found suitable?
9. Define 'Zero Base Budgeting and mention its various stages.
10. What are the important points an organization should consider if it wants to adopt Performance Budgeting?
11. State the limitations of Budgetary Control System.
12. What is ‘Budgetary Control System’ and discuss the components of the same.
13. Define Budget Manual. What are the salient features of Budget Manual?

1. MEANING OF BUDGET AND BUDGETING

Budget:
 A budget is an instrument of management used as an aid in the planning, programming and control of business activity.
 CIMA, UK defines budget as “A financial and/or quantitative statement, prepared and approved prior to a defined period
of timeof the policy to be pursued during that period for the purpose of attaining a given objective. It may include income,
expenditure and employment of capital”
 The budget is a blue-print of the projected plan of action expressed in quantitative terms for a specified period of time.

Budget v/s Forecast

 There is some similarity between the budget and forecast as both relate to a defined period of time.
 A forecast is an assessment of probable future events.
 Budget a financial/quantitative plan of a business enterprise to be pursued over a period of time.
 Therefore, at the planning stage it is necessary to forecast a probable course of action for the business.
 Budget is a commitment or a target which the management seeks to attain on the basis of the forecasts made.
 Forecasts are made regarding sales, production cost and financial requirements of the business. A forecast denotes some
degree of flexibility while a budget denotes a definite target.

Budgeting:
 Budgeting is the process of designing, implementing and operating of budget. The main emphasis in budgeting process is the
provision of resources to support plans which are being implemented.
 It is a means of coordinating the combined intelligence of an entire organisation into a plan of action based on past
performance and governed by rational judgment of factors that will influence the course of business in the future.

2. ESSENTIAL CHARACTERISTICS OF BUDGET

1. A budget is concerned for a definite future period.
2. A budget is a written document.
3. A budget is a detailed plan of all the economic activities of a business.
4. All the departments of a business unit should co-operate for the preparationof a business budget.
5. Budget is a means to achieve business objectives and it is not an end in itself.

6. Budget needs to be updated, corrected and controlled every timecircumstances change. Therefore, it is a
15.1
 Budget & Budgetary Control

continuous process.
7. Budget helps in planning, coordination and control.
8. Different types of budgets are prepared by industries according to businessrequirements.
9. A budget acts as a business barometer.
10. Budget is usually prepared in the light of past experiences.
11. Budget is a constant endeavour of the Management.

3. ESSENTIAL STEPS FOR PREPARING BUDGET

1. Organisational structure must be clearly defined and responsibility should be assigned to identifiable units within the
organisation.
2. Setting of clear objectives and reasonable targets. Objectives should be in consonance with the long-term plan of the
organisation.
3. Objectives and responsibility should be clearly stated and communicated to the management or person responsible.
4. Budgets are prepared for the future periods based on expected course of actions.
5. Budgets are updated for the events that were not kept into the mind while establishing budgets. Hence, budgets should
flexible enough for mid- term revision.
6. The entire organisation must be committed to the preparation and implementing budgeting.
7. Budgets should be quantifiable and master budget should be broken downinto various functional budgets.
8. Budgets should be monitored periodically. Variances of the actual outcomes should be compared with the actuals and
variances analysed and responsibility should be fixed.
9. Budgetary performance needs to be linked effectively to the reward system.

4. OBJECTIVES OF BUDGETING
Planning
 Budget is prepared in synchronisation with the overall objectives of the organisation, keeping mission and corporate
strategy into account. Individual plans at unit level should be in consonance with organisational plan.
 Budget reflects plans. Therefore, planning should precede the preparation of budget.
 Budgeted plans are quantified and responsibility is assigned to the persons who are responsible for execution of plan.
 Communication of business objectives through budget has helped many a company to reduce expenses during
business recession.
 During the planning phase of the budget process,all viewpoints are considered, options identified, and cost reduction
opportunities assessed.

Directing and Coordinating

 Once the budget plans are in place, these can be used to direct and coordinate operations in order to achieve the
stated targets.
 A business, however, is much more complex and requires more formal direction and coordination.
 The budget offers an important tool to direct and coordinate business activities and units to achieve stated targets of
performance.
 The budgetary units in an organisation are called responsibility centers. Each responsibility center is led by a manager
who has the authority over and responsibility for the unit’s performance.
 Objectives of each responsibility centre and degree of performance expected from them are separately communicated.

Controlling
 Control is the process of monitoring, measuring, evaluating and correcting actualresults to ensure that a firm’s goals and
plans are achieved. Control is achieved through the process of feedback.
 As time passes, the actual performance of an operation can be compared against the planned targets. This
provides prompt feedback to employees about their performance. If necessary, employees can use such feedback
to fine-tune their activities in the future.
 Feedback received in the form of budget report from the responsibility centreis helpful to know the performance of
the concerned unit.

 Any unforeseen changes into the conditions which were prevailing at the time of preparing budget are taken into
15.2
 Budget & Budgetary Control

account and budgets are revised to show true performance.

 Comparing actual results to the plan helps prevent unplanned expenditures. The budget helps employees to regulate
their spending priorities.

5. BUDGETARY CONTROL
 CIMA has defined the terms ‘budgetary control’ as the establishment of budgets relating to the responsibilities of executives
to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual
action, the objective of that policy or to provide a basis for its revision.
 It is the system of management control and accounting in which all the operations are forecasted and planned in
advance to the extent possible and the actual results compared with the forecasted and planned results.

Budgetary Control Involves

1. Establishment of budgets
2. Continuous comparison of actuals with budgets for achievement of targets.
3. Revision of budgets after considering the changes in the circumstances.
4. Fixation of the responsibility for failure to achieve the budget targets.

Objectives of Budgetary Control System

1. Portraying with precision the overall aims of the business and determining targets of performance for each section
or department of the business.
2. Laying down the responsibilities of each of the executives and other personnel so that everyone knows what is
expected of him and how he willbe judged. Budgetary control is one of the few ways in which an objective
assessment of executives or department is possible.
3. Providing a basis for the comparison of actual performance with the predetermined targets and investigation of
deviation, if any, of actual performance and expenses from the budgeted figures. This naturally helps in adopting
corrective measures.
4. Ensuring optimum use of available resources to maximise profit or production, subject to the limiting factors.
Since budgets cannot be properly drawn up without considering all aspects, usually there is good co-ordination when
a system of budgetary control operates.
5. Co-ordinating various activities of the business, and centralising control and yet enabling management to
decentralise responsibility and delegate authority in the overall interest of the business.
6. Engendering a spirit of careful forethought, assessment of what is possible and an attempt at it. It leads to
dynamism without being reckless. Of course, much depends on the objectives of the firm and the dynamism r of its
management.
7. Providing a basis for revision of current and future policies.
8. Drawing up long range plans with a fair measure of accuracy.
9. Providing a yardstick against which actual results can be compared.

Steps for establishing Budgetary Control

1. Determining the objectives to be achieved, over the budget period, andthe policy or policies that might be
adopted for the achievement of these objectives.
2. Determining the activities that should be undertaken for the achievementof the objectives.
3. Drawing up a plan or a scheme of operation in respect of each class of activity, in quantitative as well as monetary
terms for the budget period.
4. Laying out a system of comparison of actual performance by each person, ordepartment with the relevant budget
and determination of causes for thevariation, if any.
5. Ensuring that corrective action will be taken where the plan has not been achieved and, if that is not possible,
for the revision of the plan.

Feedback and Feedforward Control

Feedback Control:
 The feedback system of budgetary control, the actual results for the budgeted period are collected and compared
with the budgeted figures.
 The exercise of variance identification is done after the completion of the budget period.

 The variances are reported and based on the report corrective actions are taken, responsibility is fixed and based on

15.3
 Budget & Budgetary Control

experience, modification in future targetsis implemented. As the name suggests, it is an Ex-post Corrective control
system of budget.

Feedforward Control:
 This the opposite of feedback control system of budgetary control.
 It is Ex-Ante Preventive control mechanism of budgetary control.
 The budgets are set at the inception of the budgeted period and the actual resultsare continuously monitored and
compared.
 The targets are kept realistic as far as possible and the targets are reviewed and reset if necessary.

Budget Committee and Budget Officer

 The budget committee is a group of representatives of various functions in anorganisation. This is called coordination
in budget-making. It is a powerful force in knitting together various activities of the business and enforcing real control
over operations.
 The Chief Executive is ultimately responsible for the budget programme but it will be better if the large part of the
supervisory responsibility is delegated to an official designated as Budget Officer. The budget Officer should have
knowledge of the technical side of the business and should report to the president or CEO of the business entity.

The main responsibilities of the Budget Committee/Budget Officer are to:

1. Assist in the preparation of the separate budget for various departments by coordinating the work of the accounts
department, which is normally responsible to compile the budgets—with the relevant functional departments like
Sales, Production, Plant maintenance etc.;
2. Forward the budget to the individual departments heads who are re- sponsible to implement the budget. The
Budget Officer should guide themin overcoming any practical difficulties, in its working;
3. Prepare the periodical budget reports for circulation to the individuals concerned;
4. Follow-up action to be taken on the budget reports;
5. Prepare an overall budget working report for discussion at the BudgetCommittee meetings and to ensure follow-
up on the lines of action suggested by the Committee;
6. Prepare periodical reports for the Board meeting. Comparing budgeted Profit and Loss Account and the Balance
Sheet with the actual results attained.

Advantages of Budgetary Control System

Points Description

1. Efficiency It enables the management of a business entity to conduct its

business activities in an efficient manner.

2. Control on It is a powerful instrument used by business entity for the

expenditure control of their expenditure.
It provides a yardstick for measuring and evaluating the
performance of individuals andtheir departments.

3. Finding deviations It reveals the deviations of the actual from the budgeted
figures after making a comparison and communicating the
deviation tomanagement.

4. Effective utilisation ofresources Effective utilisation of various resources like— men,

material, machinery and money—is made possible, as the
production is planned after taking these into account.

5. Revision of plans Budget helps in the review of current trends andframing of

future policies.

15.4
 Budget & Budgetary Control

6. Implementation ofStandard Costing Budget creates suitable conditions for the implementation of
system standard costing system in a business organisation.

7. Cost Consciousness Budgetary control system encourages cost consciousness

and maximum utilisation ofavailable resources.

8. Credit Rating Management which has developed a well-ordered budget

plans and which operate accordingly, receive greater favour
from credit agencies.

Limitations of Budgetary Control System

Points Description

1. Based on Estimates Budgets are based on a series of estimates, which are based on the
conditions prevalent or expectedat the time budget is established.
It requires revision in plan if conditions change.

2. Time factor Budgets cannot be executed automatically. It requires proper

attention and time of management. Management must not expect
too much during the initial development period.
3. Co-operationRequired Staff co-operation is usually not available during the initial
budgetary control exercise. The success of thebudgetary control
depends upon willing co- operation and teamwork,
4. Expensive The implementation of budget is somewhat expensive. Budgeting
process start from the collection of information tofor preparing
the budget and performance analysis. It consumes valuable
resources (in terms of qualified manpower, equipment, etc.) for
this purpose; hence, it is an expensive process.
5. Not a substitute for Budget is only a managerial tool and must be intelligently applied
management for management to get benefited. Budgets are not a substitute for
good management.
6. Rigid document Budgets are sometime considered as rigid documents. Budget
should be flexible enough to incorporate ongoing developments in
the internaland external factors affecting the very purpose ofthe
budget.

Components of Budgetary Control System

1. Physical budgets: Those budgets which contain information in quantitative terms such as the physical units of
sales, production etc. This may include quantity of sales, quantity of production, inventories, and manpower
budgets are physical budgets.
2. Cost budgets: Budgets which provides cost information in respect of manufacturing, administration, selling and
distribution, etc. for example, manufacturing costs, selling costs, administration cost, and research and
development cost budgets are cost budgets.
3. Profit budgets: A budget which enables the ascertainment of profit. For example, sales budget, profit and loss
budget, etc.
4. Financial budgets: A budget which facilitates in ascertaining the financial position of a concern, for example,
cash budgets, capital expenditure budget, budgeted balance sheet etc.

6. BUDGETS AND MOTIVATION

 Budget is a planning exercise which quantifies the desired results into targets. The budget targets are
communicatedto the executives at different levels and they are asked to strive to get the targes achieved.
 There must be something motivating in achieving the targets, therefore, a budgeting process should have the
following consideration to make it motivating one:

15.5
 Budget & Budgetary Control

(a) Performance measurement:

 The budget, at first be communicated to allexecutives so that everybody must be informed the desired performance
expected from each of them.
 Secondly, the achievement of targets should have consideration in measurement and evaluation of performance
an executive at individual level and at departmental level.
 Rewards such as promotion, increment, Performance related pay (Pay), bonus may be appropriate motivation
factors.

(b) Achievable Targets:

 While setting targets, the practical aspects such as availability of resources and realism of figures must be considered.
 The targes should be balance one, it neither be very easy nor too tough, means it should be realistic one. An
unrealistic target has reverse impact and may be demotivate the executives.

(c) Optimum utilisation of resources:

 A budget targets which is easilyachievable may underutilise the resources such as potential skills of executives.
Pressure sometime forcing to explore innovative ways to get things done.
 Thus, to keep motivation alive, a balanced approach should be applied for optimum utilisation of resources upto its
effort zone, though beyond the comfort zone.

(d) Involvement in budgeting process:

 The budgets which involves theexecutives from all department can capture the requirement of all the users. The
participative budgeting motivates the executives and give them a senseof ownership.
 Involvement at planning stage of budget can take care of the requirements of the executives and force them accept
the targets.
 However, involvement at every stage of budgeting process may distort the objective of budget and lands
nowhere., thus, a balance approach may be followed.

7. PREPARATION OF BUDGETS
1. Defining business or organisational objectives:
 A budget is a plan for the achievement of certain organisational objectives. It is therefore desirable that these
objectives are defined precisely.
 The organisational objectives shouldbe written down; the areas of control demarcated; and items of revenue and
expenditure to be covered by the budget clearly stated.
 This will give a clear understanding of the plan and its scope to all those who must cooperate to make it successful.

2. Identification of the key budget factor:

 There are usually one or two key budget factors (sometimes there may be more than two) which set a limit to the
total activity.
 For instance, in India sometimes non-availability of power does not allow production to increase in spite of heavy
demand. Similarly, lack of demand may limit production.
 Such a factor is known as key factor.For proper budgeting, it must be identified and its influence on
productionon sales estimated properly while preparing the budget.

3. Appointment of controller/officer:
 Formulation of a budget usually requires service of a whole time senior executive. He must be assisted in this
work by a Budget Committee, consisting of all the heads of departments along with the Managing Director as the
Chairman.
 The Budget Controller/Officer is responsible for coordinating and development of budget programmes and preparing
the manual of instruction, known as Budget manual.

4. Budget Manual:
 The budget manual is a booklet specifying the objectives of an organisation in relation to its strategy. The budget is
made to decide how much an organisation would earn and spend and in what manner. In the budget, the organisation
sets its priorities too.

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 Budget & Budgetary Control

 CIMA, London, defines budget manual as, “A document which sets out the responsibilities of the persons engaged
in, the routine of, and the forms and records required for, budgetary control.”
 A budget manual is a collectionof documents that contains key information for those involved in the planning
process.

Contents of a Budget Manual

Typical budget manual may include the following:
(i) A statement regarding the objectives of the organisation and how they can be achieved through budgetary
control;
(ii) A statement about the functions and responsibilities of each executive, both regarding preparation and
execution of budgets;
(iii) Procedures to be followed for obtaining the necessary approval of budgets. The authority of granting approval
should be stated in explicit terms. Whether, one two or more signatures are required on each document should
be clearly stated;
(iv) A form of organisation chart to show who are responsible for the preparation of each functional budget and
the way in which the budgets are interrelated.
(v) A timetable for the preparation of each budget.
(vi) The manner of scrutiny and the personnel to carry it out;
(vii) Reports, statements, forms and other record to be maintained;
(viii) The accounts classification to be employed. It is necessary that the framework within which the costs, revenue
and other financial accounts are classified must be identical both in the accounts and budget department;
(ix) The reporting of the remedial action;
(x) The manner in which budgets, after acceptance and issuance, are to be revised or the matter amended these
are included in budgets and on which action can be taken only with the approval of top management
(xi) This will prevent the formation of a ‘bottleneck’ with the latepreparation of one budget holding up the
preparation of all others.
(xii) Copies of all forms to be completed by those responsible for preparing budgets, with explanations
concerning their completion.
(xiii) A list of the organization’s account codes, with full explanations of howto use them.
(xiv) Information concerning key assumptions to be made by managers intheir budgets, for example the rate
of inflation, key exchange rates, etc.

5. Budget period:
 The period covered by a budget is known as budget period. There is no general rule governing the selection of the
budget period.
 In practice the Budget Committee determines the length of the budget period suitable for the business.
 Normally, a calendar year or a period co-terminuswith the financial year is adopted.
 The budget period for the calendar or financial year is then divided into shorter periods; it may be monthly or
quarterly or for such periods as coincide with period of trading activity of the business.

6. Standard of activity or output:

 For preparing budgets for the future, past statistics, though important, cannot be completely relied upon.
 The past usually represents a combination of good and bad factors. Therefore, though results of the past should be
studied, but these should only be applied when there is a likelihood of similar conditions repeating in the future.
 Also, while setting the targets for the future, it must be remembered that in a progressive business, the achievement
of a year should normally exceed those of earlier years. Therefore, what was good in the past is only fair for the
current year and should work for much better in the future.
In budgeting, fixing the budget of sales, expenses, and of capital expenditure is important since these budgets determine the
extent of development activity.
For budgeting sales, one must consider the trend of economic activity of the country, recommendations of salesmen,
customers and employees, effect of price changeson sales, the provision for advertisement campaign plan capacity etc.

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 Budget & Budgetary Control

8. DIFFERENT TYPES OF BUDGETS

8.1 Classification on the basis of Capacity or Flexibility
These types of budgets are prepared on the basis of activity level or utilization of capacity. These are also known as
“Budgets on the basis of flexibility”.

(i) Fixed Budget:

 According to CIMA, “a fixed budget is a budget designed to remain unchanged irrespective of the level of activity
actually attained”. A fixed budget shows the expected results of a responsibility center for only one activity level.
 Once the budget is prepared, it is not changed, even if the level of activity changes. Fixed budgeting is used by many
service companies and for some administrative functions of manufacturing companies, such as purchasing, engineering,
and accounting.
 Fixed Budget is used as an effective tool of cost control. In case, the level of activity attained is different from the level of
activity for budgeting purposes, the fixed budget becomes ineffective. Fixed budget is suitable for fixed expenses. It is also
known as a static budget.

Essential conditions:
1. When the nature of business is not seasonal.
2. There is no impact of external factors on the business activities.
3. The demand of the product is certain and stable.
4. Supply orders are received and issued regularly.
5. The market of the product is normally domestic but it can also apply inrespect of service export, where fairly regular
export orders are received
6. There is no need of special labour or material in the production of theproducts.
7. Supply of production inputs is regular.
8. There is a trend of price stability.
Generally, all above conditions are not found in practice. Hence fixed budget is notsuitable in business concerns.

Merits and Demerits of fixed budgets are tabulated below:

Merits Demerits

1. Very simple to understand 1. It does not suite a dynamic organization and may give misleading
2. Less time consuming results. A pooror good performance may remain un- noticed.
2. It is not suitable for long period.
3. It is also found unsuitable particularly when the business conditions
are changing constantly.
4. Accurate estimates are not possible.

(ii) Flexible Budget:

 According to CIMA, “a flexible budget is defined as a budget which, by recognizing the difference between fixed,
semi-variable and variable costs is designed to change in relation to the level of activity attained.”
 Unlike static (fixed) budgets, the flexible budgets show the expected results of a responsibility center for different activity
levels.
 One can view a flexible budget as a series of static budgets for different levels of activity. Such budgets are especially
useful in estimating and controlling factory costs and operating expenses.
 It is more realistic and practicable because it gives due consideration to behaviour of revenue and cost at different levels
of activity.
 While preparing a flexible budget, the expenses are classified into three categories viz.
(i) Fixed,
(ii) Variable, and
(iii) Semi-variable.
Semi-variable expenses are further segregated into fixed and variable expenses. Flexible budgeting may
be resorted to under the following situations:
- In the case of new business venture, due to its typical nature, it may bedifficult to forecast the
demand of a product accurately.
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 Budget & Budgetary Control

- Where the business is dependent upon the fluctuations of nature e.g., a person dealing in wool trade
may have enough market demand, if temperature goes below the freezing point and much less
demand if theweather is relatively warm.
- In the case of labour-intensive industry where the production of the entity is dependent upon the
availability of labour.

Suitability for flexible budget:

1. Seasonal fluctuations in sales and/or production, for example in soft drinks industry;
2. a company which keeps on introducing new products or makes changes inthe design of its products frequently;
3. industries engaged in make-to-order business like ship building;
4. an industry which is influenced by changes in fashion; and
5. general changes in sales.

Merits and Demerits of flexible budgets are tabulated below:

Merits Demerits

1. With the help of flexible budget, the sales, costs and 1. The formulation of flexible budget is possible only
profit may be calculated easily by the business at various when there is proper accounting system maintained,
levels of production capacity. perfect knowledge about the factors of production
2. In flexible budget, adjustment is very simple according and various business circumstances isavailable.
to change in business conditions. 2. Flexible Budget also requires the system of
3. It also helps in determination of production level as it standard costing in business.
shows budgeted costs with classification at various levels 3. It is very expensive and labour oriented.
of activity along with sales.
4. It also shows the quantity of product to be produced to
earn determined profit.

Difference between Fixed and Flexible Budgets:

Sl. No. Fixed Budget Flexible Budget

1. It does not change with actualvolume of activity It can be re-casted on the basis ofactivity level to be
achieved. Thus, it is known as rigid or inflexible achieved. Thus, itis not rigid.
budget.

2. It operates on one level of activity and under one It consists of various budgets fordifferent levels of
set of conditions. It assumes thatthere will be no activity.
change in the prevailing conditions, whichis
unrealistic.

3. Here as all costs like - fixed, variable and semi- Here analysis of variance provides useful information
variable are related to only one level of activity as each cost is analysed according to its behaviour.
so variance analysis does not give useful
information.

4. If the budgeted and actual activity levels differ Flexible budgeting at different levels of activity
significantly, then the aspects like cost facilitates theascertainment of cost, fixation of selling
ascertainment and price fixation do not give a price and tendering of quotations.
correct picture.

5. Comparison of actual performance with It provides a meaningful basis of comparison of the

budgeted targets will be meaningless specially actual performance with the budgeted targets.
when there is a difference between the two
activity levels.

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 Budget & Budgetary Control

8.2 Classification on the basis of Function

 A functional budget is one which is related to function of the business
 for example, production budget relating to the manufacturing function.
 Functional budgets are prepared for each function and they are subsidiary to the master budget of the business.
 The various commonly used functional budgets are:
(i) Sales Budget
(ii) Production Budget
(iii) Plant Utilisation Budget
(iv) Direct-Material Usage Budget
(v) Direct-Material Purchase Budget
(vi) Direct Labour (Personnel) Budget
(vii) Production or Factory Overhead Budget
(viii) Production Cost Budget
(ix) Ending Inventory Budget
(x) Cost of Goods Sold Budget
(xi) Selling and Distribution Cost budget
(xii) Administration Expenses Budget
(xiii) Research and Development Cost Budget
(xiv) Capital Expenditure Budget
(xv) Cash Budget

The important functional budgets (also known as schedules to Master Budget) and the master budget are discussed and
illustrated below:
(i) Sales Budget:
 Sales forecast is the commencement of budgeting and hence sales budget assumes primary importance.
 The quantity which can be sold may be the principal budget factor in many business undertakings. Inany case in
order to chalk out a realistic budget programme, there must be an accurate sales forecast.
 The sales budget is prepared for each product. This includes:
- the quantity of estimated sales and
- the expected unit selling price. These data are often reported by regions or by sales representatives.
 In estimating the quantity of sales for each product, past sales volumes are often used as a starting point. These amounts
are adjusted (increased or decreased) for factors that are expected to affect future sales. Such as the factors listed
below.
(i) Backlog of unfulfilled sales orders
(ii) Planned advertising and promotion
(iii) Expected industry and general economic conditions
(iv) Productive capacity
(v) Projected pricing
(vi) Findings of market research studies
(vii) Relative product profitability.
(viii) Competition.
 Once an estimate of the sales volume is obtained, the expected sales revenue can be determined by multiplying
the volume by the expected unit sales price
 The purposes of sales budget are not to attempt to estimate or guess what the actual sales will be, but rather to develop
a plan with clearly defined objectives towards which the operational effort is directed in order to attain or exceed the
objective. Hence, sales budget is not merely a sales forecast. A budget is a planning and control document which
shows what the management intends to accomplish. Thus, the sales budget is active rather than passive
document.
 A sales forecast, , is a projection or estimate of the available customer demand. A forecast reflects the environmental
or competitive situation facing the company whereas the sales budget shows how the management intends to react to
this environmental and competitivesituation.
 A good budget hinges on aggressive management control rather thanon passive acceptance of whatever the market
appears to offer. If the company fails to make this distinction, the budget will remain more a figure-work exercise than
a working tool of dynamic management control.

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 Budget & Budgetary Control

The sales budget may be prepared under the following classification or combination of classifications:
1. Products or groups of products.
2. Areas, towns, salesmen and agents.
3. Types of customers as for example: (i) Government, (ii) Export, (iii) Homesales, (iv) Retail depots.
4. Period—months, weeks, etc.

The illustrative format of a sales budget is as under:

Last Year Total Budgeted Northern Southern Central
Year Total Region Region Region
Qty. Value Qty. Value Qty. Value Qty. Value Qty. Value
st
Product X1 Qtr.
2nd Qtr.
3rd Qtr.
4th Qtr.

Product Y 1st Qtr.

Total

Example of sales budget:

XYZ COMPANY
Sales Budget for the year ending March, 20....
Units Selling price Per unit ( ) Total ( )
Product A 5,000 75 3,75,000
Product B 10,000 80 8,00,000

11,75,000

(ii) Production Budget:

 Production Budget is a forecast of the production for the budget period ofan organisation.
 Production budget is prepared in two parts, viz. production volume budget for the physical units of the products to be
manufactured and the cost of production or manufacturing budget detailing the budgeted cost under material, labour,
and factory overhead in respect of the products.
 Production budget shows the production for the budget period based upon:
 Sales budget,
 Production capacity of the factory,
 Planned increase or decrease in finished stocks, and
 Policy governing outside purchase.
 Production budget is normally stated in units of output. The number of units to be manufactured to meet
budgeted sales and inventory needs for each product is set forth in the production budget.
 The production facility available and the sales budget will be compared and coordinated to determine the production
budget.
 If production facilities are not sufficient, consideration may be given to such factors as working overtime, introducing
shift working, sub-contracting or purchasing of additional plant and machinery.
 If, however, the production facilities are surplus, consideration should be given to promote advertising, reduction of
prices to increase the sales, sub-contracting of surplus capacity, etc.
 One of the conditions to be considered in all the compilation of production budget is the level of stock to be maintained.
 The level of stocks will depend upon the following three factors viz.:
1. Seasonal industries in which stocks have to be built up during off seasonto cater to the peak season,
2. A steady and uniform level of production to utilise the plant fully andto avoid retrenchment or lay-off of the
workers, and
3. To produce in such a way that minimum stocks are maintained at anytime to avoid locking up of funds in
inventory.

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 Budget & Budgetary Control

 Production budget can, therefore, show:

1. Stabilised production every month, say, the maximum possible production or
2. Stabilised minimum quantity of stocks which will reduce inventory costs.
3. In the case of stabilised production, the production facility will be fully utilized, but the inventory carrying costs will vary
according to stocks held. In the case of stabilised stocks method, however, the inventory carrying will be the lowest, but
there may be under-utilisation of capacity.

Example of production budget:

XYZ COMPANY
Production budget in units for the year ending March 31, 20....
Products
A B
Budgeted sales 5,000 10,000
Add : Desired closing stock 500 1,000
Total quantity required 5,500 11,000
Less : Opening stock 1,500 2,000
Units to be produced 4,000 9,000

(iii) Plant Utilisation Budget:

Plant utilisation budget represents, in terms of working hours, weight or other convenient units of plant facilities required
to carry out the programme laid down in the production budget.
The main purposes of this budget are:
 To determine the load on each process, cost or groups of machines for thebudget period.
 To indicate the processes or cost centres which are overloaded so that corrective action may be taken such as: (i) working
overtime (ii) sub- contracting (iii) expansion of production facility, etc.
 To dovetail the sales production budgets where it is not possible to increase the capacity of any of the overloaded
processes.
 Where surplus capacity is available in any of the processes, to make effort to boost sales to utilise the surplus capacity.

(iv) Direct Material usage Budget:

The steps involved in the compilation of direct materials usage budget are as under:
 The quality standards for each item of material have to be specified. In this connection, standardisation of size, quality,
colour, etc., may be considered.
 Standard requirement of each item of materials required should also be set. While setting the standard quality,
consideration should be given to normal loss in process
 Standard prices for each item of materials should be set after giving consideration to stock and contracts entered into.

After setting standards for quality, quantity and prices, the direct materials cost budget can be prepared by multiplying each
item of material required for the production by the standard price.

(v) Direct Material Purchase Budget:

 The production budget is the starting point for determining theestimated quantities of direct materials to be
purchased.
 Multiplying these quantities by the expected unit purchase pricedetermines the total cost of direct materials to be
purchased.
Two important considerations that govern purchase budgets are as follows:
(i) Economic order quantity.
(ii) Re-order point with safety stocks to cover fluctuations in demand.

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 Budget & Budgetary Control

 The direct material purchases budget helps management maintain inventory levels within reasonable limits. For this
purpose, the timing of the direct materials purchases should he coordinated between the purchasing and production
departments.

(vi) Direct Labour (Personnel) Budget:

 Once sales budget and Production budget are compiled and plant utilisation budget is decided detailed amount of the various
machine operations involved and services required can be calculated.
 This will facilitate preparation of an estimate of different grades of labour required.
Merits/advantages:
 It defines the direct and indirect labour force required.
 It enables the personnel department to plan ahead in recruitment and training of workers so that labour turnover can be
reduced to the minimum.
 It reveals the labour cost to be incurred in the manufacture, to facilitate preparation of manufacturing cost budgets and cash
budgets for financing the wage bill.

(vii) Production or Factory Overhead Budget:

 Production overheads consist of all items such as indirect materials, indirect labour and indirect expenses.
These include expenditures on factors such as power, fuel, fringe benefits, depreciation etc. The estimated overheads
which are necessary for production in the factory are called factory overhead costs and included in the factory overhead
budget.
 Factory overhead budget usually includes the total estimated cost for each item of factory overhead.
 The production overhead budget is useful for working out the pre-determined overhead recovery rates.
 A business may prepare supporting departmental schedules, in whichthe factory overhead costs are separated into
their fixed and variable cost elements.
 Example to show how the expenses are estimated-
- Fixed expenses are normally policy costs and hence they are based on policy matters.
- For estimating indirect labour, work study is resorted to and a estimate of number of indirect workers required
for each level of direct workers employed is made—for example, one supervisorfor every twenty direct workers.
- In regard to the estimate of consumption of indirect materials, the age and condition of the plant and machinery are
taken into consideration.

(viii) Production Cost Budget:

 Production Cost Budget is a forecast of the production for the budget period of an organisation.
 Production budget is prepared in two parts, viz.production volume budget for the physical units of the products to be
manufactured and the cost of production or manufacturing budget detailing the budgeted cost under material, labour, and
factory overhead in respect of the products.

(ix) Ending Inventory Budget:

 This budget shows the cost of closing stock of raw materials and finished goods, etc. required to be maintained by the
business entity.
 This informationis required to prepare cost-of-goods-sold budget and budgeted financial statements i.e., budgeted income
statement and budgeted balance sheet.

(x) Cost of Goods Sold Budget:

 This budget covers direct material cost, direct labour cost and manufacturing expenses.
 This is adjusted by addition of the cost of the opening inventory and reducing therefrom the cost of closing inventory
of finished products.

(xi) Selling and Distribution Cost Budget:

 Selling cost is defined as the cost of seeking to create and stimulate demand and of securing orders.
 These costs are, therefore, incurred to maintain and increase the level of sales.
 All expenses connected with advertising, sales promotion, sales office, salesmen, credit collection, market research, after
sales service, etc. are generally grouped together to form part of the responsibility of the sales manager.

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 Budget & Budgetary Control

 While making a budget, selling costs are divided into fixed and variable. Semi- variable costs should also be separated
into variable and fixed elements.

The problems faced in the preparation of selling cost budgets are:

 Heavy expenditure on selling and sales promotion may have to be incurred when the volume of sales is falling off. This
will increase the percentage of such costs to total sales, and

 Sometimes intensive sales and promotion efforts are called for in one year and the benefit of such efforts accrue in the
subsequent years. This makes it difficult to establish a proportion of selling cost to sales.

 In spite of these problems, some relationship between selling cost and volume of sales has to be established and it is the
duty of the Budget Controller to determine the amount of selling costs to be incurred to achieve the desired level of sales
volume.

Distribution cost has been defined as the cost of the sequence of operations which begins with making the packet of product
avail- able for dispatch and ends with making the re-conditioned returnof empty package, if any available for re-use. It
includes transport cost, storage and warehousing costs, etc.

Preparation of the advertising cost budget is the responsibility of the sales manager or advertisement manager. When preparing
the advertisement cost budget, consideration should be given to the following factors:
• The best method of advertisement must be selected; costs willvary according to the method selected.
• The maximum amount to be spent in a period, say one year, hasto be decided.
• Advertising and sales should be co-ordinated. It means that money should be spent on advertisement only when
sufficientquantities of the product advertised are ready for sale.
• An effective control over advertisement expenditure should be exercised and the effectiveness of the advertisement
should be measured.
• The choice of the method of advertising a product is based on the effectiveness of the money spent on advertisement
in increasing or maintaining sales. If the output sold increases, the production cost will come down because of the
economies of large-scale production.

 The amount to be spent on advertisement may be decided on the basis of the following factors:
1. A percentage on the total sales value of the budget period or onthe expected profit may be fixed on the basis of
past experience.
2. A sum which is expected to be incurred by the competitors maybe fixed to be spent during the budget period.
3. A fixed sum per unit of output can be fixed and added to cost.
4. An amount is fixed on the basis of the ability of the company tospend on advertising.
5. An advertisement plan is decided upon and the amount to bespent is determined.

 Depending upon the nature of the product and the effectiveness of the media of the advertising the
company prepares a schedule of various methods of advertisement, to be used for effective sales
promotion. The number of advertisements (insertions) are determined and the cost calculated as per
the rates applicable to each of the media selected. This is a sound method.

(xii) Administrative Expenses Budget:

 The administrative expenses are mostly policy costs and are, therefore, fixed in nature.
 The most practical method to follow in preparing estimate of these expenses is to follow the past experience with
due regard to anticipated changes either in general policy or the volume of business.
 Examples of such expenses are: board meeting expenses, expenditure incurred on staff employed in human resources and
finance departments, audit fees, depreciation of office equipment, insurance, subscriptions, postage, stationery,
telephone, telegrams, office supplies, etc.

(xiii) Research and Development Cost Budget:

 Research and development expenditure is to be incurred so that the products or methods of production do not become
obsolete. The research and developmentbudget is the forecast of all such expenses.

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 Budget & Budgetary Control

 Research is required in order to develop and/or improve products and methods. When research results in definite
benefit to the company, development function begins.
 For example, automobile manufacturers, and those who produce drugs, spend considerable sums on R & D to improve
their products.
 Research may be either pure research or applied research. Pure research increases knowledge whereas applied
research aims at producing definite results like improved methods of production, etc.
 Research and development expenses should be controlled carefully and hence a limit on the spending is placed, i.e.,
the amount to be spent is carefully determined or allocated.
 The following are the methods of allocation of R & D expenses.
- A percentage based on total sales value. This method is good if sales value is steady from year to year.
- A percentage based on net profit.
- A total sum is estimated on the basis of past experience and future R & D plans and policies.
- A sum is fixed on the basis of cash resources available with the company.

(xiv) Capital Expenditure Budget:

 The capital expenditure budget represents the planned outlay on fixed assets like land, building, plant and machinery,
etc. during the budget period.
 The budget is prepared to cover a long period ofyears and it projects the capital costs over the period in which the
expenditure is to be incurred and the expected earnings.

The preparation of capital budget is based on the following considerations:

 Capital Budget is a budget prepared for capital receipts and expenditure such as investment on land and building, plant
and machinery obtaining loans, issue of shares, purchase of assets etc.
 Future development plans to increase output by expansion of plant facilities.
 Replacement requests from the concerned departments.
 Factors like sales potential to absorb the increased output, possibilityof price reductions, increased costs of
advertising and sales promotionto absorb increased output, etc.
 Overhead on production facilities of certain departments as indicated by the plant utilisation budget.

Merits/Advantages of capital budgeting

1. Capital budget outlines the capital development programme andestimated capital expenditure during the budget
period.
2. It enables the company to establish a system of priorities. When thereis a shortage of funds, capital rationing
becomes necessary.
3. It serves as a tool for controlling expenditure.
4. It provides the amount of expenditure to be incorporated in the future budget summaries for calculation of estimated
return on capital employed.
5. This enables the cash budget to be completed. With other cash commitments capital expenditure commitment should
also beconsidered for the completion of the budget.
6. It facilitates cost reduction programme, particularly when modernisation and renovation is covered by this budget.

(xv) Cash Budget:

 Cash budget represents the cash requirements of the business during the budget period. It is the plan of receipts and
payments of cash for the budget period, analysed to show the monthly flow of cash drawn up in such a way that
the balance can be forecasted at regular intervals.
 This budget is usually of two parts giving detailed estimates of (i) cash receiptsand (ii) cash disbursements.
 Estimates of cash-receipts are prepared on a monthly basis and depend upon estimated cash-sales, collections from
debtors and anticipated receipts from other sources such as sale of assets, borrowings, etc.
 Estimates of cash disbursements are based on estimated cash purchases, payments to creditors, employees’
remuneration, bonus, advances to suppliers, budgeted capital expenditure for expansion, etc.

The main objectives of preparing cash budget are:

(i) The probable cash position, as a result of planned operation, is assessed; and thus, the excess or shortage of cash
becomes clear. This helps in arranging short-term borrowings in advance to meet the situations of shortage of cash or

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 Budget & Budgetary Control

making investments when cash is in excess.

(ii) Cash can be coordinated in relation to total working capital, sales investment and debt.
(iii) A sound basis for credit for current control of cash position is established.
(iv) The effect of sudden and seasonal requirements, large stocks, delay in collection of receipts, etc., on the cash position
of the organization is revealed and things become under to the management.

Advantages of cash budget

(i) It aids in securing option working capital need for smooth running ofthe operation and planning for payments to
the shareholders.
(ii) It eases strains of a cash shortage
(iii) It facilitates temporary cash investment wherever, and to whatever extent, found in excess
(iv) It provides for normal growth

8.3 Master Budget

 CIMA, London, defines it as “the summary budget, incorporating its component functional budgets, which is finally
approved, adopted and employed.”
 When allthe necessary functional budgets have been prepared, the budget officer will prepare the master budget which
may consist of budgeted profit and loss account and budgeted balance sheet. These are in fact the budget summaries.

8.4 Classification on the basis of Time Period

These types of Budgets are classified on the basis of time periods. These types of budgets reflect the planning period of
the organization.
1. Long term Budget: - Long Term Budget is a budget prepared covering a period of more than a year. The Budgets
are prepared to depict long term planning of the business.
The period of long-term Budgets varies between three to ten years.These budgets are useful for those
industries where gestation period is long i.e.,the business entities manufacturing machinery, electricity etc.

2. Short term Budget: - These budgets are generally for one or two years andare in the form of monetary terms.
The consumer’s good industries likeSugar, Cotton, and textile use short term budgets.

3. Current Budgets: - The period of current budgets is generally of months and weeks. These budgets relate to the
current activities of the business. According to CIMA London “Current budget is a budget which is created
whichis established for use over a short period of time and is related to current conditions”.

9. ZERO – BASED BUDGETING (ZBB)

 Zero-based Budgeting (ZBB) is defined as a method of budgeting which requires each cost element to be specifically
justified, though the activities to which the budget relates are not being undertaken for the first time. The cost of each activity
has to be justified and without justification, the budget allowance is zero.
 ZBB is an activity-based budgeting system where budgets are prepared for each activity rather than functional
department.
 ZBB is suitable for both corporate and non-corporate entities. In case of non- corporate entities like Government department,
local bodies, not for profit organisations, where these entities need to justify the benefits of expenditures on social
programmes like mid-day meal, installation of street lights, provision of drinking water etc.
 In case of corporate entities, ZBB is best suited for discretionary costs like research and development cost, training
programmes, advertisement etc.

9.1 Stages in Zero-based Budgeting

ZBB involves the following stages:
(i) Identification and description of Decision packages
(ii) Evaluation of Decision packages
(iii) Ranking (Prioritisation) of the Decision packages
(iv) Allocation of resources

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 Budget & Budgetary Control

(i) Identification and description of Decision packages: Decision packages are the programmes or activities for which
decision is required to be taken. The programmes or activities are described for technical specifications, financial impact
in the form of cost benefit analysis and other issues likeenvironmental, regulatory, social etc.

(ii) Evaluation of Decision packages: Once Decision packages are identified and described, it is evaluated against factors
like synchronisation with organisational objectives, availability of funds, regulatory requirement etc.

(iii) Ranking (Prioritisation) of the Decision packages: After evaluation of the decision packages, it is ranked on the basis
priority of the activities. Becauseof this prioritization feature ZBB is also known as Priority-based Budgeting.

(iv) Allocation of resources: After ranking of the decision packages, resourcesare allocated for decision packages. Budgets
are prepared like it is done first time without taking reference to previous budgets.

9.2 Advantages of Zero-based Budgeting

The advantages of zero-based budgeting are as follows:
 It provides a systematic approach for the evaluation of different activities and rank them in order of preference for
the allocation of scarce resources.
 It ensures that the various functions undertaken by the organization are critical for the achievement of its objectives
and are being performed in the best possible way.
 It provides an opportunity to the management to allocate resources for various activities only after having a thorough
cost-benefit-analysis. The chances of arbitrary cuts and enhancement are thus avoided.
 The areas of wasteful expenditure can be easily identified and eliminated.
 Departmental budgets are closely linked with corporation objectives.
 The technique can also be used for the introduction and implementation of the system of ‘management by objective.’
Thus, it cannot only be used for fulfillment of the objectives of traditional budgeting but it can also be used for a
variety of other purposes.

Zero-based budgeting is superior to traditional budgeting: Zero based budgeting is superior to traditional budgeting
in the following manner:
 It provides a systematic approach for evaluation of different activities.
 It ensures that the function undertaken are critical for the achievement of the objectives.
 It provides an opportunity for management to allocate resources to various activities after a thorough – cost benefit analysis.
 It helps in the identification of wasteful expenditure and then their elimination. If facilitates the close linkage of
departmental budgets with corporate objectives
 It helps in the introduction of a system of Management by Objectives.

9.3 Difference between Traditional Budgeting and Zero-based budgeting

Following are the points of difference between traditional budgeting and zero-based budgeting:
 Traditional budgeting is accounting oriented. Main stress happens to be on previous level of expenditure. Zero-based
budgeting makes a decision- oriented approach. It is very rational in nature and requires all programmes, old and new, to
compete for scarce resources.
 In traditional budgeting, first reference is made to past level of spending and then demand for inflation and new
programmes. In zero- based budgeting, management focuses attention to only on decision packages, which enjoy priority
to others.
 In tradition budgeting, some managers deliberately inflate their budget request so that after the cuts they still get what
they want. In zero-based budgeting, a rationale analysis of budget proposals is attempted. The managers, who unnecessarily
try to inflate the budget request, are likely tobe caught and exposed. Management accords its approval only to a carefully
devised result-oriented package.
 Traditional budgeting is not as clear and as responsive as zero-base budgeting.
 In traditional budgeting, it is for top management to decide why a particular amount should be spent on a particular decision
unit. In Zero-based budgeting, this responsibility is shifted from top management to the manager of decision unit.

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 Traditional budgeting makes a routine approach. Zero-based budgeting makes a very straightforward approach and
immediately spotlights the decision packages enjoying priority over others.

9.4 Limitations of Zero-based Budgeting

 The work involves in the creation of decision-making and their subsequent ranking has to be made on the basis of new
data. This process is very tediousto management.
 The activities selected for the purpose of ZBB are on the basis of the traditional functional departments. So, the
consideration scheme may not be implemented properly.

10. PERFORMANCE BUDGETING (PB)

 A performance budget is one which presents the purposes and objectives for which funds are required, the costs of the
programmes proposed for achieving those objectives, and quantitative data measuring the accomplishments and work
performed under each programme.
 Thus, PB is a technique of presenting budgets for costs and revenues in terms of functions. Programmes and activities are
correlating the physical and financial aspect of the individual items comprising the budget.

10.1 Traditional Budgeting vs. Performance Budgeting

 The traditional budgeting gives more emphasis on the financial aspect thanthe physical aspects or performance. PB aims
at establishing a relationship between the inputs and the outputs.
 Traditional budgets are generally prepared with the main basis towards the objects or items of expenditure i.e., it highlights
the items of expenditure, namely, salaries, stores and materials, rates, rents and taxes etc. In thePB emphasis is more on
the functions of the organisation, the programmesto discharge this function and the activities which will be involved in
undertaking these programmes.

10.2 Steps in Performance Budgeting

According to the Administrative Reforms Commission (ARC, the following steps are the basic ones in PB:
 Establishing a meaningful functional programme and activity classification of government operations.
 Bring the system of accounting and financial management in accordance with this classification.
 Evolving suitable norms, yardsticks, work units of performance and units costs, wherever possible under each programme
and activity for their reporting and evaluation.

The Report of the ARC use the following terms in an integrated sequence

Func ons Programme Ac vity Project

The team ‘function’ is used in the sense of ‘objective’. For achieving objectives‘programmes’ will have to be evolved. In
respect of time horizon, it is essentially a replacement of traditional annual fiscal budgeting by a more output-oriented, but
still an annual, exercise.

For an enterprise that wants to adopt PB, it is thus imperative that:

 the objectives of the enterprise are spelt out in concrete terms.
 the objectives are then translated into specific functions, programmes, activities and tasks for different levels of
management within the realities of fiscal; constraints;
 realistic and acceptable norms, yardsticks or standards and performance indicators should be evolved and expressed in
quantifiable physical units.
 a style of management based upon decentralised responsibility structure should be adopted, and
 an accounting and reporting system should be developed to facilities monitoring, analysis and review of actual
performance in relation to budgets.

Performance Reporting at various levels of management:

Report : A major part of the management accountant’s job
consists of preparing reports to provide informationfor purposes of control and planning.

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The important consideration in drawing up of reports and determining their scope are
the following:
Significance : Are the facts in the reports reliable? Does it either
called for action or demonstrate the effect of action?It is material enough.
Timeliness : How late can the information be and still be of use?
What is the earliest moment at which it could be usedif it were available? How frequently
is it required?
Accuracy : How small should be an inaccuracy which does not
alter the significance of the information?
Appropriateness : Is the recipient the right person to take any action that
is needed? Is there any other information which is required to support the information to
anyone elsejointly interested?
Discrimination : Will anything be lost by omitting the item? Will any of
the items gain from the omission? Is the responsibility for suppressing the item acceptable?
Presentation : Is the report clear and unbiased? Is the form of it is
suitable to the subject? Is the form of it suitable to therecipient?

The following are certain types of reports which are to be prepared and submitted to management regularly at
predetermined time interval:
1. Top Management: (Including Board of Directors and financial managers)
(i) Balance Sheet
(ii) Profit & Loss Statement
(iii) Position of stocks
(iv) Disposition of funds or working capital;
(v) Capital expenditure and forward commitments together with progressof projects in hands;
(vi) Cash-flow statements;
(vii) Sales, production, and other appropriate statistics.

2. Sales Management:
(i) Actual sales compared with budgeted sales to measure performance by:
- Products,
- Territories
- Individual salesmen, and
- Customers.
(ii) Standard profit and loss by product:
- For fixing selling prices, and
- To Concentrate on sales of most profitable products.
(iii) Selling expenses in relation to budget and sales value analyzed by:
- Products,
- Territories
- Individual salesmen, and
- Customers.
(iv) Bad debts and accounts which are slow and difficult in collection.
(v) Status reports on new or doubtful customers.

3. Production Management:
(i) To Buyer: Price variations on purchases analysed by commodities.
(ii) To Foreman:
- Operational efficiency for individual operators duly summarizedas departmental average;
- Labour utilization report and causes of lost time and controllabletime;
- Indirect shop expenses against the standard allowed; and
- Scrap report.
(iii) To Works Managers:
- Departmental operating statement;

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- General works operating statements (Expenses relating to all worksexpenses not directly allocable or
controllable by departments);
- Plant utilization report;
- Department Scrap report; and
- Material usage report.

4. Special Reports:
These reports may be prepared at the request of general management or atthe initiative of the management accountants.
These reports may range over a very wide area. Some of the matters in respect of which such reports may be required
can be:
(i) Taxation legislation and its effect on profits.
(ii) Estimates of the earning capacity of a new project.
(iii) Break-even analysis
(iv) Replacement of capital equipment.
(v) Special pricing analysis
(vi) Make or buy certain components
(vii) Statement of surplus available for payment of bonus under the labourappellate tribunal formula.

11. BUDGET RATIO

Capacity Usage Ratio: This relationship between the budgeted number of working hours and the maximum possible number
of working hours in a budget period.

Standard Capacity Employed Ratio: This ratio indicates the extent to which facilities were actually utilized during the
budget period.

Level of Activity Ratio: This may be defined as the number of standard hours equivalent to work produced expressed as a
percentage of the budget of standard hours.

Efficiency Ratio: This ratio may be defined as standard hours equivalent of work produced expressed as a percentage of
the actual hours spent in producing the work.

Calendar Ratio: This ratio may be defined as the relationship between the numberof working days in a period and the
number of working as in the relative budget period.

Budget Ratios :
(i) Efficiency Ratio = 𝑥 100

(ii) Activity Ratio = 𝑥 100

(iii) Calendar Ratio = 𝑥 100

(iv) Standard Capacity Usage Ratio = 𝑥 100

.

(v) Actual Capacity Usage Ratio = 𝑥 100

.

(vi) Actual Usage of Budgeted capacity Ratio = 𝑥 100

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