CHAPTER 1

INTRODUCTION TO COST
AND MANAGEMENT
ACCOUNTING
LEARNING OUTCOMES

 State the meaning, objective and importance of Cost and Management

Accounting.
 Discuss the functions and role of Cost Accounting department in an
organization.
 Discuss the installation of a Cost Accounting system in an organization
 Differentiate between Cost Accounting, Financial Accounting and
Management Accounting.
 List the various elements and classifications of cost.
 Explain the methods of segregating semi-variable costs into fixed and
variable cost.
 Discuss the concept of cost reduction and cost control.
 Discuss the methods and techniques of costing.
 Discuss the use of information technology in Cost Accounting

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 1.2 COST AND MANAGEMENT ACCOUNTING

Objectives of Cost
and Management Use of IT in
Accounting Cost Objects
Costing

Scope of Cost
Users of Cost and
Accounting Responsibility
Management
Centres
Accounting

Relationship of Cost and

Management Accounting Role & Functions of Cost
Cost
with other related and Management
Classification
desciplines Accounting

1.1 INTRODUCTION
Michael E. Porter in his theory of Generic Competitive Strategies has described
‘Cost Leadership’ as one of the three strategic dimensions (others are ‘Product
differentiation’ and ‘Focus or Niche’) to achieve competitive advantage in industry.
Cost Leadership implies producing goods or provision of services at lowest
cost while maintaining quality to have better competitive price. In a business
environment where each entity is thriving to achieve apex position not only in
domestic but global competitive market, it is essential for the entity to fit into any
of the three competitive strategic dimensions. Cost Leadership, also in line with the
subject Cost and Management Accounting, can be achieved if an entity has a robust
Cost and Management Accounting system in place. In this chapter, we will learn
various aspects of Cost and Management Accounting and its application in
manufacturing and service environment.
1.1.1 Meaning and Definition
(i) Cost- Cost is the amount of resource given up in exchange of some goods or
services. It can be expressed as a noun as well as a verb. As a noun, it can be

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 INTRODUCTION TO COST AND MANAGEMENT 1.3
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defined as the amount of expenditure (actual or notional) incurred on or

attributable to a specified article, product or activity.
As a verb, it can be as an action to ascertain the cost of a specified thing or activity.
(ii) Costing- Costing is defined as “the technique and process of ascertaining
costs”.
According to CIMA “an organisation’s costing system is the foundation of the
internal financial information system for managers. It provides the information that
management needs to plan and control the organisation’s activities and to make
decisions about the future.”
(iii) Cost Accounting- Cost Accounting 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- Cost Accountancy has been 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- As per CIMA Official Terminology “Management
accounting 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.”
Management accounting is an integral part of management function. It assists
management by provision of relevant information for planning, organising,
controlling, decision making etc.
(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.

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1.2 OBJECTIVES OF COST ACCOUNTING

Objectives of Cost Accounting

Determination Assisting
Ascertainment of Cost
of Selling Price Cost Control management in
Cost Reduction
and Profitability decision making

Determination of pre-determined standard

Measurement of actual performance

Comparison

Analysis of variance and action

The main objectives of Cost and Management accounting are explained as below:
(i) Ascertainment of Cost: The main objective of Cost Accounting is
accumulation and 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.
Though in a competitive business environment selling prices are determined by
external factors but cost accounting system provides a basis for price fixation and
rate negotiation.
(iii) Cost Control: Maintaining discipline in expenditure is one of the main
objectives of a good cost accounting system. It ensures that expenditures are in
consonance with predetermined set standard and any variation from these set
standards is noted and reported on continuous basis. To exercise control over
cost, following steps are followed:
(a) Determination of pre-determined standard or results: Standard cost or
performance targets for a cost object or a cost centre are set before initiation of
production or service activity. These are desired cost or result that need to be
achieved.

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(b) Measurement of actual performance: Actual cost or result of the cost object or
cost centre is measured. Performance should be measured in the same manner
in which the targets are set i.e. if the targets are set up operation-wise, and then
the actual costs should also be collected and measured operation-wise to have
a common basis for comparison.
(c) Comparison of actual performance with set standard or target: The actual
performance so measured is compared against the set standard and desired
target. Any deviation (variance) between the two is noted and reported to the
appropriate person or authority.
(d) Analysis of variance and action: The variance in results so noted is further
analysed to know the reasons for variance and appropriate action is taken to
ensure compliance in future. If necessary, the standards are further amended to
take developments into account.
(iv) Cost Reduction: It may be defined "as the achievement of real and
permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or diminution in
the quality of the product."
Cost reduction is an approach of management where cost of an object is believed
to have a scope of further reduction. No cost is termed as lowest and every
possibility of cost reduction is explored. To do cost reduction, the following action
is taken:
(a) Each activity within an entity is segmented to analyse and identify value added
and non- value added activities. All non-value added activities are eliminated
without affecting the essential characteristics of the product or process. Value
chain Analysis, a strategic tool, developed by Michael Porter, is one of the
method to do value analysis.
(b) Conducting continuous research and study to know the most optimal way to
manufacture a product or render a service.
The three-fold assumptions involved in the definition of cost reduction may be
summarised as under:
(a) There is a saving in unit cost.
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if not
improved.

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 1.6 COST AND MANAGEMENT ACCOUNTING

(v) Assisting management in decision making: Cost and Management

Accounting by providing relevant information, 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.
1.2.1 Difference between Cost Control and Cost Reduction
Cost Control Cost Reduction
1. Cost control aims at maintaining 1. Cost reduction is concerned with
the costs in accordance with the reducing costs. It challenges all standards
established standards. and endeavours to improvise them
continuously
2. Cost control seeks to attain 2. Cost reduction recognises no condition as
lowest possible cost under permanent, since a change will result in
existing conditions. lower cost.
3. In case of cost control, emphasis 3. In case of cost reduction, it is on present
is on past and present and future.
4. Cost control is a preventive 4. Cost reduction is a corrective function. It
function operates even when an efficient cost
control system exists.
5. Cost control ends when targets 5. Cost reduction has no visible end and is a
are achieved. continuous process.

1.3 SCOPE OF COST ACCOUNTING

Costing

Cost Accounting

Cost Analysis

Scope of
Cost Comparisons
Cost Accounting
Cost Control

Cost Reports

Statutory Compliances

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Scope of cost accounting consists of the following functions:

(i) Costing: Costing is the technique and process of ascertaining costs of
products or services. The cost ascertainment procedure is governed by some cost
accounting principles and rules. 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. Cost Accounting is a formal mechanism of cost ascertainment.
(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. This also helps in taking better cost management
and strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost
involved in alternative courses of action such as use of different technology 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 light of
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: This is the ultimate function of cost accounting. 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.

1.4 RELATIONSHIP OF COST AND MANAGEMENT

ACCOUNTING WITH OTHER RELATED
DISCIPLINES
Cost and Management Accounting as a discipline is interrelated and dependent on
other disciplines of accounting.

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1.4.1 Cost Accounting with Management Accounting:

As we have already studied that though Cost Accounting and Management
Accounting is used synonymously but there are a few differences. Management
Accounting is an open-ended discipline which enables managers to take informed
decisions. Management Accounting takes inputs from cost accounts, financial
accounts, statistical and operation management tools etc.
Difference between Cost Accounting and Management Accounting

Basis Cost Accounting Management Accounting

(i) Nature It records the quantitative It records both qualitative and
aspect only. quantitative aspect.
(ii) Objective It records the cost of It provides information to
producing a product and management for planning and
providing a service. co-ordination.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past and It is focused with the
data present figures. projection of figures for future.

(v) Development Its development is related Its development is related to

to industrial revolution. the need of modern business
world.
(vi) Rules and It follows certain principles It does not follow any specific
Regulation and procedures for rules and regulations.
recording costs of
different products.

1.4.2 Cost Accounting with Financial Accounting:

Cost accounting accumulates and ascertains costs for goods sold and inventories.
It provides inputs to record costs in financial accounting system.
Difference between Financial Accounting and Cost Accounting

Basis Financial Accounting Cost Accounting

(i) Objective It provides information about Ascertainment of cost for the

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the financial performance of an purpose of cost control and

entity. decision making.

(ii) Nature It classifies records, present It classifies, costs records,

and interprets transactions in present, and interprets it in a
monetary terms. significant manner.

(iii) Recording It records Historical data. It makes use of both

of data historical and pre-determined
costs.

(iv) Users of The users of financial The cost accounting

information accounting statements are information is generally used
shareholders, creditors, by internal management. But
financial analysts and sometimes regulatory
government and its agencies, authorities also.
etc.

(v) Analysis of It shows profit or loss of the It provides the cost details
cost and organization either segment for each cost object i.e.
profit wise or as a whole. product, process, job,
operation, contracts, etc.

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

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

1.4.3 Cost and Management Accounting with Financial Management:

Cost and Management Accounting is an application of financial management for
decision making purposes.
The relationship among Cost Accounting, Management Accounting, Financial
Accounting and Financial Management can be understood with the help of the
following diagram.

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 1.10 COST AND MANAGEMENT ACCOUNTING

Financial Management
Accounting Accounting

Cost
Accounting

Financial Management

1.5 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.
Though the term Cost Accounting and Management Accounting is used by various
authors synonymously but in actual practice, Cost Accounting is concerned with
accumulation and allocation of costs to different cost objects, whereas,
Management Accounting concerned with provision of information to internal
users for decision making.
The functions of Cost and Management accounting includes:
(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 (whatever nomenclature may
be used to denote the department) sets budget and standards for a particular
period or activity beforehand and these are compared with the assigned and
ascertained cost. Any deviation with the set standards are analysed and reported.
All this exercise is done to control costs.

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(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). The MIS provides relevant and timely information
related to both internal and external to the organisation to enable management at
all levels to take decisions. Decisions include cost optimisation, price fixation,
implementation of any plan related with product, process, marketing etc.
(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.

1.6 USERS OF COST AND MANAGEMENT

ACCOUNTING
Cost and Management Accounting information which is generated or collected is
used by different stakeholders. The users of the information can be broadly
categorised into internal and external to the entity.

Internal users External users

Managers Regulatory Authorities

Operational level staffs Auditors

Employees Shareholders

Creditors and Lenders

Internal Users
Internal users, who use the cost and management accounting information may
include the followings:
(a) Managers- The managers use the information
(i) to know the cost of a cost object and cost centre
(ii) to know the price for the product or service
(iii) to measure and evaluate performance of responsibility centres

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(iv) to the know the profitability- product-wise, department-wise, customer-wise

etc.
(v) to evaluate the strategic options and to make decisions
(b) Operational level staff- The operational level staff like supervisors, foreman,
team leaders require information
(i) to know the objectives and performance goals for them
(ii) to know product and service specifications like volume, quality and process
etc.
(iii) to know the performance parameters against which their performance is
measured and evaluated.
(iv) to know divisional (responsibility centre) profitability etc.
(c) 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 for
some other special purpose audit like cost audit etc. require information related
with costing and reports reviewed by management etc.
(c) 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.

(d) 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 on net debt
position and stock balances.

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1.7 ESSENTIALS OF A GOOD COST

ACCOUNTINGSYSTEM

Trust on Informative
the system and simple

Flexible Accurate
and and
adaptive authentic

Integrated Uniformity
and and
inclusive consistency

Essential features 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 consistency in
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.

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(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.

1.8 INSTALLATION OF COSTING SYSTEM

As in the case of every other form of activity, it should be considered whether it
would be profitable to have a Cost Accounting system. Management of an
organisation needs complete and accurate information to make decisions. A well-
established Costing system should provide all relevant information as and when
required by management as well as various stakeholders.
Before setting up a system of cost accounting the factors mentioned below should be
studied:
(a) Objective: The objective of setting up the costing system, for example
whether it is being introduced for fixing prices or for establishing a system of 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. For example, an oil refinery maintains process wise cost accounts to find
out the cost incurred on a particular process, say in crude refinement process etc.
(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 standard quantity 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-

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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 technical know-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).

1.9 COST ACCOUNTING WITH THE USE OF

INFORMATION TECHNOLOGY (IT)
With the expansion of e-commerce and increasing competitive business
environment, information technology is becoming an integral part of each activity
in an organisation including Cost and Management Accounting. Information
technology has changed the Cost and Management Accounting functions
dramatically with the introduction of Enterprise Resource Planning (ERP) system.
Cost accounting and Management Information System has become automated and
improved. The new industrial revolution in the form of digital innovation which
is popularly known as Industry 4.0, has more emphasis on digitisation and

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automation of business process to have a better control over cost to maintain market
competitiveness. Cost Accounting system has seen lots of savings in terms of time,
money and efforts. 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 like Bill
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 which
enables the management to take control measures immediately.
(vii) IT enables an entity to monitor and analyse each process of manufacturing or
service activity closely to eliminate non value added activities.
The above are examples of few areas where Cost Accounting is done with the help
of IT.

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1.10 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 audit
assignment, 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 ingots
in rolling mills etc.
Department Production department, Finance & Accounts, Safety etc.

1.10.1 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.
We may for instance determine the cost per ton of steel, per ton-kilometre of a
transport service or cost per machine hour. Sometime, a single order or a contract
constitutes a cost unit. A batch which consists of a group of identical items and
maintains its identity through one or more stages of production may also be
considered as a cost unit.
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)

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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
Activity Cost unit
Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material
movement, value issued/received
Personnel administration Personnel record

1.10.2 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.

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CIMA Official terminology defines cost driver as “Factor influencing the level of cost”
Often used in the context of Activity Based Costing to denote the factor which links
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.

1.11 RESPONSIBILITY CENTRES

As the organization grows, its functions, organisational structure and other related
functions also grow in terms of volume and complexity. To have a better control over
the organisation, management delegates its responsibility and authority to various
departments or persons. These departments or persons are known as responsibility
centres and are held responsible for performance in terms of expenditure, revenue,
profitability and return on investment. Performance of these responsibility centres are
measured against some set standards (input-output ratio, budgets etc.) and evaluated
against organisational goal and performance targets.

Types of responsibility centres

Revenue Investment
Cost Centres Profit Centres
Centres 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 and input
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.

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(b) Discretionary Cost Centre: The cost centre whose output cannot be measured
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 branches of 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 are 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.

11.12 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.
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.

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1.13 CLASSIFICATION OF COSTS

It means the grouping of costs according to their common characteristics. The
important 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
1.13.1 By Nature or Element
This type of classification is useful to determine the total cost.
A diagram as given below shows the elements of cost described as under:
ELEMENT OF COST

Material Cost Employee (Labour) Cost Other Expenses

Direct Material Indirect Direct Indirect Direct Indirect

Cost Material Cost Employee Employee Expenses Expenses
(Labour) Cost (Labour) Cost

Overheads

Production Administration Selling and

Overheads Overheads Distribution Overheads

(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;

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 1.22 COST AND MANAGEMENT ACCOUNTING

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 Indiarect 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 identified in 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.

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• Distribution Overheads: Indirect expenses incurred for dispatch of the

goods E.g.: warehouse charges, packing(secondary) and loading charges.
1.13.2 By Functions
Under this classification, costs are divided according to the function for which they
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
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.
Direct Materials
Direct Employees Prime Cost
(Labours)
Direct Expenses
Factory Overheads
Indirect Material Factory Cost or
Works Cost
Indirect Labour
Administration Overheads
Cost of Goods Sold
Indirect Expenses
Selling and Distribution Overheads
Cost of Sales

1.13.3 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

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with the changes in output. For example, rent, insurance of factory building etc.,
remain the same for different levels of production.

Fixed Cost
40000
35000
30000
25000
Cost (`)

20000
15000
Fixed Cost
10000
5000
0
0 100 200 300 400 500 600
Output (in units)

(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.

Variable Cost
60000
50000
40000
Cost (`)

30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)

(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. Such
costs are depicted graphically as follows:

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1.13.3.1 Methods of segregating Semi-variable costs into fixed and variable costs

Semi- Variable Cost

100000
80000
Cost (`)

60000
40000
20000
0
0 100 200 300 400 500 600
Output (in units)

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 different levels 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 cost
component in the total cost.
v. If a line is drawn at this point parallel to the X-axis, this indicates the fixed cost.
vi The variable cost, at any level of output, is derived by deducting this fixed cost
element from the total cost.

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 1.26 COST AND MANAGEMENT ACCOUNTING

The following graph illustrates this:

(b) High- Low Method: Under this method, difference between the total cost at
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.
ILLUSTRATION 1: (Segregation of fixed cost and variable cost)

Sales value Total cost

(`) (`)
At the Highest volume 1,40,000 72,000
At the Lowest volume 80,000 60,000
60,000 12,000
Thus, Variable Cost (` 12,000/` 60,000)
= 1/5 or 20% of sales value = ` 28,000 (at highest volume)
Fixed Cost ` 72,000 – ` 28,000 i.e., (20% of ` 1,40,000) = ` 44,000.
Alternatively, ` 60,000 – ` 16,000 (20% of ` 80,000) = ` 44,000.
(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. For example, some semi-variable expenses may vary to the
extent of 20% while others may vary to the extent of 80%. Although it is very
difficult to estimate the extent of variability of an expense, the method is easy to
apply. (Go through the following illustration for clarity).

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ILLUSTRATION 2: (Segregation of fixed cost and variable cost)

Suppose last month the total semi-variable expenses amounted to ` 3,000.
If the degree of variability is assumed to be 70%, then variable cost = 70% of `
3,000 = ` 2,100.
Fixed cost = ` 3,000 – ` 2,100 = ` 900.
Now in the future months, the fixed cost will remain constant, but the variable cost
will vary according to the change in production volume.
Thus, if in the next month production increases by 50%, the total semi-variable
expenses will be:
Fixed cost of ` 900, plus variable cost viz., ` 3,150 i.e., (` 2,100 (V.C.) plus 50%
increase of V.C. i.e., ` 1,050) =, ` 4,050.
(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

Suppose the following information is available:

Production Units Semi-variable expenses

(`)
January 100 260
February 140 300
Difference 40 40
The variable cost:
Change in Semi-variable expenses ` 40
= = ` 1/unit
Change in production volume 40 units
Thus, in January, the variable cost will be 100 × ` 1 = ` 100
The fixed cost element will be (` 260 – ` 100) or ` 160.
In February, the variable cost will be 140 × ` 1 = ` 140
whereas the fixed cost element will remain the same, i.e., ` 160.

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(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 this equation.
ILLUSTRATION 3: (Segregation of fixed cost and variable cost)

Level of activity
Capacity % 60% 80%
Volume (Labour hours) or ‘x’ 150 200
Semi-variable expenses (maintenance of plant) or ‘y’ ` 1,200 ` 1,275

Substituting the values of ‘x’ and ‘y’ in the equation, y = mx + c, at both the levels
of activity, we get
1,200 = 150 m + c
1,275 = 200 m + c
On solving the above equations, we get the value of ‘c’
Fixed cost or ‘c’ = ` 975 and Variable cost or ‘m’ = ` 1.50 per labour hour.
1.13.4 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 action of 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

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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 prominent and is
sometimes left to individual judgement. In fact, no cost is uncontrollable; it is only
in relation to a particular individual that we may specify a particular cost to be
either controllable or uncontrollable.
1.13.5 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 given level
of output in the conditions in which that level of output is normally attained. It is
charged to Costing Profit and loss Account.
1.13.6 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 produc-
tion 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 for cost 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 of
manufacture, or acquisition, often in terms of a unit of product computed on the
basis of information available in advance of actual production or purchase”.
Estimated costs are prospective costs since they refer to prediction of costs.
(e) Differential Cost - (Incremental and decremental costs). It represents the
change (increase or decrease) in total cost (variable as well as fixed) due to change

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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.
(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefit
of 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, in the 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

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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 effect
relationship 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 products
but are charged as expenses against the revenue of the period in which they are
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.

1.14 METHODS OF COSTING

Different industries follow different methods of costing because of the differences
in the nature of their work. The various methods of costing are as follows:

Methods Description
Single or Under this method, the cost of a product is ascertained, the
Output Costing product 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.

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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 Under this method, the cost of each contract is ascertained
Costing 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 of work
is ascertained, like cost of making pulp and cost of making
paper from pulp. In mechanical operations, the cost of each
operation may be ascertained separately; the name given is
operation costing.
Operating It is used in the case of concerns rendering services like
Costing transport, supply of water, retail trade etc.
Multiple It is a combination of two or more methods of costing outlined
Costing 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 in different
industries:

Nature of Output Method Cost Examples of

Industries
A Series of Processes Process costing For each Sugar
or Operation process
Costing
Construction of building Contract For each Real estate
Costing contract
Similar units of a Single Unit or output For the entire Cold Drinks
Product, produced by or Single activity, but
Single Process Costing averaged for
the output

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Rendering of Services Operating For all services Hospitals

Costing
Customer Specifications: Job Costing For each order/ Advertising
single Unit assignment/job
Consisting of multiple Multiple Combination of Car
varieties of activities and Costing any method Assembly
processes

1.15 TECHNIQUES OF COSTING

For ascertaining cost, following types of costing are usually used.

Techniques Description
Uniform When a number of firms in an industry agree among
Costing themselves to follow the same system of costing in detail,
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:
i. A comparison of the performance of each of the firms
can be made with that of another, or with the average
performance in the industry.
ii. Under such a system, it is also possible to determine the
cost of production of goods which is true for the industry
as a whole. It is found useful when tax-relief or pro-
tection is sought from the Government.
Marginal It is defined as the ascertainment of marginal cost by
Costing differentiating between fixed and variable costs. It is used to
ascertain effect of changes in volume or type of output on profit.
Standard It is the name given to the technique whereby standard costs
Costing and are pre-determined and subsequently compared with the
Variance recorded actual costs. It is thus a technique of cost
Analysis 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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 1.34 COST AND MANAGEMENT ACCOUNTING

Historical It is the ascertainment of costs after they have been

Costing incurred. 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 It is the practice of charging all costs, both variable and
Costing fixed to operations, processes or products. This differs from
marginal costing where fixed costs are excluded.

SUMMARY
♦ Cost:
o The amount of expenditure (actual or notional) incurred on or
attributable to a specified article, product or activity. (as a noun)
o To ascertain the cost of a specified thing or activity. (as a verb)
♦ Costing: It is the technique and process of ascertaining costs.
♦ Cost Accounting: It is 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.
♦ Cost Accountancy: It has been 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.”
♦ Management Accounting: As per CIMA Official Terminology “Management
accounting 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.”
♦ 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.

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♦ Cost Control: Maintaining discipline in expenditure is one of the main

objective of a good cost and management accounting system. It ensures that
expenditures are in consonance with predetermined set standard and any
variation from these set standards is noted and reported on continuous basis.
♦ Cost Reduction: It may be defined "as the achievement of real and
permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or
diminution in the quality of the product."
♦ 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.
♦ 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 Drivers: 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.
♦ Responsibility Centres: To have a better control over the organisation,
management delegates its responsibility and authority to various
departments or persons. These departments or persons are known as
responsibility centres and are held responsible for performance in terms of
expenditure, revenue, profitability and return on investment.
♦ 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.
♦ Revenue Centres: The responsibility centres which are accountable for
generation of revenue for the entity.
♦ 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.

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 1.36 COST AND MANAGEMENT ACCOUNTING

♦ Investment Centres: These are the responsibility centres which are not only
responsible for profitability but also has the authority to make capital
investment decisions. The performance of these responsibility centres are
measured on the basis of Return on Investment (ROI) besides profit.
♦ Classification of Costs:

Classification of Costs

By Nature or By Costs for

By Functions By Variability By By Normality
Element Managerial
or Behaviour Controllability Decision Making*
Direct Direct Material
Materials Cost
Fixed Cost Controllable
Normal Cost
Direct Employee Cost
Direct Labour
(labour) Cost
Variable Uncontrollable Abnormal
Direct Cost Cost Cost
Direct Expenses
Expenses
Semi-
Indirect Production/ variable
Materials Manufacturing Cost
Overheads
Indirect
Labour
Administration
Indirect Overheads
Expenses
Selling Overheads
Overheads
Distribution
Overheads

Research and
Development costs
etc.

By Costs for
Managerial
Decision Making* Opportunity Cost Out-of-pocket Cost

Pre-determined Cost Product Cost Shut down Cost Implicit Cost

Standard Cost Capitalized Cost Sunk Cost Explicit Cost

Marginal Cost Imputed Cost Absolute Cost Engineered Cost

Estimated Cost Differential Cost Discretionary Cost Period Cost

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CHAPTER 2

MATERIAL COST

LEARNING OUTCOMES
After studying this chapter, you would be able to-
 State the meaning, need and importance of materials,
 Discuss the procedures and documentations involved in
procuring, storing and issuing material.
 Discuss the various inventory control techniques and
determination of various stock levels.
 Compute Economic Order Quantity (EOQ) and apply the EOQ
to determine the optimum order quantity.
 Discuss the various methods of inventory accounting and
Prepare stock ledger/ account.
 Identify and explain normal and abnormal loss and its
accounting treatment.

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 2.2 COST AND MANAGEMENT ACCOUNTING

2.1 INTRODUCTION
We have acquired a basic knowledge about the concepts, objectives, advantages,
methods and elements of cost. We shall now study each element of cost separately
beginning with material cost. The general meaning of material is all commodities/
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 a
particular final product.
Direct Materials constitute a significant part for manufacturing and production of
goods. Being an input and a significant cost element, it requires adequate
management attention. Cost control starts from here, and for this purpose it is
necessary that the principle of 3Es (Economy, Efficiency and Effectiveness) i.e.

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 MATERIAL COST 2.3

economy in procurement, efficiency in handling and processing the material and

effectiveness in producing desired output as per the standard, is also applied for
this cost element. 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: The production firms need to ensure that production
process runs smoothly and should not be paused for the want of materials. 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.

2.2 MATERIAL CONTROL

In the previous chapter, we have discussed the term Cost Control, which means all
activities and control mechanism which are necessary to keep the cost in adherence
to the set standards. Material, being one of the total cost elements, are also
required to be controlled so that the overall cost control objective can be fulfilled.
2.2.1 Objectives of System of Material Control
The objectives of a system of material control are as following:
(i) Minimising interruption in production process: Material Control system
ensures that no activity, particularly production, suffers from interruption for want
of materials and stores. It should be noted that this requires constant availability of

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 2.4 COST AND MANAGEMENT ACCOUNTING

every item that may be needed in production process, howsoever, small its cost
may be.
(ii) Optimisation of Material Cost: The overall material costs includes price,
ordering costs and holding costs. Since 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: Material Control System 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. This not only helps in detecting losses and pilferages but also facilitates proper
production planning.
(v) Completion of order in time: Proper material management is very necessary
for fulfilling orders of the firm. This adds to the goodwill of the firm.
2.2.2 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.

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 MATERIAL COST 2.5

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 delivery
of 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 receipt
and 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.
2.2.3 Elements of Material Control
Material control is a systematic control over the procurement, storage and usage
of material so as to maintain an even flow of material.

Material Control

Material Procurement Material Storage

Material Usage Control
Control Control

Material control involves efficient functioning of the following operations:

• Purchasing of materials
• Receiving of materials
• Inspection of materials
• Storage of materials
• Issuing materials

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 2.6 COST AND MANAGEMENT ACCOUNTING

• Maintenance of inventory records

• Stock audit

2.3 MATERIALS PROCUREMENT PROCEDURE

Material procurement procedure can be understood with help of the following
diagram. Documents required and the departments who initiate these documents
are shown sequentially.

Diagram: Material Procurement Procedure

[The name of the departments and documents shown in the diagram are for illustrative purpose only]

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 MATERIAL COST 2.7

2.3.1 Bill of Materials

It is also known as Materials Specification List or Materials List. It is a detailed
list specifying the standard quantities and qualities of materials and
components required for producing a product or carrying out of any job. The
materials specification list is prepared by the product development team commonly
known as engineering or planning department in a standard form. This is shared
with other concerned departments like Marketing, Production, Store, and Cost/
Accounting department.
Format and content of a Bill of Materials vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
Uses of Bill of Material
Marketing Production Dept. Stores Dept. Cost/ Accounting
(Purchase) Dept.
Dept.
Materials are Production is planned It is used as a It is used to estimate
procured according to the nature, reference cost and profit. Any
(purchased) on volume of the materials document while purchase, issue and
the basis of required to be used. issuing materials usage are
specifications Accordingly, material to the compared/ verified
mentioned in it. requisition lists are requisitioning against this
prepared. department. document.

2.3.2 Material Requisition Note

It is also known as material requisition slip. It is a voucher of authority used to
get materials issued from store. Generally, it is prepared by the production
department and materials are withdrawn on the basis of material requisition list or
bill of materials. If no material list has been prepared, it is desirable that the task of
the preparation of material requisition notes be left to the planning department or
by the department requires the materials. The note is shared with Store and Cost/
Accounting department.
Format of a Material requisition note may vary on the basis of industrial
peculiarities, management information system (MIS) and accounting system in
place.

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 2.8 COST AND MANAGEMENT ACCOUNTING

Difference between Bill of Materials and Material Requisition Note:

Bill of Materials Material Requisition Note

1. It is the document prepared by the 1. It is prepared by the production
engineering or planning dept. or other consuming department.
2. It is a complete schedule of 2. It is a document asking Store-
component parts and raw materials keeper to issue materials to the
required for a particular job or work consuming department.
order.
3. It often serves the purpose of a 3. It cannot replace a bill of
material requisition as it shows the materials.
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 4. It is useful in arriving historical
quotations. cost only.
5. It helps in keeping a quantitative 5. It shows the material actually
control on materials drawn through drawn from stores.
material requisition.

2.3.3 Purchase Requisition

This is a document which 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.
This form is usually filled up by the store-keeper for regular materials and by the
departmental head for special materials (not stocked as regular items).
At the beginning a complete list of materials and stores required should be drawn
up, which should be reviewed periodically for any addition or deletion. On the basis
of standing order, once an item is included in the standard list, it becomes the
duty of the purchase department to arrange for fresh supplies before existing
stocks are exhausted. Any change in the consumption pattern should be informed
to the purchase department for necessary action from their end.
For control over buying of regular store materials, Inventory control system is to
determine stock levels to be maintained and the number of quantities to be

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 MATERIAL COST 2.9

ordered. In respect of special materials, required for a special order or purpose, it

is desirable that the concerned technical department should prepare materials
specifications list specifying the quantity, size and order for the materials.
Purchase requisition note may either be originated by the stores department in
connection with regular materials or by the production planning or other technical
departments in respect of special materials.
Format of a purchase requisition note may vary on the basis of industrial
peculiarities, management information system (MIS) and accounting system in
place.
2.3.4 Inviting Quotation/Request for Proposal (RFP)
After receipt of duly authorised purchase requisition from the store department or
other departments, role of purchase department comes into play. If a concern can
afford or the size of the concern is big enough, there should be a separate purchase
department for all purchases to be made on behalf of all other departments. Such
a department is bound to become expert in the various matters to be attended to,
for examples— units of materials to be purchased and licences to be obtained,
transport, sources of supply, probable price etc.
Materials purchase department in a business house is confronted with the following
issues:
(i) What to purchase?
(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase.
(v) At what price to purchase.
To overcome these questions, purchase department make an enquiry into the
market for the required material. The process of gathering information about the
rate, quantity, technology, services and support etc., purchase department sends
RFP to the selected vendors in case if purchase policy allows this practice. Some
organizations follow the open and transparent purchase policy and invite
quotations from the interested vendors. This process is called Tender Notification
or Invitation of Tender.

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 2.10 COST AND MANAGEMENT ACCOUNTING

2.3.5 Selection of Quotation/ Proposal

After invitation of tender from the vendors, interested vendors who are fulfilling all
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.
2.3.6 Preparation and Execution of Purchase Orders
Having decided on the best quotation that should be accepted, 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 and also
for approval of the invoice for payment.
2.3.7 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 along
with a Material Returned Note.
2.3.7.1 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.

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 MATERIAL COST 2.11

2.3.7.2 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.
2.3.8 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 checked
with 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.

2.4 VALUATION OF MATERIAL RECEIPTS

2
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. Invoice of material purchased from
the market sometime contain items such as trade discount, quantity discount, freight,
duty, insurance, cost of containers, taxes, cash discount etc.
Treatment of items associated with purchase of materials is tabulated as below

Sl No. Items Treatment

Discounts and Subsidy
(i) Trade Trade discount is deducted from the purchase price
Discount if it is not shown as deduction in the invoice.
(ii) Quantity Like trade discount quantity discount is also shown
Discount as deduction from the invoice. It is deducted from
the purchase price if not shown as deduction.

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 2.12 COST AND MANAGEMENT ACCOUNTING

(iii) Cash Discount Cash discount is not deducted from the purchase
price. It is treated as interest and finance charges. It
is ignored.
(iv) Subsidy/ Any subsidy/ grant/ incentive received from the
Grant/ Government or from other sources deducted from
Incentives the cost of purchase.
Duties and Taxes
(v) Road Tax/ Toll Road tax/ Toll tax, if paid by the buyer, is included
Tax with the cost of purchase.
(vi) Integrated Integrated Goods and Service Tax (IGST) is paid on
Goods and inter-state supply of goods and provision of services
Service Tax and collected from the buyers. It is excluded from
(IGST) the cost of purchase if credit for the same is
available. Unless mentioned specifically it should
not form part of cost of purchase.
(vii) State Goods State Goods and Service Tax (SGST) is paid on intra-
and Service Tax state supply and collected from the buyers. It is
(SGST) excluded from the cost of purchase if credit for the
same is available. Unless mentioned specifically it
should not form part of cost of purchase.
(viii) Central Goods Central Goods and Service Tax (CGST) is paid on
and Service Tax manufacture and supply of goods and collected
(CGST) from the buyer. It is excluded from the cost of
purchase if the input credit is available for the same.
Unless mentioned specifically CGST is not added
with the cost of purchase.
(ix) Basic Custom Basic Custom duty is paid on import of goods from
Duty outside India. It is added with the purchase cost.
Penalty and Charges
(x) 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
(xi) Detention Detention charges/ fines imposed for non-
charges/ Fine compliance of rule or law by any statutory authority.

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 MATERIAL COST 2.13

It is an abnormal cost and not included with cost of

purchase
(xii) Penalty Penalty of any type is not included with the cost of
purchase
Other expenditures
(xiii) Insurance Insurance charges are paid for protecting goods
charges during transit. It is added with the cost of purchase.
(xiv) Commission or Commission or brokerage paid is added with the
brokerage paid. cost of purchase.
(xv) Freight inwards It is added with the cost of purchase as it is directly
attributable to procurement of material.
(xvi) Cost of Treatment of cost of containers are as follows:
containers • Non-returnable containers: The cost of
containers is added with the cost of purchase
of materials.
• Returnable Containers: If the containers are
returned and their costs are refunded, then cost
of containers should not be considered inthe
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.
(xvii) Shortage Shortage in materials are 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.

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 2.14 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 1
SKD Company Ltd., not registered under GST, purchased material P from a company
which is registered under GST. The following information is available for the one lot
of 1,000 units of material purchased:
Listed price of one lot ` 50,000
Trade discount @ 10% on Listed price
CGST and SGST (Credit Not available) 12% (6% CGST + 6% SGST)
Cash discount @10%
(Will be given only if payment is made within 30 days.)
Freight and Insurance ` 3,400
Toll Tax paid ` 1,000
Demurrage ` 1,000
Commission and brokerage on purchases ` 2,000
Amount deposited for returnable containers ` 6,000
Amount of refund on returning the container ` 4,000
Other Expenses @ 2% of total cost
20% of material shortage is due to normal reasons.
The payment to the supplier was made within 20 days of the purchases.
You are required to calculate cost per unit of material purchased to SKD Company
Ltd.
SOLUTION
Computation of Total cost of material purchased of SKD Manufacturing
Company
Particulars Units (`)
Listed Price of Materials 1,000 50,000
Less: Trade discount @ 10% on invoice price (5,000)
45,000
Add: CGST @ 6% of ` 45,000 2,700
Add: SGST @ 6% of ` 45,000 2,700
50,400

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 MATERIAL COST 2.15

Add: Toll Tax 1,000

Freight and Insurance 3,400
Commission and Brokerage Paid 2,000
Add: Cost of returnable containers:
Amount deposited ` 6,000
Less: Amount refunded ` 4,000 2,000
58,800
` 58,800 1,200
Add: Other Expenses @ 2% of Total Cost  
×2 
 98 
Total cost of material 60,000
Less: Shortage due to Normal Loss @ 20% 200 -
Total cost of material of good units 800 60,000
Cost per unit (` 60,000/800 units) 75

Note:
1. GST is payable on net price i.e., listed price less discount.
2. Cash discount is treated as interest and finance charges; hence it is ignored.
3. Demurrage is penalty imposed by the transporter for delay in uploading or off-
loading of materials. It is an abnormal cost and not included.
4. Shortage due to normal reasons should not be deducted from cost to ascertain
total cost of good units.
ILLUSTRATION 2
An invoice in respect of a consignment of chemicals A and B provides the following
information:
(`)
Chemical A: 10,000 kgs. at ` 10 per kg. 1,00,000
Chemical B: 8,000 kgs. at ` 13 per kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240

A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to
normal breakages. You are required to COMPUTE the rate per kg. of each chemical,
assuming a provision of 2% for further deterioration.

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 2.16 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Working:
Computation of effective quantity of each chemical available for use

Chemical A (kg.) Chemical B (kg.)

Quantity purchased 10,000 8,000
Less: Shortage due to normal breakages 500 320
9,500 7,680
Less: Provision for deterioration 2% 190 153.6
Quantity available 9,310 7,526.4

Statement showing the computation of rate per kg. of each chemical

Chemical A (`) Chemical B (`)

Purchase price 10,000@ `10 per kg, 1,00,000 1,04,000
8,000@`13 per kg
Add: Basic Custom Duty @10% 10,000 10,400
Add: Railway freight
(in the ratio of quantity purchased i.e., 5:4) 2,133 1,707
Total cost (A) 1,12,133 1,16,107
Effective Quantity (see working) (B) 9,310 kg. 7,526.4 kg.
Rate per kg. (A ÷ B) 12.04 15.43

ILLUSTRATION 3
At WHAT price per unit would Part No. A 32 be entered in the Stores Ledger, if the
following invoice was received from a supplier:

Invoice (` )
200 units Part No. A 32 @ ` 5 1,000.00
Less: 20% discount (200.00)
800.00
Add: IGST @ 12% 96.00
896.00
Add: Packing charges (5 non-returnable boxes) 50.00
946.00

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 MATERIAL COST 2.17

(i) A 2 per cent cash discount will be given if payment is made in 30 days.
(ii) Documents substantiating payment of IGST are enclosed for claiming Input
credit.
SOLUTION
Computation of cost per unit
(`)
Net purchase Price 800.00
Add: Packing charges (5 non-returnable boxes) 50.00
850.00
No. of units purchased 200 units
Cost per unit 4.25

Note: (i) Cash discount is treated as interest and finance charges, hence, it is not
considered for valuation of material.
(ii) Input credit is available for IGST paid; hence it will not be added to purchase cost.

2.5 MATERIAL STORAGE & RECORDS

2
Proper storing of materials is of primary importance. It is not enough only to
purchase material of the required quality. If the purchased material subsequently
deteriorates in quality because of bad storage, the loss is even more than what
might arise from purchase of bad quality of materials. Apart from preservation of
quality, the store-keeper also ensures safe custody of the material. It should be the
function of store-keeper that the right quantity of materials always should be
available in stock.
2.5.1 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 mentioned in
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.

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(iii) Maintaining records: Store keeper should maintain proper record of

quantity received, issued, balance in hand and transferred to/ from other stores.
(iv) Initiate purchase requisition: Store keeper should initiate purchase
requisitions for the replacement of stock of all regular 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 necessary action 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.
2.5.2 Store Records
The record of stores may be maintained in three forms:
 Bin Cards
 Stock Control Cards
 Store Ledger
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.
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.

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Advantages and Disadvantages of Bin Cards

Advantages:
(i) There would be fewer chances of mistakes being made as entries are made
at 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 proximity
to material and also because of handling materials.
(iii) People handling materials are not ordinarily suitable for the clerical work
involved 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 book balance
is not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the case
of bin cards, as the Stock Control Cards are housed in cabinets or trays.
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

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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 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 It is maintained in cost accounting
the store. department.
It contains only quantitative details of It contains information both in quantity
material received, issued and returned and value.
to stores.
Entries are made when transaction It is always posted after the
takes place. transaction.
Each transaction is individually Transactions may be summarized and
posted. then posted.
Inter-department transfers do not Material transfers from one job to
appear in Bin Card. another job are recorded for costing
purposes.

2.6 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 stock maintained should be sufficient to meet the production
requirements so that uninterrupted production flow can be maintained. Insufficient
stock not only pause the production but also cause a loss of revenue and goodwill.
On the other hand, inventory requires some funds for purchase, storage,
maintenance of materials with a risk of obsolescence, pilferage etc. The main

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objective of inventory control is to maintain a trade-off between stock-out and

over-stocking. The management may employ various methods of inventory
control to have a balance. Management may adopt the following basis for inventory
control:

Inventory Control

By Setting On the basis of

Using Ratio
Quantitative Relative Physical Control
Analysis
Levels Classification

2.6.1 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 •Atleast 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 × Maximum Re-order Period

Maximum Consumption = The maximum rate of material consumption in

production activity

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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 × Average Re-
order period)
or,
= Safety Stock + Average lead time consumption

Minimum Stock Level = Minimum Stock level that must be maintained

all the time.
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 as normal 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:

2 × Annual Requirement (A) ×Cost per order (O)

EOQ =
Carrying Costper unitper annum (C)

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 MATERIAL COST 2.23

Annual Requirement (A)- It represents demand for raw material or Input for a year.
Cost per Order (O) - It represents cost of placing an order for purchase.
Carrying Cost (C) – It represents cost of carrying average inventory on annual basis.
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 are known 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 lead time is
zero.

ILLUSTRATION 4
CALCULATE the Economic Order Quantity from the following information. Also state
the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg.
Order placing cost per order : ` 50
Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory

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 2.24 COST AND MANAGEMENT ACCOUNTING

SOLUTION
2× A ×O
EOQ =
C
A = Units consumed during year = 10,000
O = Ordering cost per order = 50
C = Inventory carrying cost per unit per annum. = 8% of ` 2
2 ×10,000 × 50 2 × 10,000 × 50 × 25
EOQ = = = 2,500 kg
2×8 4
100
Total consumption of materials per annum
No. of orders to be placed in a year =
EOQ

= 10, 000 kg. = 4 Orders per year

2,500 kg.

ILLUSTRATION 5
(i) COMPUTE E.O.Q. and the total cost for the following:
Annual Demand = 5,000 units
Unit price = `Rs 20.00
Order cost = ` Rs16.00
Storage rate = 2% per annum
Interest rate = 12% per annum
Obsolescence rate = 6% per annum
(ii) DETERMINE the total cost that would result for the items if a new price of
` 12.80 is used.
SOLUTION
(i) Carrying cost (C) = Storage rate = 2%
Interest Rate = 12%
Obsolescence Rate = 6%
Total = 20% per annum
C= 20% of `Rs 20 = `Rs 4 per unit per annum.
2AO 2 × 5,000 × 16
E.O.Q = = = 40,000 = 200 units
C 4

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 MATERIAL COST 2.25

Total cost:
Purchase price of 5,000 units @ ` 20.00 per unit = ` 1,00,000
5000
Ordering cost = =25 orders @ ` 16 = ` 400
200
200
Carrying cost of average Inventory = =100 units @ ` 4 = ` 400
2
Total cost ` 1,00,800
(ii) If the new price of ` 12.80 is used:
C = 20% of 12.80 = ` 2.56 per unit per annum.

2×5,000×16
E.O.Q. = = 250 units
2.56
Total cost:
Purchase price of 5,000 units @ ` 12.80 per unit = ` 64,000
5,000
Ordering cost = = 20 orders @ `Rs 16 = ` 320
250
250
Carrying cost (of average inventory) = =125 units @ ` 2.56= ` 320
2
Total variable cost ` 64,640
(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.

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 2.26 COST AND MANAGEMENT ACCOUNTING

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 normally
held 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 StockLevel
Average Stock Level =
2

(vi) Danger level: It is the level at which normal issues of the raw material
inventory 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 be
used in case of sudden order, such stock is known as buffer stock.
All the above stock levels can be understood with the help of the following diagram:
Stock Control Chart

Quantity

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 MATERIAL COST 2.27

When the materials are purchased the level keeps rising. It may reach maximum
level if the rate of issuance is less. As the materials are consumed, the stock level
starts declining. At re-order level, reorder quantity is ordered and fresh supplies are
normally received when stocks reach minimum level. The time interval between re-
order level, when the fresh order is placed, and the time of actual receipt of
materials is known as lead time.
ILLUSTRATION 6
Two components, A and B are used as follows:
Normal usage 50 per week each
Maximum usage 75 per week each
Minimum usage 25 per week each
Re-order quantity A: 300; B: 500
Re-order period A: 4 to 6 weeks
B: 2 to 4 weeks
CALCULATE for each component (a) Re-ordering level, (b) Minimum level, (c)
Maximum level, (d) Average stock level.
SOLUTION
(a) Re-ordering level:
Maximum usage per week × Maximum delivery period.
Re-ordering level for component A = 75 units × 6 weeks = 450 units
Re-ordering level for component B = 75 units × 4 weeks = 300 units
(b) Minimum level:
Re-order level – (Normal usage × Average period)
Minimum level for component A = 450 units – (50 units × 5 weeks) = 200 units
Minimum level for component B = 300 units – (50 units × 3 weeks) = 150 units
(c) Maximum level:
Re-order level + Re-order quantity – (Min. usage × Minimum period)
Maximum level for component A = (450 units + 300 units) – (25 units × 4
weeks) = 650 units

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 2.28 COST AND MANAGEMENT ACCOUNTING

Maximum level for component B = (300 units + 500 units) – (25 units × 2
weeks) = 750 units
(d) Average stock level:
½ (Minimum + Maximum) stock level
Average stock level for component A = ½ (200 units + 650 units) =425 units.
Average stock level for component B = ½ (150 units + 750 units) =450 units.
ILLUSTRATION 7
From the details given below, CALCULATE:
(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level.
Re-ordering quantity is to be calculated on the basis of following information:
Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time : Average- 10 days, Maximum- 15 days, Minimum- 5 days.
For emergency purchases- 4 days.
Rate of consumption : Average: 15 units per day,
Maximum: 20 units per day.
SOLUTION
Basic Data:
A (Number of units to be purchased annually) = 5,000 units
O (Ordering cost per order) = ` 20
C (Annual cost of storage per unit) = `5
Purchase price per unit inclusive of transportation cost = ` 50.

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 MATERIAL COST 2.29

Computations:
(i) Re-ordering level = Maximum usage per period × Maximum lead time
(ROL) = 20 units per day × 15 days = 300 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption × Min.
(Refer to working notes1 and 2) lead time]
= 300 units + 200 units – [10 units per day × 5 days]
= 450 units
(iii) Minimum level = ROL – Average rate of consumption × Average re-
order-period
= 300 units – (15 units per day × 10 days) =150 units
(iv) Danger level = Average consumption × Lead time for emergency
purchases
= 15 units per day × 4 days = 60 units
Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X units/day + 20 units per day
15 units per day = or X = 10 units per day.
2
2. Re-order Quantity (ROQ) or Economic Order Quantity (EOQ) =
2×5,000 units×` 20
= 200 units
5
2.6.2 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. The stock- out situation costs to the entity
not only in financial terms but in non-financial terms also. Due to stock out an entity
not only loses overheads costs and profit but reputation (goodwill) also due to non-
fulfilment of commitment. Though it may not be a monetary loss in short term but
in long term it could be a reason for financial loss.

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 2.30 COST AND MANAGEMENT ACCOUNTING

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.
ILLUSTRATION 8
IPL Limited uses a small casting in one of its finished products. The castings are
purchased from a foundry. IPL Limited purchases 54,000 castings per year at a cost
of ` 800 per casting.
The castings are used evenly throughout the year in the production process on a 360-
days-per-year basis. The company estimates that it costs ` 9,000 to place a single
purchase order and about ` 300 to carry one casting in inventory for a year. The high
carrying costs result from the need to keep the castings in carefully controlled
temperature and humidity conditions, and from the high cost of insurance.
Delivery from the foundry generally takes 6 days, but it can take as much as 10 days.
The days of delivery time and percentage of their occurrence are shown in the
following tabulation:
Delivery time (days) : 6 7 8 9 10
Percentage of occurrence : 75 10 5 5 5
Required:
(i) Compute the economic order quantity (EOQ).
(ii) Assume the company is willing to assume a 15% risk of being out of stock. What
would be the safety stock? The re-order point?
(iii) Assume the company is willing to assume a 5% risk of being out of stock. What
would be the safety stock? The re-order point?
(iv) Assume 5% stock-out risk. What would be the total cost of ordering and
carrying inventory for one year?
(v) Refer to the original data. Assume that using process re-engineering the
company reduces its cost of placing a purchase order to only ` 600. In addition,
company estimates that when the waste and inefficiency caused by inventories
are considered, the true cost of carrying a unit in stock is ` 720 per year.
(a) Compute the new EOQ.
(b) How frequently would the company be placing an order, as compared to
the old purchasing policy?

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 MATERIAL COST 2.31

SOLUTION
(i) Computation of economic order quantity (EOQ)
Annual requirement (A) = 54,000 castings
Cost per casting (C) = ` 800
Ordering cost (O) = ` 9,000 per order
Carrying cost per casting p.a. (C × i) = ` 300
2AO 2 × 54,000 units × ` 9,000
EOQ = � =� = 1,800 castings
C×i ` 300

(ii) Safety stock (Assuming a 15% risk of being out of stock)

From the probability table given in the question, we can see that 85% certainty
in delivery time is achieved when delivery period is 7 days i.e. at 15% risk level
of being out of stock, the maximum delivery period should not exceed 7 days.
Annual demand
Safety stock =
360 days
× (Max. lead time - Avg. lead time)
54,000 units
=
360 days
× (7 days - 6 days)

= 150 castings
Re-order point (level) = Safety Stock + Average lead time consumption
= 150 units + (6 days × 150 units) = 1,050 castings.
(iii) Safety stocks (Assuming a 5% risk of being out of stock)
From the probability table given in the question, we can see that 95% certainty
in delivery time is achieved when delivery period is 9 days i.e. at 5% risk level
of being out of stock, the maximum delivery period should not exceed 9 days.
Annual demand
Safety stock = × (Max. lead time - Avg. lead time)
360 days
54,000 units
=
360 days
× (9 days - 6 days) = 450 castings

Re-order point (level) = Safety Stock + Average lead time consumption

= 450 units + (6 days × 150 units) = 1,350 castings.

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 2.32 COST AND MANAGEMENT ACCOUNTING

(iv) At 5% stock-out risk the total cost of ordering and carrying cost is as follows:
Annual demand
Total cost of ordering = ×Cost per order
EOQ
54,000 units
= × ` 9,000 = ` 2,70,000
1,800 units

Total cost of carrying = (Safety Stock + ½ EOQ) × Carrying cost per unit p.a.
= (450 units + ½ × 1,800 units) ` 300 = ` 4,05,000
(v) (a) Computation of new EOQ:
2 × 54,000 units × ` 600
EOQ = � = 300 castings
` 720
54,000 units
(b) Total number of orders to be placed in a year are = 180 times
300 units

Under new purchasing policy IPL Ltd. has to place order in every 2nd day, however
under the old purchasing policy it was every 12th day.
2.6.3 Just in Time (JIT) Inventory Management
JIT is a system of inventory management with an approach to have a 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. This can be
understood with the help of the following diagram:

Production Material Order for

Supplier
Demand starts to requirement is raw
sends the
for final process the sent to the materials
material for
product demand for Purchase sent to
production
product department supplier

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 MATERIAL COST 2.33

2.6.4 Inventory Control- On the basis of Relative Classification

ABC Analysis •On the basis of value and frequency of inventory

•On the basis of inventory turnover

Fast, Slow and Non Moving (FSN)

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. Such a system plans its total material requirements by making budgets.
The stocks of materials are controlled by fixing certain levels like maximum level,
minimum level and re-order level.
(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. The orders for the items, belonging to this
category may be placed after reviewing their situation periodically.
(iii) ‘C’ Category: This category of items does not require much investment; it
may be about 10% of total inventory value but they are nearly 70% of the total items
handled by store. For these category of items, there is no need of exercising con-
stant control. Orders for items in this group may be placed either after six months
or once in a year, after ascertaining consumption requirements. In this case the
objective is to economies on ordering and handling costs.

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 2.34 COST AND MANAGEMENT ACCOUNTING

Cost

ILLUSTRATION 9
From the following details, DRAW a plan of ABC selective control:
Item Units Unit cost (`)
1 7,000 4.450
2 4,000 19.140
3 1,500 8.900
4 29,000 0.180
5 10,000 8.190
6 40,000 0.450
7 60,000 0.180
8 13,000 0.980
9 10,000 0.205
10 29,000 0.360
11 11,500 6.320
12 4,000 5.220

SOLUTION
Statement of Total Cost and Ranking
Item Units % of Total Unit cost Total % of Total Ranking
units (`) cost (`) cost
1 7,000 3.1963 4.450 31,150 8.7557 4
2 4,000 1.8265 19.140 76,560 21.5195 2

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 MATERIAL COST 2.35

3 1,500 0.6849 8.900 13,350 3.7524 7

4 29,000 13.2420 0.180 5,220 1.4672 11
5 10,000 4.5662 8.190 81,900 23.0205 1
6 40,000 18.2648 0.450 18,000 5.0594 6
7 60,000 27.3973 0.180 10,800 3.0357 9
8 13,000 5.9361 0.980 12,740 3.5810 8
9 10,000 4.5662 0.205 2,050 0.5762 12
10 29,000 13.2420 0.360 10,440 2.9345 10
11 11,500 5.2511 6.320 72,680 20.4289 3
12 4,000 1.8265 5.220 20,880 5.8690 5
2,19,000 100 3,55,770 100

Basis for selective control (Assumed)

` 50,000 & above -- ‘A’ items
` 13,000 to 50,000 -- ‘B’ items
Below ` 13,000 -- ‘C’ items
On this basis, a plan of A B C selective control is given below:
Ranking Item % of Total Cost (`) % of Total Category
Nos. units Cost
1 5 4.5662 81,900 23.0205
2 2 1.8265 76,560 21.5195
3 11 5.2511 72,680 20.4289
Total 3 11.6438 2,31,140 64.9689 A
4 1 3.1963 31,150 8.7557
5 12 1.8265 20,880 5.8690
6 6 18.2648 18,000 5.0594
7 3 0.6849 13,350 3.7524
Total 4 23.9726 83,380 23.4365 B
8 8 5.9361 12,740 3.5810
9 7 27.3973 10,800 3.0357
10 10 13.2420 10,440 2.9345
11 4 13.2420 5,220 1.4672

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 2.36 COST AND MANAGEMENT ACCOUNTING

12 9 4.5662 2,050 0.5762

Total 5 64.3836 41,250 11.5946 C
Grand Total 12 100 3,55,770 100
(1) 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 can be systematized on a routine
basis, to be handled by subordinate staff.
ILLUSTRATION 10
A factory uses 4,000 varieties of inventory. In terms of inventory holding and
inventory usage, the following information is compiled:

No. of varieties of % % value of % of inventory

inventory inventory holding usage (in end-
(average) product)
3,875 96.875 20 5
110 2.750 30 10
15 0.375 50 85
4,000 100.00 100 100

CLASSIFY the items of inventory as per ABC analysis with reasons.

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 MATERIAL COST 2.37

SOLUTION
Classification of the items of inventory as per ABC analysis
1. 15 number of varieties of inventory items should be classified as ‘A’ category
items because of the following reasons:
(i) Constitute 0.375% of total number of varieties of inventory handled by
stores of factory, which is minimum as per given classification in the
table.
(ii) 50% of total use value of inventory holding (average), which is
maximum, according to the given table.
(iii) Highest in consumption, about 85% of inventory usage (in end-
product).
2. 110 number of varieties of inventory items should be classified as ‘B’ category
items because of the following reasons:
(i) Constitute 2.750% of the total number of varieties of inventory items
handled by stores of factory.
(ii) Requires moderate investment of about 30% of total use value of
inventory holding (average).
(iii) Moderate in consumption, about 10% of inventory usage (in end–
product).
3. 3,875 number of varieties of inventory items should be classified as ‘C’
category items because of the following reasons:
(i) Constitute 96.875% of total varieties of inventory items handled by
stores of factory.
(ii) Requires about 20% of total use value of inventory holding (average).
(iii) Minimum inventory consumption, i.e. about 5% of inventory usage (in
end-product).
(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 basis of
inventory turnover is decided and classified accordingly.

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 2.38 COST AND MANAGEMENT ACCOUNTING

(i) Fast Moving- This category of items are placed nearer to store issue point
and the stock is reviewed frequently for making of fresh orders.
(ii) Slow Moving- This category of items are 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 are 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 updated requirement
to the stores management
(ii) Technological upgradation in terms of new machine requiring new kind of
material or existing material becoming obsolete.
(iii) Lack of periodic review of inventories.
By careful observation, timely identification and adoption of inventory
management techniques such as maintenance of minimum level or just in time
approach, one can manage slow moving and non-moving inventories. We may
calculate inventory turnover ratio and present the reports of comparison of actual
and standards with variations, if any to the management.
(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. The
unavailability 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, unavailability
does not cause any production or efficiency loss.

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 MATERIAL COST 2.39

For instance, in hospital administration, stock of medicines and essential chemicals

are categorized as VED or FSN inventory. In case of life saving, rare and critical
drugs, they are being categorized as vital inventory. They are the ones whose
unavailability can interrupt smooth service. Those inventories which are optional or
substitutes, not leading to loss in efficiency would be categorized as desirable
inventories. FNS categorization helps the store keepers in hospitals to keep a check
on medicines whose expiry date is close and needs to be disposed off at the earliest.
The quantity of slow moving drugs are maintained accordingly.
(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, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
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.
2.6.5 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: Computation of inventory turnover ratios for
different items of material and comparison of the turnover rates provides a useful
guidance for measuring inventory performance. 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 = Cost of materials consumed during the period

Cost of average stock held duirng the period

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

365days /12months
Average no. of days of Inventory holding =
Inventory TurnoverRatio

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 2.40 COST AND MANAGEMENT ACCOUNTING

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.
ILLUSTRATION 11
The following data are available in respect of material X for the year ended 31st
March, 2021.
(`)
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000
CALCULATE:
(i) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.
SOLUTION
Inventory turnover ratio

(Refer to working note) = Cost of stock of raw material consumed

Average stock of raw material

= `2,50,000 = 2.5
`1,00,000
Average number of days for which the average inventory is held
365 365 days
= =
Inventory turnover ratio 2.5

= 146 days
Working Note:
(`)
Opening stock of raw material 90,000
Add: Material purchases during the year 2,70,000
Less: Closing stock of raw material 1,10,000
Cost of stock of raw material consumed 2,50,000

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 MATERIAL COST 2.41

ILLUSTRATION 12
From the following data for the year ended 31st March, 2021, CALCULATE the
inventory turnover ratio of the two items and put forward your comments on them.

Material A (`) Material B (`)

Opening stock 1.04.2020 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.03.2021 6,000 11,000

SOLUTION
First of all, it is necessary to find out the material consumed:

Cost of materials consumed Material A Material

(`) B
(`)
Opening stock 10,000 9,000
Add: Purchases 52,000 27,000
62,000 36,000
Less: Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory: (Opening Stock + Closing Stock) ÷ 2 8,000 10,000
Inventory Turnover ratio: (Consumption ÷ Average 7 times 2.5
inventory) times
Inventory Turnover (Number of Days in a year/IT ratio) 52 days 146
days
Comments: Material A is moving faster than Material B.
2.6.6 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.

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Issues are made out of the larger part; but as soon as it becomes necessary to 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 can be 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 Ledgershowing 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 day systematically
and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, between physical
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 and when
desired without waiting for the entire stock-taking to be done.
(2) Quick compilation of Profit and Loss Account (for interim period) due to
prompt availability of stock figures.
(3) Discrepancies are easily located and thus corrective action can be promptly
taken to avoid their recurrence.

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(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 stocks within limits
and in initiating purchase requisitions for correct quantity at 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 and corrected much
earlier than under the annual stock-taking system.
3. The system generally has a sobering influence on the stores staff because 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 possible quite
conveniently.

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2.7 MATERIAL ISSUE PROCEDURE

2
Issue of material must not be made except under properly authorised requisition slip.
Usually, it is the foreman of a department who has the authority to draw materials from
the store. Issue of material must be made on the basis of first in first out, that is, out
of the earliest lot in hand. If care is not exercised in this regard, quality of earliest lot
of material may deteriorate for having been kept for a long period.
(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 circum-
stances envisaged above, that such direct transfer should be made. At the time of
material transfer, a material transfer note should be made in duplicate. The
disposition of the copies of this note being are as follows:
Material Transfer

Cost Accounting Department

Note

Department making transfer

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 industrial peculiarities,
management information system (MIS) and accounting system in place.

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(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 a department. In either case,
material may have to be issued from stores in bulk, 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:

Store Room

Shop Credit Note Cost Accounting Department

Department Returnign it

Format of a shop credit note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.

2.8 VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are carried
in stock. But there can be a situation where the material may have been purchased
at different times and at different prices with varying discounts, taxes etc. Because
of this the problem arises as to how the material issues to production are to be
valued. There are several methods for tackling this situation. The cost accountant
should select the proper method based on following factors:

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1. The frequency of purchases, price fluctuations and its range.

2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and the type of production process.
5. Management policy relating to the valuation of closing stock.
Several methods of pricing material issues have been evolved in an attempt to
satisfactorily answer the problem. These methods may be grouped and explained
as follows:
2.8.1 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 separately and
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 specially when purchases and
represent actual and correct costs. issues are numerous.
• This method is best suited for non-
standard and specific products.

(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. Thus each issue of material only recovers the purchase price which
does not reflect the current market price.
This method is considered suitable in times of falling price because the material
cost charged to production will be high while the replacement cost of materials will
be low. But, in the case of rising prices, if this method is adopted, the charge to
production will be low as compared to the replacement cost of materials.
Consequently, it would be difficult to purchase the same volume of material (as in
the current period) in future without having additional capital resources.

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Advantages and disadvantages

Advantages Disadvantages
• It is simple to understand and easy • If the prices fluctuate frequently, this
to operate. method may lead to clerical error.
• Material cost charged to production • Since each issue of material to
represents actual cost with which production is related to a specific
the cost of production should have purchase price, the costs charged to
been charged. the same job are likely to show a
variation from period to period.
• In the case of falling prices, the use • In the case of rising prices, the real
of this method gives better results. profits of the concern being low,
while the profits in the books will
appear high. This may lead to
inability 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.

The application of FIFO method is illustrated below:

Material Received and Issued
Lot Date Quantity Lot Rate Amount
No. Kg. No. (`) (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00
July 12 200 Kgs. out of (1) 1.00 200.00
July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00

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400 Kgs. out of (4) 1.10 440.00

200 Kgs. out of (5) 0.80 160.00
The stock in hand after 8th August will be 1,000 kgs. This will be out of lot number
(5) and its value will be `Rs 800, i.e., @ ` 0.80 per kg.
(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 the quantity of the latest lot, then
earlier (lot) and its price will also be taken into consideration.
During inflationary period or period of rising prices, the use of LIFO would
help to ensure that the cost of production determined on the above basis is
approximately the current one. This method is also useful specially when there is a
feeling that due to the use of FIFO or average methods, the profits shown and tax
paid are too high.
Advantages and Disadvantages
Advantages Disadvantages
• The cost of materials issued will be • Calculation under LIFO system
either nearer to and or will reflect becomes complicated and
the current market price. Thus, the cumbersome when frequent
cost of goods produced will be purchases are made at highly
related to the trend of the market fluctuating rates.
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 • Costs of different similar batches of
period of rising prices does not reflect production carried on at the same
undue high profit in the income time may differ a great deal.
statement as it was 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.

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• In the case of falling prices profit • In time of falling prices, there will
tends to rise due to lower material be need for writing off stock value
cost, yet the finished products considerably to stick to the
appear to be more competitive and principle of stock valuation, i.e., the
are at market price. cost or the market price whichever
is lower.
• Over a period, the use of LIFO helps • This method of valuation of
to iron out the fluctuations in profits. material is 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.

It may be noted that Last in First out (LIFO) is not permitted under Accounting
Standard (AS)-2: Valuation of Inventories and Ind AS- 2: Inventories. However, for
the purpose of academic knowledge LIFO method is included in this Study
Material

ILLUSTRATION 13
The following transactions in respect of material Y occurred during the six months
ended 30th September, 2021:

Month Purchase Price per unit Issued

(units) (` ) Units
April 200 25 Nil
May 300 24 250
June 425 26 300
July 475 23 550
August 500 25 800
September 600 20 400

Required:
(a) The Chief Accountant argues that the value of closing stock remains the same
no matter which method of pricing of material issues is used. Do you agree?
Why or why not? EXPLAIN. Detailed stores ledgers are not required.

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 2.50 COST AND MANAGEMENT ACCOUNTING

(b) STATE when and why would you recommend the LIFO method of pricing
material issues?
SOLUTION
(a) Total number of units purchased = 2,500
Total number of units issued = 2,300
The closing stock at the end of six months’ period i.e., on 30th September, 2021
will be 200 units
Upto the end of August 2021, total purchases coincide with the total issues i.e.,
1,900 units. It means that at the end of August 2021, there was no closing stock. In
the month of September 2021, 600 units were purchased out of which 400 units
were issued. Since there was only one purchase and one issue in the month of
September, 2021 and there was no opening stock on 1st September 2021, the
Closing Stock of 200 units is to be valued at ` 20 per unit.
In the view of this, the argument of the Chief Accountant appears to be correct.
Where there is only one purchase and one issue in a month with no opening stock,
the method of pricing of material issues becomes irrelevant. Therefore, in the given
case one should agree with the argument of the Chief Accountant that the value of
closing stock remains the same no matter which method of pricing the issue is
used.
It may, however, be noted that the argument of Chief Accountant would not stand
if one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material
issues due to the following advantages:
(i) The cost of the materials issued will be either nearer or will reflect the current
market price. Thus, the cost of goods produced will be related to the trend of
the market price of materials. Such a trend in price of materials enables the
matching of cost of production with current sales revenues.
(ii) The use of the method during the period of rising prices does not reflect
undue high profit in the income statement, as it was 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.
(iii) In the case of falling prices, profit tends to rise due to lower material cost, yet
the finished products appear to be more competitive and are at market price.

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(iv) During the period of inflation, LIFO will tend to show the correct profit and
thus, avoid paying undue taxes to some extent.
ILLUSTRATION 14
The following information is provided by Sunrise Industries for the fortnight of April,
2021:
Material Exe:
Stock on 1-4-2021 100 units at ` 5 per unit.
Purchases
5-4-2021, 300 units at ` 6
8-4-2021, 500 units at ` 7
12-4-2021, 600 units at ` 8
Issues
6-4-2021, 250 units
10-4-2021, 400 units
14-4-2021, 500 units
Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-2021.
(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different
under the two methods of pricing of material issues used. You need not draw
up the Stores Ledgers.
SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-2021 to 15-4-2021 by using FIFO method.

Date Description Units Qty. (Units) Rate Amount

(`) (`)
1-4-2021 Opening balance 100 5 500
5-4-2021 Purchased 300 6 1,800

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6-4-2021 Issued 100 5

150 6 1,400
8-4-2021 Purchased 500 7 3,500
10-4-2021 Issued 150 6
250 7 2,650
12-4-2021 Purchased 600 8 4,800
14-4-2021 Issued 250 7
250 8 3,750
15-4-2021 Balance 350 8 2,800

Total value of material Exe consumed during the period under FIFO
method comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on
15-4-2021 is of ` 2,800.
Value of material Exe consumed during the period 01-4-2021 to
15-4-2021 by using LIFO method

Date Description Qty. Rate Amount

(Units) (`) (`)
1-4-2021 Opening balance 100 5 500
5-4-2021 Purchased 300 6 1,800
6-4-2021 Issued 250 6 1,500
8-4-2021 Purchased 500 7 3,500
10-4-2021 Issued 400 7 2,800
12-4-2021 Purchased 600 8 4,800
14-4-2021 Issued 500 8 4,000
15-4-2021 Balance 350 — 2,300*

Total value of material Exe issued under LIFO method comes to (` 1,500
+ ` 2,800 + ` 4,000) ` 8,300.
*The balance 350 units on 15-4-2021 of ` 2,300, relates to opening balance
on 1-4-2021 and purchases made on 5-4-2021, 8-4-2021 and 12-4-2021.
(100 units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100 units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-2021:
Under FIFO method ` 2,800
Under LIFO method ` 2,300

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(B) Total value of material Exe issued to production under FIFO and LIFO methods
comes to ` 7,800 and ` 8,300 respectively. The value of closing stock of
material Exe on 15-4-2021 under FIFO and LIFO methods comes to ` 2,800
and ` 2,300 respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the
following table in the value of material Exe, issued to production under FIFO
and LIFO is as follows:
Date Quantity Value Total Value Total
Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6 - 4-2021 250 1,400 1,500
10-4-2021 400 2,650 2,800
14-4-2021 500 3,750 7,800 4,000 8,300

1. On 6-4-2021, 250 units were issued to production. Under FIFO their

value comes to ` 1,400 (100 units × ` 5 + 150 units × ` 6) and under
LIFO ` 1,500 (250 × ` 6). Hence, ` 100 more was charged to production
under LIFO.
2. On 10-4-2021, 400 units were issued to production. Under FIFO their
value comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800
(400 × ` 7). Hence, ` 150 more was charged to production under LIFO.
3. On 14-4-2021, 500 units were issued to production. Under FIFO their
value comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000
(500 × ` 8). Hence, ` 250 more was charged to production under LIFO.
Thus the total excess amount charged to production under LIFO comes to ` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of 350
units of Closing Stock of material Exe under FIFO and LIFO are as follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to the
purchase of material made on 12-4-2021, whereas under LIFO these
units were from opening balance and purchases made on 5-4-2021, 8-
4-2021 and 12-4-2021.
2. Due to different purchase price paid by the concern on different days
of purchase, the value of closing stock differed under FIFO and LIFO.
Under FIFO 350 units of closing stock were valued @ ` 8 p.u. Whereas

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under LIFO first 100 units were valued @ ` 5 p.u., next 50 units @ ` 6
p.u., next 100 units @ ` 7 p.u. and last 100 units @ ` 8 p.u.
Thus, under FIFO, the value of closing stock increased by ` 500.
(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 minimum stock is known as base stock and is valued
at a price at which the first lot of materials is received and remains unaffected by
subsequent price fluctuations.
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.
2.8.2 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. However, the price of stock of that lot
which is completely sold out is not considered for taking average price.
Example - 1: During the month of April, a company has made five purchases as
follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ ` 11 each.
The issue price under Simple Average Price Method would be calculated as below:
`10 + `12 + `12 + `15 + `11
= ` 12 each
5 lots

This method is suitable when the materials are received in uniform lots of similar
quantity, and prices do not fluctuate considerably.

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Advantages and Disadvantages:

Advantages Disadvantages
• This method is simple to use for an • This method does not provide right
entity which orders materials in a stock valuation when standard quantity
lot of standard quantity, as only for purchase in a lot is not specified.
price per lot is taken to calculate
average price
• In a stable price environment, this • When price of materials fluctuates and
method gives a price which the entity chooses to customise the
approximates to the current order quantity, the price under this
market price. 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.
Example - 2: During the month of April, a company has made five purchases as
follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ ` 11 each.
The issue price under Weightage Average Price Method would be calculated as
below:
{(` 10×200 units)+(` 12×150 units)+(` 12×210 units)+(` 15×50 units)+(` 11×140 units)}
(200+150+210+50+140) units
` 8,610
= = ` 11.48 each
750 units
This method is useful in case when quantity purchased under each lot is different
and price fluctuates frequently.

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Advantages and Disadvantages:

Advantages Disadvantages
• It smoothens the price • Material cost does not represent
fluctuations, if at all it is there, actual cost price and therefore, a
due to material purchases. different profit or loss will arise out of
such a pricing method.
• Issue prices need not be • It may be difficult to compute, since
calculated for each issue unless every time lot is received, it would
new lot of materials is received. require re-computation of issue
prices.

2.8.3 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.
This method is useful to determine true cost of production and to value material
issues in periods of rising prices, because the cost of material considered in cost of
production would be able to replace the materials at the increased price.
(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 more or 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 in this method too.
2.8.4 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.

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Standard prices are fixed for each material and the requisitions are priced at the
standard price. This method is useful for controlling material cost and determining
the efficiency of purchase department. In the case of highly fluctuating prices of
materials, it is difficult to fix their standard cost on long-term basis.

Advantages Disadvantages
• The use of the standard price • The use of standard price does not
method simplifies the task of reflect the market price and thus
valuing issues of materials. results in a different or incorrect
profit or loss.
• It facilitates the control of material • The fixation of standard price
cost and the task of judging the becomes difficult when prices
efficiency of purchase department. fluctuate frequently
• 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.

2.9 VALUATION OF RETURNS & SHORTAGES

2.9.1 Valuation of Materials Returned to the Vendor
Generally, materials are checked for quality, before dispatching to the store; and if
any issues arise such as not meeting the quality requirements or any specification
or are considered unfit for production due to any reason, due notice is made and
materials are returned to the vendor. However, even if any substandard quality is
noticed, before or after reaching the store, such materials can also be 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. In stores

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ledger, the defective or sub-standard materials are shown in the issue column at
the rate shown in the ledger, and the difference between issue price and invoice
cost is debited to an inventory adjustment account.
2.9.2 Valuation of Materials Returned to Stores
When materials requisitioned for a specific job or work-in progress are found to be
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.
(1) Such returns are entered in the receipt column at the price at which they were
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.
2.9.3 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.
[Kindly refer Illustration 15 at Page no. 2.61]

2.10 TREATMENT OF NORMAL AND ABNORMAL

LOSS OF MATERIALS
Loss of materials during handling, storage, process may occur any of the following
forms:

Loss of Material

Waste Scrap Spoilage Defectives 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 and loss
account.

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(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 or production
overhead account, as the case may be.
Abnormal- The cost of abnormal spoilage (i.e., arising out of causes not inherent
in manufacturing process) is charged to the Costing Profit and Loss Account. 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 known as
rejects. The rejects may either be disposed- off or re-cycled for production process.

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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 are 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.
Reclamation of loss from defective units
In the case of articles that have been spoiled, it is necessary to take steps to reclaim
as much of the loss as possible. For this purpose:
(i) All defective units should be sent to a place fixed for the purpose;
(ii) These should be dismantled;
(iii) Goods and serviceable parts should be separated and taken back into the
stock;
(iv) Parts which can be made serviceable by further work should be separated and
sent to the workshop for the purpose and taken into stock after the defects
have been removed; and
(v) Parts which cannot be made serviceable should be collected in one place for
being melted or sold off.
Printed forms should be used to record quantities for all purposes aforementioned.
Difference between Waste and Scrap

Waste Scrap
1. It is connected with raw material or 1. It is the loss connected with the
inputs to the production process. output
2. Waste of materials may be visible 2. Scraps are generally identifiable
or invisible. and has physical substance.
3. Generally waste has no recoverable 3. Scraps are termed as by-products
value. and has small recoverable value.

Difference between Scrap and Defectives

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

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2. Scraps are not intended but 2. Defectives also are not intended but
cannot be eliminated due to the can be eliminated through a proper
nature of material or process control system.
itself.
3. Generally scraps are not used or 3. Defectives can be used after
rectified. rectification.
4. Scraps have insignificant 4. Defectives are sold at a lower value
recoverable 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 of
an 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 circum-
stances:
(i) where it is a spare part or a component of a machinery that is used in
manufacturing and is now obsolete;
(ii) where it is used in the manufacturing of a product which has now become
obsolete;
(iii) where the material itself is replaced by another material due to either
improved 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.
ILLUSTRATION 15
Imbrios India Ltd. is recently incorporated start-up company back in the year 2019.
It is engaged in creating Embedded products and Internet of Things (IoT) solutions
for the Industrial market. It is focused on innovation, design, research and

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development of products and services. One of its embedded products is LogMax, a

system on module (SoM) Carrier board for industrial use. It is a small, flexible and
embedded computer designed as per industry specifications. In the beginning of the
month of September 2021, company entered into a job agreement of providing 4800
LogMax to NIT, Mandi. Following details w.r.t. issues, receipts, returns of Store
Department handling Micro-controller, a component used in the designated
assembling process have been extracted for the month of September, 2021:

Sep. 1 Opening stock of 6,000 units @ ` 285 per unit

Issued 4875 units to mechanical division vide material requisition no.
Sep. 8
Mech 009/20
Received 17,500 units @ ` 276 per unit vide purchase order no.
Sep. 9
159/2020
Issued 12,000 units to technical division vide material requisition no.
Sep. 10
Tech 012/20
Returned to stores 2375 units by technical division against material
Sep. 12
requisition no. Tech 012/20.
Received 9,000 units @ ` 288 per units vide purchase order no. 160/
Sep. 15
2020
Returned to supplier 700 units out of quantity received vide purchase
Sep. 17
order no. 160/2020.
Issued 9,500 units to technical division vide material requisition no.
Sep. 20
Tech 165/20
On 25th September, 2021, the stock manager of the company expressed his need to
leave for his hometown due to certain contingency and immediately left the job same
day. Later, he also switched his phone off.
As the company has the tendency of stock-taking every end of the month to check
and report for the loss due to rusting of the components, the new stock manager, on
30th September, 2021, found that 900 units of Micro-controllers were missing which
was apparently misappropriated by the former stock manager. He, further, reported
loss of 300 units due to rusting of the components.
From the above information you are REQUIRED to prepare the Stock Ledger account
using ‘Weighted Average’ method of valuing the issues.

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SOLUTION
Store Ledger of Imbrios India Ltd. (Weighted Average Method)
Date Receipts Issues Balance of Stock
Qty Rate Amount Qty Rate Amount Qty Rate Amount
Sep.
(kg.) (`) (`) (kg.) (`) (`) (kg.) (`) (`)
1 - - - - - - 6,000 285.00 17,10,000
8 - - - 4,875 285.00 13,89,375 1,125 285.00 3,20,625
9 17,500 276.00 48,30,000 - - - 18,625 276.54 51,50,625
10 - - - 12,000 276.54 33,18,480 6,625 276.54 18,32,145
12 2,375 276.54 6,56,783 - - - 9,000 276.54 24,88,928
15 9,000 288.00 25,92,000 - - - 18,000 282.27 50,80,928
17 - - - 700 288.00 2,01,600 17,300 282.04 48,79,328
20 - - - 9,500 282.04 26,79,380 7,800 282.04 2199948
30 - - - 900* 282.04 2,53,836 6,900 282.04 19,46,112
30 - - - 300** - - 6,600 294.87 19,46,112

* 900 units is abnormal loss, hence it will be transferred to Costing Profit & Loss A/c.
** 300 units is normal loss, hence it will be absorbed by good units.

2.11 CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like
material, labour etc. The management for planning and control must know the cost
of using these resources in manufacturing process. The consumption of materials
takes place when it is used in the manufacturing of the product.
It is important to note that the amount of materials consumed in a period by a cost
object need not be equal to the amount of material available with the concern. For
example, during any period, the total of raw material stock available for use in
production may not be equal to the amount of materials actually consumed and
assigned to the cost object of the production. The difference between the material
available and material consumed represents the surplus stock or stock of material
at the end of the period.

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2.11.1 Identification of Materials

For the identification of consumption of materials with products of cost centres the
followings points should be noted:
1. It is required that the concern should follow coding system for all materials, so
that each material is identified by unique code number.
2. It is required that each product of a cost centre should be given a unique code
number so that the direct material issued for production of particular product of
a cost centre can be collected against the code number of that product.
However, it may not be possible to allocate all materials directly to individual
product of a cost centre e.g. maintenance materials, inspection and testing
materials etc. The consumption of these materials are collected for cost centre and
then charged to individual product by adopting suitable overhead absorption rate
of cost centre.

Overhead absorption rate of cost centre = Cost for cost centre

Base relating to cost centre
(e.g.labou r hrs. or machine hrs.)

3. Each issue of materials should be recorded. One way of doing this is to use a material
requisition note. This note shows the details of materials issued for the product of
cost centre or the cost centre which is to be charged with cost of materials.
4. A material return note is required for recording the excess materials returned to
the store. This note is required to ensure that original product of cost centre is
credited with the cost of material which was not used and that the stock records
are updated.
5. A material transfer note is required for recording the transfer of materials from
one product of cost centre to other or from one cost centre to other cost centre.
6. The cost of materials issued would be determined according to stock valuation
method used.
2.11.2 Monitoring Consumption of Materials
For monitoring consumption of materials, a storekeeper should periodically analyse
the various material requisitions, material return notes and material transfer notes.
Based on this analysis, a material abstracts or material issue analysis sheet is
prepared, which shows at a glance the value of material consumed in
manufacturing each product. This statement is also useful for ascertaining the cost
of material issued for each product.

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Format of Material Abstract

Week Ending............
Material Amount Product Nos. Total Overheads
requisition (`) for (Indirect
or Transfer Product Material
Note or charged)
Returned
101 102 103 104 105 106
Note No.
(`) (`) (`) (`) (`) (`) (`)
— — — — — — — — —

Total

The material abstract statement serves a useful purpose. It, in fact, shows the
amount of material to be debited to various products & overheads. The total
amount of stores debited to various products & overheads should be the same as
the total value of stores issued in any period.
2.11.3. Basis for consumption entries in Financial Accounts
Every manufacturing organisation assigns material costs to the products for two
purposes.
Firstly, for external financial accounting requirements, in order to allocate the
material costs incurred during the period between cost of goods produced and
inventories; secondly to provide useful information for managerial decision
making requirements. In order to meet external financial accounting requirements,
it may not be necessary to accurately trace material costs to individual products.
Some products costs may be overstated and others may be understated. But this
may not matter for financial accounting purposes, as long as total of individual
materials costs transactions are recorded i.e., transactions between cost centre
within the firm are recorded in a manner that facilitates analysis of costs for
assigning them to cost units.
The consumption entries in financial accounts are made on the basis of total cost of
purchases of materials after adjustment for opening and closing stock of materials.

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Following equation is applicable here:

Consumption of Materials = Opening Stock of material + Purchases – Closing Stock
of materials
The stock of materials is taken at cost or net realisable value, whichever is less.

SUMMARY
♦ Material Control: It is the systematic control over the procurement, storage
and usage of materials to maintain even flow of materials and avoiding at the
same time excessive investment in inventories.
♦ Material Requisition Note: Document used to authorize and record the issue
of materials from store.
♦ Purchase Requisition Note: Document is prepared by the storekeeper to
initiate the process of purchases.
♦ Purchase Order: It is a written request to the supplier to supply certain specified
materials at specified rates and within a specified period.
♦ Goods Received Note: This document is prepared by receiving department
which unpacks the goods received and verify the quantities and other details.
♦ Material Transfer Note: This document is prepared when the material is
transferred from one department to another.
♦ Material Return Note: It is a document given with the goods being returned
from factory back to the stores.
♦ Bin Card: A prime entry record of the quantity of stocks, kept on in/out/balance,
held in designated storage areas.
♦ Stores Ledger: A ledger containing a separate account for each item of material
and component stocked in store giving details of the receipts, issues and balance
both in terms of quantity and value.
♦ Minimum Level: It is the minimum quantity, which must be retained in stock
ROL- (Avg. consumption × Avg. Lead time)
♦ Maximum Level: It is the maximum limit up to which stock can be stored at any
time
ROL + ROQ – (Min consumption × Min Lead Time)
♦ Re order Level: It is the level at which new order needs to be placed
Maximum lead time × Maximum Usage

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Or
Minimum level + (Average rate of consumption × Average time to obtain fresh
supplies).
♦ Average Inventory Level = Minimum level + 1/2 Re-order quantity
Or

= Maximum level+Minimum level

2

♦ Danger Level: The level where normal issue of materials is stopped, and only
emergency materials are issued.
Danger level = Average consumption × Lead time for emergency purchases.
♦ Stock-out = Stock out is said to be occurred when an inventory item could not
be supplied due to insufficient stock in the store.
♦ Just-in-time (JIT) Inventory management = JIT is a system of inventory
management with an approach to have a zero inventories in stores. According
to this approach material should only be purchased when it is actually required
for production.
♦ ABC analysis :Items are classified into the following categories:
A Category: Quantity less than 10 % but value more than 70 %
B Category: Quantity less than 20 % but value about 20 %
C Category: Quantity about 70 % but value less than 10%
♦ Fast Moving, Slow Moving and Non Moving (FSN) Inventory: Under this
system, inventories are controlled by classifying them on the basis of frequency of
usage.
♦ 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.
♦ High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
♦ Two bin system: If one bin items exhausts, new order is placed and in the mean
time, quantity from the smaller bin is used or issued.

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♦ First-in First-out method: The materials received first are to be issued first when
material requisition is received. Materials left as closing stock will be at the price
of the latest purchases.
♦ Last-in First-out method: The materials purchased last are to be issued first when
material requisition is received. Closing stock is valued at the oldest available stock
price.
♦ Simple Average Method: Material Issue Price
Total of unit price of each purchase
=
Total number of Purchases

♦ Weighted Average Price Method: This method gives due weightage to

quantities purchased and the purchase price to determine the issue price.

Total cost of material in stock

Weighted Average Price =
Total quantity of materials

♦ Various Material Losses

(a) Wastage: Portion of basic raw material lost in processing, having no
recoverable value
(b) Scrap: The incidental material residue coming out of certain manufacturing
operations, having low recoverable value.
(c) Spoilage: Goods damaged beyond rectification, to be sold off without
further processing.

♦ Defectives: Goods which can be rectified and turned out as good units by the
application of additional labour or other services.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Direct material can be classified as
(a) Fixed cost
(b) Variable cost
(c) Semi-variable cost.
(d) Prime Cost

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CHAPTER 3

EMPLOYEE COST

LEARNING OUTCOMES

After studying this chapter, you would be able to-

 State the meaning and importance of employee (labour) cost
in an organisation.
 Discuss the attendance and payroll procedures.
 State the meaning and treatment of idle time and overtime
cost.
 Compute employee (labour) turnover discuss its meaning,
reasons, methods of measurement and cost impacts.
 Discuss and apply the various methods of remuneration and
incentive system in calculation of wages, bonus etc.
 Discuss the efficiency rating procedures.

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 3.2 COST AND MANAGEMENT ACCOUNTING

3.1 INTRODUCTION
To manufacture a product or to make provision for service, the role of human
exertion is inevitable. The term used for human resources may include workers,
employees, labourers, staffs etc. Whatsoever nomenclature may be used to denote
them; they are required to be compensated for their exertions. The compensation
so paid, either in monetary terms or in kind and facility is known as wages. Cost of
paying wages to workers is popularly known as labour cost as it relates to labour
(exertion) they put for manufacturing of product or provision of services; hence,
employee cost is also interchangeably known as labour cost. In a nutshell,
employee cost is wider term which includes wages, salary, bonus, incentives
etc. paid to an employee and charged to a cost object as labour cost.
Unlike other costs, employee costs are influenced by human behaviour. Due to this
peculiarity, divergence in employee compensation is observed across the different
industries. Wages are determined on both quantitative and qualitative factors like
volume of work, skills required etc. Hence, it is necessary that employees should be
monitored, measured, and compensated appropriately to achieve economy in cost,
efficiency in performance and effectiveness in desired output.

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 EMPLOYEE COST 3.3

3.2 EMPLOYEE (LABOUR) COST

Employee (Labour) cost: Benefits paid or payable to the employees of an entity,
whether permanent, or temporary for the services rendered by them. Employee cost
includes payments made in cash or kind. Employee cost includes the following:
(i) Wages and salary;
(ii) Allowances and incentives;
(iii) Payment for overtimes;
(iv) Employer’s contribution to Provident fund and other welfare funds;
(v) Other benefits (leave with pay, free or subsidised food, leave travel
concession etc.) etc.
Classification of Employee (Labour) cost: Employee cost are broadly
classified as direct and indirect employee 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. This can be easily identified and
allocated to an activity, contract, cost centre, customer, process, product etc.
(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
1. It is the cost incurred in payment 1. Cost incurred for payment of
of employees who are directly employee who are not directly
engaged in the production engaged in the production
process. process.
2. Direct employee cost can be 2. Indirect employee cost is
easily identified and allocated to apportioned on some
cost unit. appropriate basis.
3. Direct employee cost varies with 3. Indirect employee cost may not
the volume of production and vary with the volume of
has positive relationship with the production.
volume.

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 3.4 COST AND MANAGEMENT ACCOUNTING

3.3 EMPLOYEE (LABOUR) COST CONTROL

Employee costs are associated with human beings. To control employee costs one
has to understand human behavior. Employee cost control means control over the
cost incurred on employees. Control over employee costs does not imply control
over the size of the wage bill; it also does not imply that wages of each employee
should be kept as low as possible.
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.
A well-motivated team of employees can bring about wonders. Each concern
should, therefore, constantly strive to raise the productivity of employee. The
efforts for the control of employee costs should begin from the very beginning.
There has to be a concerted effort by all the concerned departments.

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

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 EMPLOYEE COST 3.5

3. Time-keeping i) Concerned with the maintenance of

Department attendance records i.e. time keeping and
ii) Time spent by an employee on various jobs
i.e. time booking etc.
4. Payroll Department i) The preparation of payroll of the employees.
ii) It disburses salary and wage payments.
5. Cost Accounting i) Accumulation and classification of employee
Department costs.
ii) Analysis and allocation of costs to various
cost centres or cost objects

3.3.1 Important Factors for the Control of Employee Cost

To exercise an effective control over the employee costs, the essential requisite is
efficient utilisation of employee and allied factors. 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.
3.3.2 Collection of Employee Costs
The task of collecting employee costs is performed by the Cost Accounting
Department which record separately wages paid to direct and indirect employee. It
is the duty of this 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 jobs completed;
(ii) the amount treated as indirect employee cost and thus included in overheads;
and

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 3.6 COST AND MANAGEMENT ACCOUNTING

(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 profit and
loss account.
Through this process costs of various jobs are ascertained. Naturally, in this the
proper recording of time spent by the employees is essential.

3.4 ATTENDANCE & PAYROLL PROCEDURES

3.4.1 Attendance Procedure / Time-keeping
It refers to correct recording of the employees’ attendance time. Students may note
the difference between “time keeping” and “time booking”. The latter refers to
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: Correct recording of employees’ attendance time is
of utmost importance where payment is made on the basis of time worked.
Where payment is made by results viz; straight piece work, it would still be
necessary to correctly record attendance for the purpose of ensuring that proper
discipline and adequate rate of production are maintained. 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: There are various methods of time-keeping, which
may be categorized into manual and mechanical methods. The choice of a
particular method depends upon the requirements and policy of an entity; but
whichever method is followed, it should make a correct record of the time by
incurring minimum possible expenditure and it should minimise the risk of
fraudulent payments of wages. The examples of time keeping methods are follows:

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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. This method is
simple and expensive and is suitable for small organisations. However, this method
may lead to dishonest practice of time manipulation by way of recording wrong
time and back date entry in collusion with time keeper.
(b) Metal Disc/ Token method- This method of time recording is very old and
is almost obsolete in practice. 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. Like
attendance register method, this method also has some disadvantages like error in
recording, proxy attendance etc.
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 in and/or out. This system does not require to employ
any time keeper and minimises the risk of recording error and time manipulation.
(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. Bio-metric attendance
system includes fingerprint recognition system, face recognition system, Time and
attendance tracking technology etc. This system reduces the risk of time
manipulation and proxy attendance. However, it may not be suitable for small
organisations due to cost associated with set-up and maintenance.
Requisites of a Good Time-keeping System: A good time-keeping system should
have following requisites:
1. System of time-keeping should be such which should not allow proxy for
another employee under any circumstances.
2. There should also be 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.

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 3.8 COST AND MANAGEMENT ACCOUNTING

3. Time of arrival as well as time of departure of employees should be recorded

so that total time of employees may be recorded and wages may be
calculated accordingly.
4. As far as possible, method of recording of time should be mechanical so that
chances of disputes regarding time may not arise between employees and
the time-keeper.
5. Late-comers should record late arrivals. Any relaxation by the time-keeper in
this regard will encourage indiscipline.
6. The system should be simple, smooth and quick. Unnecessary queuing for
marking attendance should be avoided.
7. The system should be reviewed and maintained periodically to prevent any
error.
3.4.2 Time-Booking
Time keeping just records the time spent by an employee in the premises for
production but it does not show how much time a person spent on a particular job.
Time booking refers to a method wherein each activity of an employee is
recorded. This data recorded is further used for measure the time spent on a
particular job for costing, measurement of efficiency, fixation of responsibility etc.
Time booking for costing: The time spent on a particular job or activity is used to
compute the cost of the job or activity.
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.

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 is further classified as controllable and uncontrollable. The controllable
reasons are those which can be avoided by due care and efficiency. On the other
hand, 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.

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 EMPLOYEE COST 3.9

For the collection of all such data, a separate record, generally known as Time (or
Job) card, is kept.
The time (or 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.
Thus, the job card would record the total time spent on a particular job or
operation. If a number of people are engaged on the same job or operation,
the time of all those employees would be booked on the same card.
One advantage of this method is that it provides complete data on the
employee content of job or operation collectively so that the computation of
employee cost is greatly facilitated.
But this method has drawbacks as well. Since an employee’s job timing is
scattered over a number of job cards the time spent on all these jobs and idle
time must be abstracted periodically for finding each employee’s total time
spent on different jobs and the time for which he remained idle during the
period. The total of these two times (job and idle) must obviously equal his
total attendance time, as shown by his attendance record.
• The other with reference to each employee: In this case, it would greatly
facilitate reconciliation of the employee’s job time with his attendance time
recorded.
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 so that the card would have
a complete history on it as to how his time had been spent during the period.
The format of job or time may vary industry to industry and according to the
accounting system into used.

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 3.10 COST AND MANAGEMENT ACCOUNTING

3.4.3 Payroll Procedure

Steps included in this process are as under:

Time -keeping Personnel/ HR

Department Department
1. Time and Attendance

2. Employee Details
Payroll
Department

3. Wage and Salary sheet

5. Deposit of deductions and

Cost/ Accounting contributions
Department

4. Payment after deductions and

contributions

Statutory Bodies
Employees

Diagram: Payroll Procedures

1. Attendance and Time 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.
Further, payroll department with the help of time booking records calculate
any further incentives such as overtime payment, bonus to be paid to the
employees.
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 employee is paid.
3. Computation of wages and other incentives: Payroll department based on
the details provided by the time keeping department and personnel

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 EMPLOYEE COST 3.11

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.
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 deducted
Scheme (ESI) from the salary/ wages.
3. Tax Deduction at Source Employer is obliged to deduct tax at source if
(TDS) it will be paying to the employee net salary
exceeding maximum exemption limit, in equal
monthly installments 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
Provident fund over and above the contribution payable by
the employer.
2. Contribution to any An employee may contribute to any
benevolent fund. benevolent fund voluntarily by putting a
request to the payroll department.

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 3.12 COST AND MANAGEMENT ACCOUNTING

3. Loan deductions Installments of any loan taken by the

employee.
4. Other advances and dues Other advances like festival advance and
unadjusted advances taken.

3.5 IDLE TIME

The time during which no production is carried-out because the worker remains
idle but are paid. In other words, it is the difference between the time paid and the
time booked. Idle time can be normal or abnormal. The time for which employees are
paid includes holidays, paid leaves, allowable rest or off time etc.
Normal idle time: It is the time which cannot be avoided or reduced in the normal
course of business.

Causes Treatment
1. The time lost between factory gate It is treated as a part of cost of
and the place of work, production. Thus, in the case of direct
workers an allowance for normal idle
time is considered setting of standard
hours or standard rate.
In case of indirect workers, normal idle
2. The interval between one job and
time is considered for the computation of
another,
overhead rate.
3. The setting up time for the
machine,
4. Normal rest time, break for lunch
etc.

Abnormal idle time: Apart from normal idle time, there may be factors which give rise
to abnormal idle time.

Causes Treatment
1. Idle time may also arise due to Abnormal idle time cost is not included
abnormal factors like lack of as a part of production cost and is
coordination shown as a separate item in the Costing
2. Power failure, Breakdown of Profit and Loss Account.
machines The cost of abnormal idle time should be
further categorised into controllable and

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 EMPLOYEE COST 3.13

3. Non-availability of raw materials, uncontrollable. For each category, the

strikes, lockouts, poor break-up of cost due to various factors
supervision, fire, flood etc. should be separately shown. This would
4. The causes for abnormal idle time help the management in fixing
should be further analysed into responsibility for controlling idle time.
controllable and uncontrollable. Management should aim at eliminating
i) Controllable abnormal idle time controllable idle time and on a long-
refers to that time which could term basis reducing even the normal idle
have been put to productive use time. This would require a detailed
had the management been more analysis of the causes leading to such
alert and efficient. All such time idle time.
which could have been avoided is
controllable idle time.
ii) Uncontrollable abnormal idle time
refers to time lost due to
abnormal causes, over which
management does not have any
control e.g., breakdown of
machines, flood etc. may be cha-
racterised as uncontrollable idle
time.

ILLUSTRATION 1
‘X’ an employee of ABC Co. gets the following emoluments and benefits:
(a) Basic pay ` 10,000 p.m.
(b) Dearness allowance ` 2,000 p.m.
(c) Bonus 20% of salary and D.A.
(d) Other allowances ` 2,500 p.m.
(e) Employer’s contribution to P.F. 10% of salary and D.A.
‘X’ works for 2,400 hours per annum, out of which 400 hours are non-productive and
treated as normal idle time. You are required to COMPUTE the effective hourly cost
of employee ‘X’.

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 3.14 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Statement showing computation of effective hourly cost of employee ‘X’

Per month (`) Per annum (`)

(A) Earning of Employee ‘X’:
Basic pay 10,000 1,20,000
Dearness Allowance 2,000 24,000
Bonus 2,400 28,800
Employer’s contribution to provident fund 1,200 14,400
Other allowances 2,500 30,000
18,100 2,17,200
(B) Effective working hours (refer workings) 2,000 hours
(C) Effective hourly cost {(A) ÷ (B)} `108.60

Workings:
Calculation of effective working hours:
Annual working hours less Normal idle time = 2,400 hours – 400 hours = 2,000 hours.
ILLUSTRATION 2
In a factory working six days in a week and eight hours each day, a worker is paid at
the rate of ` 100 per day basic plus D.A. @ 120% of basic. He is allowed to take 30
minutes off during his hours shift for meals-break and a 10 minutes recess for rest.
During a week, his card showed that his time was chargeable to :
Job X 15 hrs.
Job Y 12 hrs.
Job Z 13 hrs.
The time not booked was wasted while waiting for a job. In Cost Accounting, STATE
how would you allocate the wages of the workers for the week?
SOLUTION
Working notes:
(i) Total effective hours in a week:
[(8 hrs. – (30 mts. + 10 mts.)] × 6 days = 44 hours

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 EMPLOYEE COST 3.15

(ii) Total wages for a week:

(` 100 + 120% of ` 100) × 6 days = ` 1,320
(iii) Wage rate per hour = 1320 ÷ 44 hours = ` 30
(iv) Time wasted waiting for job (Abnormal idle time):
= 44 hrs. – (15 hrs. + 12 hrs. + 13 hrs.) = 4 hrs.
Allocation of wages in Cost Accounting

(`)
Allocated to Job X : 15 hours × ` 30 450
Allocated to Job Y : 12 hours × ` 30 360
Allocated to Job Z : 13 hours × ` 30 390
Charged to Costing Profit & Loss A/c : 4 hours × ` 30 120
Total 1,320

3.6 OVERTIME
Work done beyond normal working hours is known as ‘overtime work’. Overtime
payment is the amount of wages paid for working beyond normal working hours.
Overtime payment consist of two elements- (i) Normal wages for overtime work and (ii)
Premium payment for 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;
usually it is at double the normal rates. The extra amount so paid over the normal rate
is called overtime premium.
Rate and conditions for overtime premium may either be fixed by an entity itself or it
may be required by any statute in force. The overtime premium should not be less than
the premium calculated as per the statute.
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 fourty 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.”

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 3.16 COST AND MANAGEMENT ACCOUNTING

Where any workers in a factory are paid on a piece-rate basis, the time rate shall
be deemed to be equivalent to the daily average of their full-time earnings for the
days on which they actually worked on the same or identical job during the month
immediately preceding the calendar month during which the overtime work was
done, and such time rates shall be deemed to be the ordinary rates of wages of
those workers
Ordinary rate of wages means the basic wages plus such allowances, including the
cash equivalent of the advantage accruing through the concessional sale to workers
of food grains and other articles, as the worker is for the time being entitled to, but
does not include a bonus and wages for overtime work.
Occasional overtime is a healthy sign as it indicates that the firm has the optimum
capacity and that the capacity is being fully utilised. But persistent overtime is rather a
bad sign because it may indicate either (a) that the firm needs larger capacity in men
and machines, or (b) that men have got into the habit of postponing their ordinary
work towards the evening so that they can earn extra money in the form of overtime
wages.
Causes of Overtime and Treatment of Overtime premium in cost accounting

Causes Treatment
(1) The customer may agree to bear (1) If overtime is resorted to at the
the entire charge of overtime desire of the customer, then
because urgency of work. overtime premium may be charged
to the job directly.
(2) Overtime may be called for to (2) If overtime is required to cope with
make up any shortfall in general production programmes or
production due to some for meeting urgent orders, the
unexpected development. overtime premium should be
treated as overhead cost of the
particular department or cost
centre which works overtime.
(3) Overtime work may be (3) If overtime is worked in a
necessary to make up a shortfall department due to the fault of
in production due to some fault another department, the overtime
of management. premium should be charged to the
latter department.

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 EMPLOYEE COST 3.17

(4) Overtime work may be resorted (4) Overtime worked on account of

to, to secure an out-turn in abnormal conditions such as flood,
excess of the normal output to earthquake etc., should not be
take advantage of an expanding charged to cost, but to Costing
market or of rising demand Profit and Loss Account.

ILLUSTRATION 3
CALCULATE the earnings of A and B from the following particulars for a month and
allocate the employee cost to each job X, Y and Z:
A B
(i) Basic Wages (`) 10,000 16,000
(ii) Dearness Allowance 50% 50%
(iii) Contribution to provident Fund (on basic wages) 8% 8%
(iv) Contribution to Employee’s State Insurance (on basic wages) 2% 2%
(v) Overtime (Hours) 10 --
The normal working hours for the month are 200. Overtime is paid at double the
total of normal wages and dearness allowance. Employer’s contribution to state
Insurance and Provident Fund are at equal rates with employees’ contributions. The
two workers were employed on jobs X, Y and Z in the following proportions:

Jobs X Y Z
Worker A 40% 30% 30%
Worker B 50% 20% 30%

Overtime was done on job Y.

SOLUTION
Statement showing Earnings of Workers A and B
A (`) B (`)
Basic wages 10,000 16,000
Dearness Allowance (50% of Basic Wages) 5,000 8,000
Overtime wages (Refer to Working Note 1) 1,500 --
Gross wages earned 16,500 24,000
Less: Contribution to Provident fund (800) (1,280)

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 3.18 COST AND MANAGEMENT ACCOUNTING

Less: Contribution to ESI (200) (320)

Net wages earned 15,500 22,400

Statement of Employee Cost

A (`) B (`)
Gross Wages (excluding overtime) 15,000 24,000
Add: Employer’s contribution to PF 800 1,280
Add: Employer’s contribution to ESI 200 320
Gross wages earned 16,000 25,600
Normal working hours 200 200
Ordinary wages rate per hour 80 128

Statement Showing Allocation of Wages to Jobs

Total Jobs
Wages (`) X (`) Y (`) Z (`)
Worker A:
- Ordinary Wages (4: 3 : 3) 16,000 6,400 4,800 4,800
- Overtime 1,500 -- 1,500 --
Worker B:
- Ordinary Wages (5 : 2 : 3) 25,600 12,800 5,120 7,680
43,100 19,200 11,420 12,480

Working Notes
1. Normal Wages are considered as basic wages
2× (Basic wage + DA ) ×10 hours
Over time =
200
 `15,000 
= 2×   ×10 hours =`150 × 10 hours=`1,500
 200 
ILLUSTRATION 4
It is seen from the job card for repair of the customer’s equipment that a total of 154
labour hours have been put in as detailed below:

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 EMPLOYEE COST 3.19

Worker ‘A’ paid Worker ‘B’ paid Worker ‘C’ paid

at ` 200 per day at ` 100 per day at ` 300 per day
of 8 hours of 8 hours of 8 hours
Monday (hours) 10.5 8.0 10.5
Tuesday (hours) 8.0 8.0 8.0
Wednesday (hours) 10.5 8.0 10.5
Thursday (hours) 9.5 8.0 9.5
Friday (hours) 10.5 8.0 10.5
Saturday (hours) -- 8.0 8.0
Total (hours) 49.0 48.0 57.0

In terms of an award in employee conciliation, the workers are to be paid dearness allowance
on the basis of cost of living index figures relating to each month which works out @ ` 968 for
the relevant month. The dearness allowance is payable to all workers irrespective of wages rate
if they are present or are on leave with wages on all working days.
Sunday is a weekly holiday and each worker has to work for 8 hours on all week days and 4
hours on Saturdays; the workers are however paid full wages for Saturday (8 hours for 4
hours worked).
Overtime is paid twice of ordinary wage rate if a worker works for more than nine hours
in a day or forty-eight hours in a week. Excluding holidays, the total number of hours works
out to 176 in the relevant month. The company’s contribution to Provident Fund and
Employees State Insurance Premium are absorbed into overheads.
CALCULATE the wages payable to each worker.
SOLUTION
(1) Calculation of hours to be paid for worker A:

Normal Extra Overtime Equivalent normal Total

hours hours hours hours for normal
overtime worked hours
Monday 8 1 1½ 3 12
Tuesday 8 -- -- -- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10

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 3.20 COST AND MANAGEMENT ACCOUNTING

Friday 8 1 1½ 3 12
Saturday -- -- -- -- --
Total 40 4 5 10 54

Calculation of hours to be paid for worker B:

Normal Extra Overtime Equivalent normal Total

hours hours hours hours for overtime normal
worked hours
Monday 8 --- --- --- 8
Tuesday 8 --- --- --- 8
Wednesday 8 --- --- --- 8
Thursday 8 --- --- --- 8
Friday 8 --- --- --- 8
Saturday 4 4* --- --- 8
Total 44 4 --- --- 48

(*Worker-B has neither worked more than 9 hours in any day nor more than
48 hours in the week)
Calculation of hours to be paid for worker C:

Normal Extra Overtime Equivalent normal Total

hours hours hours hours for overtime normal
worked hours
Monday 8 1 1½ 3 12
Tuesday 8 --- --- --- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday 4 4* --- --- 8
Total 44 8 5 10 62

(*Worker-C will be paid for equivalent 8 hours, though 4 hours of working is

required on Saturday. Further, no overtime will be paid for working beyond 4
hours since it is paid for working beyond 9 hours.)

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 EMPLOYEE COST 3.21

Wages payable:
A B C
Basic Wages per hour (`) 25.00 12.50 37.50
Dearness allowance per hour (`) 5.50 5.50 5.50
Hourly rate (`) 30.50 18.00 43.00
Total normal hours 54.00 48.00 62.00
Total Wages payable (`) 1,647.00 864.00 2,666.00

ILLUSTRATION 5
In a factory, the basic wage rate is `100 per hour and overtime rates are as follows:

Before and after normal working hours 175% of basic wage rate
Sundays and holidays 225% of basic wage rate
During the previous year, the following hours were worked
- Normal time 1,00,000 hours
- Overtime before and after working hours 20,000 hours
Overtime on Sundays and holidays 5,000 hours
Total 1,25,000 hours

The following hours have been worked on job ‘Z’

Normal 1,000 hours
Overtime before and after working hrs. 100 hours.
Sundays and holidays 25 hours.
Total 1,125 hours

You are required to CALCULATE the labour cost chargeable to job ‘Z’ and overhead in
each of the following instances:
(a) Where overtime is worked regularly throughout the year as a policy due to the
workers’ shortage.
(b) Where overtime is worked irregularly to meet the requirements of production.
(c) Where overtime is worked at the request of the customer to expedite the job.

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 3.22 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Workings
Basic wage rate : ` 100 per hour
Overtime wage rate before and after working hours : ` 100 × 175% = ` 175 per hour
Overtime wage rate for Sundays and holidays : ` 100 × 225% = ` 225 per hour
Computation of effective average wage rate (including overtime premium):
Particulars Amount (`)
Annual wages for the previous year for normal time 1,00,00,000
(1,00,000 hrs. × `100)
Wages for overtime before and after working hours 35,00,000
(20,000 hrs. × `175)
Wages for overtime on Sundays and holidays 11,25,000
(5,000 hrs. × `225)
Total wages for 1,25,000 hrs. 1,46,25,000

` 1, 46,25,000
Effective average wage rate = = `117
1,25,000 hours
(a) Where overtime is worked regularly as a policy due to workers’ shortage:
The overtime premium is treated as a part of employee cost and job is charged at
an effective average wage rate. Hence, employee cost chargeable to job Z
= Total hours × effective average wage rate = 1,125 hrs. × ` 117 = `1,31,625
(b) Where overtime is worked irregularly to meet the requirements of production:
Basic wage rate is charged to the job and overtime premium is charged to factory
overheads as under:
Employee cost chargeable to Job Z: 1,125 hours @ `100 per hour =
` 1,12,500
Factory overhead: {100 hrs. × ` (175 – 100)} + {25 hrs. × ` (225 – 100)} = {`7,500
+ `3,125} = `10,625

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 EMPLOYEE COST 3.23

(c) Where overtime is worked at the request of the customer, overtime premium
is also charged to the job as under:
(`)
Job Z Employee cost 1,125 hrs. @ ` 100 = 1,12,500
Overtime premium 100 hrs. @ ` (175 – 100) = 7,500
25 hrs. @ ` (225 – 100) = 3,125
Total 1,23,125

3.7 LABOUR UTILISATION

For identifying utilisation of labour a statement is prepared (generally weekly) for
each department / cost centre. This statement should 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.
3.7.1 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 overhead
expenses.
3.7.2 Identification of labour hours with work order or batches 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.

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(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 batches or
capital jobs or overhead work orders by using overhead absorption rate.

3.8 SYSTEMS OF WAGE PAYMENT AND

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

Time based
System of Wages Payment

Output based

Combination of time and output based

Premium Bonus method

Group bonus scheme

Incentives for indirect workers

3.8.1 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.
Time based wages payment is suitable for the employees (i) whose services cannot
be directly or tangibly measured, e.g., general helpers, supervisory and clerical staff
etc. (ii) engaged in highly skilled jobs, (iii) where the pace of output is independent
of the operator, e.g., automatic chemical plants.
Wages under time rate system is calculated as under:

Wages = Time Worked (Hours/ Days/ Months) × Rate for the time

3.8.2 Output Based (Piece Rate System)

Straight Piece Rate System: Under this system, each operation, job or unit of
production is termed a piece. A rate of payment, known as the piece rate or piece

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 EMPLOYEE COST 3.25

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

3.8.3 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 the 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
opportunity for increasing earnings by with piece rate system. In fact
increasing production. the harder the worker works,
2. The system is equitable in as much as the lesser he gets per piece.
the employer gets a direct return for his 2. The sharing principle may not
efforts in improving production be liked by employees.
methods and providing better
equipment.

ILLUSTRATION 6
CALCULATE the earnings of a worker under Halsey System. The relevant data is as below:
Time Rate (per hour) ` 60
Time allowed 8 hours

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 3.26 COST AND MANAGEMENT ACCOUNTING

Time taken 6 hours

Time saved 2 hours
SOLUTION
Calculation of total earnings:
= Time taken × Time rate + 50% (Time Allowed – Time Taken) × Time rate
= 6 hrs. × `60 + 1/2 × (2 hrs. × `60) or `360 + `60 = `420
Of his total earnings, `360 is on account of the time worked and `60 is on account
of his share of the premium bonus.
(ii) Rowan Premium Plan: According to this system a standard time allowance
is fixed for the performance of a job and bonus is paid if time is saved.
Under Rowan System the bonus is that proportion of the time wages as time saved
bears to the standard time.

Time Saved
Time taken × Rate per hour + × Time taken × 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 1. The system is a bit
as much as a worker can never double complicated.
his earnings even if there is bad rate
setting.
2. It is admirably suitable for encouraging 2. The incentive is weak at a
moderately efficient workers as it high production level where
provides a better return for moderate the time saved is more than
efficiency than under the Halsey Plan. 50% of the time allowed.
3. The sharing principle appeals to the 3. The sharing principle is not
employer as being equitable. generally welcomed by
employees.

ILLUSTRATION 7
CALCULATE the earnings of a worker under Rowan System. The relevant data is given as
below:
Time rate (per Hour) ` 60
Time allowed 8 hours.

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 EMPLOYEE COST 3.27

Time taken 6 hours.

Time saved 2 hours.
SOLUTION
Calculation of total earnings:
Time Saved
=Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
2 hours
= 6 hours × `60 + × 6 hours × ` 60 = ` 360 + ` 90 = ` 450
8 hours
Highly Efficient Worker and Less Efficient Worker obtaining same bonus
Under this system, a highly efficient worker may obtain same bonus as less efficient
worker. We can understand this with the help of following example:
Example - 1:
Time rate (per Hour) ` 60
Time allowed 8 hours.
Time taken by ‘X’ 6 hours.
Time taken by ‘Y’ 2 hours.
Time Saved
Bonus = × Time taken × Rate per hour
Time Allowed
2 hours
For ‘X' = × 6 hours × ` 60 = ` 90
8 hours
6 hours
For ‘Y’ = × 2 hours × ` 60 = ` 90
8 hours
From the above example, it can be concluded that a highly efficient worker may
obtain same bonus as less efficient worker under this system.
ILLUSTRATION 8
Two workmen, ‘A’ and ‘B’, produce the same product using the same material. Their
normal wage rate is also the same. ‘A’ is paid bonus according to the Rowan system,
while ‘B’ is paid bonus according to the Halsey system. The time allowed to make the
product is 50 hours. ‘A’ takes 30 hours while ‘B’ takes 40 hours to complete the
product. The factory overhead rate is ` 5 per man-hour actually worked. The factory
cost for the product for ‘A’ is ` 3,490 and for ‘B’ it is ` 3,600.

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 3.28 COST AND MANAGEMENT ACCOUNTING

Required:
(a) COMPUTE the normal rate of wages;
(b) COMPUTE the cost of materials cost;
(c) PREPARE a statement comparing the factory cost of the products as made by the
two workmen.
SOLUTION
Step 1 : Let X be the cost of material and Y be the normal rate of wages per hour.
Step 2 : Factory Cost of Workman ‘A’
(`)
A. Material Cost X
B. .Wages (Rowan Plan) 30 Y

C. Bonus = 30 × (50 - 30) × Y 12 Y

50
D. Overheads (30 × `5) 150
E.Factory Cost 3,490
Or, X + 42 Y = `3,490 (Given) – `150 = `3,340……………………………...equation (i)

Step 3 : Factory Cost of Workman ‘B’

(`)
A. Material Cost X
B. Wages (Halsey Plan) 40 Y
C. Bonus = 50% of (SH - AH) × R 5Y
= 50% of (50 - 40) × R
D. Overheads (40 × `5) 200
E. Factory Cost 3,600
Or, X + 45 Y = `3,600 (Given) – `200 = `3,400………………………….equation (ii)

Step 4 : Subtracting equation (i) from equation (ii)

3Y = `60
Y = `60/3 = `20 per hour.
(a) The normal rate of wages: `20 per hour

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 EMPLOYEE COST 3.29

(b) The cost of material: X + 45 × ` 20 = ` 3,400 or, X = ` 3,400 – ` 900 = ` 2,500

(c) Comparative Statement of the Factory Cost of the product made by the two
workmen.

‘A’ (`) ‘B’ (`)

Material cost 2,500 2,500
Direct Wages 600 800
(30 × `20) (40 × `20)
Bonus 240 100
(12 × `20) (5 × `20)
Factory Overhead 150 200
Factory Cost 3,490 3,600

ILLUSTRATION 9
(a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved equals
the bonus paid under the Rowan System. When will this statement hold good?
(Your answer should contain the proof).
(b) The time allowed for a job is 8 hours. The hourly rate is ` 8. PREPARE a statement showing:
i. The bonus earned
ii. The total earnings of employee and
iii. Hourly earnings.
Under the Halsey System with 50% bonus for time saved and Rowan System for
each hour saved progressively.
SOLUTION
50
(a) Bonus under Halsey Plan = × (SH - AH) × R (i)
100
AH
Bonus under Rowan Plan : = × (SH - AH) × R (ii)
SH
Bonus under Halsey Plan will be equal to the bonus under Rowan Plan when the
following condition holds good:
50 AH
× (SH - AH) × R = × (SH - AH) × R
100 SH
50 AH
=
100 SH

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 3.30 COST AND MANAGEMENT ACCOUNTING

Hence, when the actual time taken (AH) is 50% of the time allowed (SH),
the bonus under Halsey and Rowan Plans is equal.
(b) Statement of Bonus, total earnings of Employee and hourly earnings under
Halsey and Rowan Systems.
SH AH Time Basic Bonus Bonus Total Total Hourly Hourly
saved wages under under Earning Earnin Earning Earnings
(AH Halsey Rowan s under gs s under under
x`8) (B System system Halsey under Halsey Rowan
x `8)  50  B  System Rowan System System
100 ×C×8  A ×C ×8  D+E Syste G/B H/B
m D+F
A B C= D E F G H I J
Hours hours (A-B) ` ` ` ` ` ` `
hours
8 8 - 64 - - 64 64 8.00 8.00
8 7 1 56 4 7 60 63 8.57 9.00
8 6 2 48 8 12 56 60 9.33 10.00
8 5 3 40 12 15 52 55 10.40 11.00
8 4 4 32 16 16 48 48 12.00 12.00
8 3 5 24 20 15 44 39 14.67 13.00
8 2 6 16 24 12 40 28 20.00 14.00
8 1 7 8 28 7 36 15 36.00 15.00

ILLUSTRATION 10
A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of ` 30 per hour. The standard
time per unit for a particular product is 4 hours. Mr. P, a machine man, has been paid wages
under the Rowan Incentive Plan and he had earned an effective hourly rate of
` 37.50 on the manufacture of that particular product.
STATE what could have been his total earnings and effective hourly rate, had he been put on
Halsey Incentive Scheme (50%)?
SOLUTION
Total earnings (under 50% Halsey Scheme) = Hours worked × Rate per hour + ½
× time saved × Rate per hour
= 3 hours × ` 30 + ½ × 1 hour × `30 = `105

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 EMPLOYEE COST 3.31

Total earnings ` 105

Effective hourly rate = = = `35
Hours taken 3 hours

Working Note:
Let T hours be the total time worked in hours by the skilled workers (machine man P),
`30 is the rate per hour; standard time is 4 hours per unit and effective hourly earnings
rate is `37.50 then
Time saved
Earning (under Rowan plan) = Hours worked × Rate per hr + ×
Time allowed
Time taken × Rate per hr
(4 − T)
`37.5 T = T × `30 + × T × `30
4
(both sides are divided by T)
` 37.5 = ` 30 + (4 – T) × ` 7.5
` 37.5 = ` 30 + `30 - 7.5T
or, ` 7.5 T = `60-`37.5
or, ` 7.5 T = ` 22.5
or, T = 3 hours.
ILLUSTRATION 11
A factory having the latest sophisticated machines wants to introduce an incentive scheme
for its workers, keeping in view the following:
(i) The entire gains of improved production should not go to the workers.
(ii) In the name of speed, quality should not suffer.
(iii) The rate setting department being newly established are liable to commit mistakes.
You are required to PREPARE a suitable incentive scheme and DEMONSTRATE by an
illustrative numerical example how your scheme answers to all the requirements of the
management.
SOLUTION
Rowan Scheme of premium bonus (variable sharing plan) is a suitable incentive
scheme for the workers of the factory. If this scheme is adopted, the entire gains
due to time saved by a worker will not pass to him.
Another feature of this scheme is that a worker cannot increase his earnings or
bonus by merely increasing its work speed. The reason for this is that the bonus under

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 3.32 COST AND MANAGEMENT ACCOUNTING

Rowan Scheme is maximum when the time taken by a worker on a job is half of the
time allowed. As this fact is known to the workers, therefore, they work at such a
speed which helps them to maintain the quality of output too.
Lastly, Rowan System provides a safeguard in the case of any loose fixation of the
standards by the rate-setting department. It may be observed from the following
illustration that in the Rowan Scheme the bonus paid will be low due to any loose
fixation of standards. Workers cannot take undue advantage of such a situation.
The above three features of Rowan Plan can be discussed with the help of the
following illustration:
(i) Time allowed = 4 hours
Time taken = 3 hours
Time saved = 1 hour
Rate = `5 per hour
Time taken
Bonus = × Time saved × Rate
Time allowed
3 hours
= × 1 hour × `5 = `3.75
4 hours
In the above illustration time saved is 1 hour and, therefore, total gain is ` 5. Out
of `5 according to Rowan Plan only `3.75 is given to the worker in the form of
bonus and the remaining ` 1.25 remains with the management. In other words,
a worker is entitled for 75 percent of the time saved in the form of bonus.
(ii) The figures of bonus in the above illustration when the time taken is 2 hours and
1 hour respectively are as below:
Time taken
Bonus = × Time saved × Rate
Time allowed
2 hours
= × 2 hours × `5 = `5
4 hours
1 hours
= × 3 hours × `5 = `3.75
4 hours
The above figures of bonus clearly show that when time taken is half of the time
allowed, the bonus is maximum. When the time taken is reduced from 2 to 1
hour, the bonus figure fell by `1.25. Hence, it is quite apparent to workers that it
is of no use to increase speed of work. This feature of Rowan Plan thus protects
the quality of output.

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 EMPLOYEE COST 3.33

(iii) If the rate-setting department erroneously sets the time allowed as 10 hours instead
of 4 hours, in the above illustration; then the bonus paid will be as follows:
3 hours
Bonus = × 7 hours × `5 = `10.50
10 hours
The bonus paid for saving 7 hours thus is `10.50 which is approximately equal to the
wages of 2 hours. In other words, the bonus paid to the workers is low. Hence workers
cannot take undue advantage of any mistake committed by the time setting
department of the concern.

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 3.34 COST AND MANAGEMENT ACCOUNTING

3.9 ABSORPTION OF WAGES

3.9.1 Elements of wages
In common parlance, the term ‘wages’ represents monetary payment which an
employee receives at regular intervals for the services rendered. Strictly speaking,
however, from the point of view of the employer and the cost to the industry, wages
should be taken to include also non-monetary benefits which an employee receives
by virtue of employment. Such 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.
Such benefits are generally given in an industrial establishment. In some cases, the
provision of benefits is compulsory. Therefore, while computing the wage cost per
worker, the monetary value of such non-monetary benefits should also be taken
into account.
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 conditions or methods
of manufacture.
Dearness allowance is an allowance provided to cover the increase in cost of living
from one period to another. This allowance is calculated either as percentage of
the basic wage or as a fixed amount for the days worked. In either case, the
percentage or the fixed amount is subject to revision whenever the cost of living
index or consumer price Index rises or falls by a certain figure as agreed to by the
employer with the Employee union. When permanent rise in the cost of living index
occurs, a part of the dearness allowance is often absorbed in the basic wage.

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 EMPLOYEE COST 3.35

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 quantum of
profits calculated as per the Act.
3.9.2.Component of wages cost or wages for costing purposes
In addition to wages (including allowances, such as D.A.) that are paid to workers,
a firm may have to spend on many other items (such as premium to the ESI or
provident fund or bonus).
Further, the worker does not spend all the time for which he is paid on productive
work.
This is because he is entitled to weekly holiday and various type of leave. There is
also a certain amount of unavoidable idle time. The question is to what extent such
additional payment or cost in respect of Employee can be charged directly to unit
of cost as part of direct Employee cost? Of course, in the case of indirect Employee,
all such payments as also the wages paid to them, must be treated as part of
overheads.
But in the case of direct workers, two alternatives are possible. The additional
charges may be treated as overheads. Alternatively, the wage rates being charged
to job may be computed by including such payments; automatically then, such
payments will be charged to the work done along with wages of the worker. (It
should be remembered that such wage rate will be only for costing purposes and
not for payment to workers). The total of wages and additional payment should be
divided by effective hours of work to get such wage rates for costing purposes.
ILLUSTRATION 12
A worker is paid ` 10,000 per month and a dearness allowance of ` 2,000 p.m. Worker
contribution to provident fund is @ 10% and employer also contributes the same
amount as the employee. The Employees State Insurance Corporation premium is
6.5% of wages of which 1.75% is paid by the employees. It is the firm’s practice to
pay 2 months’ wages as bonus each year.

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 3.36 COST AND MANAGEMENT ACCOUNTING

The number of working days in a year are 300 of 8 hours each. Out of these the worker is
entitled to 15 days leave on full pay. CALCULATE the wage rate per hour for costing
purposes.
SOLUTION

(`)
Wages paid to worker during the year {(` 10,000 +2,000) × 12} 1,44,000
Add: Employer Contribution to:
Provident Fund @ 10% 14,400
E.S.I. Premium @ 4.75% (6.5 – 1.75) 6,840
Bonus at 2 months’ wages (Basic + DA) 24,000
Total 1,89,240

Effective hours per year: 285 days × 8 hours = 2,280 hours

Wage-rate per hour (for costing purpose): ` 1,89,240/2,280 hours = ` 83
3.9.3 Holiday and leave wages
One alternative to account for wages paid on account of paid holiday and leave
can be to include them as departmental overheads. In such a case, it is necessary to
record such wages separately from “worked for wages”. Such a segregation can be
made possible by providing a separate column in the payroll for holiday and leave
wages in the same way as there are columns for dearness allowance, provident fund
deductions, etc. 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.
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.
ILLUSTRATION 13
CALCULATE the Employee hour rate of a worker X from the following data:
Basic pay ` 10,000 p.m.
D.A. ` 3,000 p.m.
Fringe benefits ` 1,000 p.m.
Number of working days in a year 300. 20 days are availed off as holidays on full pay in
a year. Assume a day of 8 hours.

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 EMPLOYEE COST 3.37

SOLUTION
(i) Effective working days in a year 300
Less: Leave days on full pay 20
Effective working days 280 days
Total effective working hours (280 days × 8 hours) 2,240
(ii) Total wages paid in a year (`)
Basic pay 1,20,000
D.A. 36,000
Fringe benefits 12,000
1,68,000
(iii) Hourly rate : `1,68,000/2,240 hours ` 75.00
3.9.4 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.
3.9.5 Absorption rates of Employee cost:
Employee cost as stated above include monetary compensation and non-monetary
benefits to workers.
Monetary benefits include, basic wages, D.A., overtime pay, incentive or production
bonus contribution to employee provident fund, House Rent Allowance, Holiday
and vacation pay etc.
The non-monetary benefits include medical facilities, subsidized canteen services,
subsidized housing, education and training facilities.
Accounting of monetary and non-monetary benefits to indirect workers does not
pose any problems because the total of monetary and non-monetary benefits are
treated as overhead and absorbed on the basis of rate per direct employee hour, if
overheads are predominantly employee oriented.
For direct workers, the ideal method is to charge jobs or units produced by
supplying per hour rate calculated as below:
Total estimated monetarybenefits and costof non monetary benefits
Rate per hour =
Budgeted direct employee hour-Normal idletime

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 3.38 COST AND MANAGEMENT ACCOUNTING

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.

3.10 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.
Time allowed as per standard
Efficiency in % = ×100
Time Taken
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. Computation of efficiency rating: The efficiency rating of each worker can
be computed by using the above-mentioned Formula.
3.10.1 Need for efficiency rating
1. As discussed earlier 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 efficiency level.
2. The efficiency rating also helps the management in preparing employee
requirement budget or for preparing manpower requirements.
Example - 2: P Ltd. manufactures two products by using one grade of
employees. The following estimates are available:

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 EMPLOYEE COST 3.39

Product- A Product- B
Budgeted production (units) 3,480 4,000
Standard hours allowed per product 5 4

It is further worked out that the efficiency rating (efficiency ratio) for productive
hours worked by direct workers in actually manufacturing the production is 80%
then the exact standard employee-hours requirement can be worked out as
follows:

Product- A Product- B Total

Budgeted production 3,480 4,000
(units)
Standard hours allowed 17,400 16,000 33,400
for budgeted production (3,480 units × 5 hours) (4,000 units × 4 hours)

Since efficiency ratio is given as 80% therefore standard employee hours

 100 
required for 100% efficiency level is  33, 400 hours×  = 41,750 hours.
 80 

Employee Productivity: Productivity is generally determined by the input/output

ratio. In case of employees, it is calculated as below:
Standard timefor doing actual work
Actual timetaken

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.

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 3.40 COST AND MANAGEMENT ACCOUNTING

4. Taking appropriate measures to avoid the situation of excess or shortage of

employees.
5. Carrying out work study for fixation of wages and for the simplification and
standardisation of work.

3.11 EMPLOYEE (LABOUR) TURNOVER

3.11.1 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.
The standard of usual employee turnover in the industry or locality or the employee
turnover rate for a past period may be taken as the index or norm against which
actual turnover rate is compared.
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
×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
×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:

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 EMPLOYEE COST 3.41

Number of employeesSeparated+
Number of employees Replaced during the period
×100
Average number of employees during the period on roll

Employee turnover due to new recruitment: Generally, employees recruited on

account of expansion of an organisation, are not considered for calculation of
employee turnover. But it is considered that the newly recruited employees are also
responsible for changes in the composition or work force. Due to this feature, some
management accountants feel to take new recruitment for calculating employee
turnover. 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 of the
following expressions:
No. of Separation+ No. of Replacements+No. of new Joinings
×100
Average no. of employees duringthe period on roll
Or
No. of Separations+No. of Accessions
×100
Average no. 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 annual
employee turnover rate by using the following formula:

Employee Turnover rate for the period

×365
Number of days inthe period

ILLUSTRATION 14
The Accountant of Y Ltd. has computed employee turnover rates for the quarter ended
31st March, 2021 as 10%, 5% and 3% respectively under ‘Flux method’, ‘Replacement

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 3.42 COST AND MANAGEMENT ACCOUNTING

method’ and ‘Separation method’ respectively. If the number of workers replaced during
that quarter is 30, FIND OUT the number of workers for the quarter
(i) recruited and joined and (ii) left and discharged and (iii) Equivalent employee turnover
rates for the year.
SOLUTION
Working Note:
Average number of workers on roll (for the quarter):
Employee Turnover rate using Replacement method
No. of replacements
= ×100
Average number of workers on roll
5 30
Or, =
100 Average number of workers on roll
30×100
Or, Average number of workers on roll = = 600
5
(i) Number of workers recruited and joined:
Employee turnover rate (Flux method)
No. of Separations * (S)+No. of Accessions(A)
=
Average number of workers on roll

10 18 *+A  6000 
Or, = Or, A = − 80  = 42
100 600  100 
No. of workers recruited and joined 42.
(ii) Number of workers left and discharged:
Employee turnover rate (Separation method)
No. of Separations(S) 3 S
= × 100 = = Or, S* = 18
Average number of workers on roll 100 600

Hence, number of workers left and discharged comes to 18

(iii) Calculation of Equivalent employee turnover rates:
Employee Turnover ratefor thequarter(s)
= ×4 quarters
Number of quarter(s)

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10%
Using Flux method = ×4 = 40%
1
5%
Using Replacement method = ×4 = 20%
1
3%
Using Separation method = ×4 = 12%
1
3.11.2 Causes of Employee (Labour) Turnover:
The reasons for employee turnover in an organisation can be classified under the
following 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.
In all the above cases the employee leaves the organisation at his will and,
therefore, it is difficult to suggest any possible remedy in the first three cases.
But the last one can be overcome by creating conditions leading to a healthy
working environment. For this, officers should play a positive role and make sure
that their subordinates work under healthy working conditions.
(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;

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 3.44 COST AND MANAGEMENT ACCOUNTING

(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:
(1) Dissatisfaction with job, remuneration, hours of work, working conditions, etc.,
(2) Strained relationship with management, supervisors or fellow workers;

(3) Lack of training facilities and promotional avenues;

(4) Lack of recreational and medical facilities;
(5) Low wages and allowances.
Proper and timely management action can reduce the employee turnover
appreciably so far as avoidable causes are concerned.
3.11.3 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 is
low 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 keep it
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

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 EMPLOYEE COST 3.45

experience of good work, additional costs will have to be incurred on new workers,
i.e., cost of recruitment, training and induction, abnormal breakage and scrap and
extra wages and overheads due to the inefficiency of new workers.
It is obvious that 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. Each company must, therefore, work out the
optimum level of Employee turnover keeping in view its personnel policies and the
behaviour of replacement cost and preventive costs at various levels of Employee
turnover rates.
ILLUSTRATION 15
The management of B.R Ltd. is worried about their increasing employee turnover in
the factory and before analyzing the causes and taking remedial steps; it wants to
have an idea of the profit foregone as a result of employee turnover in the last year.
Last year sales amounted to ` 83,03,300 and P/V ratio was 20 per cent. The total number of
actual hours worked by the direct employee force was 4.45 lakhs. The actual direct employee
hours included 30,000 hours attributable to training new recruits, out of which half of the
hours were unproductive. As a result of the delays by the Personnel Department in filling
vacancies due to employee turnover, 1,00,000 potentially productive hours (excluding
unproductive training hours) were lost.
The costs incurred consequent on employee turnover revealed, on analysis, the
following:
Settlement cost due to leaving ` 43,820
Recruitment costs ` 26,740
Selection costs ` 12,750
Training costs ` 30,490
Assuming that the potential production lost as a consequence of employee turnover
could have been sold at prevailing prices, FIND the profit foregone last year on
account of employee turnover.
SOLUTION
Workings:
(i) Computation of productive hours
Actual hours worked (given) 4,45,000

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 3.46 COST AND MANAGEMENT ACCOUNTING

Less: Unproductive training hours 15,000

Actual productive hours 4,30,000
(ii) Productive hours lost:
Loss of potential productive hours + Unproductive training hours
= 1,00,000 + 15,000 = 1,15,000 hours
(iii) Loss of contribution due to unproductive hours:
Sales value
= ×Total unproductive hours
Actual productive hours

` 83,03,300
= × 1,15,000 hours = `22,20,650
4,30,000 hrs
` 22,20,650
Contribution lost for 1,15,000 hours = ×20 = `4,44,130
100
Computation of profit forgone on account of employee turnover

(`)
Contribution foregone (as calculated above) 4,44,130
Settlement cost due to leaving 43,820
Recruitment cost 26,740
Selection cost 12,750
Training costs 30,490
Profit foregone 5,57,930

SUMMARY
Employee Cost: Benefits paid or payable to the employees of an entity, whether
permanent or temporary for the services rendered by them. Employee cost includes
payments made in cash or kind.
Direct Employee (Labour) Cost: Benefits paid or payable to the employees which
can be attributed to a cost object in an economically feasible manner.
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.

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 EMPLOYEE COST 3.47

Idle Time: The time for which the employer pays but obtains no direct benefit or
for no productive purpose.
Normal Idle Time: Time which cannot be avoided or reduced in the normal course
of business. The cost of normal idle time should be charged to the cost of
production.
Abnormal Idle Time: It arises on account of abnormal causes and should be
charged to Costing Profit and Loss account.
Time Keeping: It refers to recording and keeping of the employees’ attendance
time.
Time Booking: It is basically recording the details of work done and the time spent
by an employee on each job or process.
Overtime: Payment to employees, when an employee works beyond the normal
working hours. Usually overtime has to be paid at double the rate of normal hours.
Overtime Premium: It’s the amount of extra payment paid to an employee for
extra work.
Employee (Labour) Turnover: It is the rate of change in employee force during a
specified period due to resignation, retirement and retrenchment. If the employee
turnover is high, it’s a sign of instability and may affect the profitability of the firm.
Employee (Labour) turnover can be measured through the following methods:
(i) Replacement Method:
Number of employees replaced
×100
Average number of employees on roll

(ii) Separation Method:

Number of employees separated during the year
×100
Average number of employees on rolls during the period

(iii) Flux Method

Number of employees separated+number of employees replacements
×100
Average number of employees on rolls during the period

(iv) Employee turnover due to new recruitment:

Number of new employees joining in a period (excluding replacements)
×100
Average number of employees on the roll in a period

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 3.48 COST AND MANAGEMENT ACCOUNTING

(v) Employee turnover including accessions:

No. of Separation+ No. of Replacements+No. of new Joinings
×100
Average no. of employees duringthe period on roll

OR
Number of separations + number of accessions
×100
Average number of employees

Time Rate System: The system of wage payment where wages to an employee is
paid on the basis of time irrespective of production volume.
Straight Piece Work: The system of wage payment where wages is paid on the
basis of number of units produced irrespective of time spent for production.
Calculation takes number of units produced by the employee multiplied by rate per
unit.
Halsey System: Time taken × Time rate + 50% of time saved × Time rate.

Rowan System: Time taken × Rate per hour + Time Saved × Time taken × Rate
Time allowed
per hour

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Idle time is the time under which-
(a) Full wages are paid to workers
(b) No productivity is given by the workers
(c) Both (a) and (b)
(d) None of the above
2. Cost of idle time due to non- availability of raw material is-
(a) Charged to overhead costs
(b) Charged to respective jobs
(c) Charged to costing profit and loss account
(d) None of the above
3. Time and motion study is conducted by-
(a) Time keeping department

© The Institute of Chartered Accountants of India

CHAPTER 4

OVERHEADS –
ABSORPTION COSTING
METHOD

LEARNING OUTCOMES
After studying this chapter, you would be able to-
 Discuss the meaning of Overheads- Production,
Administrative and Selling & Distribution.
 Discuss the meaning and methods of allocation,
apportionment and absorption of overheads.
 Discuss the meaning and treatment of under-absorption and
over-absorption of overheads and apply the same in cost
computation.
 State the accounting and control of administrative, selling
and distribution overheads.
 Discuss and apply the various methods to calculate overhead
rate.

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 4.2 COST AND MANAGEMENT ACCOUNTING

4.1 INTRODUCTION
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 e.g., wages paid to watch and ward staff, heating and
lighting expenses of factory etc. Overheads are also very important cost element
along with direct materials and direct employees. Often in a manufacturing
concern, overheads exceed direct wages or direct materials and at times even both
put together. On this account, it would be a grave mistake to ignore overheads
either for the purpose of arriving at the cost of a job or a product or for controlling
total expenditure.
Overheads also represent expenses that have been incurred in providing certain
ancillary facilities or services which facilitate or make possible the carrying out of
the production process; by themselves these services are not of any use. For
instance, a boiler house produces steam so that machines may run and, without the
generation of steam, production would be seriously hampered. But if machines do
not run or do not require steam, the boiler house would be useless and the
expenses incurred would be a waste.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.3

Overheads are incurred not only in the factory of production but also on
administration, selling and distribution.

4.2 CLASSIFICATION OF OVERHEADS

Description Example
By Function
Factory or Manufacturing overhead is (i) Stock keeping expenses,
Manufacturing the indirect cost incurred for (ii) Repairs and maintenance of
or Production manufacturing or production plant, (iii) Depreciation of
Overhead activity in a factory. factory building, (iv) Indirect
Manufacturing overhead labour, (v) cost of primary
includes all expenditures packing (vi) Insurance of plant
incurred from the procurement and machinery etc. Production
of materials to the completion overhead includes
of finished product. administration costs relating
to production, factory, works
or manufacturing.
Office and Office and Administrative (i) Salary paid to office
Administrative overheads are expenditures staffs, (ii) Repairs and
Overheads incurred on all activities maintenance of office building,
relating to general (iii) Depreciation of office
management and building (iv) postage and
administration of an stationery, (v) Lease rental in
organisation. It includes case of operating lease (in case
formulating the policy, of finance lease, lease rental
directing the organisation excluding finance cost) (vi)
and controlling the accounts and audit expenses
operations of an undertaking etc.
which is not related directly to
production, selling, distribu-
tion, research or development
activity or function.
Selling and (i) Selling overhead: expenses (i) Salesmen commission, (ii)
Distribution related to sale of products Advertisement cost, (iii) Sales
Overheads and include all indirect office expenses etc.
expenses in sales

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 4.4 COST AND MANAGEMENT ACCOUNTING

management for the

organisation. (i) Delivery van expenses,
(ii) Distribution overhead: cost (ii) Transit insurance, (iii)
incurred on making product warehouse and cold storage
available for sale in the expenses, (iv) secondary
market. packing expenses etc.
By Nature
Fixed These are the costs which are (i) Salary paid to permanent
Overhead incurred for a period, and employees,
which, within certain output (ii) Depreciation of building
and turnover limits, tend to be and plant and equipment, (iii)
unaffected by fluctuations in Interest on capital, (iv)
the levels of activity (output Insurance.
or turnover). They do not tend
to increase or decrease with
the changes in output.
Variable These costs tend to vary with (i) Indirect materials, (ii) Power
Overhead the volume of activity. Any and fuel, (iii) lubricants, (iv)
increase in the activity results tools and spares etc.
in an increase in the variable
cost and vice-versa.
Semi-Variable These costs contain both fixed (i) Electricity cost, (ii) water
Overheads and variable components and cost, (iii) telephone and
are thus partly affected by internet expenses etc.
fluctuations in the level of
activity.
By Element
Indirect Materials which do not (i) Stores used for maintaining
materials normally form part of the machines and buildings
finished product (cost object) (lubricants, cotton waste,
are known as indirect bricks etc.) (ii) Stores used by
materials. service departments like power
house, boiler house, canteen
etc.
Indirect Employee costs which cannot (i) Salary paid to foreman and
employee cost be allocated but can be supervisor.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.5

apportioned to or absorbed (ii) Salary paid to

by cost units or cost centres is administration staff etc.
known as indirect employee.
Indirect Expenses other than direct (i) Rates & taxes, (ii) insurance,
expenses expenses are known as (iii) depreciation, (iv)
indirect expenses, that cannot advertisement expenses etc.
be directly, conveniently and
wholly allocated to cost
centres.
By Control
Controllable These are those costs which (i) Materials cost, (ii) wages and
costs can be controlled by the salary, (iii) power and fuel etc.
implementation of
appropriate managerial
influence and proper policies.
Uncontrollable Overhead costs which cannot (i) Rates and taxes, (ii)
costs be controlled by the Depreciation, (iii) Interest on
management even after the borrowings.
implementation of
appropriate managerial
influence and proper polices
are known as uncontrollable
costs.
4.2.1 Advantages of Classification of Overheads into Fixed and Variable
The primary objective of segregating semi-variable expenses into fixed and variable
is to ascertain marginal costs. Besides this, it has the following advantages also.
(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. They are incurred irrespective of the output and
hence are more or less non controllable. Variable expenses vary with the volume
of activity and the responsibility for incurring such expenditure is determined in
relation to the output. The management can control these costs by giving proper
allowances in accordance with the output achieved.
(b) Preparation of Budget Estimates: The segregation of overheads into fixed and
variable part helps in the preparation of flexible budget. It enables a firm to

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 4.6 COST AND MANAGEMENT ACCOUNTING

estimate costs at different levels of activity and make comparison with the actual
expenses incurred.
Suppose in October, 2021 the output of a factory was 1,000 units and the
expenses were:
(`)
Fixed 5,00,000
Variable 4,00,000
Semi-variable (40% fixed) 6,00,000
15,00,000
In November, 2021 the output was likely to increase to 1,200 units. In that case
the budget or estimate of expenses will be:
(`)
Fixed 5,00,000
 ` 4,00,000 ×1,200 units 
Variable   4,80,000
 1,000 units 
Semi-variable
Fixed, 40% of ` 6,00,000 2,40,000

 ` 3,60,000 ×1,200 units 

Variable:   4,32,000
 1,000 units 
16,52,000
It would be a mistake to think that with the output going up from 1,000 units to
1,200 units the expenses would increase proportionately to ` 18,00,000. This
would be wrong budgeting.
(c) Decision Making: The segregation of semi variable cost between fixed and
variable overhead also helps the management to take many important decisions.
For example, decisions regarding the price to be charged during depression or
recession or for export market. Likewise, decisions on make or buy, shut down
or continue, etc., are also taken after separating fixed costs from variable costs.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.7

In fact, when any change is contemplated, say, increase or decrease in production,

change in the process of manufacture or distribution, it is necessary to know the
total effect on cost (or revenue) and that would be impossible without a correct
segregation of fixed and variable costs. The technique of marginal costing, cost
volume profit relationship and break-even analysis are all based on such
segregation.

4.3 ACCOUNTING
4 AND CONTROL OF
MANUFACTURING OVERHEADS
We have already seen that overheads are by nature those costs which cannot be
directly related to a product or to any other cost unit. Yet for working out the total
cost of a product or a unit of service, the overheads must be included. Thus, we
have to find out a way by which the overheads can be distributed over the various
units of production.
One method of working out the distribution of overheads over the various products
could be to ascertain the amount of actual overheads and distribute them over the
products. This, however, creates a problem since the actual amount of overheads
can be known only after the financial accounts are closed. If we wait that long, the
cost sheets lose their main advantages and utility to the management. All the
decisions for which cost sheets are prepared are immediate decisions and cannot
be postponed till the actual overheads are known. Therefore, some method has to
be found by which overheads can be included in the cost of the products, as soon
as prime cost, the cost of raw materials, direct employees and other direct
expenses, is ascertained.
One method is to work out pre-determined rates for absorbing overheads.
These rates are worked out before an accounting period begins by estimating the
amount of overheads and the level of activity in the ensuing period. Thus, as soon
as the prime cost of a product or a job is available, the various overheads are
charged by these rates. Of course, this implies that the overheads are charged on
an estimated basis. Later, when the actual overheads are known, the difference
between the overheads charged to the products and actual overheads is worked
out and adjusted.
Manufacturing Overheads: Generally manufacturing overheads form a substantial
portion of the total overheads. It is important, that such overheads should be
properly absorbed over the cost of production. The following procedure may be
adopted in this regard. The steps given below shows how factory overhead rates

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 4.8 COST AND MANAGEMENT ACCOUNTING

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 traceability of the
overheads in an economically feasible manner.
Assignment of the manufacturing overhead is done on the basis of either of the
following two principles:
(i) Cause and Effect: Cause is the process or operation or activity and effect is
the incurrence of cost.
(ii) Benefit received: Manufacturing overheads are to be apportioned to various
cost objects in proportion to the benefits received by them.

(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. For example- if a separate power meter has been installed for a
department, the entire power cost ascertained from the meter is allocated to that
department. The salary of the works manager cannot be directly allocated to any
one department since he looks after the whole factory. It is, therefore, obvious that
many overhead items will remain unallocated after this step.
(b) Cost Apportionment: There are some items of estimated overheads (like the
salary of the works manager) which cannot be directly allocated to the various
departments and cost centres. Such unallocable expenses are to be spread over the
various departments or cost centres on the basis of two principles. This is called
apportionment. Thus, apportionment implies “the allotment of proportions of items
of cost to cost centres or departments”. After this stage, all the overhead costs would
have been either allocated to or apportioned over the various departments.
(c) Re-apportionment: Upto the last stage all overheads are allocated and
apportioned to all the departments- both production and service departments.

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Service departments are those departments which do not directly take part in
the production of goods or providing services. Such departments provide
auxiliary services across the entity and renders services to other cost centres and in
some cases to outside parties. Examples of such departments are engineering,
quality control and assurance, laboratory, canteen, stores, time office, dispensary
etc. The overheads of these departments are to be shared by the production
departments since service departments operate primarily for the purpose of
providing services to production departments. 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 in respective
departments. This process of recovering overheads of a department or any other
cost center from its output is called recovery or absorption.
Absorption of manufacturing overheads shall be as follows:
(i) Variable Manufacturing overheads: The variable manufacturing overheads
shall be absorbed on the basis of actual production.
(ii) Fixed Manufacturing overheads: The fixed manufacturing overhead shall be
absorbed on the basis of normal capacity.

The overhead expenses can be absorbed by estimating the overhead (as assigned
above) and then working out an absorption rate. When overheads are estimated,
their absorption is carried out by adopting a pre-determined overhead absorption
rate. This rate can be calculated by using any one method as discussed in this
chapter at the end.
As the actual accounting period begins, each unit of production automatically
absorbs a certain amount of factory overheads through pre-determined rates.
During the year a certain amount will be absorbed over the various products. This
is known as the total amount of absorbed overheads.
4. Treatment of over and under absorption of overheads: After the year end
the total amount of actual factory overheads is known. There is bound to 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. The difference has to be adjusted keeping in view of such differences
and the reasons therefore.

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 4.10 COST AND MANAGEMENT ACCOUNTING

Students will thus see that the whole discussion as above is meant to serve the
following two purposes:
(a) to charge various products and services with an equitable portion of the total
amount of factory overheads; and
(b) to charge factory overheads immediately as the product or the job is completed
without waiting for the figures of actual factory overheads.

4.4 STEPS FOR THE DISTRIBUTION OF

OVERHEADS
The various steps for the distribution of overheads have been discussed in detail as
below:

Estimation of overheads:
Allocation of overheads:
By standing
Orders Apportionment of overheads:
Directly
Through Re-apportionment
apportionment of
attributable to
budgeting department/ On the basis of overheads:
process cost cenres Benefit Absorption:
received Service
department to
On the basis of Production By actual units
cause & effect departments at
predetermined
Other suitable
rate
basis

4.4.1 Estimation and Collection of Overheads

The amount of overheads is required to be estimated. The estimation is usually
done with reference to past data adjusted for known future changes. The overhead
expenses are usually collected through a system of standing orders.
Standing Orders: In every manufacturing business, expenses are incurred on direct
materials and direct labour in respect of several jobs or other units of production.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.11

Incurrence of these expenses are authorised by production orders or work orders.

The term “Standing Order” denotes sanction for indirect expenses under various
heads of expenditure.
In large factories, usually the classification of indirect expenditures is combined
with a system of Standing Orders (sometimes also referred as Service “Orders”). 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. The extent
of such analysis and the nomenclature adopted are settled by the management
according to the needs of the industry.
4.4.2 Allocation of Overheads over various Departments or
Departmentalisation of Overheads
Most of the manufacturing processes functions are performed in different
departments of a factory. Some of the departments of the factory are engaged in
production process while few may function as ancillary departments. The ancillary
departments are service departments supporting the production departments in
manufacturing, administration, selling & distribution of goods or services.
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. It is thus obvious that the principal object of setting
up cost centres is to collect data, in respect of similar activities more conveniently.
This avoids a great deal of cost analysis. When costs are collected by setting up
cost centres, several items can be ascertained definitely and the element of
estimation is reduced considerably. For instance, the allowance of the normal idle
time or the amount to be spent on consumable stores, etc. There are two main
types of cost centres - machine or personal - depending on whether the process of
manufacture is carried on at a centre by man or machine. For the convenience of
recording of expenditure, cost centres are sometimes allotted a code number.
Advantages of Departmentalisation: The collection of overheads department
wise gives rise to the following advantages:
(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

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 4.12 COST AND MANAGEMENT ACCOUNTING

separately available. It is one of the main principles of control that one should
know for each activity how much should have been spent and how much is
actually spent. If information about expenses is available only for factory as a
whole, it will not be possible to know which department has been over
spending.
(c) Ascertainment of Cost for each department: From the point of view of
ascertaining the cost of each job, the expenses incurred in the departments
through which the job or the product has passed should be known. It is only
then that the cost of the job or the product can be charged with the
appropriate share of indirect expenses. 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 that
only 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 manu-
factured, but single or output costing when the product is assembled.
4.4.3 Apportioning overhead expenses over various departments
Overheads which are related to more than one department are required to be
distributed between/ among the departments. This distribution of overheads
between/ among the departments is called apportionment. The example of
overheads may include e.g. rent of building, power, lighting, insurance,
depreciation etc. 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 that
may be adopted for the apportionment of expenses are stated below:

Overhead Cost Bases of Apportionment

1. (i) Rent and other building Floor area, or volume of department
expenses
(ii) Lighting and heating
(conditioning)

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 OVERHEADS- ABSORPTION COSTING METHOD 4.13

(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 maintenance
of 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 Metered
units
8. Electric power (machine Horse power of machines, or Number of
operation) machine hour, or value of machines or
units consumed.
9. (i) Material handling Weight of materials, or volume of
(ii) Stores overhead materials, or value of materials or unit of
materials.

Some other basis of apportioning overhead costs: We have considered already

that the benefit received by the department generally is the principal criterion on

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 4.14 COST AND MANAGEMENT ACCOUNTING

which the costs of service departments or common expenses are apportioned. But
other bases of apportionments which may be used are mentioned below:
(a) Analysis or survey of existing conditions.
(b) Ability to pay.
(c) Efficiency or incentive.
A concern may have predominantly only one criterion or may use all (including the
service or benefit criterion) for different phases of its activity.
Analysis or Survey of existing conditions: At times it may not be possible to
determine the advantage of an item of expenses without undertaking an analysis of
expenditure. For example, lighting expenses can be distributed over departments only
on the basis of the number of light points fixed in each department.
Ability to pay: It is a principle of taxation which has been applied in cost accounting
as well for distributing the expenditure on the basis of income of the paying
department, on a proportionate basis. For example, if a company is selling three
different products in a territory, it may decide to distribute the expenses of the sales
organisation to the amount of sales of different articles in these territories. This basis,
though simple to apply, may be inequitable since the expenditure charged to an article
may have no relation to the actual effort involved in selling it. Easy selling lines thus
may have to bear the largest proportion of expenses while, on the other hand, these
should bear the lowest charge.
Efficiency or Incentives: Under this method, the distribution of overheads is made
on the basis of pre-determined levels of production or sales. When distribution of
overhead cost is made on this basis and if the level of production exceeds the pre-
determined level of production the incidence of overhead cost gets reduced and
the total cost per unit of production or of sales, lowered. The opposite is the effect
if the assumed levels are not reached.
Thus, the department whose sales are increasing is able to show a greater profit
and thereby is able to earn greater goodwill and appreciation of the management
than it would have if the distribution of overheads was made otherwise.
Difference between Allocation and Apportionment
The difference between the allocation and apportionment is important to
understand because the purpose of these two methods is the identification of the
items of cost to cost units or centers. However, the main difference between the
above methods is given below.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.15

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

(3) The allocation or apportionment of an expense is not dependent on its nature,

but the relationship between the expense and the cost centre decides that
whether it is to be allocated or apportioned.
(4) Allocation is a much wider term than apportionment.
4.4.4 Re-apportionment of service department overheads over
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,
2. Planning and progress Direct labour wages, Asset value x Hours
worked
3. Tool room
4. Canteen and Welfare No of direct workers
5. Hospital and Dispensary No. of employees etc.
6. Personnel Department
7. Time-keeping No. of card punched, No. of employees

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 4.16 COST AND MANAGEMENT ACCOUNTING

8. Computer Section Computer hours, Specific allocation to

departments
9. Power House (electric lighting Floor area, Cubic content, No. of electric
cost) 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

Notes:
(1) Repairs included in repairs shop cost, building maintenance cost included in
maintenance shop cost etc. should be apportioned on the basis of capital values.
(2) Economy, practicability, equitability and reliability are the matters of
consideration for selection of the base.
Methods for Re-apportionment: The re-apportionment of service department
expenses over the production departments may be carried out by using any one of
the following methods:
(i) Direct re-distribution method.
(ii) Step method of secondary distribution or non-reciprocal method.
(iii) Reciprocal Service method.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.17

Direct re-distribution
method

Methods for Re- Step method or non- Simultaneous Equation

apportionment reciprocal method. method

Reciprocal Service
Trial and error method
method

Repeated distribution
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. To understand the applications
of this method, go through the illustration which follows.
ILLUSTRATION 1
XL Ltd. has three production departments and four service departments. The expenses for
these departments as per Primary Distribution Summary are as follows:
Production Departments: (`) (`)
Dept.-A 30,00,000
Dept.-B 26,00,000
Dept.-C 24,00,000 80,00,000
Service Departments: (`) (`)
Stores 4,00,000
Time-keeping and Accounts 3,00,000
Power 1,60,000
Canteen 1,00,000 9,60,000
The following information is also available in respect of the production departments:
Dept. A Dept. B Dept. C
Horse power of Machine 300 300 200
Number of workers 20 15 15
Value of stores requisition in (`) 2,50,000 1,50,000 1,00,000
PREPARE a statement apportioning the costs of service departments over the production
departments using direct re-distribution method.

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 4.18 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Secondary Overhead Distribution Statement

Items of cost Basis of Total Production Departments

(as per primary apportionment (`) A (`) B (`) C (`)
distribution
summary)
Cost as per primary 80,00,000 30,00,000 26,00,000 24,00,000
distribution
summary
Stores (5:3:2) Value of Store 4,00,000 2,00,000 1,20,000 80,000
requisition
Time-keeping and No. of workers 3,00,000 1,20,000 90,000 90,000
Accounts (4:3:3)
Power (3:3:2) H.P. of Machine 1,60,000 60,000 60,000 40,000
Canteen (4:3:3) No. of workers 1,00,000 40,000 30,000 30,000
89,60,000 34,20,000 29,00,000 26,40,000

(ii) Step Method or Non-reciprocal method: This method gives cognizance to the
services rendered by service department to another service department. Therefore, as
compared to previous method, this method is more complicated because a sequence
of apportionments has to be selected here. The sequence here begins with the
department that renders maximum number of services to the other service
department(s). In other words, the cost of the service department that serves the
largest number of services to the other service department(s) and production
department(s) is distributed first. After this, the cost of service department serving the
next largest number of departments is apportioned.
This process continues till the cost of last service department is apportioned. The cost
of last service department is apportioned among production departments only.
Some authors are of the view that the cost of service department with largest
amount of cost should be distributed first.

© The Institute of Chartered Accountants of India

 OVERHEADS- ABSORPTION COSTING METHOD 4.19

ILLUSTRATION 2
Suppose the expenses of two production departments A and B and two service
departments X and Y are as under:
Department Amount (`) Apportionment Basis
Y A B
Dept.-X 2,00,000 25% 40% 35%
Dept.-Y 1,50,000 — 40% 60%
Dept.-A 3,00,000
Dept.-B 3,20,000
PREPARE a statement apportioning the costs of service departments over the
production departments using step method.
SOLUTION
Summary of Overhead Distribution
Departments X (`) Y (`) A (`) B (`)
Amount as given above 2,00,000 1,50,000 3,00,000 3,20,000
Expenses of service (2,00,000) 50,000 80,000 70,000
dept.-X is apportioned
among other
departments- Y, A and B
in the ratio (5:8:7)
2,00,000 3,80,000 3,90,000
Expenses of Dept. -Y - (2,00,000) 80,000 1,20,000
apportioned between
department A and B in
the ratio (2:3)
Total Nil Nil 4,60,000 5,10,000
(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;

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 4.20 COST AND MANAGEMENT ACCOUNTING

(b) Trial and error method;

(c) Repeated distribution method.

Reciprocal Service Method

Simultaneous Equation Trial and error Repeated distribution

Method Method Method

(a) Simultaneous Equation Method:

According to this method firstly, the costs of service departments are ascertained.
These costs are then re-distributed to production departments on the basis of given
percentages. (Refer to the following illustration to understand the method)
ILLUSTRATION 3
Service departments’ expenses

(`)
Boiler house 3,00,000
Pump room 60,000
Total 3,60,000

The allocation basis is:

Production Department Service Department

A B Boiler House Pump Room
Boiler House 60% 35% - 5%
Pump Room 10% 40% 50% -
SOLUTION
The total expenses of the two service departments will be determined as follows:
Let B stand for Boiler House expenses and P for Pump Room expenses.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.21

Then
B = 3,00,000 + 0.50 P
P = 60,000 + 0.05 B
Substituting the value of B,
P = 60,000 + 0.05 (3,00,000 + 0.5 P)
= 60,000 + 15,000 + 0.025 P
= 75,000 + 0.025 P
P - 0.025P = 75,000
75,000
P =
0.975
P = `76,923
The total of expenses of the Pump Room is `76,923 and that of the Boiler House is
`3,38,462 i.e., `3,00,000 + 0.5 × ` 76,923.
The expenses will be allocated to the production departments as under:

Production Department
Dept.-A Dept.-B
Boiler House (60% and 35% of ` 3,38,462) 2,03,077 1,18,462
Pump Room (10% and 40% of ` 76,923) 7,692 30,769
Total 2,10,769 1,49,231
The total of expenses apportioned to A and B is ` 3,60,000.
(b) Trial and Error Method:
According to this method the cost of one service cost centre is apportioned to
another service cost centre. The cost of another service centre plus the share
received from the first cost centre is again apportioned to the first cost centre. This
process is repeated till the amount to be apportioned becomes negligible, that
means repeated distribution method is followed to the extent of service
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. (Refer to the following
illustration to understand this method.)

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 4.22 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 4
Sanz Ltd. is a manufacturing company having three production departments, ‘A’, ‘B’ and ‘C’
and two service departments ‘X’ and ‘Y’. The following is the budget for December 2021:

Total (`) A (` ) B (`) C (`) X (` ) Y (` )

Direct material 1,00,000 2,00,000 4,00,000 2,00,000 1,00,000

Direct wages 5,00,000 2,00,000 8,00,000 1,00,000 2,00,000
Factory rent 4,00,000
Power 2,50,000
Depreciation 1,00,000
Other overheads 9,00,000
Additional information:
Area (Sq. ft.) 500 250 500 250 500
Capital value of assets 20 40 20 10 10
(` lakhs)
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25

A technical assessment of the apportionment of expenses of service departments is as under:

A B C X Y

Service Dept. ‘X’ (%) 45 15 30 – 10

Service Dept. ‘Y’ (%) 60 35 – 5 –

Required:
(i) PREPARE a statement showing distribution of overheads to various departments.
(ii) PREPARE a statement showing re-distribution of service departments expenses to
production departments using Trial and error method.

© The Institute of Chartered Accountants of India

 OVERHEADS- ABSORPTION COSTING METHOD 4.23

SOLUTION
(i) Overhead Distribution Summary

Basis Total (`) A (`) B (`) C (`) X (`) Y (`)

Direct Direct – – – – 2,00,000 1,00,000
materials
Direct wages Direct – – – – 1,00,000 2,00,000
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000
(2:1:2:1:2)
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000
(10:16:16:3:5) Machine
* Hrs.
Depreciation Capital 1,00,000 20,000 40,000 20,000 10,000 10,000
(2:4:2:1:1) value
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000
overheads hrs.
(1:2:4:1:1)
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000

*{(1000×50) : (2000×40) : (4000×20) : (1000×15) : (1000×25)}

(50000 : 80000 : 80000 : 15000 : 25000)

(ii) Redistribution of Service Department’s expenses:

Service Departments
X (`) Y (`)
Overheads as per primary distribution 4,75,000 5,35,000
(i) Apportionment of Dept-X expenses to Dept-Y
--- 47,500
(10% of ` 4,75,000)
--- 5,82,500
(ii) Apportionment of Dept-Y expenses to Dept-X
29,125 ---
[5% of (` 5,35,000 + ` 47,500)]
(i) Apportionment of Dept-X expenses to Dept-Y
--- 2,913
(10% of ` 29,125)

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 4.24 COST AND MANAGEMENT ACCOUNTING

(ii) Apportionment of Dept-Y expenses to Dept-X

146 ---
(5% of ` 2,913)
Total 5,04,271 5,85,413
Distribution of Service departments’ overheads to Production departments
Production Departments
A (`) B (`) C (`)
Overhead as per primary distribution 2,70,000 3,70,000 6,00,000
Dept- X (90% of ` 5,04,300) 2,26,900 75,600 1,51,300
Dept- Y (95% of ` 5,85,400) 3,51,300 2,04,900 ---
8,48,200 6,50,500 7,51,300

(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. (Refer to the following illustration to understand this
method)
ILLUSTRATION 5
Taking all the information from Illustration 4 above, PREPARE a statement showing re-
distribution of service departments’ expenses to production departments using repeated
distribution method. Also CALCULATE machine hour rates of the production departments
‘A’, ‘B’ and ‘C’.
SOLUTION
Redistribution of Service Department’s expenses using ‘repeated distribution
method’:

A (`) B (`) C (`) X (`) Y (`)

Total overheads {Refer (i) of 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000

Solution to Illustration 4}

Dept. X overhead apportioned in 2,13,750 71,250 1,42,500 (4,75,000) 47,500

the ratio (45:15:30: —:10)

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 OVERHEADS- ABSORPTION COSTING METHOD 4.25

Dept. Y overhead apportioned in 3,49,500 2,03,875 − 29,125 (5,82,500)

the ratio (60:35: —:5: —)

Dept. X overhead apportioned in 13,106 4,369 8,738 (29,125) 2,912

the ratio (45:15:30: —:10)

Dept. Y overhead apportioned in 1,747 1,019 − 146 (2,912)

the ratio (60:35: —:5: —)

Dept. X overhead apportioned in 65 22 44 (146) 15

the ratio (45:15:30: —:10)

Dept. Y overhead apportioned in 9 6 - - (15)

the ratio (60:35: —:5: —)

8,48,177 6,50,541 7,51,282 − −

Calculation of machine hour rate:

A B C

A Total overheads (`) 8,48,177 6,50,541 7,51,282

B Machine hours 1,000 2,000 4,000

C Machine hour rate (`) [A ÷ B] 848.18 325.27 187.82

4.4.5 Absorbing overheads over cost units, products, etc.

Collection of the figure of overheads for the factory as a whole or for various
departments is not enough. It is clearly necessary to ascertain how much of the
overheads is to be debited to the cost of the various jobs, products etc. This process is
called absorbing the overhead to cost units. We take up below the various implica-
tions of this process. However, if only one uniform type of work is done, the task is
easy and under such a situation the overhead expenses to be absorbed may be
calculated by dividing actual overheads by the number of units of work done or
estimated overheads by the estimated output.
The whole process of overhead distribution and absorption to units produced is
depicted in the synopsis as below:

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 4.26 COST AND MANAGEMENT ACCOUNTING

Synopsis of Allocation, Apportionment, Re-apportionment and Absorption

Expenses related to Expenses related to All Departments

Department-A

Apportionment

Department-A Department-B Department-C Service- Service-

Department- Department-
1 2

Allocated Allocated Allocated Allocated Allocated

Overheads Overheads Overheads Overheads Overheads

+ + + + +

Apportioned Apportioned Apportioned Apportioned Apportioned

Overheads Overheads Overheads Overheads Overheads
(and re- (and re-
apportioned) apportioned)

+ + + Total Total
Overheads Overheads

Re-apportionment

Re-apportioned Re-apportioned Re-apportioned

Overheads Overheads Overheads

Total Overheads Total Overheads Total Overheads

Absorption

Unit Unit Unit Unit Unit1 Unit2 Unit3 Unit4 Unit1 Unit2 Unit3 Unit4
1 2 3 4

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 OVERHEADS- ABSORPTION COSTING METHOD 4.27

4.5 METHODS OF ABSORBING OVERHEADS TO

VARIOUS PRODUCTS OR JOBS
The method selected for charging overheads to products or jobs should be such as
will ensure:
(i) that the total amount charged (or recovered) in a period does not differ
materially from the actual expenses incurred in the period. and
(ii) that the amount charged to individual jobs or products is equitable. In case of
factory overhead, this means:
(a) that the time spent on completion of each job should be taken into
consideration;
(b) that a distinction should be made between jobs done by skilled workers
and those done by unskilled workers. and
(c) that jobs done by manual labour and those done by machines should be
distinguished.
In addition, the methods should be capable of being used conveniently; and yield
uniform result from period to period as far as possible; any change that is apparent
should reflect a change in the underlying situation such as substitution of human
labour by machines.
Several methods are commonly employed either individually or jointly for
computing the appropriate overhead rate. The more common of these are:

Methods of Absorption of Overheads

Percentage Percentage Percentage

Labour hour Machine Rate per unit
of direct of prime of direct
rate hour rate of Output
materials cost labour cost

(1) Percentage of direct materials,

(2) Percentage of prime cost,
(3) Percentage of direct labour cost,

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 4.28 COST AND MANAGEMENT ACCOUNTING

(4) Labour hour rate,

(5) Machine hour rate and
(6) Rate per unit of Output
4.5.1 Percentage of Direct material cost
Under this method, the cost of direct material consumed is the base for calculating the
amount of overhead absorbed. This overhead rate is computed by the following formula:
Total Production Overheads of a Department
Overhead rate = ×100
Budgeted Direct Material cost of all products

4.5.2 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:

Total Production Overheads of a Department

Overhead rate = ×100
Prime cost

Example for the above two methods:

Suppose for a given period, actual figures are estimated as follows:
`
Direct materials 2,00,000
Direct labour 1,00,000
Factory overheads 90,000
The percentage of factory overheads to direct materials will be 45%, to prime cost
30%. If, on a job, material cost is ` 10,000 and direct labour is `7,000 the cost, after
absorbing factory overhead, will be as follows:
(i) ` 17,000 + 45% ` 10,000 or ` 21,500,
(ii) ` 17,000 + 30% ` 17,000 or ` 22,100, and
One can see how, with a different method, the works cost comes out to be different.
Of these methods, the first and second are generally considered to be unsuitable
on account of the following reasons:

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 OVERHEADS- ABSORPTION COSTING METHOD 4.29

(i) Manufacturing overhead expenses are mostly a function of time i.e., time is the
determining factor for the incurrence and application of manufacturing
overhead expenses. That they are so would be clear if we recall that overhead
expenses, specially manufacturing expenses, can in the ultimate analysis be
regarded as expenditure incurred in providing the necessary facilities and service
to workers employed in the productive process. The question of facilities and
service made available to workers naturally is dependent on the length of time
during which workers make use of the facilities. It may, therefore, be said that
the job or product on which more time has been spent would entail larger
manufacturing expenses than the job requiring less time. The factor is ignored
altogether by the first method and largely by the second method.
(ii) Overheads are neither related to the prime cost nor to direct material cost except
to a very small extent. Thus, if the percentage of material cost is used when there
are two jobs requiring the same operational time but using material having
varying prices, their manufacturing overhead cost would be different whereas
this should not normally be so.
The method of absorbing overhead costs on the basis of prime cost also does not
take into consideration the time factor. The fact that the amount includes labour
cost in addition to material cost does not render the prime cost to be more
suitable; infact, the results are liable to be more misleading because of the
cumulative error of using both the labour and material cost as the basis of
allocation of overhead expenses, on neither of which they are already dependent.
(iii) Since material prices are prone to frequent and wide fluctuations, the
manufacturing overheads, if based on material cost or prime cost, also would
fluctuate violently from period to period.
(iv) The skill of the workers involved and whether machines were used or not, are
ignored when these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of
absorbing material handling and store overheads.
4.5.3 Percentage of direct labour cost
Formula to be used under this method is-
Direct Labour Cost Percentage Rate

Total Production Overheads of a Department

Overhead rate = ×100
Direct Labour cost

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 4.30 COST AND MANAGEMENT ACCOUNTING

Advantages Disadvantages
(i) The method is simple and (i) It gives rise to certain inaccuracies
economical to apply. due to the time factor not being
(ii) The time factor is given given full importance.
recognition even if indirectly. (ii) Where machinery is used to some
(iii) Total expenses recovered will extent in the process of
not differ much from the manufacture, an allowance for such
estimated figure since total a factor is not made.
wages paid are not likely to (iii) It does not provide for varying skills
fluctuate much. of workers

4.5.4 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. Suppose
factory overheads are estimated at `90,000 and labour hours at 1,50,000. The overhead
absorption rate will be `0.60. If 795 direct labour hours are spent on a job, `477 will be
absorbed as overhead. It can be calculated for each category of workers.
Formula to be used under this method is-

Total Production Overheads of a Department

Direct Labour Hour Rate = ×100
4.4.5 Machine hour rate Direct Labour Hour

Machine hour rate implies, cost of running a machine for an hour to produce goods.
There are two methods of computing machine hour rates:
(i) Direct Machine hour rate: According to the first method, 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: It will be obvious, however, that 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

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 OVERHEADS- ABSORPTION COSTING METHOD 4.31

department as a whole and, hence, not charged to any particular machine or group
of machines. In order to see that such expenses are not left out of production costs,
one should include a portion of such expenses to compute the machine hour rate.
Alternatively, the overheads not directly related to machines may be absorbed on
the basis of Productive Labour Hour Rate Method or any other suitable method.
Note: Some people even prefer to add the wages paid to the machine operator in
order to get a comprehensive rate of working a machine for one hour.
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. Overheads
apportioned to a production department are further apportioned to machines or
group of machines. These apportioned costs are divided by the estimated
productive machine hour to get machine hour rate.
The steps involved in determining of Machine hour rate are as follows:

Step1: Calculate total of overheads apportioned to a production department (as

discussed earlier in this chapter)

Step 2: Apportion further these overheads to machines or group of machines in

the department.

Step 3: Allocate machine specific costs (directly identifiable with the machine)

Step 4: Estimate total productive hours for the machine

Step 5: Aggregate overheads as apportioned in step-2 and allocated in step-3

and divide it by Estimated total productive hours

Step 6: The resultant figure is machine hour rate

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 4.32 COST AND MANAGEMENT ACCOUNTING

The above costs are further divided into fixed cost or standing charges and variable
cost. Costs which remain constant irrespective of operation of machine are treated as
fixed cost or standing charges. Examples of fixed cost include insurance premium
for machine, rent for premises, supervisor’s salary, depreciation (if relates to
effluxion of time) etc.
Costs which vary with the operation of the machine are treated as variable cost.
Examples of variable cost include cost for power, cost for consumables (lubricants,
oils etc.), repairs and maintenance, depreciation (if it relates to activity) etc.
Advantages and disadvantages of Machine hour rate:

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

4.5.6 Rate per unit of output method

This is the simplest of all the methods. In this method overhead rate is determined by
the following formula:
Amount of overheads
Overheads Rate=
Number of units

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 OVERHEADS- ABSORPTION COSTING METHOD 4.33

4.6 TYPES OF OVERHEAD RATES

The overhead rates may be of the following types:

Type of Overhead Rates

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

1. Normal Rate: This rate is calculated by dividing the actual overheads by

actual base. It is also known as actual rate.
It is calculated by the following formula:

Actual amount of overheads

Normal overhead Rate =
Actual base

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:

Budgeted amount of overheads

Pre-determined Rate =
Budgeted base

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. The assumption is that
the value of production as well as overheads will remain constant or that the
two will change, proportionately.
(2) The overhead rate for the year may be determined on the basis of estimated
expenses and anticipated volume of production activity.
For instance, if expenses are estimated at `10,000 and output at 4,000 units,
the overhead rate will be `2.50 per unit.
(3) The overhead rate for a year may be fixed on the basis of the normal
volume of the business.

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 4.34 COST AND MANAGEMENT ACCOUNTING

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:
Total overheads for the factory
Blanket Rate =
Total number of units of base for the factory

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:

Overheads of department or cost centre

Departmental overhead Rate =
Corresponding base

ILLUSTRATION 6
A machine costing ` 1,00,00,000 is expected to run for 10 years. At the end of this
period its scrap value is likely to be ` 9,00,000. Repairs during the whole life of the
machine are expected to be ` 18,00,000 and the machine is expected to run 4,380
hours per year on the average. Its electricity consumption is 15 units per hour, the
rate per unit being ` 5. The machine occupies one-fourth of the area of the
department and has two points out of a total of ten for lighting. The foreman has to
devote about one sixth of his time to the machine. The monthly rent of the

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 OVERHEADS- ABSORPTION COSTING METHOD 4.35

department is ` 30,000 and the lighting charges amount to ` 8,000 per month. The
foreman is paid a monthly salary of ` 19,200. FIND OUT the machine hour rate,
assuming insurance is @ 1% p.a. on ` 1,00,00,000 and the expenses on oil, etc., are
` 900 per month.
SOLUTION
Total number of hours per annum- 4,380
Total number of hours per month- 365
Computation of Machine Hour Rate

Per month (`) Per hour (`)

Fixed costs (Standing Charges)
Depreciation (Refer working note-1) 75,833
Rent (`30,000 × ¼ ) 7,500
Lighting charges {(`8,000 × 2 points) ÷ 10 points} 1,600
Foreman’s salary (`19,200 × 1/6) 3,200
Sundry expenses (oil etc.) 900
Insurance {(1% of ` 1,00,00,000) ÷ 12 months} 8,333
97,366 266.76
Variable costs:
Repairs (Refer working note -2) 41.10
Electricity (15 units × ` 5) 75.00
Machine Hour rate 382.86

Working Notes:
Cost of Machine-Scrap value
(1) Depreciation per month =
Lifeof themachine

` 1,00,00,000 - ` 9,00,000
= =` 75,833
(10 years ×12months) *

*In the question the life of the machine is given as 10 years and it is also
mentioned the machine will run for 4,380 hours per annum. The depreciation
can be calculated either on the basis of time i.e. 10 years or on the basis of activity
of 43,800 hours (4,380 hours p.a.)

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 4.36 COST AND MANAGEMENT ACCOUNTING

(2) Repairs for the whole life is ` 18,00,000, which can be linked to activity level of
`18,00,000
43,800 hours. Thus, Repairs cost per hour = = ` 41.10
43,800 hours

ILLUSTRATION 7
A machine shop cost centre contains three machines of equal capacities. To operate
these three machines nine operators are required i.e. three operators on each
machine. Operators are paid ` 20 per hour. The factory works for fourty eight hours
in a week which includes 4 hours set up time. The work is jointly done by operators.
The operators are paid fully for the fourty eight hours. In additions they are paid a
bonus of 10 per cent of productive time. Costs are reported for this company on the
basis of thirteen four-weekly period.
The company for the purpose of computing machine hour rate includes the direct
wages of the operator and also recoups the factory overheads allocated to the
machines. The following details of factory overheads applicable to the cost centre
are available:
 Depreciation 10% per annum on original cost of the machine. Original cost of
the each machine is `52,000.
 Maintenance and repairs per week per machine is `60.
 Consumable stores per week per machine are `75.
 Power: 20 units per hour per machine at the rate of 80 paise per unit. No power
is used during the set-up hours.
 Apportionment to the cost centre: Rent per annum `5,400, Heat and Light per
annum `9,720, foreman’s salary per annum `12,960 and other miscellaneous
expenditure per annum `18,000.
Required:
CALCULATE the cost of running one machine for a four-week period.
SOLUTION
Effective Machine hour for four-week period
= Total working hours – unproductive set-up time
= {(48 hours × 4 weeks) – {(4 hours × 4 weeks)}
= (192 – 16 hours) =176 hours.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.37

(i) Computation of cost of running one machine for a four-week period

(`) (`)
(A) Standing charges (per annum)
Rent 5,400
Heat and light 9,720
Forman’s salary 12,960
Other miscellaneous expenditure 18,000
Standing charges (per annum) 46,080
Total expenses for one machine for four- 1,181.54
week period
 `46,080 
 
 3machines ×13four - week period 
Wages (48 hours × 4 weeks × ` 20 × 3 11,520.00
operators)
Bonus {(176 hours × ` 20 × 3 operators) × 1,056.00
10%}
Total standing charges 13,757.54
(B) Machine Expenses
Depreciation 400.00
 1 
 `52,000 ×10% × 
 13four - week period 

Repairs and maintenance (`60 × 4 weeks) 240.00

Consumable stores (`75 × 4 weeks) 300.00
Power (176 hours × 20 units ×` 0.80)
2,816.00
Total machine expenses 3,756.00
(C) Total expenses (A) + (B) 17,513.54
` 17,513.54
(ii) Machine hour rate = = `99.51
176hours

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 4.38 COST AND MANAGEMENT ACCOUNTING

4.7 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.
Estimated / Normal overheads for the period
Pre-determined overhead rate =
Budgeted Number of units during the period

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 a variation may arise due to any one of the following situations:
(i) Estimated overheads for the period under consideration may remain the same
or they coincide with actual overheads but the number of units produced
during the period is either more or less in comparison with budgeted figure. In
the former case actual overhead rate will be less and in the latter case, actual
overhead rate will be more than the pre-determined overhead rate, hence
over-absorption and under-absorption will occur respectively.
(ii) Similarly, if the number of units actually produced during the period remains
the same as budgeted figure but the actual overheads incurred are more or
less than the estimated overheads for the period, then a situation of under-
absorption or over-absorption will arise respectively.
(iii) If changes occur in different proportion both in the actual overheads and in
the number of units produced during the period, then a situation of under
or over-absorption (depending upon the situation) will arise.
(iv) If the changes in the numerator (i.e. in actual overheads) and denominator
(i.e. in number of units produced) occur uniformly (without changing the
proportion between the two) then a situation of neither under nor of over-
absorption will arise.
Such over or under-absorption as arrived at under different situations may also
be 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.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.39

The situations of under/ over absorption can be summarized as below:

When the absorbed amount is less than the actual amount it is called under-
absorption. Similarly, when the absorbed amount is more than the actual amount
it is called over-absorption.

Budgeted Actual Figure Absorbed Difference Result

Figure Amount

Amount Units Amount Units Under/Over

absorption
1 2 3 4 5=1/2×4 6=3-5

100 100 110 100 100 10 Under-

absorption

100 100 90 100 100 -10 Over-

absorption

100 100 100 90 90 10 Under-

absorption

100 100 100 110 110 -10 Over-

absorption

100 100 90 90 90 0 No under/over-

absorption

100 100 110 110 110 0 No under/over-

absorption

100 100 110 90 90 20 Under-

absorption

100 100 90 110 110 -20 Over-

absorption

`100
In above example Pre-determined rate is =`1
100units

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

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

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 4.40 COST AND MANAGEMENT ACCOUNTING

Is there any under/over

absorption of
overheads?

Yes

Amount of under/over Yes

absorption is small

No Costing P&
L A/c

Due to wrong Yes

estimation and
abnormal reasons

No

Calculate Supplementary Rate and Charge to Cost of

Sales A/c. Finished Goods A/c and W-I-P A/c.

As regards the treatment of such debit or credit balances, the general view is that
if the balances are small they should be transferred to the Costing Profit and
Loss Account and the cost of individual products should not be increased or
reduced as these would be representing normal cost.
Where, however the difference is large and due to wrong estimation, it would be
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:

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 OVERHEADS- ABSORPTION COSTING METHOD 4.41

Under /Over - absorbed OH

Supplementary rate =
Units produced

Supplementary overhead rate as calculated above is applied to finished goods,

semi-finished goods (WIP) and goods finished and sold. Therefore, under/ over
absorbed 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:
In case of Under-absorption:

Accounts Dr/Cr Calculation of amount

1. Stock of Finished goods A/c Debit Units of Finished stock ×
Supplementary rate per unit
2. Stock of Semi-finished goods Debit Equivalent completed units ×
(WIP) A/c Supplementary rate per unit
3. Cost of Sales A/c Debit Units sold × Supplementary
rate per unit
In case of Over-absorption:

Accounts Dr/Cr Calculation of amount

1. Stock of Finished goods A/c Credit Units of Finished stock ×
Supplementary rate per unit
2. Stock of Semi-finished goods Credit Equivalent completed units ×
(WIP) A/c Supplementary rate per unit
3. Cost of Sales A/c Credit Units sold × Supplementary
rate 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 Costing
Profit and Loss Account.
ILLUSTRATION 8
The total overhead expenses of a factory is ` 4,46,380. Taking into account the normal
working of the factory, overhead was recovered in production at ` 1.25 per hour. The
actual hours worked were 2,93,104. STATE how would you proceed to close the books of
accounts, assuming that besides 7,800 units produced of which 7,000 were sold, there
were 200 equivalent units in work-in-progress?

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 4.42 COST AND MANAGEMENT ACCOUNTING

On investigation, it was found that 50% of the unabsorbed overhead was on account
of increase in the cost of indirect materials and indirect labour and the remaining
50% was due to factory inefficiency.
SOLUTION
Calculation of under/ over- absorption of overhead

Amount (`)
Actual factory overhead expenses incurred 4,46,380
Overheads absorbed (2,93,104 hours × ` 1.25) 3,66,380
Under-absorption of overhead 80,000
Reasons for unabsorbed overheads
(i) 50% of the unabsorbed overhead was on account of increase in the cost of
indirect material and indirect labour.
(ii) 50% of the unabsorbed overhead was due to factory inefficiency.
Treatment of unabsorbed overheads in Cost Accounting
1. Unabsorbed overhead amounting to ` 40,000, which were due to increase in the
cost of indirect material and labour should be charged to units produced by
using a supplementary rate.
` 40,000
Supplementary rate = = ` 5 per unit
(7,800 + 200) units
The sum of ` 40,000 (unabsorbed overhead) should be distributed by using a
supplementary rate among cost of sales, finished goods and work-in progress
A/cs. The amount to be debited is calculated as below:

Amount (`)
Stock of finished goods 4,000
[(7,800-7,000) × ` 5]
Work-in progress 1,000
(200 units × ` 5)
Cost of sales 35,000
(7,000 units × ` 5)
Total 40,000

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 OVERHEADS- ABSORPTION COSTING METHOD 4.43

1. The use of cost of sales figure, would reduce the profit for the period by
` 35,000 and will increase the value of stock of finished goods and work-
in-progress by ` 4,000 and ` 1,000 respectively.
2. The balance amount of unabsorbed overheads of ` 40,000 due to factory
inefficiency should be debited to Costing Profit & Loss Account, as this is
an abnormal loss.

4.8 ACCOUNTING AND CONTROL OF ADMINIS-

TRATIVE OVERHEADS
Definition - According to CIMA Terminology, Administrative overhead is defined
as “The sum of those costs of general management and of secretarial accounting and
administrative services, which cannot be directly related to the production,
marketing, research or development functions of the enterprise.” According to this
definition, administrative overhead constitutes the expenses incurred in connection
with the formulation of policy directing the organisation and controlling the
operations of an undertaking. These overheads are also collected and classified in
the same way as the factory overheads.
4.8.1 Accounting of Administrative Overheads
There are three distinct methods of accounting of administrative overheads, which
are briefly discussed below:
(a) Apportioning Administrative Overheads between Production and Sales
Departments: According to this method administrative overheads are apportioned
over production and sales departments. 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. Therefore,
each department should be charged with the proportionate share of the same.
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 overhead apportionment
over production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.

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 4.44 COST AND MANAGEMENT ACCOUNTING

(3) It is not justified to apportion total administrative overheads only over

production and sales departments when other equally important department
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. The reason
for charging to Costing Profit & Loss are firstly, 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. Secondly, it is
difficult to determine a suitable basis for apportioning administrative overheads
over production and sales departments. Lastly, 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 not charged
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 formulating the policy,
directing the organisation and controlling the operations are taken as a separate
charge to the cost of the jobs or a product, sold along with 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.
4.8.2 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. But at
the same time these overheads should not be allowed to grow disproportionately.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.45

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:
According to this method 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.
However, this method provides only a limited degree of control and
comparison does not give useful results if the level of activity is not constant
during the periods under comparison. To overcome this difficulty, overhead
absorption rates may also be compared from period to period; the extent of
over or under absorption will reveal the efficiency or otherwise of the
department. It may be possible to compare the cost of a service department
with that of similar services obtainable from outside and a decision may be
taken whether it is economical to continue the department or entrust the
work to outsiders.
(ii) Control through Budgets - According to this method, 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.
ILLUSTRATION 9 (Reverse Calculation of Factory Overhead and Administrative
overheads)
In an engineering company, the factory overheads are recovered on a fixed
percentage basis on direct wages and the administrative overheads are absorbed on
a fixed percentage basis on factory cost.

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 4.46 COST AND MANAGEMENT ACCOUNTING

The company has furnished the following data relating to two jobs undertaken by it
in a period:
Job 101 Job 102
(` ) (` )
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Selling price 1,66,650 1,28,250
Profit percentage on Total Cost 10% 20%

Required:
(i) COMPUTATION of percentage recovery rates of factory overheads and
administrative overheads.
(ii) CALCULATION of the amount of factory overheads, administrative overheads and
profit for each of the two jobs.
(iii) Using the above recovery rates DETERMINE the selling price of job 103. The
additional data being:
Direct materials ` 24,000
Direct wages ` 20,000
Profit percentage on selling price 12-½%
SOLUTION
(i) Computation of percentage recovery rates of factory overheads and
administrative overheads.
Let the factory overhead recovery rate as percentage of direct wages be F and
administrative overheads recovery rate as percentage of factory cost be A.
Factory Cost of Jobs:
Direct materials + Direct wages + Factory overhead
For Job 101 = ` 54,000 +` 42,000 + ` 42,000F
For Job 102 = ` 37,500 +` 30,000 + ` 30,000F
Total Cost of Jobs:

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 OVERHEADS- ABSORPTION COSTING METHOD 4.47

Factory cost + Administrative overhead

For Job 101 = (` 96,000 + ` 42,000F) + (` 96,000+ ` 42,000F) A = ` 1,51,500*
For Job-102 = (` 67,500 + ` 30,000F) + (` 67,500+ ` 30,000F) A = ` 1,06,875**
The value of F & A can be found using following equations

96,000 + 42,000F + 96,000A + 42,000AF = 1,51,500 …………eqn (i)

67,500 + 30,000F + 67,500A + 30,000AF = 1,06,875 …………eqn (ii)
Multiply equation (i) by 5 and equation (ii) by 7

4,80,000 + 2,10,000F + 4,80,000A + 2,10,000AF = 7,57,500 ……eqn (iii)

4,72,500 + 2,10,000F + 4,72,500A + 2,10,000AF = 7,48,125 ……eqn (iv)
- - - - -
7,500 + 7,500A = 9,325
7,500 A = 9,325 – 7,500
A = 0.25
Now put the value of A in equation (i) to find the value of F
96,000 + 42,000F + 24,000 + 10,500F = 1,51,500
52,500F = 1,51,500 – 1,20,000
F = 0.6
On solving the above relations: F = 0.60 and A = 0.25
Hence, percentage recovery rates of:
Factory overheads = 60% of wages and
Administrative overheads = 25% of factory cost.
Working note:
Selling price
Total Cost =
(100% + Percentage of profit)

`1,66,650
*For Job 101= = ` 1,51,500
(100% + 10%)

`1,28,250
**For Job 102= = ` 1,06,875
(100% + 20%)

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 4.48 COST AND MANAGEMENT ACCOUNTING

(ii) Statement of jobs, showing amount of factory overheads, administrative

overheads and profit:

Job 101 Job 102

(`) (`)
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Prime cost 96,000 67,500
Factory overheads
60% of direct wages 25,200 18,000
Factory cost 1,21,200 85,500
Administrative overheads
25% of factory cost 30,300 21,375
Total cost 1,51,500 1,06,875
Profit (10% & 20% respectively) 15,150 21,375
Selling price 1,66,650 1,28,250
(iii) Selling price of Job 103

(` )
Direct materials 24,000
Direct wages 20,000
Prime cost 44,000
Factory overheads (60% of Direct Wages) 12,000
Factory cost 56,000
Administrative overheads (25% of factory cost) 14,000
Total cost 70,000
Profit margin (balancing figure) 10,000
 Total Cost 
Selling price  
 87.5%  80,000

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 OVERHEADS- ABSORPTION COSTING METHOD 4.49

4.9 ACCOUNTING AND CONTROL OF SELLING

AND 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.
Examples of selling and distribution expenses have been considered earlier in this
booklet. From the definitions it is clear that the two types of expenses represent
two distinct type of functions. Some concerns group together these two types of
overhead expenses into one composite class, namely, selling and distribution
overhead, for the purpose of Cost Accounting.
4.9.1 Accounting of selling and distribution overheads
The collection and accumulation of each expense is made by means of appropriate
standing orders in the usual way. Where it is decided to apportion a part of the
administrative overhead to the selling division the same should also be collected
through appropriate standing orders.
As in the case of administrative overheads, it is not easy to determine an entirely
satisfactory basis for computing the overhead rate for absorbing selling 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.
It is considered that the sale value is ordinarily the most logical basis, there being
some connection between the amount of sales and the amount of expenses
incurred to achieve them. The cost of production, however, is not as satisfactory
basis as it may not have any direct relationship with the selling and distribution
cost.
The basis of gross profit on sales results in a larger share of the selling overhead
being applied to goods yielding a large margin of profit and vice versa. The basis
therefore follows the principle of ‘ability to pay, it may not reflect costs or incurred
efforts.

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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 derived
by 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 Department Estimated time devoted to the sale of
and of the sales men. various 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 of
advertisement expenditure on each
product.
Show Room expenses Average space occupied by each product.
Rent of finished goods godowns Average quantities delivered during a
and Expenses on own delivery vans period.

If a suitable basis for apportioning expenses does not exist it may be apportioned
in the proportion of sales of various products.
The total of fixed expenses apportioned in this manner, divided by the number of
units sold or likely to be sold, will give the fixed expenses per unit. To this should
be added the variable expenses which will be different for each product. These
expenses are, packaging, freight outwards, insurance in transit, commission payable
to salesmen, rebate allowed to customers, etc. All these items will be worked out
per unit for each product separately. These items added to fixed expenses per unit
will give an estimated amount of the selling and distribution expenses per unit.
4.9.2 Control of Selling & Distribution Overheads
Control of selling and distribution expenses is a difficult task. The reasons for this
are as follows:
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.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.51

2. These overheads are dependent upon the customers, behaviour, their liking
and 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 to
control.
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.
ILLUSTRATION 10
A company which sells four products, some of these are unprofitable. Company
proposes to discontinue to sale one of these products. The following information is
available regarding income, costs and activity for the year ended 31st March.

Products
A B C D
Sales (`) 30,00,000 50,00,000 25,00,000 45,00,000
Cost of goods sold (`) 20,00,000 45,00,000 21,00,000 22,50,000
Area of storage (Sq.ft.) 50,000 40,000 80,000 30,000
Number of parcels sent 1,00,000 1,50,000 75,000 1,75,000
Number of invoices sent 80,000 1,40,000 60,000 1,20,000

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 4.52 COST AND MANAGEMENT ACCOUNTING

Selling and Distribution overheads and the basis of allocation are:

Amount (`) Basis of allocation

to products
Fixed Costs
Rent & Insurance 3,00,000 Area of storage
(Sq.ft.)
Depreciation 1,00,000 No. of Parcels sent
Salesmen’s salaries & expenses 6,00,000 Sales Volume
Administrative wages and salaries 5,00,000 No. of invoices sent
Variable Costs:
Packing wages & materials ` 2 per parcel
Commission 4% of sales
Stationery ` 1 per invoice
You are required to PREPARE Costing Profit & Loss Statement, showing the
percentage of profit or loss to sales for each product.
SOLUTION
Statement of Profit or Loss on Various Products during the year ended March 31st.
Total (`) Products
A (`) B (`) C (`) D (`)
Sales 1,50,00,000 30,00,000 50,00,000 25,00,000 45,00,000
Variable costs:
Cost of goods sold 1,08,50,000 20,00,000 45,00,000 21,00,000 22,50,000
Commissions 4% of sales 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
Packing wages & 10,00,000 2,00,000 3,00,000 1,50,000 3,50,000
materials @ ` 2 per parcel
Stationery @ ` 1 per 4,00,000 80,000 1,40,000 60,000 1,20,000
invoice
Total variable costs 1,28,50,000 24,00,000 51,40,000 24,10,000 29,00,000
Contribution 21,50,000 6,00,000 (1,40,000) 90,000 16,00,000
(Sales – variable cost)

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 OVERHEADS- ABSORPTION COSTING METHOD 4.53

Fixed Costs:
Rent & Insurance (5:4:8:3) 3,00,000 75,000 60,000 1,20,000 45,000
Depreciation (4:6:3:7) 1,00,000 20,000 30,000 15,000 35,000
Salesmen’s salaries & 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
expenses (6:10:5:9)
Administrative wages & 5,00,000 1,00,000 1,75,000 75,000 1,50,000
salaries (4:7:3:6)
Total Fixed costs 15,00,000 3,15,000 4,65,000 3,10,000 4,10,000
Profit or Loss 6,50,000 2,85,000 (6,05,000) (2,20,000) 11,90,000
(Contribution–fixed
Costs)
Percentage of profit or 4.33 9.50 (12.10) (8.80) 26.4
Loss on sales (%)

4.10 CONCEPTS RELATED TO CAPACITY

(i) Installed/ Rated capacity: It refers to the maximum capacity of producing
goods or providing services. Installed capacity is determined either on the basis of
technical specification or through a technical evaluation. 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. It is
also known as operating capacity. This capacity takes into account loss of time
due to repairs, maintenance, minor breakdown, idle time, set up time, normal
delays, Sundays and holidays, stock taking etc. Generally, practical capacity is taken
between 80 to 90% of the rated capacity. It is also used as a base for determining
overhead rates. Practical capacity is also called net capacity or available capacity.
(iii) Normal capacity: Normal capacity is the volume of production or services
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 planned maintenance xxx

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 4.54 COST AND MANAGEMENT ACCOUNTING

(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. It
is 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 and Normal
capacity.
(b) Abnormal Idle Capacity: It is the difference between Normal capacity and
Actual capacity utilization where the actual capacity is lower than the normal
capacity.
The idle capacity may arise due to lack of product demand, non-availability of raw
material, shortage of skilled labour, absenteeism, shortage of power fuel or
supplies, seasonal nature of product etc.
Installed Capacity
Normal Idle Capacity
Normal Capacity
Abnormal Idle Capacity
Actual 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.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.55

4.11 TREATMENT OF CERTAIN ITEMS IN

COSTING
(i) Interest and financing charges: It includes any payment in nature of interest
for use of non- equity funds and incidental cost that an entity incurs in arranging
those funds. Example of interest and financing charges are interest on borrowings,
financing charges in respect of finance leases, cash discount allowed to customers.
The term interest and financing charges, finance costs and borrowing costs are
used interchangeably. It does not include imputed costs.
(ii) Depreciation: Depreciation “is the diminution in the intrinsic value of an asset
due to use and/or the lapse of time.” Depreciation is thus the result of two factors
viz., the use, and the lapse of time. We know that each fixed asset loses its intrinsic
value due to their continuous use and as such the greater the use the higher is the
amount of depreciation. The loss in the intrinsic value may also arise even if the
asset in question is not in service.
Assignment of 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 of the product from the
factory to the customer should become a part of the distribution cost. If the cost
of special packing is at the request of the customer, the same should be charged
to the specific work order or the job. The cost of fancy packing necessary to attract
customers is an advertising expenditure. Hence, it is to be treated as a selling
overhead.
(iv) Fringe benefits: These are the additional payments or facilities provided to
the workers apart from their salary and direct cost-allowances like house rent,
dearness and city compensatory allowances. These benefits are given in the form
of overtime, extra shift duty allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of
employees towards the organisation. 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.

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 4.56 COST AND MANAGEMENT ACCOUNTING

(v) Expenses on removal and re-erection of machines: Expenses are sometime

incurred on removal and re-erection of machinery in factories. Such expenses may
be incurred due to factors like change in the method of production; an addition or
alteration in the factory building, change in the flow of production, etc. 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: There is no unanimity among different authors of Cost
Accounting about the treatment of bad debts. One view is that ‘bad debts’ should
be excluded from cost. According to this view bad debts are financial losses and
therefore, they should not be included in the cost of a particular job or product.
According to another view it should form part of selling and distribution overheads,
especially when they arise in the normal course of trading. Therefore 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.
(vii) Training expenses: Training is an essential input for industrial workers.
Training expenses in fact includes wages of workers, costs incurred in running
training department, loss arising from the initial lower production, extra spoilage
etc. Training expenses of factory workers are treated as part of the cost of production.
The training expenses of office; sales or distribution workers should be treated as office; sales
or distribution overhead as the case may be. These expenses can be spread over various
departments of the concern on the basis of the number of workers on roll.
Training expenses would be abnormally high in the case of high labour turnover such
expenses should be excluded from costs and charged to the costing profit and loss
account.
(viii) Canteen expenses: The subsidy provided or expenses borne by the firm in
running the canteen should be regarded as a production overhead. If the canteen
is meant only for factory workers therefore this expenses should be apportioned
on the basis of the number of workers employed in each department. If office
workers also take advantage of the canteen facility, a suitable share of the expenses
should be treated as office overhead.
(ix) Carriage and cartage expenses: It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and goods.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.57

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: Workers in the factories, which operate during night
time are paid some extra amount known as ‘night shift allowance’. This extra
amount 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 this allowance is treated as part of direct wages, the jobs/production carried at
night will be costlier than jobs/production performed during the day. However, if
additional expenditure on night shift is incurred to meet some 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: The Terminology defines research
expenses as “the expenses of searching for new or improved products, new application
of materials, or new or improved methods.” Similarly, development expenses are
defined as “the expenses of the process which begins with the implementation of the
decision to produce a new or improved product.”
If research is conducted in the methods of production, the research expenses
should be charged to the production overhead; while the expenditure becomes a
part of the administration overhead if research relates to administration. Similarly,
market research expenses are charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product should be
charged directly to that product. Such expenses are usually treated as “deferred
revenue expenses,” and recovered as a cost per unit of the product when
production is fully established.
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.

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 4.58 COST AND MANAGEMENT ACCOUNTING

Even in this case, if the amount involved is substantial it may be treated as a

deferred revenue expenditure, and spread over the period during which the benefit
would accrue. Expenses on fundamental research, not relating to any specific
product, are treated as a part of the administration overhead. Where research
proves a failure, the cost associated with it should be excluded from costs and
charged to the costing Profit and Loss Account.

SUMMARY
♦ Overheads: Overheads represent expenses that have been incurred in
providing certain ancillary facilities or services which facilitate or make
possible the carrying out of the production process; by themselves these
services are not of any use.
♦ Cost allocation: The term ‘allocation’ refers to assignment or allotment of an
entire item of cost to a particular cost center or cost unit.
♦ Cost apportionment: Apportionment implies the allotment of proportions
of items of cost to cost centres or departments.
♦ Re-apportionment: The process of assigning service department overheads
to production departments is called reassignment or re-apportionment.
♦ Absorption- The process of recovering overheads of a department or any
other cost center from its output is called recovery or absorption.
♦ Direct re-distribution method: Under this method service department costs
are apportioned over the production departments only, ignoring the services
rendered by one service department to the other.
♦ Step Method or Non-reciprocal method: This method gives cognizance to
the service rendered by service department to another service department.
The sequence here begins with the department that renders service to the
maximum number of other service departments.
♦ Reciprocal Service Method: These methods are used when different service
departments render services to each other, in addition to rendering services
to production departments. In such cases various service departments have
to share overheads of each other. The methods available for dealing with
reciprocal services are
(a) Simultaneous equation method;
(b) Repeated distribution method;
(c) Trial and error method.

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 OVERHEADS- ABSORPTION COSTING METHOD 4.59

♦ Blanket overhead rates: 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.
Overhead costs for the whole factory
Blanket Overhead rate = ×100
Total units of the selected base

TEST YOUR KNOWLEDGE

MCQs based Questions
1. “Fixed overhead costs are not affected in monetary terms during a given period by
a change in output”. But this statement holds good provided:
(a) Increase in output is not substantial
(b) Increase in output is substantial
(c) Both (a) and (b)
(d) None of the above
2. _________ capacity is defined as actually utilised capacity of a plant.
(a) Theoretical
(b) Installed
(c) Practical
(d) Normal
3. The allotment of whole items of cost to cost centres or cost units is called:
(a) Overhead absorption
(b) Cost apportionment
(c) Cost allocation
(d) None of the above
4. Primary packing cost is a part of:
(a) Direct material cost
(b) Production Cost
(c) Selling overheads
(d) Distribution overheads

© The Institute of Chartered Accountants of India

CHAPTER 5

ACTIVITY BASED
COSTING
LEARNING OUTCOMES

After studying this chapter, you would be able to-

 Discuss problem of traditional costing system
 Discuss usefulness of Activity Based Costing (ABC)
 Discuss Cost Allocation under ABC
 Discuss Different level of activities under ABC
 Understand stages, advantages, and limitations of ABC
 Discuss various requirements in ABC implementation
 Explain the concept of Activity Based Management (ABM)
 Explain the concept of Activity Based Budgeting (ABB)

Activity Based Costing

Concept Usefullness Cost Hierarchy Steps

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 5.2 COST AND MANAGEMENT ACCOUNTING

5.1 INTRODUCTION
5
As discussed in chapter 4 i.e. Overhead, in traditional costing system, overhead costs are
grouped together under cost center and then absorbed into product costs on either of
the basis such as direct labour hours, machine hours, volume etc. In certain cases, this
traditional costing system gives inaccurate cost information. Though, it should not be
assumed that all traditional absorption costing systems are not accurate enough to give
adequate information for pricing purposes or other long-run management decision
purposes. Some traditional systems treat overheads in a detailed way and relate them
to service cost centres as well as production cost centres. The service centre overheads
are then spread over the production cost centres before absorption rates are calculated.
The main cause of inaccuracy is in the calculation of the overhead rate itself, which is
usually based on direct labour hours or machine hours. These rates assume that products
that take longer to make, generate more overheads and so on.
Organisations, who do not wish to know how much it costs to make a product with
precise accuracy, may be happy with traditional costing system. Others, however,
fix their price on cost basis and need to determine it with reasonable accuracy. The
latter organisations have been greatly benefitted from the development of activity
based costing (ABC), which is considered as a modern absorption costing method,
and was evolved to give more accurate product costs.
5.1.1 Factors prompting the development of ABC
Various factors lead to the development of ABC include:
1. Growing overhead costs because of increasingly automated production
2. Increasing market competition, which necessitated more accurate product
costs.
3. Increasing product diversity to secure economies of scope & increased market share.
4. Decreasing costs of information processing because of continual
improvements and increasing application of information technology.
5.1.2 Usefulness/Suitability of ABC
ABC is particularly needed by organisations for product costing in the following
situations:
1. High amount of overhead: When production overheads are high and form
significant costs, ABC is more useful than traditional costing system.

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 ACTIVITY BASED COSTING 5.3

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 is a superior and better option.
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 is very useful. 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.

5.2 MEANING AND DEFINITION

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 cost
to cost objects, such as products or customers, based on their use of activities. ABC
can track the flow of activities in organization by creating a link between the activity
(resource consumption) and the cost object.
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.”

5.3 MEANING OF TERMS USED IN ABC

5
(i) Activity – Activity, here, refers to an event that incurs cost.
(ii) Cost Object–It is an item for which cost measurement is required e.g. a
product or a customer.

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 5.4 COST AND MANAGEMENT ACCOUNTING

(iii) 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.
(iv) Cost Pool-It represents a group of various individual cost items. It consists of
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, services • Number of products in design
and procedures • Number of parts per product
• Number of engineering hours
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

5.4 COST ALLOCATION UNDER ABC

5
Under activity based cost allocation overheads are attributed to products on the
activity base. Traditionally, overhead costs are grouped together under cost centre
and then absorbed into product costs on some basis such as direct labour hours.
Activity based costing identifies the activities which cause cost to be incurred and
searches for fundamental cost drivers of these activities. Once the activities and
there cost drivers have been identified this information can be used to assign
overheads to cost objects (e.g. products) which have actually caused cost to be
incurred.

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 ACTIVITY BASED COSTING 5.5

5.5 TRADITIONAL ABSORPTION COSTING VS ABC

5
Cost Allocation under Traditional and Activity Based Costing system

Direct Cost
Tracing of Product/
Cost Ascertainment Service
Cost
Indirect Cost
Cost
Allocation

Traditional Costing Activity based Costing

Based on Machine
hours, labour Hours, Based on Cost Driver
Volume etc.

Cost Allocation under Traditional and Activity Based Costing System

In traditional absorption costing overheads are first related to cost centres
(Production & Service Centres) and then to cost objects, i.e., products. In ABC
overheads are related to activities or grouped into cost pools. Then they are related
to the cost objects, e.g., products. The two processes are, therefore, very similar,
but the first stage is different, as ABC uses activities instead of functional
departments (cost centres). The problem with functional departments is that they
tend to include a series of different activities, which incur a number of different
costs that behave in different ways. Activities also tend to run across functions; for
instance, procurement of materials often includes raising a requisition note in a
manufacturing department or stores. It is not raised in the purchasing department
where most procurement costs are incurred. Activity costs tend to behave in a
similar way to each other i.e., they have the same cost driver. Therefore, ABC gives
a more realistic picture of the way in which costs behave.

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 5.6 COST AND MANAGEMENT ACCOUNTING

Activity Based Costing Traditional Absorption Costing

1. Overheads are related to 1. Overheads are related to cost
activities and grouped into centers/departments.
activity cost pools.
2. Costs are related to activities and 2 Costs are related to cost centers
hence are more realistic. and hence not realistic of cost
behaviour.
3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be
determined. the only cost driver governing
costs in all departments.
4. Activity–wise recovery rates are 4. Either multiple overhead recovery
determined and there is no rates (for each department) or a
concept of a single overhead single overhead recovery rate may
recovery rate. be determined for absorbing
overheads.
5. Cost are assigned to cost 5. Costs are assigned to Cost Units
objects, e.g. customers, i.e. to products, or jobs or hours.
products, services, departments,
etc.
6. Essential activities can be 6. Cost Centers/ departments cannot
simplified and unnecessary be eliminated. Hence, not suitable
activities can be eliminated. Thus, for cost control.
the corresponding costs are also
reduced/ minimized. Hence ABC
aids cost control.

5.6 LEVEL OF ACTIVITIES UNDER ABC METHO-

DOLOGY/COST HIERARCHY
These categories are generally accepted today, but were first identified by Cooper
(1990). The categories of activities help to determine the type of activity cost driver
required.

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 ACTIVITY BASED COSTING 5.7

The categories of activities are:

Level of Meaning Example

Activities
1.Unit level These are those activities • The use of indirect
activities for which the consumption materials/consumables tends to
of resources can be increase in proportion to the
identified with the number number of units produced.
of units produced. • The inspection or testing of every
item produced, if this was deemed
necessary or, perhaps more likely,
every 100th item produced.
2.Batch level The activities such as • Material ordering–where an order
activities setting up of a machine or is placed for every batch of
processing a purchase production
order are performed each • Machine set-up costs–where
time a batch of goods is machines need resetting between
produced. The cost of each different batch of production.
batch related activities • Inspection of products where the
varies with number of first item in every batch is
batches made, but is inspected rather than every 100th
common (or fixed) for all item quoted above.
units within the batch.
3. Product These are the activities • Designing the product,
level which are performed to • Producing parts specifications
activities support different • Keeping technical drawings of
products in product line products up to date.
4.Facilities These are the activities • Maintenance of buildings
level which cannot be directly • Plant security
activities attributed to individual
products. These activities
are necessary to sustain
the manufacturing
process and are common
and joint to all products
manufactured

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 5.8 COST AND MANAGEMENT ACCOUNTING

5.7 STAGES IN ACTIVITY BASED COSTING (ABC)

The different stages in ABC calculations are listed below:
(1) Identify the different activities within the organisation: Usually the
number of cost centres that a traditional overhead system uses is quite small,
say up to fifteen. In ABC, the number of activities will be much more, say 200;
the exact number will depend on how the management subdivides the
organisation’s activities. It is possible to break the organisation down into
many very small activities. But if ABC is to be acceptable as practical system
it is necessary to use larger groupings, say, 40 activities may be used in
practice. The additional number of activities over cost centres means that ABC
should be more accurate than the traditional method regardless of anything
else. 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. The question to ask is –
what causes the activity to incur costs? In production scheduling, for example,
the driver will probably be the number of batches ordered.
(5) Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.

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 ACTIVITY BASED COSTING 5.9

Activity cost driver rate = Total cost of activity

Activity driver

The activity driver rate can be used not only to identify cost of products, as
in 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 of the benefit of ABC.
The activity cost driver rates will be multiplied by the different amounts of
each activity that each product/other cost object consumes.

Cost allocation under ABC

Let us take a small example to understand the steps stated above:
Assume that a company makes widgets and the management decides to install an
ABC system. The management decides that all overhead costs will have only three
cost drivers viz. direct labour hours, machine hours and number of purchase orders.
The general ledger of the company shows the following overhead costs –

General Ledger Amount (`)

Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
Total 11,250

So, which overheads do you think are driven by direct labour hours?

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 5.10 COST AND MANAGEMENT ACCOUNTING

The answer is

Payroll taxes ` 1,000

Fringe benefits ` 2,000
Unemployment insurance ` 1,500
Total ` 4,500

Similarly, overheads driven by machine hours include Machine maintenance,

depreciation and Electricity totaling ` 2,500 and finally overheads driven by number
of purchase orders include purchasing department labour and purchasing
department supplies totaling ` 4,250.
Now, overhead rate is calculated by the formula
Total cost in the activity pool ÷ Base,
base being the total number of labour hours, machine hours and total number of
purchase orders in the given case.
Assume that the total number of labour hours be 1,000 hours, machine hours be
250 hours and total purchase orders be 100 orders.
So, Cost driver rate would be
Cost Driver Rate (`)
` 4,500/ 1,000 ` 4.50 per labour hour
` 2,500/ 250 ` 10 per machine hour
` 4,250/ 100 ` 42.50 per purchase order

Now, let’s allocate the overheads between two widgets A and B the details of which
are given below:

Particulars Widget A Widget B

Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50

So, total overhead costs applied to widget A = (400×4.50) + (100×10) + (50×42.50)

= ` 4,925

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 ACTIVITY BASED COSTING 5.11

And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) =

` 6,325
So total overheads = ` 4,925 + ` 6,325 = ` 11,250.
Generally, in the traditional costing method, overheads are applied on the basis of
direct labour hours (total 1,000 labour hours in the given case). So, in that case the
overhead absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and the
total overheads applied to Widget A would have been = 400 × 11.25 =
` 4,500 and to Widget B = 600 ×11.25 = ` 6,750.
Hence Widget A would have been undervalued and Widget B overvalued by ` 425.
Some of the examples of cost drivers for different activity pools in a production
department are stated below:

Activity Cost Pools Related Cost Drivers

Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours

ILLUSTRATION 1
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The
budgeted costs and production for the year ending 31st March are as follows:
A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
- Direct Materials (Kg.) 4 6 3
- Direct Labour (Minutes) 30 45 60

The budgeted direct labour rate was ` 10 per hour, and the budgeted material cost
was ` 2 per kg. Production overheads were budgeted at ` 99,450 and were absorbed
to products using the direct labour hour rate. ABC Ltd. followed the Absorption
Costing System.

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 5.12 COST AND MANAGEMENT ACCOUNTING

ABC Ltd. is now considering to adopt an Activity Based Costing system. The following
additional information is made available for this purpose.
1. Budgeted overheads were analysed into the following:

(`)
Material handling 29,100
Storage costs 31,200
Electricity 39,150

2. The cost drivers identified were as follows:

Material handling Weight of material handled

Storage costs Number of batches of material
Electricity Number of Machine operations

3. Data on Cost Drivers was as follows:

A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operations 6 3 2

You are requested to:

1. PREPARE a statement for management showing the unit costs and total costs
of each product using the absorption costing method.
2. PREPARE a statement for management showing the product costs of each
product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two
approaches?
SOLUTION
1. Traditional Absorption Costing

A B C Total
(a) Quantity (units) 4,000 3,000 1,600 8,600

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 ACTIVITY BASED COSTING 5.13

(b) Direct labour (minutes) 30 45 60 -

(c) Direct labour hours (a × b)/60 minutes 2,000 2,250 1,600 5,850

Overhead rate per direct labour hour:

= Budgeted overheads ÷Budgeted labour hours
= ` 99,450 ÷ 5,850 hours
= ` 17 per direct labour hour
Unit Costs:

A (`) B (`) C (`)

Direct Costs:
- Direct Labour 5.00 7.50 10.00
- Direct Material 8.00 12.00 6.00
Production Overhead: 8.50 12.75 17.00
 17×30   17×45   17×60 
     
 60   60   60 
Total unit costs 21.50 32.25 33.00
Number of units 4,000 3,000 1,600
Total costs 86,000 96,750 52,800

2. Activity Based Costing

A B C Total
Quantity (units) 4,000 3,000 1,600 -
Material Weight per unit (Kg.) 4 6 3 -
Total material weight 16,000 18,000 4,800 38,800
Machine operations per unit 6 3 2 -
Total operations 24,000 9,000 3,200 36,200
Total batches of Material 10 5 15 30

Material handling rate per kg. = ` 29,100 ÷ 38,800 kg. = ` 0.75 per kg.

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 5.14 COST AND MANAGEMENT ACCOUNTING

Electricity rate per machine operations = ` 39,150 ÷ 36,200

= ` 1.081 per machine operations
Storage rate per batch = ` 31,200 ÷ 30 batches
= ` 1,040 per batch
Unit Costs:

A (`) B (`) C (`)

Direct Costs:
Direct Labour 5.00 7.50 10.00
Direct material 8.00 12.00 6.00
Production Overheads:
Material Handling 3.00 4.50 2.25
(`0.75 × 4) (`0.75 × 6) (`0.75 × 3)
Electricity 6.49 3.24 2.16
(`1.081 × 6) (`1.081 × 3) (`1.081 × 2)
Storage 2.60 1.73 9.75
 ` 1,040   `1,040   `1,040 
 `10 ×   `5×   `15× 
 4,000   3,000   1,600 
Total unit costs 25.09 28.97 30.16
Number of units 4,000 3,000 1,600
Total costs ` 1,00,360 ` 86,910 ` 48,256

3. Comments: The difference in the total costs under the two systems is due to
the differences in the overheads borne by each of the products. The Activity Based
Costs appear to be more precise.

5.8 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.

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 ACTIVITY BASED COSTING 5.15

(iv) Utilizes unit cost rather than just total cost

(v) Help to identify non-value added activities which facilitates cost reduction.
(vi) It is helpful to the organizations with multiple products.
(v) It highlights problem areas which require attention of the management.

5.9 LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive, particularly in comparison with traditional costing
system.
(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 difficult
or complicated.

5.10 REQUIRMENTS IN ABC IMPLEMENTATION

A number of distinct practical stages are required in the ABC implementation which
are given as below:
(1) Staff Training: The co-operation of the workforce is critical to the successful
implementation of ABC. Staff training should be done to create an awareness on
the purpose of ABC.
(2) Process Specification: Informal, but structured interviews with key members
of personnel will identify the different stages of the production process, the
commitment of resources to each, processing times and bottlenecks.
(3) Activity Definition: The activities must be defined clearly in the early stage
in order to manage the problems, if any, effectively. There might be overloading of
information from the new data, but the same is needed in codification.
(4) Activity Driver Selection: Cost driver for each activity shall be selected.
(5) Assigning Cost: A single representative activity driver can be used to assign
costs from the activity pools to the cost objects.

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 5.16 COST AND MANAGEMENT ACCOUNTING

5.11 PRACTICAL APPLICATIONS OF ACTIVITY

BASED COSTING
5.11.1 As a Decision-Making Tool
ABC can act as a decision making tool in the following ways:
(i) ABC along with some other cost management technique can be utilized to
improve performance and profitability of an organization.
(ii) 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.
(iii) ABC can assist in decisions related to facility and resource expansion. Often
the basis for relocation or opening of a new distribution center is based on cost
associations. Reduction in freight or other logistic costs can offset the expense of
the new facility, staff or equipment. The ABC model can identify the specific cost
elements being targeted, providing a much clearer picture which aids in
management actions.
(iv) ABC augments decision support for human resources.. Since the activity (and
therefore costs) 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.
(v) Companies who wish to determine price based on cost plus markup basis find
ABC method of costing very relevant and are able to determine competitive prices
for their products.
5.11.2 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 Cost 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.

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 ACTIVITY BASED COSTING 5.17

Various analysis in Activity Based Management

The various types of analysis involved in ABM are as follows:
(1) Cost Driver Analysis: The factors that cause activities to be performed need
to 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. Moving materials and machine set up
for a production run are examples of NVA activities.
(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 output and 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.

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 5.18 COST AND MANAGEMENT ACCOUNTING

(iv) Performance Measurement: Many organisations are now focusing on

activity performance as a means of facing competitors and managing costs by
monitoring the efficiency and effectiveness of activities.

Area Measure
Quality of purchased component Zero defects
Quality of output % yield
Customer awareness Orders; number of complaints

5.11.3 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 in
accordance 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:-
1. Activity Based Budgeting (ABB) can enhance accuracy of financial forecasts
and increasing management understanding.
2. When automated, ABB can rapidly and accurately produce financial plans and
models based on varying levels of volume assumptions.

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 ACTIVITY BASED COSTING 5.19

3. ABB eliminates much of the needless rework created by traditional budgeting

techniques.
ILLUSTRATION 2
MST Limited has collected the following data for its two activities. It calculates activity
cost rates based on cost driver capacity.

Activity Cost Driver Capacity Cost

Power Kilowatt hours 50,000 kilowatt hours ` 2,00,000
Quality Inspections Number of Inspections 10,000 Inspections ` 3,00,000
The company makes three products M, S and T. For the year ended March 31st, the
following consumption of cost drivers was reported:

Product Kilowatt hours Quality Inspections

M 10,000 3,500
S 20,000 2,500
T 15,000 3,000

Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level to
compute the budgeted fixed overhead cost rate.
SOLUTION
(i) Statement of cost allocation to each product from each activity

Product
M (`) S (`) T (`) Total
(`)
Power (Refer 40,000 80,000 60,000 1,80,000
to working (10,000 kWh (20,000 kWh (15,000 kWh
note) × `4) ×`4) ×`4)
Quality 1,05,000 75,000 90,000 2,70,000
Inspections (3,500 (2,500 (3,000
(Refer to inspections inspections × inspections ×
working note) × `30) ` 30) ` 30)

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 5.20 COST AND MANAGEMENT ACCOUNTING

Working note
Rate per unit of cost driver:

Power (` 2,00,000 / 50,000 kWh) ` 4/kWh

Quality Inspection (` 3,00,000 / 10,000 ` 30 per inspection
inspections)
(ii) Computation of cost of unused capacity for each activity:

(`)
Power (` 2,00,000 – ` 1,80,000) or 5,000 x 4 20,000
Quality Inspections (` 3,00,000 – ` 2,70,000) or 1,000 x 30 30,000
Total cost of unused capacity 50,000

(iii) Factors management consider in choosing a capacity level to compute

the budgeted fixed overhead cost rate:
- Effect on product costing & capacity management
- Effect on pricing decisions.
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements.
- Difficulties in forecasting.
ILLUSTRATION 3
ABC Ltd. Manufactures two types of machinery equipment Y and Z and
applies/absorbs overheads on the basis of direct-labour hours. The budgeted
overheads and direct-labour hours for the month of December are
` 12,42,500 and 20,000 hours respectively. The information about Company’s
products is as follows:

Equipment Equipment
Y Z
Budgeted Production volume 2,500 units 3,125 units
Direct material cost ` 300 per unit ` 450 per unit
Direct labour cost

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 ACTIVITY BASED COSTING 5.21

Y : 3 hours @ ` 150 per hour

Z : 4 hours @ ` 150 per hour ` 450 ` 600
ABC Ltd.’s overheads of ` 12,42,500 can be identified with three major activities:
Order Processing (` 2,10,000), machine processing (` 8,75,000), and product
inspection (` 1,57,500). These activities are driven by number of orders processed,
machine hours worked, and inspection hours, respectively. The data relevant to these
activities is as follows:
Orders processed Machine hours Inspection hours
worked
Y 350 23,000 4,000
Z 250 27,000 11,000
Total 600 50,000 15,000

Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production,
COMPUTE the unit manufacturing cost of the equipment Y and Z, if the
budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs
of the equipment Y and Z, if the budgeted manufacturing volume is achieved.
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct-labour hours
as an application base, CALCULATE the amount of cost distortion (under-costed
or over-costed) for each equipment.
SOLUTION
(i) Overheads application base: Direct labour hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Overheads* 186.38 248.50
936.38 1,298.50

Budgeted overheads ` 12, 42,500

*Pre-determined rate = = = `62.125
Budgeted direct labour hours 20, 000 hours

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 5.22 COST AND MANAGEMENT ACCOUNTING

(ii) Estimation of Cost-Driver rate

Overhead cost Cost-driver level Cost driver

Activity rate
(`) (`)
Order processing 2,10,000 600 350
Orders processed
Machine 8,75,000 50,000 17.50
processing Machine hours
Inspection 1,57,500 15,000 10.50
Inspection hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Prime Cost 750 1,050
Overhead Cost
Order processing 350 : 250 or Rs 350 per 1,22,500 87,500
order
Machine processing 23,000 : 27,000 or ` 4,02,500 4,72,500
17.5 per hour
Inspection 4,000 : 11,000 42,000 1,15,500
Total overhead cost 5,67,000 6,75,500

Per unit cost

5,67,000 /2,500 226.80 ` 216.16
6,75,500/ 3,125
Unit manufacturing cost (Prime ` 976.80 ` 1,266.16
Cost + Overhead per unit)

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 ACTIVITY BASED COSTING 5.23

(iii)
Equipment Equipment
Y (`) Z (`)
Unit manufacturing cost–
using direct labour hours 936.38 1,298.50
as an application base
Unit manufacturing cost- 976.80 1,266.16
using activity based
costing
Cost distortion (-)40.42 + 32.34
Low volume product Y is under-costed and high volume product Z is over costed
using direct labour hours for overhead absorption.
ILLUSTRATION 4
‘Humara - Apna’ bank offers three products, viz., deposits, Loans and Credit Cards.
The bank has selected 4 activities for a detailed budgeting exercise, following activity
based costing methods.
The bank wants to know the product wise total cost per unit for the selected activities,
so that prices may be fixed accordingly.
The following information is made available to formulate the budget:

Activity Present Estimation for the budget

Cost (`) period
ATM Services:
(a) Machine Maintenance 4,00,000 All fixed, no change.
(b) Rents 2,00,000 Fully fixed, no change.
(c) Currency Replenishment 1,00,000 Expected to double during budget
Cost period.
7,00,000 (This activity is driven by no. of
ATM transactions)
Computer Processing 5,00,000 Half this amount is fixed and no
change is expected.
The variable portion is expected
to increase to three times the
current level.

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 5.24 COST AND MANAGEMENT ACCOUNTING

(This activity is driven by the

number of computer
transactions)
Issuing Statements 18,00,000 Presently, 3 lakh statements are
made. In the budget period, 5
lakh statements are expected.
For every increase of one lakh
statement, one lakh rupees is the
budgeted increase.
(This activity is driven by the
number of statements)
Computer Inquiries 2,00,000 Estimated to increase by 80%
during the budget period.
(This activity is driven by
telephone minutes)

The activity drivers and their budgeted quantifies are given below:
Activity Drivers Deposits Loans Credit
Cards
No. of ATM Transactions 1,50,000 --- 50,000
No. of Computer Processing 15,00,000 2,00,000 3,00,000
Transactions
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000

The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and
14,000 Credit Card Accounts.
Required:
(i) CALCULATE the budgeted rate for each activity.
(ii) PREPARE the budgeted cost statement activity wise.
(iii) COMPUTE the budgeted product cost per account for each product using (i) and
(ii) above.

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 ACTIVITY BASED COSTING 5.25

SOLUTION
Statement Showing “Budgeted Cost per unit of the Product”
Activity Activity Activity No. of Activity Deposits Loans Credit
Cost Driver Units of Rate (`) Cards
(Budgeted) Activity
(` ) Driver
(Budget)
ATM 8,00,000 No. of ATM 2,00,000 4.00 6,00,000 --- 2,00,000
Services Transaction
Computer 10,00,000 No. of 20,00,000 0.50 7,50,000 1,00,000 1,50,000
Processing Computer
processing
Transaction
Issuing 20,00,000 No. of 5,00,000 4.00 14,00,000 2,00,000 4,00,000
Statements Statements
Customer 3,60,000 Telephone 7,20,000 0.50 1,80,000 90,000 90,000
Inquiries Minutes
Budgeted 41,60,000 29,30,000 3,90,000 8,40,000
Cost
Units of Product (as estimated in the budget period) 58,600 13,000 14,000
Budgeted Cost per unit of the product 50 30 60

Working Note

Activity Budgeted Remark

Cost (` )
ATM Services:
(a) Machine 4,00,000 − All fixed, no change.
Maintenance −
(b) Rents 2,00,000 − Fully fixed, no change.
(c) Currency
Replenishment 2,00,000 − Doubled during budget period.
Cost
Total 8,00,000

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 5.26 COST AND MANAGEMENT ACCOUNTING

Computer Processing 2,50,000 − ` 2,50,000 (half of ` 5,00,000) is

fixed and no change is expected.
− ` 2,50,000 (variable portion) is
7,50,000 expected to increase to three
times the current level.
Total 10,00,000
Issuing Statements 18,00,000 − Existing.
2,00,000 − 2 lakh statements are expected
to be increased in budgeted
period. For every increase of one
lakh statement, one lakh rupees
is the budgeted increase.
Total 20,00,000
Computer Inquiries 3,60,000 − Estimated to increase by 80%
during the budget period.
Total 3,60,000 (` 2,00,000 x 180%)

SUMMARY
♦ 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.
♦ Unit level activities, batch level activities, product level activities and facility
level activities are the categories of activities that help to determine the type
of activity cost driver required.
♦ ABC is very much useful to the organization with multiple products.
♦ The limitations of ABC are that, it is very costly and cannot be applied to all
companies.
♦ The use of ABC as a costing tool to manage costs at activity level is known as
Activity Based Cost 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.
♦ The value-added activities are those activities which are indispensable in
order to complete the process.

© The Institute of Chartered Accountants of India

CHAPTER 6

COST SHEET

LEARNING OUTCOMES

 Classify and ascertain cost on the basis of function.

 Prepare cost sheet/statement for production of goods and
providing of services.

Cost Sheet

Functional Head of Costs in Format of Cost Advantages of

Classification Cost Sheet Sheet Cost Sheet

6.1 INTRODUCTION
One of the objectives of cost accounting system is ascertainment of cost for a
cost object. The cost objects may be a product, service or any cost centre.
Ascertainment of cost includes elementwise collection of costs, accumulation

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 6.2 COST AND MANAGEMENT ACCOUNTING

of the costs so collected for a certain volume or period and then arrange all
these accumulated costs into a sheet to calculate total cost for the cost
object. In this chapter, a product or a service will be the cost object for cost
calculation and cost ascertainment. A Cost Sheet or Cost Statement is “a
document which provides a detailed cost information. In a typical cost sheet,
cost information are presented on the basis of functional classification. However,
other classification may also be adopted as per the requirements of users of the
information.

6.2 FUNCTIONAL CLASSIFICATION OF ELEMENTS

6
OF COST
Under this classification, costs are divided according to the function for which
they have been incurred. The following are the classification of costs based on
functions:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.

6.3 COST HEADS IN A COST SHEET

6
The costs as classified on the basis of functions 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

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 COST SHEET 6.3

6.3.1 Prime Cost

Prime cost represents the total of direct materials costs, direct employee
(labour) costs and direct expenses. The total of cost for each element has to be
calculated separately.

Direct Material Cost xxx

Direct Employees (labour) Cost xxx
Direct Expenses xxx
Prime Cost: xxxx

(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

The valuation of materials purchased and issued for production shall be done as
per methods discussed in the ‘Chapter- 2 Material Cost’. Few examples are:
(a) Cost of material;
(b) Freight inwards;
(c) Insurance and other expenditure directly attributable to procurement;
(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: It is the total of payment made to the
employees who are engaged in the production of goods and provision of
services. Employee cost is also known as labour cost; it includes the following:
(a) Wages and salary;
(b) Allowances and incentives;
(c) Payment for overtimes;
(d) Bonus/ ex-gratia;

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 6.4 COST AND MANAGEMENT ACCOUNTING

(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 cost
object. The following costs are examples for direct expenses:
(a) Cost of utilities such as 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 product/ service specific design or drawing;
(g) Cost of product/ service specific software;
(h) Other expenses which are directly related with the production of goods or
provision of service.

6.3.2 Cost of Production

In a conventional cost sheet, this item of cost can be seen. It is the total of
prime cost and factory related costs and overheads.

Prime Cost xxx

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

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 COST SHEET 6.5

Less: Credit for recoveries (miscellaneous income) (xxx)

Add: Packing Cost (Primary packing) xxx
Cost of Production xxxx

(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 of
cost. Students may refer the ‘Chapter- Process & Operation Costing’ to know the
WIP valuation methods.
(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 overhead
is 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.

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 6.6 COST AND MANAGEMENT ACCOUNTING

(vii) Joint products and By-products: Joint costs are allocated

between/among the products on a rational and consistent basis. In case of by-
products, the net realisable value of by-products is deducted from the cost of
production.
(viii) Packing Cost (primary): Packing material which is essential to hold and
preserve the product for its use by the customer.

6.3.3 Cost of Goods Sold

It is the cost of production for goods sold. It is calculated after adjusting the
values of opening and closing stocks of finished goods. It can be calculated as below:

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

6.3.4 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. It is calculated as below:

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. It includes the followings:
(a) Depreciation and maintenance of, building, furniture etc. of corporate
or general management.
(b) Salary of administrative employees, accountants, directors, secretaries
etc.

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 COST SHEET 6.7

(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.
It includes the following costs:
(a) Salary and wages related with sales department and employees
directly related with selling of goods.

(b) Rent, depreciation, maintenance and other cost related with sales
department.
(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 the
goods available to the customers. The costs are
(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 costs
related with distribution vehicles etc.

6.4 COST SHEET/STATEMENT

6.4.1 Presentation of cost information
The cost items in the cost statement shall be presented on ‘basis of relevant
classification’.
Specimen Format of Cost Sheet for a Manufacturing entity

Particulars Total Cost per

Cost (`) unit (`)
1. Direct materials consumed:

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 6.8 COST AND MANAGEMENT ACCOUNTING

Opening Stock of Raw Material xxx

Add: Additions/ Purchases xxx
Less: Closing stock of Raw Material xxx
xxx
2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx
5. Add: 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. 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 xxx
production activity)
13. Less: Credit for Recoveries/Scrap/By-Products/ (xxx)
misc. income
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

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6.4.2 Treatment of various items of cost in Cost sheet/statement

(i) Abnormal costs- Any abnormal cost, where it is material and quantifiable,
shall 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 - These types of expenses are not
form part of cost.

(iv) Interest and other finance costs- 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. Interest and finance charges are not
included in cost of production.

6.4.3 Advantages of Cost sheet or Cost Statements

The main advantages of a Cost Sheet are as follows:
(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 submitting
tenders.
(iv) It provides sufficient help in arriving at the figure of selling price.
(v) It facilitates cost control by disclosing operational efficiency.
ILLUSTRATION 1
The following data relates to the manufacture of a standard product during the
month of April:

Particulars (Amount)
Raw materials ` 1,80,000
Direct wages ` 90,000
Machine hours worked (hours) 10,000

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 6.10 COST AND MANAGEMENT ACCOUNTING

Machine hour rate (per hour) `8

Administration overheads (general) ` 35,000
Selling overheads (per unit) `5
Units produced 4,000
Units sold 3,600
Selling price per unit ` 125
You are required to PREPARE a cost sheet in respect of the above showing:
(i) Cost per unit
(ii) Profit for the month
SOLUTION
(i) Cost Sheet Output: 4,000 units

Particulars Total Cost per

Cost (`) (unit) (`)
Raw materials 1,80,000 45.00
Direct wages 90,000 22.50
Prime cost 2,70,000 67.50
Add: Factory overheads (10,000 hrs × ` 8 per hour) 80,000 20.00
Cost of Production 3,50,000 87.50
Less: Closing Stock of finished goods (4,000 – (35,000) --
3,600 units)
Cost of Goods Sold 3,15,000 87.50
Add: Administration overheads (general) 35,000 9.72
Add: Selling Overheads (3,600 units × ` 5 unit) 18,000 5.00
Cost of sales (total Cost) 3,68,000 102.22
(ii) Statement of Profit

Particulars Total Cost

(`)
Sales revenue (3,600 units @ ` 125) 4,50,000
Less: Cost of sales 3,68,000
Profit 82,000

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ILLUSTRATION 2
The following information has been obtained from the records of ABC
Corporation for the period from June 1 to June 30.

On June 1 On June
(` ) 30 (` )
Cost of raw materials 60,000 50,000
Cost of work-in-process 12,000 15,000
Cost of stock of finished goods 90,000 1,10,000
Purchase of raw materials during June 2020 4,80,000
Wages paid 2,40,000
Factory overheads 1,00,000
Administration overheads (related to production) 50,000
Selling & distribution overheads 25,000
Sales 10,00,000

PREPARE a statement giving the following information:

(a) Raw materials consumed;
(b) Prime cost;
(c) Factory cost;
(d) Cost of goods sold; and
(e) Net profit.
SOLUTION
Statement of Cost & Profit
(for the month of June)

Amount (`)
Opening stock of raw materials 60,000
Add: Purchase of raw materials during the month of June 4,80,000
Less: Closing stock of raw materials (50,000)
(a) Raw materials consumed 4,90,000

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 6.12 COST AND MANAGEMENT ACCOUNTING

Add: Direct wages 2,40,000

(b) Prime cost 7,30,000
Add: Factory overheads 1,00,000
Works cost 8,30,000
Add: Opening work-in-process 12,000
Less: Closing work-in-process (15,000)
(c) Factory cost 8,27,000
Add: Administration overheads 50,000
Cost of production 8,77,000
Add: Opening stock of finished goods 90,000
Less: Closing stock of finished goods (1,10,000)
(d) Cost of goods sold 8,57,000
Add: Selling & distribution overheads 25,000
Cost of sales 8,82,000
(e) Net Profit 1,18,000
Sales 10,00,000

ILLUSTRATION 3
Arnav Inspat Udyog Ltd. has the following expenditures for the year ended 31st
March, 2021:

Sl. Amount Amount (`)

No. ( `)
(i) Raw materials purchased 10,00,00,000
(ii) GST paid on the above purchases @18% 1,80,00,000
(eligible for input tax credit)
(iii) Freight inwards 11,20,600
(iv) Wages paid to factory workers 29,20,000
(v) Contribution made towards employees’ PF
& ESIS 3,60,000

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 COST SHEET 6.13

(vi) Production bonus paid to factory workers 2,90,000

(vii) Royalty paid for production 1,72,600
(viii) Amount paid for power & fuel 4,62,000
(ix) Amount paid for purchase of moulds and
patterns (life is equivalent to two years
production) 8,96,000
(x) Job charges paid to job workers 8,12,000
(xi) Stores and spares consumed 1,12,000
(xii) Depreciation on:
Factory building 84,000
Office building 56,000
Plant & Machinery 1,26,000
Delivery vehicles 86,000 3,52,000
(xiii) Salary paid to supervisors 1,26,000
(xiv) Repairs & Maintenance paid for:
Plant & Machinery 48,000
Sales office building 18,000
Vehicles used by directors 19,600 85,600
(xv) Insurance premium paid for:
Plant & Machinery 31,200
Factory building 18,100
Stock of raw materials & WIP 36,000 85,300
(xvi) Expenses paid for quality control check
activities 19,600
(xvii) Salary paid to quality control staffs 96,200
(xviii) Research & development cost paid for
improvement in production process 18,200
(xix) Expenses paid for pollution control and
engineering & maintenance 26,600
(xx) Expenses paid for administration of factory
work 1,18,600

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 6.14 COST AND MANAGEMENT ACCOUNTING

(xxi) Salary paid to functional mangers:

Production control 9,60,000
Finance & Accounts 9,18,000
Sales & Marketing 10,12,000 28,90,000
(xxii) Salary paid to General Manager 12,56,000
(xxiii) Packing cost paid for:
Primary packing necessary to maintain
quality 96,000
For re-distribution of finished goods 1,12,000 2,08,000
(xxiv) Wages of employees engaged in
distribution of goods 7,20,000
(xxv) Fee paid to auditors 1,80,000
(xxvi) Fee paid to legal advisors 1,20,000
(xxvii) Fee paid to independent directors 2,20,000
(xxviii) Performance bonus paid to sales staffs 1,80,000
(xxix) Value of stock as on 1st April, 2020:
Raw materials 18,00,000
Work-in-process 9,20,000
Finished goods 11,00,000 38,20,000
(xxx) Value of stock as on 31st March, 2021:
Raw materials 9,60,000
Work-in-process 8,70,000
Finished goods 18,00,000 36,30,000

Amount realized by selling of scrap and waste generated during manufacturing

process – ` 86,000/-
From the above data you are required to PREPARE Statement of cost for Arnav Ispat
Udyog Ltd. for the year ended 31st March, 2021, showing (i) Prime cost, (ii) Factory
cost, (iii) Cost of Production, (iv) Cost of goods sold and (v) Cost of sales.

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 COST SHEET 6.15

SOLUTION
Statement of Cost of Arnav Ispat Udyog Ltd. for the year ended 31st March, 2021:

Sl. Particulars Amount Amount (`)

No. (`)
(i) Material Consumed:
Raw materials purchased 10,00,00,000
Freight inwards 11,20,600
Add: Opening stock of raw materials 18,00,000
Less: Closing stock of raw materials (9,60,000) 10,19,60,600
(ii) Direct employee (labour) cost:
Wages paid to factory workers 29,20,000
Contribution made towards employees’ PF
& ESIS 3,60,000
Production bonus paid to factory workers 2,90,000 35,70,000
(iii) Direct expenses:
Royalty paid for production 1,72,600
Amount paid for power & fuel 4,62,000
Amortised cost of moulds and patterns 4,48,000
Job charges paid to job workers 8,12,000 18,94,600
Prime Cost 10,74,25,200
(iv) Works/ Factory overheads:
Stores and spares consumed 1,12,000
Depreciation on factory building 84,000
Depreciation on plant & machinery 1,26,000
Repairs & Maintenance paid for plant &
machinery 48,000
Insurance premium paid for plant &
machinery 31,200
Insurance premium paid for factory
building 18,100
Insurance premium paid for stock of raw 36,000

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 6.16 COST AND MANAGEMENT ACCOUNTING

materials & WIP

Salary paid to supervisors 1,26,000
Expenses paid for pollution control and
engineering & maintenance 26,600 6,07,900
Gross factory cost 10,80,33,100
Add: Opening value of W-I-P 9,20,000
Less: Closing value of W-I-P (8,70,000)
Factory Cost 10,80,83,100
(v) Quality control cost:
Expenses paid for quality control check
activities 19,600
Salary paid to quality control staffs 96,200 1,15,800
(vi) Research & development cost paid for
improvement in production process 18,200
(vii) Administration cost related with
production:
-Expenses paid for administration of
factory work 1,18,600
-Salary paid to Production control manager 9,60,000 10,78,600
(viii) Less: Realisable value on sale of scrap and
waste (86,000)
(ix) Add: Primary packing cost 96,000
Cost of Production 10,93,05,700
Add: Opening stock of finished goods 11,00,000
Less: Closing stock of finished goods (18,00,000)
Cost of Goods Sold 10,86,05,700
(x) Administrative overheads:
Depreciation on office building 56,000
Repairs & Maintenance paid for vehicles
used by directors 19,600
Salary paid to Manager- Finance & 9,18,000

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 COST SHEET 6.17

Accounts
Salary paid to General Manager 12,56,000
Fee paid to auditors 1,80,000
Fee paid to legal advisors 1,20,000
Fee paid to independent directors 2,20,000 27,69,600
(xi) Selling overheads:
Repairs & Maintenance paid for sales office
building 18,000
Salary paid to Manager- Sales & Marketing 10,12,000
Performance bonus paid to sales staffs 1,80,000 12,10,000
(xii) Distribution overheads:
Depreciation on delivery vehicles 86,000
Packing cost paid for re-distribution of
finished goods 1,12,000
Wages of employees engaged in
distribution of goods 7,20,000 9,18,000
Cost of Sales 11,35,03,300

Note:
GST paid on purchase of raw materials would not be part of cost of materials as it
is eligible for input tax credit.

SUMMARY
♦ Cost Sheet: A Cost Sheet or Cost Statement is “a document which provides a
detailed cost information. In a typical cost sheet, cost information are
presented on the basis of functional classification. However, other classification
may also be adopted as per the requirements of users of the information.
♦ 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.
♦ Prime Cost: Prime cost represents the total of direct materials costs, direct
employee (labour) costs and direct expenses.

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 6.18 COST AND MANAGEMENT ACCOUNTING

♦ Cost of Production: Cost of production consists of cost of materials

consumed, direct employee (labour) costs, direct expenses, production
overheads, quality control costs, primary packing cost, R&D and
administration cost relating to production.
♦ Primary Packing Cost: Cost incurred on packing materials which are
essential to hold and preserve the product for further processing or its use
by consumer.
♦ Secondary Packing Cost: Cost incurred on packing materials which is used
to store, transport, and promote the product.
♦ Cost of goods sold: Cost of production adjusted with opening and closing
inventories of finished goods.
♦ Administrative overheads: Cost incurred of all activities relating to general
management and administration of an entity.
♦ Marketing overheads: Marketing overheads comprise of selling overheads
and distribution overheads.
♦ Selling Overheads: Expenses related to sale of products or services.
♦ Distribution overheads: Costs incurred in handling a product or service
from the time it is ready to dispatch or delivery until it reaches the ultimate
consumer.
♦ Cost of Sales: It is the total cost of a product incurred to make the product
available to the customer or consumer. It is the aggregate of cost of goods
sold, administrative costs, marketing costs and other separate line items of
cost which could not form part of cost of production.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Generally, for the purpose of cost sheet preparation, costs are classified on
the basis of:
(a) Functions
(b) Variability
(c) Relevance
(d) Nature

© The Institute of Chartered Accountants of India

CHAPTER 7

COST ACCOUNTING
SYSTEMS

LEARNING OUTCOMES

 Discuss the Cost Accounting System.

 Differentiate between Integral and Non- Integral system of
accounting.
 Identify the ledgers maintained under Integral and Non-
Integral accounting system.
 Analyse the reasons for differences in profit under financial
and cost accounting systems.
 Prepare reconciliation statement for profit under financial
and cost accounting systems.
 Discuss the accounting for management information and
cost control.

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 7.2 COST AND MANAGEMENT ACCOUNTING

Integral

7.1 INTRODUCTION
7
To operate business operations efficiently and successfully, it is necessary to make use
of an appropriate accounting system. Such a system should state in clear terms
whether cost and financial transactions should be integrated or kept separately (Non-
integrated). Where cost and financial accounting records are integrated, the
system so evolved is known as integrated or integral accounting system. In case
cost and financial transactions are kept separately, the system is called Non-
Integrated Accounting system or Cost Control System. While non-integrated
system of accounting necessitates reconciliation between financial and cost accounts
but no reconciliation is required under integrated accounting system.

7.2 NON-INTEGRATED ACCOUNTING SYSTEM

7
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’.

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 COST ACCOUNTING SYSTEMS 7.3

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. Items of accounts
which are excluded are represented by an account known as Cost ledger
control account.
The important ledgers to be maintained under non-integrated accounting
system in the Cost Accounting are the followings:
(a) Cost Ledger - This is the principle ledger of the cost department in which
impersonal accounts are recorded. This ledger is made self-balancing by
maintaining therein a Control Account for each subsidiary ledger.
(b) Stores Ledger - It contains an account for each item of stores. The entries in each
account maintained in this ledger are made from the invoice, goods received note,
material requisitions, material received note etc. Accounts in respect of each item of
stores show receipt, issue and balance in physical as well as in monetary terms.
(c) Work-in-Process Ledger - This ledger is also known as job ledger, it contains
accounts of unfinished jobs and processes. All material costs, wages and overheads
for each job in process are posted to the respective job accounts in this ledger. The
balance in a job account represents total balance of job/work-in-process, as shown
by the job account.
(d) Finished Goods Ledger - It contains an account for each item of finished
product manufactured or the completed job. If the finished product is transferred
to stock, a credit entry is made in the work-in-process ledger and a corresponding
debit entry is made in this ledger.
7.2.1 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 purchase
of material and credited for issue of materials from the stores. The

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 7.4 COST AND MANAGEMENT ACCOUNTING

balance in this account indicates the total balance of all the individual stores
accounts. 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 Overheads Adjustment
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, and 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.

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(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 and
recovered is transferred usually to Overhead Adjustment Account.
(9) Cost of Sales Account - 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.
Note: Sometimes, Overhead Adjustment Account is dispensed with and under/over
absorbed overheads is directly transferred to Costing Profit & Loss Account from
the respective overhead accounts.
7.2.2 Scheme of Accounting Entries
The manner in which the Cost Ledger, when maintained on a double entry basis,
would operate is illustrated by the following statements of various journal entries
as would appear in the cost books.

Material:
(a) Purchase—` 5,000 (credit or cash) (`) (`)
(i) Material Control A/c …………………………….. Dr. 5,000
To Cost Ledger Control A/c 5,000
(ii) Stores Ledger Control A/c ……………………… Dr. 5,000
To Material Control A/c 5,000
Note: Sometimes Material Control Account is dispensed with and entries are
directly made into Stores Ledger Control A/c, giving a credit to Cost Ledger
Control A/c.

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 7.6 COST AND MANAGEMENT ACCOUNTING

(b) Purchases worth ` 500 for special job

Work-in-Process Ledger Control A/c…………………. Dr. 500
To Cost Ledger Control A/c 500
(c) Material returned to vendor—` 500
Cost Ledger Control A/c …………………………………. Dr. 500
To Store Ledger Control A/c 500
(d) (i) Material (Direct) issued to production—` 1,000
Work-in-Process Control A/c……………………. Dr. 1,000
To Store Ledger Control A/c 1,000
(ii) Material (Indirect) issued to production—` 200
Production Overhead Control A/c…………………. Dr. 200
To Store Ledger Control A/c 200
(e) (i) Material worth ` 200 returned from shop to
stores
Stores Ledger Control A/c…………………. Dr. 200
To Work-in-Process Control A/c 200
(ii) Material worth ` 100 is transferred from Job-1 to Job- 2
Job- 2 A/c………………………………………… Dr. 100
To Job- 1 A/c 100
(f) Material worth ` 100 is issued from stores for repairs
Production Overhead Control A/c………………………. Dr. 100
To Stores Ledger Control A/c 100
Labour:
(g) Direct wages paid to workers— ` 1,000
Wages Control A/c………………………………………… Dr. 1,000
To Cost Ledger Control A/c 1,000
(h) Indirect wages paid to workers in the production— ` 700
(i) Wages Control A/c……………………………………… Dr. 700
To Cost Ledger Control A/c 700

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 COST ACCOUNTING SYSTEMS 7.7

(ii) Production Overhead Control A/c…………………… Dr. 700

To Wages Control A/c 700
(i) Indirect wages paid to workers in administration— ` 500
(i) Wages Control A/c……………………………………… Dr. 500
To Cost Ledger Control A/c 500
(ii) Administration Overhead A/c………………………… Dr. 500
To Wages Control A/c 500
(j) Indirect wages paid to workers in Selling & Dist. department— ` 300
(i) Wages Control A/c……………………………………… Dr. 300
To Cost Ledger Control A/c 300
(ii) Selling & Dist. Overhead A/c…………………………. Dr. 300
To Wages Control A/c 300
Direct Expenses:
(k) Direct expenses incurred ` 500 for Job No. 12
Job No. 12 A/c (WIP Control A/c)………………………. Dr. 500
To Cost Ledger Control A/c 500
Overheads:
(l) Overhead expenses incurred ` 500 (Production `150;
Administrative `150; Selling and Distribution `200)
Production Overhead Control A/c……………………….. Dr. 150
Administrative Overhead Control A/c…………………… Dr 150
Selling & Dist. Overhead Control A/c…………………… Dr 200
To Cost Ledger Control A/c 500
(m) Carriage Inward (Direct to Factory) —` 100
Production Overhead Control A/c……………………….. Dr. 100
To Cost Ledger Control A/c 100

© The Institute of Chartered Accountants of India

 7.8 COST AND MANAGEMENT ACCOUNTING

(n) Production overhead recovered—` 1,000

Work-in-Process Ledger Control A/c…………………... Dr. 1,000
To Production Overhead Control A/c 1,000
(o) Administrative Overhead recovered ` 500 from finished goods
Finished Goods Ledger Control A/c…………………….. Dr. 500
To Administrative Overhead Control A/c 500
(p) Selling and Distribution Overhead ` 100 recovered from sales
Cost of Sales A/c………………………………………….. Dr. 100
To Selling & Dist. Overhead Control A/c 100
(q) Under recovery of overheads
Costing Profit & Loss A/c…………………………………. Dr. xxx
To Administrative Overhead Control A/c xxx
(r) Over recovery of overheads
Production Overheads Control A/c…………………….. Dr. xxx
To Costing Profit & Loss A/c xxx
Sales:
(s) Cost Ledger Control A/c………………………………….. Dr. xxx
To Costing Profit & Loss A/c xxx
Profit/ Loss:
(t) In case of Profit
(i) Costing Profit & Loss A/c…………………………… Dr. xxx
To Cost Ledger Control A/c xxx
(u) In case of Loss
(ii) Cost Ledger Control A/c…………………………… Dr. xxx
To Costing Profit & Loss A/c xxx

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.9

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.
ILLUSTRATION 1
As on 31st March, the following balances existed in a firm’s Cost Ledger:

Dr. Cr.
(` ) (` )
Stores Ledger Control A/c 3,01,435
Work-in-Process Control A/c 1,22,365
Finished Stock Ledger Control A/c 2,51,945
Manufacturing Overhead Control A/c 10,525
Cost Ledger Control A/c 6,65,220
6,75,745 6,75,745

© The Institute of Chartered Accountants of India

 7.10 COST AND MANAGEMENT ACCOUNTING

During the next three months the following items arose:

(` )
Finished product (at cost) 2,10,835
Manufacturing overhead incurred 91,510
Raw materials purchased 1,23,000
Factory Wages 50,530
Indirect Labour 21,665
Cost of Sales 1,85,890
Material issued to production 1,27,315
Sales returned at Cost 5,380
Material returned to suppliers 2,900
Manufacturing overhead charged to production 77,200

You are required to PASS the Journal Entries; write up the accounts and schedule the
balances, stating what each balance represents.
SOLUTION
Journal entries are as follows:

Dr. Cr.
(`) (`)
1. Finished stock ledger Control A/c Dr. 2,10,835
To Work-in-Process Control A/c 2,10,835
2. Manufacturing Overhead Control A/c Dr. 91,510
To Cost Ledger Control A/c 91,510
3. Stores Ledger Control A/c Dr. 1,23,000
To Cost Ledger Control A/c 1,23,000
4. (i) Wage Control A/c Dr. 72,195
To Cost Ledger Control A/c 72,195
(ii) Work-in-Process Control A/c Dr. 50,530
To Wages Control A/c 50,530
(iii) Manufacturing Overhead Control A/c Dr. 21,665
To Wages Control A/c 21,665

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.11

5. Cost of Sales A/c Dr. 1,85,890

To Finished Stock Ledger A/c 1,85,890
6. Work-in-Process Control A/c Dr. 1,27,315
To Stores Ledger Control A/c 1,27,315
7. Finished Stock Ledger Control A/c Dr. 5,380
To Cost of Sales A/c 5,380
8. Cost Ledger Control A/c Dr. 2,900
To Stores Ledger Control A/c 2,900
9. Work-in-Process Control A/c Dr. 77,200
To Manufacturing Overhead Control A/c 77,200

COST LEDGERS
Cost Ledger Control Account

Particulars (`) Particulars (`)

To Stores Ledger Control 2,900 By Balance b/d 6,65,220
A/c (return)
” Balance c/d 9,49,025 ” Manufacturing OH 91,510
Control A/c
” Stores Ledger Control 1,23,000
A/c
” Wages Control A/c 72,195
9,51,925 9,51,925

Stores Ledger Control Account

Particulars (`) Particulars (`)

To Balance b/d 3,01,435 By Work in Process Control 1,27,315
A/c
” Cost Ledger Control A/c 1,23,000 ” Cost Ledger Control A/c 2,900
” Balance c/d 2,94,220
4,24,435 4,24,435

© The Institute of Chartered Accountants of India

 7.12 COST AND MANAGEMENT ACCOUNTING

Wages Control Account

Particulars (`) Particulars (`)

To Cost Ledger Control A/c 72,195 By Work in Process Control A/c 50,530
” Manufacturing OH Control 21,665
A/c
72,195 72,195

Manufacturing Overhead Control Account

Particulars (`) Particulars (`)

To Cost Ledger Control 91,510 By Balance b/d 10,525
A/c
” Wages Control A/c 21,665 ” Work in Process Control 77,200
A/c
” Balance c/d 25,450
1,13,175 1,13,175

Work-in-Process Control Account

Particulars (`) Particulars (`)

To Balance b/d 1,22,365 By Finished Stock Ledger 2,10,835
Control A/c
” Wages Control A/c 50,530 ” Balance c/d 1,66,575
” Stores Ledger Control 1,27,315
A/c
” Manufacturing OH 77,200
Control A/c
3,77,410 3,77,410

Finished Stock Ledger Control Account

Particulars (`) Particulars (`)

To Balance b/d 2,51,945 By Cost of Sales Control A/c 1,85,890
” Work in Process 2,10,835 ” Balance c/d 2,82,270
Control A/c

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.13

” Cost of Sales Control 5,380

A/c (Return at cost)
4,68,160 4,68,160

Cost of Sales Account

Particulars (`) Particulars (`)

To Finished Stock Ledger 1,85,890 By Finished Stock Ledger 5,380
Control Control (Return)
” Balance c/d 1,80,510
1,85,890 1,85,890

Trial Balance

Particulars Dr. Cr.

(`) (`)
Stores Ledger Control A/c 2,94,220
Work-in-Process Control A/c 1,66,575
Finished Stock Ledger Control A/c 2,82,270
Manufacturing Overhead Control A/c 25,450
Cost of Sales A/c 1,80,510
Cost Ledger Control A/c 9,49,025
9,49,025 9,49,025

ILLUSTRATION 2
Acme Manufacturing Co. Ltd. opens the costing records, with the balances as on 1st
July as follows:
(`) (`)
Material Control A/c 1,24,000
Work-in-Process Control A/c 62,500
Finished Goods Control A/c 1,24,000
Production Overhead Control A/c 8,400
Administrative Overhead Control A/c 12,000
Selling & Distribution Overhead Control A/c 6,250

© The Institute of Chartered Accountants of India

 7.14 COST AND MANAGEMENT ACCOUNTING

Cost Ledger Control A/c 3,13,150

3,25,150 3,25,150

The following are the transactions for the quarter ended 30th September:
(`)
Materials purchased 4,80,100
Materials issued to jobs 4,77,400
Materials to works maintenance 41,200
Materials to administrative office 3,400
Materials to sales department 7,200
Wages direct 1,49,300
Wages indirect 65,000
Transportation for indirect materials 8,400
Production overheads incurred 2,42,250
Absorbed production overheads 3,59,100
Administrative overheads incurred 74,000
Administrative overheads allocated to production 52,900
Administrative overheads allocated to sales department 14,800
Selling & Distribution overheads incurred 64,200
Selling & Distribution overheads absorbed 82,000
Finished goods produced 9,58,400
Finished goods sold 9,77,300
Sales 14,43,000

Make up the various accounts as you envisage in the Cost Ledger and PREPARE a
Trial Balance as at 30th September.
SOLUTION
Cost Ledgers
Material Control A/c*

Particulars (`) Particulars (`)

To Balance b/d 1,24,000 By Work-in-process Control 4,77,400
A/c

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.15

” Cost Ledger Control 4,80,100 ” Production OH Control 41,200

A/c (purchase) A/c
” Admn. OH Control A/c 3,400
” S&D OH Control A/c 7,200
” Balance c/d 74,900
6,04,100 6,04,100
*Material Control A/c may also be written as Stores Ledger Control A/c
Wages Control A/c

Particulars (`) Particulars (`)

To Cost Ledger Control 2,14,300 By Work-in-process Control 1,49,300
A/c A/c
” Production OH Control 65,000
A/c
2,14,300 2,14,300
Production Overhead Control A/c

Particulars (`) Particulars (`)

To Balance b/d 8,400 By Work-in-process 3,59,100
Control A/c
” Cost Ledger Control
A/c:
- Transportation 8,400
- Production OH 2,42,250
” Wages Control A/c 65,000
” Material Control A/c 41,200 ” Balance c/d 6,150
3,65,250 3,65,250

Administrative Overhead Control A/c

Particulars (`) Particulars (`)

To Cost Ledger Control 74,000 By Balance b/d 12,000
A/c

© The Institute of Chartered Accountants of India

 7.16 COST AND MANAGEMENT ACCOUNTING

” Material Control A/c: 3,400 ” Finished Goods 52,900

Control A/c
” Balance c/d 2,300 ” Cost of sales A/c 14,800
79,700 79,700

Work-in-Process Control A/c

Particulars (`) Particulars (`)

To Balance b/d 62,500 By Finished goods Control 9,58,400
A/c
” Material Control A/c 4,77,400
” Wages Control A/c 1,49,300
” Production OH 3,59,100
Control A/c
” Balance c/d 89,900
10,48,300 10,48,300

Finished Goods Control A/c

Particulars (`) Particulars (`)

To Balance b/d 1,24,000 By Cost of Sales A/c 9,77,300
“ Administrative 52,900
Overhead Control A/c
” Work-in-process 9,58,400 ” Balance c/d 1,58,000
Control A/c
11,35,300 11,35,300

Selling and Distribution Overhead Control A/c

Particulars (`) Particulars (`)

To Balance b/d 6,250 By Cost of Sales A/c 82,000
” Cost Ledger Control 64,200
A/c:
” Material Control A/c 7,200
” Balance c/d 4,350
82,000 82,000

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.17

Cost of Sales A/c

Particulars (`) Particulars (`)

To Finished Goods 9,77,300 By Costing P&L A/c 10,74,100

Control A/c
” Admn. OH Control 14,800
A/c
” S&D OH Control A/c 82,000
10,74,100 10,74,100

Cost Ledger Control A/c

Particulars (`) Particulars (`)

To Costing P&L A/c (Sales) 14,43,000 By Balance b/d 3,13,150

” Material Control A/c 4,80,100
” Wages Control A/c 2,14,300
(`1,49,300+`65,000)
” Production OH Control A/c 2,50,650
(`8,400+`2,42,250)
” Administrative OH A/c 74,000
” S&D OH Control A/c 64,200
” Balance c/d 3,22,300 ” Costing P&L A/c 3,68,900
17,65,300 17,65,300

Costing Profit & Loss A/c

Particulars (`) Particulars (`)

To Cost of sales A/c 10,74,100 By Cost Ledger Control 14,43,000

” Cost Ledger Control 3,68,900 A/c (sales)
A/c (profit) (balancing
figure)
14,43,000 14,43,000

© The Institute of Chartered Accountants of India

 7.18 COST AND MANAGEMENT ACCOUNTING

Trial Balance as at 30th September

Dr. (`) Cr. (`)

Material Control A/c 74,900
Production OH Control A/c 6,150
Administrative OH Control A/c 2,300
Selling & Distribution OH Control A/c 4,350
Work-in-process Control A/c 89,900
Finished Goods Control A/c 1,58,000
Cost Ledger Control A/c 3,22,300
3,28,950 3,28,950

7.3 INTEGRATED (OR INTEGRAL) ACCOUNTING

7
SYSTEM
Integrated Accounts is the name given to a system of accounting, whereby cost
and financial accounts are kept in the same set of books. Obviously, then 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.
7.3.1 Advantages
The main advantages of Integrated Accounts are as follows:
(a) No need for Reconciliation- The question of reconciling costing profit and
financial 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 in
efforts made.
(c) Less time consuming- No delay is caused in obtaining information as it is
provided from books of original entry.

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.19

(d) Economical process- It is economical also as it is based on the concept of

“Centralisation of Accounting function”.
7.3.2 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 sets
of 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.
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 will
be a number of subsidiary ledgers; in addition to the useful Customers’ Ledger and
the Purchase Ledger, there will be: (a) Stores Ledger; (b) Stock Ledger and (c) Job
Ledger.
7.3.3 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 does not
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 are used
for “General Ledger Adjustment Account/ Cost Ledger Control Account” of non-
integrated system:
(a) Bank account

© The Institute of Chartered Accountants of India

 7.20 COST AND MANAGEMENT ACCOUNTING

(b) Receivables (Debtors) account

(c) Payables (Creditors) account
(d) Provision for depreciation account etc.
In integrated system, all accounts necessary for showing classification of cost will
be used but the cost ledger control account of non-integrated accounting is
replaced by use of following accounts:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account
(e) Fixed assets account
(f) Share capital account
If the illustration given below is to be worked out on integrated account basis, the
journal entries would be as follows:
ILLUSTRATION 3
JOURNALISE the following transactions assuming that cost and financial transactions
are integrated:
(`)
Raw materials purchased 2,00,000
Direct materials issued to production 1,50,000
Wages paid (30% indirect) 1,20,000
Wages charged to production 84,000
Manufacturing expenses incurred 84,000
Manufacturing overhead charged to production 92,000
Selling and distribution costs 20,000
Finished products (at cost) 2,00,000
Sales 2,90,000
Closing stock Nil
Receipts from debtors 69,000
Payments to creditors 1,10,000

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.21

SOLUTION
Journal entries are as follows:

DR. (`) CR. (`)

Stores Ledger Control A/c……………………………… Dr. 2,00,000
To Payables (Creditors)/ Bank A/c 2,00,000
(Materials purchased)
Work-in-Process Control A/c…………………………… Dr. 1,50,000
To Stores Ledger Control A/c 1,50,000
(Materials issued to production)
Wages Control A/c………………………………………. Dr. 1,20,000
To Bank A/c 1,20,000
(Wages paid)
Factory Overhead Control A/c…………………………. Dr. 36,000
To Wages Control A/c 36,000
(30% of wages paid being indirect charged to
overhead)
Work-in-Process Control A/c…………………………… Dr. 84,000
To Wages Control A/c 84,000
(Direct wages charged to production)
Factory Overhead Control A/c………………………… Dr. 84,000
To Bank A/c 84,000
(Manufacturing overhead incurred)
Work-in-Process Control A/c…………………………… Dr. 92,000
To Factory Overhead Control A/c 92,000
(Manufacturing overhead charged to production)
Selling & Distribution Overhead Control A/c………. Dr. 20,000
To Bank A/c 20,000
(Selling and distribution costs incurred)
Finished Goods Control A/c……………………………. Dr. 2,00,000
To Work-in-Process Control A/c 2,00,000
(Cost of finished goods)
Cost of Sales A/c………………………………………… Dr. 2,20,000
To Finished Goods Control A/c 2,00,000

© The Institute of Chartered Accountants of India

 7.22 COST AND MANAGEMENT ACCOUNTING

To Selling and Distribution Control A/c 20,000

(Costs of sales)
Receivables (Debtors)/ Bank A/c…………………………… Dr. 2,90,000
To Sales A/c 2,90,000
(Finished goods sold)
Bank A/c…………………………………………………... Dr. 69,000
To Receivables (Debtors) A/c 69,000
(Receipts from receivables)
Payables (Creditors) A/c………………………………... Dr. 1,10,000
To Bank A/c 1,10,000
(Payment made to payables)

ILLUSTRATION 4
In the absence of the Chief Accountant, you have been asked to prepare a month’s
cost accounts for a company which operates a batch costing system fully integrated
with the financial accounts. The following relevant information is provided to you:

(`) (`)
Balances at the beginning of the month:
Stores Ledger Control Account 25,000
Work-in-Process Control Account 20,000
Finished Goods Control Account 35,000
Prepaid Production Overheads brought forward from 3,000
previous month
Transactions during the month:
Materials Purchased 75,000
Materials Issued:
To production 30,000
To factory maintenance 4,000 34,000
Materials transferred between batches 5,000
Total wages paid:
To direct workers 25,000
To indirect workers 5,000 30,000

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.23

Direct wages charged to batches 20,000

Recorded non-productive time of direct workers 5,000
Selling and Distribution Overheads Incurred 6,000
Other Production Overheads Incurred 12,000
Sales 1,00,000
Cost of Finished Goods Sold 80,000
Cost of Goods completed and transferred into finished 65,000
goods during the month
Physical value of work-in-Process at the end of the month 40,000

The production overhead absorption rate is 150% of direct wages charged to work-
in-Process.
Required:
PREPARE the following accounts for the month:
(a) Stores Ledger Control Account.
(b) Work-in-Process Control Account.
(c) Finished Goods Control Account.
(d) Production Overhead Control Account.
(e) Costing Profit and Loss Account.
SOLUTION
(a) Stores Ledger Control Account
(`) (`)
To Balance b/d 25,000 By Work in Process Control A/c 30,000
” Creditors/ Bank A/c 75,000 ” Production OH Control A/c 4,000
” Balance c/d 66,000
1,00,000 1,00,000
(b) Wages Control Account
(`) (`)
To Bank A/c (Paid to 25,000 By Work in Process Control A/c 20,000
direct workers) (Charged to batches)

© The Institute of Chartered Accountants of India

 7.24 COST AND MANAGEMENT ACCOUNTING

” Bank A/c (Paid to 5,000 ,, Production OH Control A/c 5,000

indirect workers)
” Production OH Control A/c 5,000
(Non-productive wages)
30,000 30,000
(c) Production Overhead Control Account

(`) (`)
To Balance b/d 3,000 By Work-in-Process 30,000
(Prepaid amount) Control A/c (150% of
direct wages)
” Stores Ledger 4,000
Control A/c
” Wages Control 10,000
A/c
(`5,000 + `5,000)
” Bank A/c 12,000
” Costing P&L A/c 1,000
(Over-absorption,
balancing figure)
30,000 30,000

(d) Work-in-Process Control Account

(`) (`)
To Balance b/d 20,000 By Finished Goods 65,000
Control A/c
” Store Ledger Control A/c 30,000 ” Balance c/d 40,000
(Physical value)
” Wages Control A/c 20,000
” Production OH Control A/c 30,000
(150% of direct wages)
” Costing P&L A/c 5,000
(Stock Gains)
1,05,000 1,05,000

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.25

(e) Finished Goods Control Account

(`) (`)
To Balance b/d 35,000 By Cost of Goods Sold* A/c 80,000
” Work-in-Process 65,000 ” Balance c/d 20,000
Control A/c
1,00,000 1,00,000
* Alternatively, Costing Profit & Loss Account
(f) Costing Profit & Loss Account

(`) (`)
To Finished goods 80,000 By Sales A/c 1,00,000
control A/c or Cost of
Goods Sold A/c
” Selling & distribution 6,000 ” Production OH 1,000
OH A/c Control A/c
” Balance c/d 20,000 ” Work-in-Process 5,000
Control A/c
(Stock gain)
1,06,000 1,06,000

Notes:
(1) Materials transferred between batches will not affect the Control
Accounts.
(2) Non-production time of direct workers is a production overhead and
therefore will not be charged to work-in-Process control A/c.
(3) Production overheads absorbed in work-in-Process Control A/c equals
to ` 30,000 (150% of ` 20,000).
(4) In the work-in-Process Control A/c the excess physical value of stock is
taken resulting in stock gain. Stock gain is transferred to Profit & Loss
A/c.
ILLUSTRATION 5
A fire destroyed some accounting records of a company. You have been able to collect
the following from the spoilt papers/records and as a result of consultation with
accounting staff for the month of January:

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 7.26 COST AND MANAGEMENT ACCOUNTING

(i) Incomplete Ledger Entries:

Materials Control A/c
(`) (`)
To Balance b/d 32,000

Work-in-Process Control A/c

(`) (`)
To Balance b/d 9,200 By Finished Goods 1,51,000
Control A/c

Payables (Creditors) A/c

(`) (`)
By Balance b/d 16,400
To Balance c/d 19,200

Manufacturing Overheads Control A/c

(`) (`)
To Bank A/c (Amount 29,600
spent)

Finished Goods Control A/c

(`) (`)
To Balance b/d 24,000
By Balance c/d 30,000

(ii) Additional Information:

(1) The bank-book showed that ` 89,200 have been paid to creditors for raw-
material.

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 COST ACCOUNTING SYSTEMS 7.27

(2) Ending inventory of work-in-process included materials of ` 5,000 on

which 300 direct labour hours have been booked against wages and
overheads.
(3) The job card showed that workers have worked for 7,000 hours. The wage
rate is ` 10 per labour hour.
(4) Overhead recovery rate was ` 4 per direct labour hour.
You are required to COMPLETE the above accounts in the cost ledger of the
company.
SOLUTION
Materials Control A/c
(`) (`)
To Balance b/d 32,000 By Work-in-process 53,000
Cost Ledger Control A/c control A/c
To Payables (Creditors) A/c 92,000 By Balance c/d 71,000
(Purchases)
1,24,000 1,24,000
Manufacturing Overheads A/c
(`) (`)
To Bank A/c (amount 29,600 By Work-in-process control 28,000
spent) A/c (`4 × 7,000 hours)
By Costing P/L A/c 1,600
(Under-absorbed OH)
29,600 29,600

Work-in-Process Control A/c

(`) (`)
To Balance b/d 9,200 By Finished Goods Control 1,51,000
A/c
To Wages Control A/c 70,000 By Balance c/d:
(`10 × 7,000 hours)
To Overheads Control A/c 28,000 -Material 5,000
(`4 × 7,000 hours)

© The Institute of Chartered Accountants of India

 7.28 COST AND MANAGEMENT ACCOUNTING

-Wages (`10 × 3,000

300 hours)
To Materials Control A/c 53,000 - Overheads (`4 1,200 9,200
(Balancing figure) × 300 hours)
1,60,200 1,60,200

Finished Goods Control A/c

(`) (`)
To Balance b/d 24,000 By Cost of sales A/c (Bal. 1,45,000
fig.)
To Work-in-process 1,51,000 By Balance c/d 30,000
Control A/c (as above)
1,75,000 1,75,000

Payables (Creditors) A/c

(`) (`)
To Bank A/c 89,200 By Balance b/d 16,400
To Balance c/d 19,200 By Material Control A/c 92,000
(Purchases)
(Balancing fig.)
1,08,400 1,08,400

7.4 RECONCILIATION OF COST AND FINANCIAL

7
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 that
in the financial accounts, the expenses should be analysed in the same way as in
the cost accounts.
The General Ledger Adjustment Account in the Cost Ledger may be studied to know
the items which are included here and how differently these are presented in the
financial 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 or those charged in

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 COST ACCOUNTING SYSTEMS 7.29

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.
It is important, however, to know the causes which, generally, give rise to
differences in the Cost and Financial Accounts. These are briefly summarised below:
7.4.1 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) Goodwill written off
(vi) Preliminary expenses written off
(vii) Income tax, donations, subscriptions
(viii) 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
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.

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 7.30 COST AND MANAGEMENT ACCOUNTING

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

objective of cost accounting is to provide information to management for
decision making and control purposes while financial accounting conforms
to external reporting requirements. Hence there are chances that certain
items are treated differently in the two sets of accounts. For example, LIFO
method is not allowed for inventory valuation in India as per the Accounting
Standard 2 issued by the Council of the ICAI. However, this method may be
adopted for cost accounts as it is more suitable for arriving at costs which
may be used as a base for deciding selling prices. 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.
7.4.2 Procedure for reconciliation: There are 3 steps involved in the
procedure for reconciliation.
1. Ascertainment of profit as per financial accounts
2. Ascertainment of profit as per cost accounts
3. Reconciliation of both the profits (similar to the bank reconciliation statement)
Circumstances where reconciliation statement can be avoided: When the Cost and
Financial Accounts are integrated - there is no need to have a separate reconciliation
statement between the two sets of accounts. Integration means that the same set of
accounts fulfil the requirement of both i.e., Cost and Financial Accounts.
ILLUSTRATION 6
The following figures are available from the financial records of ABC Manufacturing
Co. Ltd. for the year ended 31st March.
(`)
Sales (20,000 units) 25,00,000
Materials 10,00,000
Wages 5,00,000
Factory Overheads 4,50,000
Administrative Overhead (production related) 2,60,000

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 COST ACCOUNTING SYSTEMS 7.31

Selling and distribution Overheads 1,80,000

Finished goods (1,230 units) 1,50,000

(`) (`)
Work-in-Process:
Materials 30,000
Labour 20,000
Factory overheads 20,000 70,000
Goodwill written off 2,00,000
Interest on loan taken 20,000
In the Costing records, factory overhead is charged at 100% of wages, administrative
overhead 10% of factory cost and selling and distribution overhead at the rate of `
10 per unit sold.
PREPARE a statement reconciling the profit as per cost records with the profit as per
financial records.
SOLUTION
Profit & Loss Account of ABC Manufacturing Co. Ltd.
(for the year ended 31st March)

(`) (`)
To Opening Stock - By Sales (20,000 units) 25,00,000
To Materials 10,00,000 By Closing Stock:
To Wages 5,00,000 Finished goods 1,50,000
(1,230 units)
To Factory Overheads 4,50,000 Work-in-Process 70,000
To Admn. Overheads 2,60,000
To S&D Overheads 1,80,000
To Goodwill written off 2,00,000
To Interest on loan 20,000
To Net Profit 1,10,000
27,20,000 27,20,000

© The Institute of Chartered Accountants of India

 7.32 COST AND MANAGEMENT ACCOUNTING

Cost Sheet
(` )
Materials 10,00,000
Wages 5,00,000
Direct Expenses Nil
Prime Cost 15,00,000
Add: Factory overhead @ 100% of wages 5,00,000
Gross Factory Cost 20,00,000
Less: Closing WIP (70,000)
Factory Cost of (20,000 + 1,230) units 19,30,000
Add: Admn. Overhead @ 10% of Factory cost 1,93,000
21,23,000
Less: Closing Stock of finished goods (1,230 units) (1,23,000)*
Cost of Goods sold (20,000 units) 20,00,000
Add: Selling & Dist. Overhead @ ` 10 per unit 2,00,000
Cost of sales (20,000 units) 22,00,000
Sales of 20,000 units 25,00,000
Profit 3,00,000
* (`21,23,000 × 1,230 units/ 21,230 units)
Reconciliation Statement

(`) (`)
Profit as per Cost Accounts 3,00,000
Add: Factory overheads over-absorbed 50,000
(` 5,00,000 – ` 4,50,000)
Selling & Dist. Overhead over-absorbed 20,000
(` 2,00,000 – ` 1,80,000)
Difference in the valuation of closing stock of 27,000 97,000
finished goods (` 1,50,000 – ` 1,23,000)
3,97,000
Less: Admn. overhead under-absorbed 67,000
(` 2,60,000 – ` 1,93,000)
Goodwill written off 2,00,000
Interest on loan 20,000 2,87,000
Profit as per financial accounts 1,10,000

© The Institute of Chartered Accountants of India

 COST ACCOUNTING SYSTEMS 7.33

ILLUSTRATION 7
Following are the figures extracted from the Cost Ledger of a manufacturing unit.
(` )
Stores:
Opening balance 15,000
Purchases 80,000
Transfer from WIP 40,000
Issue to WIP 80,000
Issue to repairs and maintenance 10,000
Sold as a special case at cost 5,000
Shortage in the year 3,000
Work-in-Process:
Opening inventory 30,000
Direct labour cost charged 30,000
Overhead cost charged 1,20,000
Closing Balance 20,000
Finished Products:
Entire output is sold at 10% profit on actual cost from work-in-
process.
Others:
Wages for the period 35,000
Overhead Expenses 1,25,000

ASCERTAIN the profit or loss as per financial account and cost accounts and reconcile
them.
SOLUTION
Stores Ledger Control A/c
(`) (`)
To Balance b/d 15,000 By Work-in-process Control 80,000
A/c (Issued to WIP)
To Cost Ledger Control 80,000 By Overhead Control A/c 10,000
A/c (Purchases) (Issued for repairs)

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 7.34 COST AND MANAGEMENT ACCOUNTING

To Work-in-process 40,000 By Cost Ledger Control A/c 5,000

Control A/c (Sold at cost)
(Return from WIP)
By Overheads Control A/c* 3,000
(Shortages)
By Balance c/d 37,000
1,35,000 1,35,000
* Assumed normal

Wages Control A/c

(`) (`)
To Cost Ledger Control A/c 35,000 By Work-in-process Control 30,000
A/c
By Overhead Control A/c 5,000
35,000 35,000
Overhead Control A/c
(`) (`)
To Stores Ledger Control A/c 10,000 By Work-in-process 1,20,000
To Stores Ledger Control A/c 3,000 Control A/c
To Cost Ledger Control A/c 1,25,000
To Wages Control A/c 5,000 By Balance c/d 23,000
1,43,000 1,43,000
WIP Control A/c

(`) (`)
To Balance b/d 30,000 By Stores Ledger 40,000
Control A/c
To Stores Ledger Control A/c 80,000 By Finished goods 2,00,000*
Control A/c
To Wages Control A/c 30,000
To Overheads Control A/c 1,20,000 By Balance c/d 20,000
2,60,000 2,60,000
* Finished output at cost 2,00,000
Profit at 10% on actual cost from WIP Sales 20,000
2,20,000

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 COST ACCOUNTING SYSTEMS 7.35

Statement of Profit as per Costing Records

(`)
Direct material Cost (`80,000 – `40,000) 40,000
Direct wages 30,000
Prime Cost 70,000
Production Overheads 1,20,000
Works Cost 1,90,000
Add: Opening WIP 30,000
2,20,000
Less: Closing WIP (20,000)
Cost of finished goods 2,00,000
Profit (10% of cost) 20,000
Sales 2,20,000

Profit & Loss A/c

(`) (`)
To Material (Op. bal. + 90,000 By Sales A/c 2,20,000
Purchases - Sale)
To Opening WIP 30,000 By Closing WIP 20,000
To Wages for the period 35,000 By Closing stock of 37,000
Raw Material
To Overheads expenses 1,25,000 By Net loss 3,000
2,80,000 2,80,000

Reconciliation Statement

(` )
Profit (loss) as per Financial Accounts (3,000)
Add: Overheads over absorbed (refer Overhead control A/c) 23,000
Net Profit as per Cost Accounts 20,000

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 7.36 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 8
The following figures have been extracted from the Financial Accounts of a
manufacturing firm for the first year of its operation:

(`)
Direct Material Consumption 50,00,000
Direct Wages 30,00,000
Factory Overheads 16,00,000
General administrative overheads 7,00,000
Selling and Distribution Overheads 9,60,000
Bad debts 80,000
Preliminary expenses written off 40,000
Legal charges 10,000
Dividends received 1,00,000
Interest received on deposits 20,000
Sales (1,20,000 units) 1,20,00,000
Closing stock:
Finished goods (4,000 units) 3,20,000
Work-in-Process 2,40,000

The cost accounts for the same period reveal that the direct material consumption
was ` 56,00,000. Factory overhead is recovered at 20% on prime cost. Administration
overhead is recovered at ` 6 per unit of goods sold. Selling and distribution overheads
are recovered at ` 8 per unit sold.
PREPARE the Profit and Loss Accounts both as per financial records and as per cost
records. RECONCILE the profits as per the two records.
SOLUTION
Profit and Loss Account
(As per financial records)

(`) (`)
To Direct Material 50,00,000 By Sales (1,20,000 1,20,00,000
units)
To Direct Wages 30,00,000 By Closing Stock
To Factory Overheads 16,00,000 Work-in-process 2,40,000

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 COST ACCOUNTING SYSTEMS 7.37

To Gross Profit c/d 29,60,000 Finished Goods 3,20,000

(4,000 units)
1,25,60,000 1,25,60,000
To General 7,00,000 By Gross Profit b/d 29,60,000
Administrative
Overheads
To Selling and Dist. 9,60,000 By Dividend received 1,00,000
OH
To Bad debts 80,000 By Interest received 20,000
To Preliminary 40,000
Expenses written
off
To Legal Charges 10,000
To Net Profit 12,90,000
30,80,000 30,80,000
Statement of Cost and Profit
(As per Cost Records)

Total (`)
Direct Material 56,00,000
Direct Wages 30,00,000
Prime Cost 86,00,000
Factory Overhead (20% of `86,00,000) 17,20,000
1,03,20,000
Less: Closing Stock (WIP) (2,40,000)
Works Cost or Cost of production (1,24,000 units) 1,00,80,000
Less: Finished Goods (4,000 units @ `81.29) (3,25,160)
Cost of goods sold (1,20,000 units) 97,54,840
Administrative overhead (1,20,000 units @ ` 6 p.u.) 7,20,000
Selling and Distribution Overhead (1,20,000 @ ` 8 p.u.) 9,60,000
Cost of Sales 1,14,34,840
Net profit (Balancing figure) 5,65,160
Sales Revenue 1,20,00,000

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 7.38 COST AND MANAGEMENT ACCOUNTING

Statement of Reconciliation of profit as obtained under Cost and Financial

Accounts
(`) Total (`)
Profit as per Cost Records 5,65,160
Add: Excess of Material Consumption 6,00,000
Factory Overhead 1,20,000
Administrative Overhead 20,000
Dividend Received 1,00,000
Interest Received 20,000 8,60,000
14,25,160
Less: Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Over-valuation of stock in cost book
(` 3,25,160 – ` 3,20,000) 5,160 (1,35,160)
Profit as per Financial Records 12,90,000

7.5 ACCOUNTING FOR MANAGEMENT

INFORMATION AND COST CONTROL
With a view to control costs, standard cost for each element of cost is set. The
standard costs so set are used to measure and compare the actual costs. This
enables the management to trace cost variances from the standard cost. The
variances so obtained are analysed and necessary actions are taken. This ensures
that standard costs are adhered.
For cost control purpose, the management needs specific accounting system which
fulfils the management objective of controlling costs. On the basis of timing of
variance analysis, two main types of management accounting systems are
followed:
(I) SINGLE PLAN:
Under this system of management accounting, the variances in costs from the set
standards are reported at its happenings without waiting for books closing. Timely analysis
is done so that much time is not lost in taking corrective action wherever needed.
The single plan system envisages the posting of all items in the debit side of the
work-in-process account at the standard cost leaving the credit side to represent

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 COST ACCOUNTING SYSTEMS 7.39

the standard cost of finished production and work-in-progress.

This system enables the ascertainment of variances as and when the transaction
is posted to work-in-process account. In other words, the analysis of variances
is done from the original documents like invoices, labour sheets, etc., and this
method of analysis is known as analysis at source.
Since, the single plan system contemplates the analysis of variances at source, the
installation of this system requires more planning so that effective documentation
at each stage is introduced for proper recording and analysis of variance.
Thus for example, the issue of bill of materials to the stores enables the storekeeper
to calculate the standard value of materials. If any material is requisitioned beyond
the standard, he can mark the same for material usage variance account. In the
production department, as and when the finished output is recorded, the standard
waste and actual waste can be compared and necessary entries can be made by the
shop supervisors for posting the excessive usage to appropriate variance accounts.
Scheme of entries: So far as materials are concerned, material price variances
are recorded at the time of receipt of the material and the material quantity
variances are recorded as far as possible when excess materials are used. The
entries will be as illustrated below:
1. Material Control A/c …………………………….Dr.
Material Price Variance A/c ……………….…Dr.
(Actual Cost > Standard Cost)
To Creditors/ Cost Ledger Control A/c.
To Material Price Variance A/c
(Actual Cost < Standard Cost)
This entry enables the firm to debit the material control account with the actual
purchases at standard cost and credit the creditor’s account at the actual cost of
actual prices thereby transferring the variances to price variance account.
2. Work-in-process Control A/c …………….Dr.
Material Usage Variances A/c………………Dr.
(Actual usage > Standard usage)
To Material Control A/c

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 7.40 COST AND MANAGEMENT ACCOUNTING

To Material Usage Variances A/c

(Actual usage < Standard usage)
This entry charges the work-in-progress control account with the standard cost of
standard quantity and credit the material control account at the standard cost of
actual issue, the variance being transferred to usage variance account.
3. Wages Control A/c ……………………….…….Dr.
Labour Rate Variances A/c ………….….….Dr.
(Actual wage rate > Standard wage rate)
To Cash (or Bank) / Cost Ledger Control A/c
To Labour Rate Variances A/c
(Actual wage rate < Standard wage rate)
This entry is passed to record the wages at standard rate thereby transferring rate
variances to the appropriate account.
4. Work-in-process Control A/c ……………..Dr.
Overhead Expense Variances A/c ……..….Dr.
(Actual OH > Standard OH)
To Overhead Expense Control A/c.
To Overhead Expense Variances A/c
(Actual OH < Standard OH)
(II) PARTIAL PLAN:
In the partial plan, variances are analysed at the end of period. Under this
method the work-in-process account is charged at the actual cost of production
for the period and is credited with the standard cost of the period’s production of
finished product.
The closing balance of work-in-process is also shown at standard cost. The
balance after making the credit entries represents the variance from standard for
the period. The analysis of the variances is done after the end of the period. This
method is simple in operation because variances are analysed after the end of
period but may present difficulties if the firm makes a variety of products.
Recapitulation:
(1) Current standards are used in both the systems.

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 COST ACCOUNTING SYSTEMS 7.41

(2) Under the partial plan, material stocks are carried at actual cost whereas the
same are carried out at standard cost under the single plan.
(3) The work-in-process and finished goods are valued at standard cost under
both the methods.
(4) Computation of variances :
(a) In partial plan, material price variance is computed on material used in
finished goods and work-in-process whereas in single plan it is
computed on the material quantity purchased.
(b) The partial plan is suitable where simple analysis of variance is sufficient
at the end of the period whereas the single plan is preferred if frequent
detailed analysis of variance is desired, as (a) the comparison of actual
with standard cost of each operation or operator or (b) the daily
reporting of standard cost of excess material used.

SUMMARY
♦ Cost Control Accounts: These are accounts maintained for the purpose of
exercising control over the costing ledgers and also to complete the double
entry in cost accounts.
♦ Integral System of Accounting: A system of accounting where both costing
and financial transactions are recorded in the same set of books.
♦ Non- Integral System of Accounting: A system of accounting where two sets
of books are maintained- (i) for costing transactions; and (ii) for financial
transactions
♦ Reconciliation: In the Non-Integral System of Accounting, since the cost and
financial accounts are kept separately, it is imperative that those should be
reconciled; otherwise the cost accounts would not be reliable. The reason for
differences in the cost & financial accounts can be of purely financial nature
(Income and expenses) and notional nature.
♦ On the basis of timing of variance analysis:
● Single Plan- Under this system of management accounting, the variances
in costs from the set standards are reported at its happenings without
waiting for books closing.
● Partial Plan- In this pan, variances are analysed at the end of period.

© The Institute of Chartered Accountants of India

CHAPTER 8

UNIT & BATCH COSTING

LEARNING OUTCOMES

 Describe Unit Costing method.

 Prepare and calculate the cost under Unit Costing.
 Describe Batch Costing methods.
 Explain the accounting entries for cost elements under the
method.
 Determine the cost for a batch
 Differentiate between Job Costing and Batch Costing.

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 8.2 COST AND MANAGEMENT ACCOUNTING

Meaning

Unit Costing
Process of Cost
Accumulation and
Calculation

Methods of Costing Meaning

Process of Cost
Accumulation and
Calculation
Batch Costing
Determination of
Economic Batch
Quantity (EBQ)

Difference between Job

and Batch Costing

8.1 INTRODUCTION
So far, we have discussed in earlier chapters, the element wise cost collection,
calculation and its accounting under integral and non- integral accounting systems.
Now we will discuss how the cost accounting information can be presented and
used according the needs of the management. To fulfil the need of the users of the
cost accounting information, different methods of costing are followed. Costing
methods enable the users to have customized information of any cost object
according to the need and suitability. Different methods of costing have been
developed according to the needs and nature of industries. For the sake of
simplicity, industries can be grouped into two basic types i.e. Industries doing job
work and industries engaged in mass production of a single product or identical
products.

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 UNIT & BATCH COSTING 8.3

8.1.1 For industry doing job work

An entity which is engaged in the execution of special orders, each order being
distinguishable from each other, such a concern is thought of involved in
performing job works. Jobs are worked strictly in accordance with the customer’s
specifications and requirements, thus, each job order is unique. Examples of job
order types of production are: ship building, construction of road and bridges,
manufacturing of heavy electrical machineries and tools, wood and furniture works
etc. Here, each job or unit of production is treated as a separate identity for the
purpose of costing. The methods of costing for ascertaining cost of each job are
known as a job costing, contract costing and batch costing.
8.1.2 For continuous or process type of industries
The continuous or process type of industries are characterised by the continuous
production of uniform products according to the standard specifications. In such a
case the successive lots are generally indistinguishable as to size and form and,
even if there is some variation in specifications, it is of a minor character. Examples
of continuous type of industries are chemical and pharmaceutical products,
paper/food products, canning, paints and varnish oil, rubber, textile etc. Here the
methods of costing used for the purpose of ascertaining costs are: process costing;
single output costing; operating costing etc.
In this chapter two methods of costing are being discussed and distinguished from
each type. Other methods will also be discussed in subsequent chapters.

8.2 UNIT COSTING

Unit costing is that method of costing where the output produced is identical and
each unit of output requires identical cost. Unit costing is synonymously known as
single or output costing, but these are sub-division of unit costing method. 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.
If we have to state it in the form of a formula, then

Total Cost of Production

Cost per unit =
No. 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.

© The Institute of Chartered Accountants of India

 8.4 COST AND MANAGEMENT ACCOUNTING

8.3 COST COLLECTION PROCEDURE IN UNIT

COSTING
The cost for production of output is collected element wise and posted in the cost
accounting system for cost ascertainment. The element-wise collection is done as below:
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. The
cost of material so accumulated is posted in cost accounting system. Through the
cost accounting system, cost sheet for the period or activity is prepared to know
cost for the period element-wise and functions-wise.
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. The time booked or recorded
in the job time and idle time cards is valued at appropriate rates and entered in the
cost accounting system. Other items of indirect employee (labour) costs are
collected from the payrolls books for the purpose of posting against standing order
or expenses code numbers in the overhead expenses ledger.
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.
8.3.1 Treatment of spoiled and defective work
Circumstances Treatment
(1) Loss due to When a normal rate of defectives has already been
normal reasons 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

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 UNIT & BATCH COSTING 8.5

rectification or loss beyond normal limits are written

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

ILLUSTRATION 1
The following data relate to the manufacture of a standard product during the 4-
week ended 28th February:

Raw Materials Consumed ` 4,00,000

Direct Wages ` 2,40,000
Machine Hours Worked 3,200 hours
Machine Hour Rate ` 40
Office Overheads 10% of works cost
Selling Overheads ` 20 per unit
Units produced and sold 10,000 at ` 120 each
You are required to FIND OUT the cost per unit and profit for the 4-week ended 28th
February.
SOLUTION
Statement of Cost per Unit No. of units produced: 10,000 units
Particulars Cost per Amount
unit (`) (`)
Raw Materials Consumed 40.00 4,00,000
Direct Wages 24.00 2,40,000
Prime cost 64.00 6,40,000
Add: Manufacturing Overheads (3,200 hours × ` 40) 12.80 1,28,000
Works cost 76.80 7,68,000
Add: Office Overheads (10% of Works Cost) 7.68 76,800
Cost of goods sold 84.48 8,44,800
Add: Selling Overheads (10,000 units × ` 20) 20.00 2,00,000
Cost of sales / Total cost 104.48 10,44,800
Add: Profit (Bal Figure) 15.52 1,55,200
Sales 120.00 12,00,000

© The Institute of Chartered Accountants of India

 8.6 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 2
Atharva Pharmacare Limited produced a uniform type of product and has a
manufacturing capacity of 3,000 units per week of 48 hours. From the records of the
company, the following data are available relating to output and cost of 3 consecutive
weeks

Week Units Direct Direct Factory

Number Manufactured Material (`) Wages (`) Overheads (`)
1 1,200 9,000 3,600 31,000
2 1,600 12,000 4,800 33,000
3 1,800 13,500 5,400 34,000

Assuming that the company charges a profit of 20% on selling price, FIND OUT the
selling price per unit when the weekly output is 2,000 units
SOLUTION
Statement of Cost and Selling price for 2,000 units of output

Particulars Cost per unit Total Cost

(`) (`)
Direct Materials 7.50 15,000
Direct Labour 3.00 6,000
Prime cost 10.50 21,000
Add: Factory Overheads (Refer working note-2) 17.50 35,000
Total cost 28.00 56,000
Add: Profit (20% of Sales is equivalent to 25% 7.00 14,000
of Cost)
Sales 35.00 70,000

Working Notes:
(1) Direct Material and Direct Labour cost is varying directly in proportion to
units produced and shall remain same per unit of output. Thus, direct material
cost is equal to ` 9000 ÷ 1200 units = ` 7.50 per unit and labour cost is equal
to ` 3600 ÷ 1200 units = ` 3 per unit.
(2) Calculation of Factory Overheads- An observation of cost related to different
output levels for factory overheads shall reveal 2 things

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 UNIT & BATCH COSTING 8.7

a. Total cost increases from `31,000 to `34,000 along with increase in

output from 1,200 units to 1,800 units but cost per unit is not constant.
Thus, it is not a variable cost. Cost per unit is reducing along with
increase in output from ` 25.83 (` 31,000 ÷ 1,200 units) to ` 18.89
(`34,000 ÷ 1,800 units)
b. Since the cost is varying with the output, it is also not a fixed cost.
Hence, we can see that the cost is a semi- variable cost and has to be
calculated for 2,000 units by analysing its fixed and variable components

Week Number Units Manufactured Factory Overheads

1 1,200 31,000
2 1,600 33,000
Difference 400 2,000

Therefore, Variable Cost per unit = Change in Factory Overheads ÷ Change

in output
= `2,000 ÷ 400 = `5
Now total factory overheads for week 2 = `33,000
Out of this, Variable Overheads = 1,600 units × `5 = ` 8,000
Thus, fixed component = ` 33,000 – ` 8,000 = ` 25,000
Therefore, Variable Cost for 2,000 units = 2,000 units × `5 = ` 10,000
Fixed Cost will not change and hence will be = `25,000
Therefore, Total Factory Cost = Variable Overheads + Fixed Overheads
Overheads for 2,000 units = `10,000 + `25,000 = ` 35,000

8.4 BATCH COSTING

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. Under this method of manufacturing, the inputs
are accumulated in the assembly line till it reaches minimum batch size. Soon after
a batch size is reached, all inputs in a batch is processed for further operations.

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 8.8 COST AND MANAGEMENT ACCOUNTING

Reasons for batch manufacturing may be either technical or economical or both.

For example, in pen manufacturing industry, it would be too costly to manufacture
one pen of a particular design at a time to meet the demand of one customer. On
the other hand, the production, of say 10,000 pens, of the same design will reduce
the cost to a sizeable extent.
To initiate production process, an entity has to incur expenditures on engaging
workers for production and supervision, setting-up of machine to run for
production 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.

8.5 COSTING PROCEDURE IN BATCH COSTING

To facilitate convenient cost determination, one number is allotted for each batch.
Material cost for the batch is arrived at on the basis of material requisitions for the
batch and labour cost is arrived at by multiplying the time spent on the batch by
direct workers as ascertained from time cards or job tickets. Overheads are
absorbed on some suitable basis like machine hours, direct labour hours etc.
ILLUSTRATION 3
Arnav Confectioners (AC) owns a bakery which is used to make bakery items like
pastries, cakes and muffins. AC use to bake at most 50 units of any item at a time.
A customer has given an order for 600 muffins. To process a batch of 50 muffins,
the following cost would be incurred:
Direct materials- ` 500
Direct wages- ` 50
Oven set- up cost ` 150
AC absorbs production overheads at a rate of 20% of direct wages cost. 10% is
added to the total production cost of each batch to allow for selling, distribution
and administration overheads.
AC requires a profit margin of 25% of sales value.
DETERMINE the selling price for 600 muffins.

© The Institute of Chartered Accountants of India

 UNIT & BATCH COSTING 8.9

SOLUTION
Statement of cost per batch and per order
No. of batch = 600 units ÷ 50 units = 12 batches

Particulars Cost per Total

batch (`) Cost (`)
Direct Material Cost 500.00 6,000
Direct Wages 50.00 600
Oven set-up cost 150.00 1,800
Add: Production Overheads (20% of Direct wages) 10.00 120
Total Production cost 710.00 8,520
Add: S&D and Administration overheads 71.00 852
(10% of Total production cost)
Total Cost 781.00 9,372
Add: Profit (1/3rd of total cost) 260.33 3,124
Selling price 1,041.33 12,496
Selling Price per unit = 1041.33÷ 50 = ` 20.83

ILLUSTRATION 4
A jobbing factory has undertaken to supply 200 pieces of a component per month for
the ensuing six months. Every month a batch order is opened against which materials
and labour hours are booked at actual. Overheads are levied at a rate equal to per
labour hour. The selling price contracted for is ` 8 per piece. From the following data
CALCULATE the cost and profit per piece of each batch order and overall position of
the order for 1,200 pieces.

Month Batch Output Material cost Direct wages Direct labour

(` ) (` ) hours
January 210 650 120 240
February 200 640 140 280
March 220 680 150 280
April 180 630 140 270
May 200 700 150 300
June 220 720 160 320

© The Institute of Chartered Accountants of India

 8.10 COST AND MANAGEMENT ACCOUNTING

The other details are:

Month Overheads Direct labour

(` ) hours
January 12,000 4,800
February 10,560 4,400
March 12,000 5,000
April 10,580 4,600
May 13,000 5,000
June 12,000 4,800

SOLUTION

Particulars Jan. Feb. March April May June Total

Batch output (in 210 200 220 180 200 220 1,230
units)
Sale value (`) 1,680 1,600 1,760 1,440 1,600 1,760 9,840
Material cost (`) 650 640 680 630 700 720 4,020
Direct wages (`) 120 140 150 140 150 160 860
Overheads* (`) 600 672 672 621 780 800 4,145
Total cost (`) 1,370 1,452 1,502 1,391 1,630 1,680 9,025
Profit per batch (`) 310 148 258 49 (30) 80 815
Total cost per unit (`) 6.52 7.26 6.83 7.73 8.15 7.64 7.34
Profit per unit (`) 1.48 0.74 1.17 0.27 (0.15) 0.36 0.66

Overall position of the order for 1,200 units

Sales value of 1,200 units @ ` 8 per unit ` 9,600
Total cost of 1,200 units @ ` 7.34 per unit ` 8,808
Profit ` 792
∗
Overheads
×Direct labour hours for batch
Direct labour hour for the month

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 UNIT & BATCH COSTING 8.11

8.6 ECONOMIC BATCH QUANTITY (EBQ)

As the product is produced in batches or lots, the lot size chosen will be critical in
achieving least cost of operation. Primarily, the total production cost under batch
production comprises of two main costs, namely,
1. Machine Set Up Costs and
2. Inventory holding costs.
If the size is higher, the set up cost may decline due to lesser number of set ups
required; but units in inventory will go up leading to higher holding costs. If the lot
size is lower, lower inventory holding costs are accomplished but only with higher
set up costs. 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

As can be seen in the above diagram, costs are shown on the Y axis and Batch size
or batch quantity is shown on the X axis. With the higher batch size, holding cost
shows a tendency to increase whereas set-up costs show a declining trend. The
point where both the cost lines intersect each other represents the lowest cost
combination.
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 which
batch size gives the minimum cost. Alternatively, a formula can be derived which is
similar to determination of Economic Order Quantity (EOQ). The objective here
being to determine the production lot (Batch size) that optimizes on both set up
and inventory holding cots formula. The mathematical formula usually used for its
determination is as follows:

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 8.12 COST AND MANAGEMENT ACCOUNTING

2DS
EBQ =
C
Where, D = Annual demand for the product
S = Setting up cost per batch
C = Carrying cost per unit of production
ILLUSTRATION 5
Monthly demand for a product 500 units
Setting-up cost per batch ` 60
Cost of manufacturing per unit ` 20
Rate of interest 10% p.a.
DETERMINE economic batch quantity.
SOLUTION
2DS 2 × 500 × 12 × 60
EBQ = = = 600 units.
C 0.1× 20
ILLUSTRATION 6
M/s. KBC Bearings Ltd. is committed to supply 48,000 bearings per annum to M/s.
KMR Fans on a steady daily basis. It is estimated that it costs ` 1 as inventory holding
cost per bearing per month and that the set up cost per run of bearing manufacture
is ` 3,200
(i) DETERMINE the optimum run size of bearing manufacture?
(ii) STATE what would be the interval between two consecutive optimum runs?
(iii) FIND OUT the minimum inventory holding cost?
SOLUTION
(i) Optimum batch size or Economic Batch Quantity (EBQ):

2DS 2 × 48,000 × 3,200

EBQ = = = 5,060 units.
C 12

(ii) Number of Optimum runs = 48,000 ÷ 5,060 = 9.49 or 10 run

Interval between 2 runs (in days) = 365 days ÷ 10 = 36.5 days

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 UNIT & BATCH COSTING 8.13

(iii) Minimum Inventory Cost = Average Inventory × Inventory Carrying Cost per
unit per annum

Average Inventory = 5,060 units ÷ 2 = 2,530 units

Carrying Cost per unit per annum= `1 × 12 months = ` 12
Minimum Inventory Holding Costs = 2,530 units × ` 12 = ` 30,360
ILLUSTRATION 7
A Company has an annual demand from a single customer for 50,000 litres of a paint
product. The total demand can be made up of a range of colour to be produced in a
continuous production run after which a set-up of the machinery will be required to
accommodate the colour change. The total output of each colour will be stored and
then delivered to the customer as single load immediately before production of the
next colour commences.
The Set up costs are ` 100 per set up. The Service is supplied by an outside company
as required.
The Holding costs are incurred on rented storage space which costs ` 50 per sq. meter
per annum. Each square meter can hold 250 Litres suitably stacked.
You are required to:
(i) CALCULATE the total cost per year where batches may range from 4,000 to
10,000 litres in multiples of 1,000 litres and hence choose the production batch
size which will minimize the cost.
(ii) Use the economic batch size formula to CALCULATE the batch size which will
minimise total cost.
SOLUTION
(i)

Production Set-up costs Holding Total Costs

Batch Size per annum (`) Costs per per annum
(Lt.) annum (`) (`)
4,000 1,250 400 1,650
5,000 1,000 500 1,500
6,000 833 600 1,433
7,000 714 700 1,414
8,000 625 800 1,425

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 8.14 COST AND MANAGEMENT ACCOUNTING

9,000 556 900 1,456

10,000 500 1000 1,500

As the total cost is minimum at 7,000 ltr. i.e. ` 1,414, thus economic
production lot would be 7,000 Litres
(ii) Economic Batch Quantity (EBQ):
2 DS
EBQ =
C
Where,
D = Annual demand for the product = 50,000 Litres
S = Setting up cost per batch = `100 per set-up
C = Carrying cost per unit of production
= ` 50 / 250 litres = 0.20 per litre per annum

2 × 50,000 × 100
= = 7,071 Litres
0.2 × 1
Working Note:
1. For Production batch size of 7,000 litres
Number of set ups per year = 50,000 ÷ 7,000 = 7.14 or 8 set-ups
Hence, annual set up cost per year = 8 × `100 = `800
Average Quantity = 7,000 ÷ 2 = 3,500 litres
Holding Costs = 3,500 ltr. ÷250 × 50 = ` 700
2. It can be seen that EBQ determined with mathematical formula (7,071
litres) slightly varies from the one determined by trial and error method
(7,000 Litres)

8.7 DIFFERENCE BETWEEN JOB AND BATCH

COSTING
Sr. No Job Costing Batch Costing
1 Method of costing used for Homogeneous products produced in
non- standard and non- a continuous production flow in lots.
repetitive products produced

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 UNIT & BATCH COSTING 8.15

as per customer specifications

and against specific orders.
2 Cost determined for each Job Cost determined in aggregate for the
entire Batch and then arrived at on
per unit basis.
3 Jobs are different from each Products produced in a batch are
other and independent of each homogeneous and lack of
other. Each Job is unique. individuality

SUMMARY
♦ Unit Costing: Unit costing is that method of costing where the output
produced by an entity is identical and each unit of output require identical
cost.
♦ Job Costing: Job costing is the method of costing required to be done for
unique products manufacturing done against specific orders.
♦ Batch Costing: 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.
♦ Economic Batch Quantity (EBQ): Economic batch quantity is the size of a
batch where total cost of set-up and holding costs are at minimum.

2DS
EBQ =
C

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Different businesses in order to determine cost of their product or service
offering follow:
(a) Different methods of Costing
(b) Uniform Costing
(c) Different techniques of costing
(d) None of the above

© The Institute of Chartered Accountants of India

CHAPTER 9

JOB AND CONTRACT

COSTING

LEARNING OUTCOMES

 Describe Job Costing methods.

 Explain the accounting entries for cost elements under both
the methods.
 Determining cost for a job.
 Ascertain the cost of a contract, Progress payment,
Retention money, Value of work certified, Cost of Work not
certified.
 Discuss Escalation clause, Cost plus contract.
 Compute Notional or Estimated profit from a contract.

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 9.2 COST AND MANAGEMENT ACCOUNTING

Methods of Costing

Specific Order Costing

Job Costing Contract Costing

9.1 JOB COSTING

9.1.1 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.” According
to 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. The job costing method is also applicable to
industries in which production is carried out in batches. Batch production
basically is of the same character as the job order production, the difference
being mainly one in the size of different orders.

9.1.2 Principles of Job Costing

The job costing method may be regarded as the principal method of costing since
the 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

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 JOB AND CONTRACT COSTING 9.3

The basic principles enunciated for the job costing method are valid essentially
for all types of industry. For example, printing; furniture; hardware; ship-building;
heavy machinery; interior decoration, repairs and other similar work.

9.1.3 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 cards
respectively)
• When job is completed, overhead charges are added for ascertaining total
expenditure

9.1.4 Suitability of Job Costing

• When jobs are executed for different customers according to their
specifications.
• 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
the number of jobs in hand.

9.2 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.
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: _____________________

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 9.4 COST AND MANAGEMENT ACCOUNTING

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 Checked by: _________________
Selling & Distribution
Overheads

TOTAL COST
PROFIT/LOSS
SELLING PRICE

9.3 COLLECTION OF COSTS FOR A JOB

9.3.1 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. Where a bill of material is
prepared, it provides the basis for the preparation of these stores requisitions. But
when the entire quantity of materials specified in the bill of materials is drawn in
one lot or in installments, the bill itself could be made to serve as a substitute for
the stores requisition.
After the materials have been issued and the stores requisitions have been priced,
it is usual to enter the value of the stores requisition in a material abstract or

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 JOB AND CONTRACT COSTING 9.5

analysis book. It serves to analyse and collect the cost of all direct materials
according to job or work orders and departmental standing orders or expense
code numbers. From the abstract book, the summary of materials cost of each
job is posted to individual job cost sheets or cards in the Work-in-Progress
ledger. The postings are usually made weekly or monthly. Similarly, at periodic
intervals, from the material abstract books, summary cost of indirect material is
posted to different standing orders or expense code numbers in the Overhead
Expenses ledger. If any special material has been purchased for a particular job, it
is generally the practice to charge such special material direct to the job
concerned without passing it through the Stores Ledger, as soon as it is
purchased.
If any surplus material is left over in the case of any job, unless it can be
immediately and economically used on some other job, the same is returned to
the stores with a proper supporting document/stores Debit Note or Shop Credit,
and the relevant job account is credited with the value of excess material returned
to the stores. If the surplus material is utilised on some other job, instead of
being returned to the stores first, a material transfer note is prepared. The
transfer note would show the number of the transfer to job as well as transferee
job (or jobs) so that, on that basis, the cost thereof can be adjusted in the Work-
in-Progress Ledger.
9.3.2 Collection of Labour Cost
All direct labour cost must be analysed according to individual jobs or work
orders. Similarly, different types of indirect labour cost also must be collected
and accumulated under appropriate standing order or expenses code number.
The analysis of labour according to jobs or work orders is, usually, made by
means of job time cards or sheets. 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 (where the job time
card is issued job-wise). The time booked or recorded in the job time and idle
time cards is valued at appropriate rates and entered in the labour abstract or
analysis book. All direct employee cost is accumulated under relevant job or
work order numbers, and the total or the periodical total of each job or work
order is then posted to the appropriate job cost card or sheet in Work-in-
Progress ledger. The postings are usually made at the end of each week or
month.

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 9.6 COST AND MANAGEMENT ACCOUNTING

The abstraction of idle time costs under suitable standing order or expenses
code numbers is likewise done and the amounts are posted to the relevant
departmental standing order or expense code number in the Overhead Expenses
Ledger at periodical intervals. As regards other items of indirect labour cost these
are collected from the payrolls books for the purpose of posting against standing
order or expenses code numbers in the Overhead Expenses ledger.
9.3.3 Collection of Overheads
Manufacturing overheads are collected under suitable standing order 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.
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. The problem of accurately absorbing, in each individual job or
work order, the overhead cost of different cost centres or departments involved in
the manufacture is difficult under the job costing method. It is because the cost
or the expenses thereof cannot be traced to or identified with any particular job
or work order. In such circumstances, the best that can be done is to apply a
suitable overhead rate to each individual article manufactured or to each
production order. This is essentially an arbitrary method.
9.3.4 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. Normally, all the
manufacturing operations are not fully successful; they result in turning out a
certain amount of defective work. Nonetheless, over a period of time it is possible
to work out a normal rate of defectives for each manufacturing process which
would represent the number of defective articles which a process shall produce in
spite of due care. Defects arise in the following circumstances:

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 JOB AND CONTRACT COSTING 9.7

Circumstances Treatment
(1) Where a percentage When a normal rate of defectives has already
of defective work is been established, if the actual number of
allowed in a defectives is within the normal limit or is near
particular batch as it thereto the cost of rectification will be
cannot be avoided. charged to the whole job and spread over
the entire output of the batch. If, on the
other hand, the number of defective units
substantially exceeds the normal, the cost of
rectification of the number which exceeds the
normal will be written off as a loss in the
Costing Profit and Loss Account.
(2) Where defect is due In this case cost of rectification will be
to bad workmanship. abnormal cost, i.e., not a legitimate element of
the cost. Therefore, the cost of rectification
shall be written off as a loss, unless by an
arrangement, it is to be recovered as a penalty
from the workman concerned. It is possible,
however that the management did provide for
a certain proportion of defectives on account
of bad workmanship as an unavoidable
feature of production. If that be the case, the
cost of rectifying to the extent provided for by
the management will be treated as a normal
cost and charged to the batch.
(3) Where defect is due In this case the cost of rectification will be
to the Inspection charged to the department and will not be
Department wrongly considered as cost of manufacture of the
accepting incoming batch. Being an abnormal cost, it will be
material of poor written off to the Costing Profit and Loss
quality. Account.

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 9.8 COST AND MANAGEMENT ACCOUNTING

9.4 ACCOUNTING OF COSTS FOR A JOB

9.4.1 Entries in Control Accounts
1. For purchase of materials-
Stores Ledger Control A/c Dr.
To Cost Ledger Control A/c*
2. For the value of direct materials issued to
jobs-
Work-in-Process Control A/c Dr.
To Stores Ledger Control A/c
3. For return of direct materials from jobs-
Stores Ledger Control A/c Dr.
To Work-in-Process Control A/c
4. For return of materials to suppliers –
Cost Ledger Control A/c Dr.
To Stores Ledger Control A/c
5. For indirect materials-
Factory Overhead Control A/c Dr.
To Stores Ledger Control A/c
6. For wages paid-
Wages Control A/c Dr.
To Cost Ledger Control A/c
7. For direct wages incurred on jobs-
Work-in-Process Control A/c Dr.
To Wages Control A/c
8. For indirect wages –
Factory Overhead Control A/c Dr.
To Wages Control A/c
9. For any indirect expense paid-
Factory Overhead Control A/c Dr.
To Cost Ledger Control A/c
10. For charging overhead to jobs-
Work-in-Process Control A/c Dr.
To Factory Overhead Control A/c

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 JOB AND CONTRACT COSTING 9.9

11. For the total cost of jobs completed-

Cost of Sales A/c Dr.
To Work-in-Progress Control A/c
12. The balance of Cost of Sales A/c is
transferred to Costing Profit and Loss a/c;
For such transfer –
Costing Profit and Loss A/c Dr.
To Cost of Sales A/c
13. For the sales value of jobs completed -
Cost Ledger Control A/c Dr.
To Costing Profit and Loss A/c**
*General ledger adjustment account is another name of Cost Ledger Control Account.
**The balance of Costing Profit and Loss Account shall now represent profit or loss. The
balance of Cost Ledger Control Account shall be carried forwarded. With the balance on all
the accounts trial balance can be drawn.
ILLUSTRATION 1:
The manufacturing cost of a work order is ` 1,00,000; 8% of the production against
that order spoiled and the rejection is estimated to have a realisable value of
` 2,000 only. The normal rate of spoilage is 2%. RECORD this in the costing journal.
SOLUTION
Actual loss due to spoilage = 8% of ` 1,00,000 = `8,000 and Normal loss = 2% of
` 1,00,000 = `2,000, therefore abnormal loss = `6,000.
The rejection has a realisable value of ` 2,000, which is to be apportioned
between normal loss and abnormal loss in the ratio of 2 : 6.
The accounting entries necessary for recording the above facts would be:
( `) ( `)
General Ledger Control Account Dr. 2,000
Overhead Control Account Dr. 1,500
Costing Profit and Loss Control Account Dr. 4,500
To Work-in-Progress Control Account 8,000
In the case of defectives being inherent in the manufacturing process, the
rectification cost may be charged to the specific jobs in which they have arisen. In
case detectives cannot be identified with jobs, the cost of rectification may be

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 9.10 COST AND MANAGEMENT ACCOUNTING

treated as factory overheads. Abnormal defectives should be written off to the

Costing Profit and Loss Account.
ILLUSTRATION 2
A shop floor supervisor of a small factory presented the following cost for Job No.
303, to determine the selling price.
Per unit (`)
Materials 70
Direct wages 18 hours @ ` 2.50 45
(Deptt. X 8 hours; Deptt. Y 6 hours; Deptt. Z 4 hours)
Chargeable expenses 5
120
Add : 33-1/3 % for expenses cost 40
160
Analysis of the Profit/Loss Account
(for the current financial year)
(` ) (` )
Materials used 1,50,000 Sales less returns 2,50,000
Direct wages:
Deptt. X 10,000
Deptt. Y 12,000
Deptt. Z 8,000 30,000
Special stores items 4,000
Overheads:
Deptt. X 5,000
Deptt. Y 9,000
Deptt. Z 2,000 16,000
Works cost 2,00,000
Gross profit c/d 50,000 _______
2,50,000 2,50,000
Selling expenses 20,000 Gross profit b/d 50,000
Net profit 30,000 ______
50,000 50,000
It is also noted that average hourly rates for the three Departments X, Y and Z are
similar.

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 JOB AND CONTRACT COSTING 9.11

You are required to:

(i) PREPARE a job cost sheet.
(ii) CALCULATE the entire revised cost using current financial year actual figures
as basis.
(iii) Add 20% to total cost to DETERMINE selling price.
SOLUTION
Job Cost Sheet
Customer Details ——— Job No._________________
Date of commencement —— Date of completion _________
Particulars Amount
(`)
Direct materials 70
Direct wages:
Deptt. X ` 2.50 × 8 hrs. = ` 20.00
Deptt. Y ` 2.50 × 6 hrs. = ` 15.00
Deptt. Z ` 2.50 × 4 hrs. = ` 10.00 45
Chargeable expenses 5
Prime cost 120
Overheads:
`5,000
Deptt. X = × 100 = 50% of ` 20 = ` 10.00
`10,000
`9,000
Deptt. Y = × 100 = 75% of ` 15 = ` 11.25
`12,000
`2,000
Deptt. Z = × 100 = 25% of ` 10 = ` 2.50 23.75
`8,000
Works cost 143.75
`20,000
Selling expenses= × 100 = 10% of work cost 14.38
`2,00,000
Total cost 158.13
Profit (20% of total cost) 31.63
Selling price 189.76

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 9.12 COST AND MANAGEMENT ACCOUNTING

9.4.2 Advantages and Disadvantages of Job Costing

Some of the advantages and disadvantages of Job costing are summarised as
below:

Advantages Disadvantages
1. The details of Cost of material, 1. Job Costing is costly and laborious
labour and overhead for all job method.
is available to control.
2. Profitability of each job can be 2. As lot of clerical process is involved
derived. the chances of error is more.
3. It facilitates production 3. This method is not suitable in
planning. inflationary condition.
4. Budgetary control and Standard 4. Previous records of costs will be
Costing can be applied in job meaningless if there is any change in
costing. market condition.
5. Spoilage and detective can be
identified and responsibilities
can be fixed accordingly.

9.4.3 Difference between Job Costing and Process Costing

The main points which distinguish job costing and process costing are as below:

Job Costing Process Costing

(i) A Job is carried out or a product The process of producing the product has a
is produced by specific orders. continuous flow and the product
produced is homogeneous.
(ii) Costs are determined for each Costs are compiled on time basis i.e., for
job. production of a given accounting period
for each process or department.
(iii) Each job is separate and Products lose their individual identity as
independent of other jobs. they are manufactured in a continuous
flow.
(iv) Each job or order has a number The unit cost of process is an average cost
and costs are collected against for the period.
the same job number.

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 JOB AND CONTRACT COSTING 9.13

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

9.5 CONTRACT COSTING

Contract costing is a form of specific order costing where job undertaken is
relatively large and normally takes period longer than a year to complete.
Contract costing is usually adopted by the contractors engaged in any type of
contracts like construction of building, road, bridge, erection of tower, setting up
of plant etc. Contract costing have the following distinct features:
1. The major part of the work in connection with each contract is ordinarily
carried out at the site of the contract.
2. The bulk of the expenses incurred by the contractor are considered as
direct.
3. The indirect expenses mostly consist of office expenses, stores and works.
4. A separate account is usually maintained for each contract.
5. The number of contracts undertaken by a contractor at a time is usually few.
6. The cost unit in contract costing is the contract itself.
A contract takes longer period to complete and the result of the contract can
be known only after the completion of the contract. To have a better control
over the contract and cost, it is necessary to have an idea of profitability of
contracts at regular intervals or atleast in a year. For this purpose, a contractor
needs to calculate expected profit or notional profit for a contract. It also helps in
profit comparison for a period and provide a good basis for performance
measurement and evaluation of those who are engaged in the contract. The
expected or notional profit in respect of each contract in progress (i.e. incomplete
contracts) is transferred to the costing profit and loss account (consolidated) for
the year to determine overall profitability of the contractor.

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 9.14 COST AND MANAGEMENT ACCOUNTING

9.6 RECORDING OF CONTRACT COSTS

(i) Material Cost
All materials supplied from the stores or purchased directly for the contract are
debited to the concerned contract account.
Contract Account (Contract No:)…………….……. Dr.
To Stores Ledger Control A/c (Issued from stores) or
To Cost Ledger Control A/c (Direct purchase)
In the case of transfer of excess material from one contract to another, cost of
these excess materials are adjusted on the basis of Material Transfer Note.
Contract Account (Contract No. XYZ) ……………. Dr.
To Contract Account (Contract No. ABC)
In case the return of surplus material appears uneconomical on account of high
cost of transportation, the same is sold and the concerned contract account is
credited with the price realised. Any loss or profit arising therefrom is transferred
to the Costing Profit and Loss Account.
Cost Ledger Control A/c ……………...…Dr.
Costing Profit & Loss A/c (Loss)………. Dr.
To Contract A/c
To Costing Profit & Loss A/c (Profit)
Any loss of material due to theft or destruction etc. is transferred to the Costing
Profit and Loss Account.
Costing Profit & Loss A/c………………. Dr.
To Contract A/c
If any stores items are used for manufacturing tools, the cost of such stores items
are charged to the work expenses account.
Works expenses A/c……………………. Dr.
To Stores Ledger Control A/c
(With amount of stores used for works)

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 JOB AND CONTRACT COSTING 9.15

Contract A/c………………………………. Dr.

To Works expenses
(With amount of works used in the contract)
If the contractee has supplied some materials without affecting the contract price,
no accounting entries will be made in the contract account, only a note may be
given about it.
(ii) Employee Labour Cost
Workers employed on the site of the contract is regarded as direct employees
(irrespective of the nature of the task performed) and the wages paid to them are
charged to the concerned contract directly. If an employee is engaged
concurrently in other contract also then the total wages paid is apportioned to
the contacts on some reasonable basis, usually on time basis.
Contract A/c………………………………. Dr.
To Wages Control A/c
(iii) Direct Expenses
Direct expenses (if any) are directly charged to the concerned contract account.
Contract A/c………………………………. Dr.
To Direct Expenses A/c
(iv) Indirect Expenses
Indirect expenses (such as expenses of engineers, surveyors, supervisors,
corporate office etc.) may be distributed over several contracts on certain
reasonable basis as overheads.
Contract A/c………………………………. Dr.
To Overheads A/c
(v) Plant and Machinery
The value of the plant in a contract may be either debited to contract account and
the written down value thereof at the end of the year entered on the credit side
for closing the contract account, or only a charge (depreciation) for use of the
plant may be debited to the contract account.
Contract A/c………………………………. Dr.
To Plant and Machinery A/c (with cost)

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 9.16 COST AND MANAGEMENT ACCOUNTING

Plant and Machinery A/c (with WDV) …. Dr.

To Contract A/c
Or
Contract A/c………………………………. Dr.
To Depreciation on Plant and Machinery A/c
(vi) Sub-Contract
Sub-contract costs are also debited to the Contract Account.
Contract A/c………………………………. Dr.
To Cost of Sub-Contract A/c
Extra work: The extra work amount payable by the contractee should be added
to the contract price. If extra work is substantial, it is better to treat it as a
separate contract. If it is not substantial, expenses incurred should be debited to
the contract account as “Cost of Extra work”.

9.7 MEANING OF THE TERMS USED IN

CONTRACT COSTING
(i) Work-in-Progress: Work-in-progress in contract costing refers to the
contract which is not complete at the reporting date. In Contract Accounts,
the value of the work-in-progress consists of
(i) the cost of work completed, both certified and uncertified;
(ii) the cost of work not yet completed; and
(iii) the amount of estimated/ notional profit.
In the Balance Sheet (prepared for management), the work-in-progress is
usually shown under two heads, viz., certified and uncertified. The cost of work
completed and certified and the profit credited will appear under the head
‘certified’ work-in-progress, while the completed work not yet certified, cost of
material, employee and other expenses which has not yet reached the stage of
completion are shown under the head “uncertified” work-in-progress.
(ii) Cost of Work Certified or Value of Work Certified: A contract is a
continuous process and to know the cost or value of the work completed as on
a particular date; assessment of the completion of work is carried out by an
expert (it may be any professional like surveyor, architect, engineer etc.). The

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 JOB AND CONTRACT COSTING 9.17

expert, based on his assessment, certifies the work completion in terms of

percentage of total work. The cost or value of certified portion is calculated
and is known as Cost of work certified or Value of work certified respectively.
Mathematically:

(a) Value of Work Certified = Value of Contract × Work certified (%)

(b) Cost of Work Certified = Cost of work to date – (Cost of work uncertified
+ Material in hand + Plant at site)

(iii) Cost of Work Uncertified: It represents the cost of the work which has
been carried out by the contractor but has not been certified by the expert. It is
always shown at cost price. The cost of uncertified work may be ascertained as
follows:

(`) (`)
Total cost to date xxx
Less: Cost of work certified xxx
Material in hand xxx
Plant at site xxx xxx
Cost of work uncertified xxx

(iv) Progress Payment: A Contractor gets payments for work done on a

contract based on work completion. Since, a contract takes longer period to
complete and requires large investment in working capital to progress the
contract work, hence, it is desirable by the contractor to have periodic payments
from the contractee against the work done to avoid working capital shortage. For
this a contactor enters into an agreement with the contractee and agrees on
payment on some reasonable basis, which generally, includes percentage of work
completion as certified by an expert.
Mathematically:

Progress payment = Value of work certified – Retention money – Payment to date

(v) Retention Money: In a contract, a contractee generally keeps some

amount payable to contractor with himself as security deposit. In a contract, a
contractor undertakes to completed a job work on the basis of pre- determined

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 9.18 COST AND MANAGEMENT ACCOUNTING

terms and conditions and work specifications. To ensure that the work carried out
by the contractor is as per the plan and specifications, it is monitored periodically
by the contractee. To have a cushion against any defect or undesirable work,
the contractee upholds some money payable to contractor. This security
money upheld by the contractee is known as retention money. In some
contracts the contractor has to deposit some security money before staring of the
contract as a term of contract. This is known as Earnest money. If any deficiency
or defect is noticed in the work, it is to be rectified by the contractor before the
release of the retention money. Retention money provides a safeguard against
the risk of loss due to faulty workmanship.
Mathematically:

Retention Money = Value of work certified – Payment actually made/ cash paid

(vi) Cash Received: It is ascertained by deducting the retention money from the
value of work certified i.e.

Cash received = Value of work certified – Retention money

(vii) Notional Profit: It represents the difference between the value of work
certified and cost of work certified. It is determined:

Notional profit = Value of work certified – (Cost of work to date – Cost of work not
yet certified)

(viii) Estimated Profit: It is the excess of the contract price over the estimated
total cost of the contract.
ILLUSTRATION 3:
COMPUTE estimated profit on a contract (which has been 90% complete) from the
following particulars:

(`)
Total expenditure to date 22,50,000
Estimated further expenditure to complete the contract (including 2,50,000
contingencies)
Contract price 32,50,000
Work certified 27,50,000

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 JOB AND CONTRACT COSTING 9.19

Work uncertified 1,75,000

Cash received 21,25,000

SOLUTION
Calculation of Estimated Profit:
(`)
Total expenditure to date 22,50,000
Estimated further expenditure to complete the contract
(including contingencies) 2,50,000
25,00,000
Estimated profit on contract (Balancing figure) 7,50,000
Contract price 32,50,000

9.8 COST PLUS CONTRACT

Cost- plus contract is a contract where the value of the contract is determined
by adding an agreed percentage of profit to the total cost. These types of
contracts are entered into when it is not possible to estimate the contract cost
with reasonable accuracy due to unstable condition of factors that affect the cost
of material, employees, etc.
Cost plus contracts have the following advantages and disadvantages:
Advantages:
(i) The Contractor is assured of a fixed percentage of profit. There is no risk
of incurring any loss on the contract.
(ii) It is useful specially when the work to be done is not definitely fixed at
the time of making the estimate.
(iii) Contractee can ensure himself about ‘the cost of the contract’, as he is
empowered to examine the books and documents of the contractor to
ascertain the veracity of the cost of the contract.
Disadvantages - The contractor may not have any inducement to avoid wastages
and effect economy in production to reduce cost.

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 9.20 COST AND MANAGEMENT ACCOUNTING

9.8.1 Escalation Clause in a Contract

Escalation clause in a contract empowers a contractor to revise the price of
the contract in case of increase in the prices of inputs due to some macro-
economic or other agreed reasons. A contract takes longer period to complete
and the factors based on which price negotiation is done at the time of entering
into the contract may change till the contract completes. This protect the
contractor from adverse financial impacts and empowers the contractor to
recover the increased prices. As per this clause, the contractor increases the
contract price if the cost of materials, employees and other expenses
increase beyond a certain limit. Inclusion of such a clause in a contract deed is
called an “Escalation Clause”.
ILLUSTRATION 4
The following expenses were incurred on a contract: ( `)
Materials purchased 6,00,000
Material drawn from stores 1,00,000
Wages 2,25,000
Plant issued 75,000
Chargeable expenses 75,000
Apportioned indirect expenses 25,000
The contract was for ` 20,00,000 and it commenced on April 1, 2020. The value of the
work completed and certified upto 28th February, 2021 was ` 13,00,000 of which `
10,40,000 was received in cash, the balance being held back as retention money by the
contractee. The value of work completed subsequent to the architect’s certificate but
before 31st March, 2021 was ` 60,000. There were also lying on the site materials of
the value of ` 40,000. It was estimated that the value of plant as at 31st March, 2021
was ` 30,000.
You are required to COMPUTE value of work certified, cost of work not certified and
notional profit on the contract till the year ended 31st March, 2021.
SOLUTION
Contract Account

Particulars (`) Particulars (`)

To Material purchased 6,00,000 By Work-in-progress:
” Stores issued 1,00,000 Value of work 13,00,000

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 JOB AND CONTRACT COSTING 9.21

certified
” Wages 2,25,000 Cost of work 60,000
uncertified
” Plant 75,000 ” Material unused 40,000
” Chargeable expenses 75,000 ” Plant less 30,000
depreciation
” Indirect expenses 25,000
” Costing P&L A/c 3,30,000
(Notional profit) (bal.
figure)
14,30,000 14,30,000

ILLUSTRATION 5
A contractor prepares his accounts for the year ending 31st March each year. He
commenced a contract on 1st July, 2020.
The following information relates to the contract as on 31st March, 2021:
(`)
Material issued 2,51,000
Wages 5,65,600
Salary to Foreman 81,300
A machine costing ` 2,60,000 has been on the site for 146 days, its working life is
estimated at 7 years and its final scrap value at ` 15,000.
A supervisor, who is paid ` 8,000 p.m. has devoted one-half of his time to this
contract.
All other expenses and administration charges amount to ` 1,36,500.
Material in hand at site costs ` 35,400 on 31st March, 2021.
The contract price is ` 20,00,000. On 31st March, 2021 two-third of the contract
was completed. The architect issued certificates covering 50% of the contract price,
and the contractor had been paid ` 7,50,000 on account.
PREPARE Contract A/c and show the notional profit or loss as on 31st March, 2021.

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 9.22 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Contract Account

Particulars (`) Particulars (`)

To Material issued 2,51,000 By Machine (Working 2,46,000
note 1)
” Wages 5,65,600 ” Material (in hand) 35,400
” Foreman’s salary 81,300 ” Works cost 10,49,000
(balancing figure)
” Machine 2,60,000
” Supervisor’s salary 36,000
(` 8,000 × 9)/2
” Administrative 1,36,500
charges
13,30,400 13,30,400
” Works cost 10,49,000 ” Value of work 10,00,000
certified
” Costing P&L A/c 2,13,250 ” Cost of work 2,62,250
(Notional profit) uncertified
(Working Note 2)
12,62,250 12,62,250

Working notes:
1. Written down value of Machine:

= `2,60,000 − `15,000 ×146days = ` 14,000

7 years 365days

Hence the value of machine after the period of 146 days = ` 2,60,000 –
` 14,000 = ` 2,46,000
2. The cost of 2/3rd of the contract is ` 10,49,000
` 10, 49,000
∴ Cost of 100% " " " " ×3 = ` 15,73,500
2
∴Cost of 50% of the contract which has been certified by the architect is
`7,86,750. Also, the cost of 1/3rd of the contract, which has been completed
but not certified by the architect is ` 2,62,250.

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 JOB AND CONTRACT COSTING 9.23

ILLUSTRATION 6
M/s. Bansals Construction Company Ltd. took a contract for ` 60,00,000 expected to
be completed in three years. The following particulars relating to the contract are
available:

2018-19 (`) 2019-20 (`) 2020-21 (`)

Materials 6,75,000 10,50,000 9,00,000
Wages 6,20,000 9,00,000 7,50,000
Transportation cost 30,000 90,000 75,000
Other expenses 30,000 75,000 24,000
Cumulative work certified 13,50,000 45,00,000 60,00,000
Cumulative work uncertified 15,000 75,000 —

Plant costing ` 3,00,000 was bought at the commencement of the contract.

Depreciation was to be charged at 25% per annum, on the written down value
method. The contractee pays 75% of the value of work certified as and when
certified and makes the final payment on completion of the contract.
You are required to PREPARE a contract account for three years and total estimated
profit/ loss from the contract.
SOLUTION
Contract Account (For the year 2018-19)

Particulars (`) Particulars (`)

To Materials 6,75,000 By Plant at site c/d 2,25,000
(75% of `3,00,000)
” Wages 6,20,000 ” Work-in-progress c/d:
” Transportation 30,000 - Work certified 13,50,000
cost
” Other expenses 30,000 - Work uncertified 15,000
” Plant 3,00,000 ” Costing P&L A/c 65,000
(Loss for the year)
16,55,000 16,55,000

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 9.24 COST AND MANAGEMENT ACCOUNTING

Costing Profit & Loss A/c for the year 2018-19

Particulars (`) Particulars (`)

To Contract A/c 65,000 By Balance c/d (Loss) 65,000
(Notional Loss on
contract)
65,000 65,000

Contract Account (For the year 2019-20)

Particulars (`) Particulars (`)

To Plant at site b/d 2,25,000 By Plant at site c/d 1,68,750
(75% of `2,25,000)
” Work-in-progress b/d: ” Work-in-progress c/d:
- Work certified 13,50,000 - Work certified 45,00,000
-Work uncertified 15,000 13,65,000 - Work uncertified 75,000 45,75,000
” Materials 10,50,000
” Wages 9,00,000
” Transportation cost 90,000
” Other expenses 75,000
” Costing P&L A/c 10,38,750
(Notional Profit for the
year)
47,43,750 47,43,750

Costing Profit & Loss A/c for the year 2019-20

Particulars (`) Particulars (`)

To Balance b/d 65,000 By Contract A/c 10,38,750
(Notional profit on
contract)
To Balance c/d (Profit) 9,73,750
10,38,750 10,38,750

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 JOB AND CONTRACT COSTING 9.25

Contract Account (For the year 2020-21)

Particulars (`) Particulars (`)

To Plant at site b/d 1,68,750 By Plant at site c/d 1,26,563
(75% of `1,68,750)
” Work-in-progress b/d: ” Contractee A/c 60,00,000
- Work certified 45,00,000 ” Costing P&L A/c 3,66,187
(Notional Loss for the
year)
-Work uncertified 75,000 45,75,000
” Materials 9,00,000
” Wages 7,50,000
” Transportation cost 75,000
” Other expenses 24,000

64,92,750 64,92,750

Costing Profit & Loss A/c for the year 2020-21

Particulars (`) Particulars (`)

To Contract A/c (Notional 3,66,187 By Balance b/d 9,73,750
loss on contract)
To Estimated profit on 6,07,563
Contract
9,73,750 9,73,750

ILLUSTRATION 7:
A contractor has entered into a long term contract at an agreed price of ` 17,50,000
subject to an escalation clause for materials and wages as spelt out in the contract
and corresponding actual are as follows:

Standard Actual
Materials Qty (tons) Rate (`) Qty (tons) Rate (`)
A 5,000 50.00 5,050 48.00
B 3,500 80.00 3,450 79.00
C 2,500 60.00 2,600 66.00

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 9.26 COST AND MANAGEMENT ACCOUNTING

Wages Hours Hourly Rate (`) Hours Hourly Rate (`)

X 2,000 70.00 2,100 72.00
Y 2,500 75.00 2,450 75.00
Z 3,000 65.00 3,100 66.00

Reckoning the full actual consumption of material and wages, the company has
claimed a final price of ` 17,73,600. Give your ANALYSIS of admissible escalation
claim and indicate the final price payable.
SOLUTION
Statement showing final claim

Standard Standard Actual Variation in Escalation

Qty/Hrs. Rate (`) Rate (`) Rate (`) Claim (`)
(a) (b) (c) (d) = (c)–(b) (e) =(a) × (d)
Materials
A 5,000 50.00 48.00 (–) 2.00 (–) 10,000
B 3,500 80.00 79.00 (–) 1.00 (–) 3,500
C 2,500 60.00 66.00 (+) 6.00 15,000
Materials escalation claim: (A) 1,500
Wages
X 2,000 70.00 72.00 (+) 2.00 4,000
Y 2,500 75.00 75.00 − −
Z 3,000 65.00 66.00 (+) 1.00 3,000
Wages escalation claim: (B) 7,000
Final claim: (A + B) 8,500

Statement showing final price payable

Agreed price ` 17,50,000

Agreed escalation:
Material cost ` 1,500
Labour cost ` 7,000 ` 8,500
Final price payable ` 17,58,500

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 JOB AND CONTRACT COSTING 9.27

The claim of ` 17,73,600 is based on the total increase in cost. This can be verified
as shown below:
Statement showing total increase in cost

Standard Cost Actual Cost Increase/

Qty/hrs Rate Amount Qty/hrs Rate Amount (Decreas
(`) (`) (`) (`) e)

(a) (b) (c) = (d) (e) (f) =(d) g = (f) –

(a)×(b) × (e) (c)
I. Materials
A 5,000 50.00 2,50,000 5,050 48.00 2,42,400 (7,600)
B 3,500 80.00 2,80,000 3,450 79.00 2,72,550 (7,450)
C 2,500 60.00 1,50,000 2,600 66.00 1,71,600 21,600
6,80,000 6,86,550 6,550
II. Wages
X 2,000 70.00 1,40,000 2,100 72.00 1,51,200
Y 2,500 75.00 1,87,500 2,450 75.00 1,83,750
Z 3,000 65.00 1,95,000 3,100 66.00 2,04,600
5,22,500 5,39,550 17,050
23,600

Contract price ` 17,50,000

Add: Increase in cost ` 23,600
The final price claimed by the company ` 17,73,600

This claim is not admissible because escalation clause covers only that part of
increase in cost, which has been caused by inflation.
Note: It is fundamental principle that the contractee would compensate the
contractor for the increase in costs which are caused by factors beyond the
control of contractor and not for increase in costs which are caused due to
inefficiency or wrong estimation.

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 9.28 COST AND MANAGEMENT ACCOUNTING

SUMMARY
♦ Job Costing: 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.
♦ Contract Costing: It is a form of specific order costing where job
undertaken is relatively large and normally takes period longer than a year
to complete.
♦ Value of Work Certified: The value of a contract which is certified by an
expert in terms of percentage of total work.
♦ Cost of Work Uncertified: It represents the cost of the work which has
been carried out by the contractor but has not been certified by the expert.
♦ Retention Money: Portion of value of work certified, which is kept by a
contractee as security money for any loss or damage caused by the
contractor.
♦ Cost-plus Contract: A contract where the value of the contract is
determined by adding an agreed percentage of profit to the total cost.
♦ Escalation Clause: A clause in a contract which empowers a contractor to
revise the price of the contract in case of increase in the prices of inputs due
to some macro-economic or other agreed reasons.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. In case product produced or jobs undertaken are of diverse nature, the
system of costing to be used should be:
(a) Process costing
(b) Operating costing
(c) Job costing
(d) None of the above
2. The production planning department prepares a list of materials and stores
required for the completion of a specific job order, this list is known as:
(a) Bin card
(b) Bill of material

© The Institute of Chartered Accountants of India

CHAPTER 11

JOINT PRODUCTS
AND BY PRODUCTS
LEARNING OUTCOMES

 Discuss the meaning of Joint products and By- products.

 Differentiate between joint products and by- products.
 Discuss the various methods of apportionment of joint
costs to joint products and to by- products.
 State the treatment of by product’s cost in cost accounting.

Joint Products & By-

Products

Meaning of Joint Treatment of By-

Apportionment of
Products and By- Product Cost in Cost
Joint Costs
Products Accounting

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 11.2 COST AND MANAGEMENT ACCOUNTING

11.1 MEANING OF JOINT PRODUCTS AND BY-

PRODUCTS
Agricultural product industries, chemical process industries, sugar industries,
and extractive industries are some of the industries where two or more products
of equal or unequal importance are produced either simultaneously or in the
course of processing operation of a main product.
In all such industries, the management is faced with the problems such as,
valuation of inventory, pricing of product and income determination, problem
of taking decision in matters of further processing of by-products and/or joint
products after a certain stage etc. In fact, the various problems relate to
(i) apportionment of common costs incurred for various products and
(ii) aspects other than mere apportionment of costs incurred upto the point
of separation.
Before taking up the above problems, we first define the various necessary
concepts.
(i) 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”.
In other words, two or more products of equal importance, produced,
simultaneously from the same process, with each having a significant relative
sale value are known as joint products. 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.
(ii) 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.” Thus by-products emerge as a result of processing operation of
another product or they are produced from the scrap or waste of materials of a
process. In short a by-product is a secondary or subsidiary product which
emanates as a result of manufacture of the main product.
The point at which they are separated from the main product or products is known
as split-off point. The expenses of processing are joint till the split –off point.

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 JOINT PRODUCTS AND BY PRODUCTS 11.3

Examples of by-products are molasses in the manufacture of sugar, tar,

ammonia and benzole obtained on carbonisation of coal and glycerin obtained
in the manufacture of soap.
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.
(iii) Co-Products - Joint products and co-products are used synonymously in
common parlance, but strictly speaking a distinction can be made between two.
Co-products may be defined as two or more products which are
contemporary 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.

11.2 APPORTIONMENT OF JOINT COSTS

Joint product costs occur in many industries such as petroleum, oil refinery, textiles,
dairy, food processing and many other process industries. The management of
business concerns require accurate and reliable cost information related with the
joint products to make managerial decisions such as to process further or to sell at
split-off stage. To arrive at either decision, it is necessary to know the share of joint
costs to be apportioned to the different joint products.
Joint costs are the expenditures incurred upto the point of separation i.e.
split-off point. The main problem faced in the case of joint products/ by-products
is the apportionment of this joint costs to joint products/ or by products. For costs
incurred after the split off point there is no problem, as these costs can be directly
allocated to individual joint products or by-products.

11.3 METHODS OF APPORTIONMENT OF JOINT

COST TO JOINT PRODUCTS
Proper apportionment of joint cost over the joint products is of considerable
importance, as this affects (a) Valuation of closing inventory; (b) Pricing of

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 11.4 COST AND MANAGEMENT ACCOUNTING

products; and (c) Profit or loss on the sale of different 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. Accordingly,
joint costs here are apportioned on the basis of some physical base, such
as weight, numbers etc. In other words, the basis used for apportioning joint
cost over the joint products is the physical volume of material present in the
joint products at the point of separation. Any loss arises during the joint
production process is also apportioned over the products on the same basis.
This method cannot be applied if the physical units of the two joint products
are different. The main defect of this method is that it gives equal importance
and value to all the joint products.
ILLUSTRATION 1
A coke manufacturing company produces the following products by using 5,000
tons of coal @ `1,100 per ton into a common process.
Coke 3,500 tons
Tar 1,200 tons
Sulphate of ammonia 52 tons
Benzol 48 tons
PREPARE a statement apportioning the joint cost amongst the products on the
basis of the physical unit method.

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 JOINT PRODUCTS AND BY PRODUCTS 11.5

SOLUTION
Products
Coke Tar Sulphate Benzole Wastage Total
of
ammonia
Output (in ton) 3,500 1,200 52 48 200 5,000
Wastage (in 146 50 2 2 (200)
ton)
(Refer Note-1)
Input (in ton) 3,646 1,250 54 50 - 5,000
Share of Joint 40,10,600 13,75,000 59,400 55,000 - 55,00,000
Cost @ `1,100
per ton (in `)

Note-1: Apportionment of wastage of 200 tons over the four products on the
basis of physical weights (3,500:1,200:52:48) is as follows:
200
Coke: × 3,500 tons = 146 tons
4,800
200
Tar : × 1,200 tons = 50 tons
4,800
200
Sulphate of ammonia: × 52 tons = 2 tons
4,800
200
Benzole : × 48 tons = 2 tons
4,800
(ii) Net Realisable Value at Split-off Point Method: In this method of joint
cost apportionment the followings are deducted from the sales value of joint
products at final stage i.e. after processing:
(i) Estimated profit margins,
(ii) Selling and distribution expenses, if any, and
(iii) Post split- off costs.
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.

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 11.6 COST AND MANAGEMENT ACCOUNTING

Product- A Product- B Product- C

Amount (`) Amount (`) Amount
(`)
Sales Value (Units after xxx xxx xxx
processing × Selling Price)
Less: Profit Margin (xxx) (xxx) (xxx)
Less: Selling & Distribution (xxx) (xxx) (xxx)
costs
Less: Post split-off cost (xxx) (xxx) (xxx)
Net Realisable Value xxx xxx xxx
Example -1: An entity incurs a joint cost of ` 64,500 in producing two products
A (200 units) and B (200 units) and earns a sales revenue of ` 86,000 by selling
@ ` 170 per unit of product A and product B @ ` 260 per unit. Further processing
costs for products A and B are ` 4,000 and ` 32,000 respectively the Joint cost
can be apportioned to products A and B as follows:

Product- A Product- B
Amount (`) Amount (`)
Sales Value 34,000 52,000
(`170 × 200 units) (`260 × 200 units)
Less: Post split-off cost (4,000) (32,000)
(Further processing cost)
Net Realisable Value 30,000 20,000
Apportionment of Joint Cost 38,700 25,800
of `64,500 in ratio of 3:2

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.

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 JOINT PRODUCTS AND BY PRODUCTS 11.7

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 where further processing
costs are incurred disproportionately.
To determine the apportionment of joint costs over joint products, a factor
known as multiplying factor is determined. This multiplying factor on
multiplication with the sales values of each joint product gives rise to the
proportion of joint cost.
Joint Cost
Multipy in factor : ×100
Total Sales Revenue
Example – 2: An entity incurs a joint cost of ` 64,500 in producing two products
A (200 units) and B (200 units) and earns a sales revenue of ` 86,000 by selling
@ ` 170 per unit of product A and product B @ ` 260 per unit.
The multiplying factor in this case is obtained by dividing the total joint cost by
total sales revenue and finally multiplying the figure so obtained by 100. The
multiplying factor based on the data can be computed as follows:
` 64,500
Multiplying Factor: × 100 = 75%
` 86,000
Joint cost apportioned over product A = Sales revenue of product A × 75%
= ` 34,000 × 75%
= ` 25,500
Joint cost apportioned over product B = Sales revenue of product B × 75%
= ` 52,000 × 75% = ` 39,000
Alternatively - This joint cost may be apportioned in the ratio of sales values of
different joint products.
(ii) Market value after further processing: Here the basis of apportionment
of joint cost is the total sales value of finished products and involves the same
principle as discussed above.

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 11.8 COST AND MANAGEMENT ACCOUNTING

Example – 3: Suppose that in the example – 2 given above, if sales prices of

products A and B after further processing are ` 200 and ` 300 respectively the
joint cost apportioned over Products A and B is as follows:
The pre-separation costs of ` 64,500 will be apportioned in the ratio of (2: 3) as
follows:
Market sales value after further processing
( `)
A : 200 units × ` 200 = 40,000
B : 200 units × ` 300 = 60,000
1,00,000
Joint cost apportionment:
` 40,000
A = ` 64,500 × = ` 25,800
` 1,00,000
` 60,000
B = ` 64,500 × = ` 38,700
` 1,00,000
The use of this method is unfair where further processing costs after the
point of separation are disproportionate or when all the joint products are
not 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) ÷ Total
units 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 basis
for 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 have
to pay less price on their purchase.
[Note: Students may note that the physical unit method also follows the same
steps of calculation as followed under Average unit cost method, ultimately
giving the same outcome.]

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 JOINT PRODUCTS AND BY PRODUCTS 11.9

ILLUSTRATION 2
FIND OUT the cost of joint products A, B and C using average unit cost method
from the following data:
(a) Pre-separation Joint Cost ` 60,000
(b) Production data:
Products Units produced
A 500
B 200
C 300
1,000
SOLUTION
Total joint costs ` 60,000
Average cost per unit = = = ` 60
Units produced 1,000 units

The joint costs apportioned @ ` 60 are as follows:

Products Units Cost per unit (`) Value (`)

A 500 60 30,000
B 200 60 12,000
C 300 60 18,000
60,000

(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. In case the products are further processed after
the point of separation, then all variable cost incurred be added to the variable
costs determined earlier. In this way total variable cost is arrived which is
deducted from their respective sales values to ascertain their contribution. The
fixed costs are then apportioned over the joint products on the basis of the
contribution ratios.

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 11.10 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 3
FIND OUT the cost of joint products A and B using contribution margin method
from the following data :
Sales
A : 100 kg @ ` 60 per kg.
B : 120 kg @ ` 30 per kg.
Joint costs
Marginal cost ` 4,400
Fixed cost ` 3,900
SOLUTION
The marginal cost (variable cost) of ` 4,400 is apportioned over the joint
products A and B in the ratio of their physical quantity i.e 100 : 120
100
Marginal cost for Product A : ` 4,400 × = ` 2,000
220
120
Marginal cost for Product B : ` 4,400 × = ` 2,400
220
The fixed cost of ` 3,900 is apportioned over the joint products A and B in the
ratio of their contribution margin i.e. 40 : 12
(Refer to working note)
Product A : ` 3,900 × 40/52 = ` 3,000
Product B : ` 3,900 × 12/52 = ` 900
Working Note:
Computation of contribution margin ratio

Products Sales revenue Marginal cost Contribution

(`) (`) (`)
A 6,000 2,000 4,000
B 3,600 2,400 1,200
(Refer to above)

Contribution ratio is 40 : 12

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 JOINT PRODUCTS AND BY PRODUCTS 11.11

ILLUSTRATION 4
Inorganic Chemicals purchases salt and processes it into more refined products
such as Caustic Soda, Chlorine and PVC. In the month of July, Inorganic Chemicals
purchased Salt for ` 40,000. Conversion cost of ` 60,000 were incurred upto the
split off point, at which time two sealable products were produced. Chlorine can
be further processed into PVC.
The July production and sales information is as follows:

Production Sales Quantity Selling price

(in ton) (in ton) per ton (`)
Caustic Soda 1,200 1,200 50
Chlorine 800 — —
PVC 500 500 200

All 800 tons of Chlorine were further processed, at an incremental cost of

` 20,000 to yield 500 tons of PVC. There was no beginning or ending inventories
of Caustic Soda, Chlorine or PVC in July.
There is active market for Chlorine. Inorganic Chemicals could have sold all its
July production of Chlorine at ` 75 per ton.
Required :
(1) SHOW how joint cost of ` 1,00,000 would be apportioned between Caustic
Soda and Chlorine under each of following methods:
(a) sales value at split- off point ;
(b) physical unit method, and
(c) estimated net realisable value.
(2) Lifetime Swimming Pool Products offers to purchase 800 tonnes of Chlorine
in August at ` 75 per tonne. This sale of Chlorine would mean that no PVC
would be produced in August. EXPLAIN how the acceptance of this offer for
the month of August would affect operating income?

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 11.12 COST AND MANAGEMENT ACCOUNTING

SOLUTION:
1. (a) Sales value at split- off point method

Products Sales (in Selling Price Sales Joint Cost

Ton) per Ton (`) Revenue Apportioned
(`) (`)
Caustic Soda 1,200 50 60,000 50,000
Chlorine 800 75 60,000 50,000
1,20,000 1,00,000

Apportionment of joint cost

Total joint cost
= × Sale revenue of each product
Total sale value
` 1,00,000
Joint cost apportioned to Caustic Soda = × ` 60,000
` 1,20,000
= `50,000
` 1,00,000
Joint cost apportioned to Chlorine = × ` 60,000
` 1,20,000
= `50,000
(b) Physical measure method

Products Sales (in Ton) Joint Cost Apportioned (`)

Caustic Soda 1,200 60,000
Chlorine 800 40,000
1,00,000

Apportioned joint cost

Total joint cost
= × Physical units of each product
Total physical value

Joint cost apportioned to Caustic Soda

` 1,00,000
= × 1,200 tonnes
2,000 tonnes
= `60,000

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 JOINT PRODUCTS AND BY PRODUCTS 11.13

` 1,00,000
Joint cost apportioned to chlorine = × 800 tonnes
2,000 tonnes
= `40,000
(c) Estimated net realisable value method:

Caustic Soda Chlorine

Amount ( ` ) Amount ( ` )

Sales Value 60,000 1,00,000

( ` 50 × 1,200 tons) ( ` 200 × 500 tons)

Less: Post split-off cost

(Further processing cost) - (20,000)
Net Realisable Value 60,000 80,000
Apportionment of Joint Cost 42,857 57,143
of ₹1,00,000 in ratio of 3:4
2. Incremental revenue from further processing of Chlorine into PVC
(500 tons × `200 – 800 tons × `75) `40,000
Less : Incremental cost of further processing
of Chlorine into PVC `20,000
Incremental operating income from further processing `20,000
The operating income of Inorganic Chemicals will be reduced by `20,000
in August if it sells 800 tons of Chlorine to Lifetime Swimming Pool
Products, instead of further processing of Chlorine into PVC for sale.

11.4 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.

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 11.14 COST AND MANAGEMENT ACCOUNTING

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.
(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 that
it 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.

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 JOINT PRODUCTS AND BY PRODUCTS 11.15

11.5 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 small
total 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 from
the 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 rather
than 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 over
joint 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 subtracting
the 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 as
per the provisions discussed above under (a).
In the contrary case, the amount realised from the sale of by-products will be
considerable and thus it may be treated as discussed under (b).

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 11.16 COST AND MANAGEMENT ACCOUNTING

SUMMARY
♦ Joint Products. Two or more products of equal importance, produced,
simultaneously from the same process, with each having a significant
relative sale value are known as joint products.
♦ Co-Products. Two or more products which are contemporary but do not
emerge necessarily from the same material in the same process.
♦ By-Products. Products recovered from material discarded in a main
process, or from the production of some major products.
♦ Methods of apportioning joint cost over 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
♦ Methods of apportioning joint cost over by-products:
(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.
(ii) Standard cost in technical estimates- 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.

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 JOINT PRODUCTS AND BY PRODUCTS 11.17

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.
(iii) Comparative price- Value of the by-product is ascertained with
reference to the price of a similar or an alternative material.
(iv) Re-use basis- The value put on the by-product should be same as
that of the materials introduced into the process.
♦ Treatment of By-Product Cost in Cost-Accounting
(i) When they are of small total value:
1. The sales value of the by-products may be credited to the
Profit and Loss Account and no credit be given in the Cost
Accounts. The credit to the 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 from the production cost or from the
cost of sales.
(ii) When the by-products are of considerable total value - The joint
costs may be divided over joint products and by-products by
using relative market values; physical output method (at the point of
split off) or ultimate selling prices (if sold).
(iii) Where they require further processing -The net realisable value of
the by-product at the split-off point may be arrived at by subtracting
the 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 as per the provisions discussed above under (i).
In the contrary case, the amount realised from the sale of by-products will
be considerable and thus it may be treated as discussed under (ii).

© The Institute of Chartered Accountants of India

CHAPTER 12

SERVICE COSTING

LEARNING OUTCOMES

 Discuss the cost accounting method for service sectors.

 State the units used in different service sectors.
 Calculate the costs for different service industries.

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 12.2 COST AND MANAGEMENT ACCOUNTING

Application of Service
Costing

Service Costing vs
Product Costing
Composite Unit
Methods of Ascertaining
Service cost unit
Equivalent Unit

Service Cost Statement

Service Costing

Costing of Services:
(i)Transport
(ii) Hotels & Lodges
(iii) Hospitals
(iv) IT & ITES
(v) Toll Roads
(vi) Educational Institutes
(vii) Insurance
viii) Financial Institutes
(ix) Others

12.1 INTRODUCTION
Service sector, being a fastest growing sector and having a significant contribution
towards the GDP in India, is a very important sector where the role of the cost and
management accounting is inevitable. The competitiveness of a service entity is
very much dependent on a robust cost and management accounting system for

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 SERVICE COSTING 12.3

competitive pricing and identification of value adding activities. Providers of

services like transportation, hotels, financial services & banking, insurance,
electricity generation, transmission and distribution etc. are very much cost
conscious and thrive to provide services in a cost-effective manner. Irrespective of
regulatory requirements to maintain cost records and get the records audited,
service costing becomes integral and inseparable part of each service entity. In this
chapter we will be discussing how costing is done in service sectors like
Transportation, Toll roads, Electricity generation, transmission and distribution,
Hospitals, Canteen & Restaurants, Hotels & Lodges, Educational institutes, Financial
institutions, Insurance, Information Technology (IT) & Information Technology
Enabled Services (ITES) etc.
Service costing is also known as operating costing.
12.1.1 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 of support
services are 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 like 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.
12.1.2 Service Costing versus 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) Unlike products, services are intangible and cannot be stored, hence, there is
no inventory for the services.
(ii) Use of Composite cost units for cost measurement and to express the volume
of outputs.

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 12.4 COST AND MANAGEMENT ACCOUNTING

(iii) Unlike a product manufacturing, employee (labour) cost constitutes a major

cost element than material cost.
(iv) 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.

12.2 SERVICE COST UNIT

To compute the Service cost, it is necessary to understand the unit for which the
cost is to be computed. All the costs incurred during a period are collected and
analyzed and then expressed in terms of a cost per unit of service.
One specific issue with service costing is the difficulty in defining a realistic cost
unit that represents a suitable measure of the service provided. The cost unit to be
applied needs to be defined carefully and frequently, a composite cost unit may be
deemed more appropriate.
For example, Hotels may use the ‘Occupied Room Days’ as an appropriate unit for
cost ascertainment and control.
Other typical cost unit that may be used include:

Service industry Unit of cost (examples)

Transport Services Passenger- km., (In public transportation)
Quintal- km., or Ton- 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 Financial Per transaction, per services (e.g. per letter of credit,
Institutions 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.

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 SERVICE COSTING 12.5

The costing should be comprehensive enough to show the effects like off-season
and peak-season demand, full time, part time, etc.
12.2.1 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. For example, a public
transportation undertaking would measure the operating cost per passenger per
kilometre.
Examples of Composite units are Ton- 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 summation of the products of
qualitative and quantitative factors. For example, to calculate absolute Ton-Km for
a goods transport is calculated as follows.:

∑(Weight Carried × Distance)1 + (Weight Carried × Distance)2 +….+(Weight

Carried × Distance)n

Similarly, in case of Cinema theatres, price for various classes of seats are 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 Ton-Km is arrived at by multiplying total distance km., by average load
quantity.

 W1+ W2 +....+ Wn 
∑(Distance1 + Distance2 + …………...…+ Distancen) ×  
 n 

© The Institute of Chartered Accountants of India

 12.6 COST AND MANAGEMENT ACCOUNTING

In both the example, variable cost is dependent of distance and is a quantitative

factor. Since, the weight carried does not affect the variable cost hence and is a
qualitative factor.
To understand the concept of absolute ton-km., and commercial ton-km., the
following illustration may be referred.
ILLUSTRATION 1
A Lorry starts with a load of 20 MT of Goods from Station ‘A’. It unloads 8 MT in
Station ‘B’ and balance goods in Station ‘C’. On return trip, it reaches Station ‘A’ with
a load of 16 MT, loaded at Station ‘C’. The distance between A to B, B to C and C to
A are 80 Kms, 120 Kms and 160 Kms, respectively. COMPUTE “Absolute MT-
Kilometer” and “Commercial MT – Kilometer”.
(MT = Metric Ton or Ton).

SOLUTION:
Weighted Average or Absolute basis – MT – Kilometer:
= (20 MT × 80 Kms) + (12 MT × 120 Kms) + (16 MT × 160 Kms)
= 1,600 + 1,440 + 2,560 = 5,600 MT - Kilometer
Simple Average or Commercial basis – MT – Kilometer:
= [{(20+12+16) / 3} MT × {(80+120+160) Kms]
= 16 MT × 360 Kms = 5,760 MT – Kilometer
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.
For Example:
A hotel has three types of suites for its customers, viz., Standard, Deluxe and
Luxurious
Following information is given:
Type of suite Number of rooms Room Tariff
Standard 100 --
Deluxe 50 2.5 times of the Standard suits
Luxurious 30 Twice of the Deluxe suits

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 SERVICE COSTING 12.7

The rent of Deluxe suite is to be fixed at 2.5 times of the Standard suite and that of
Luxurious suite as twice of the Deluxe suite.
Since, all three types of suits use same amount of overheads but to attach
qualitative weight, these rooms are required to be converted into equivalent units.
This can be done in two ways
(i) Making all suits equivalent to Standard suits:

Nature of suite Occupancy (Room-days) Equivalent single room

suites (Room-days)
Standard 36,000 36,000
(100 rooms × 360 days) (36,000 × 1)
Deluxe 18,000 45,000
(50 rooms × 360 days) (18,000 × 2.5)
Luxurious 10,800 54,000
(30 rooms × 360 days) (10,800 × 5)
1,35,000

Or
(ii) Making all suits equivalent to Luxurious suits:

Nature of suite Occupancy (Room-days) Equivalent Luxurious

suites (Room-days)
Standard 36,000 7,200
(100 rooms × 360 days) (36,000 × 1/5)
Deluxe 18,000 9,000
(50 rooms × 360 days) (18,000 × ½)
Luxurious 10,800 10,800
(30 rooms × 360 days) (10,800 × 1)
27,000

© The Institute of Chartered Accountants of India

 12.8 COST AND MANAGEMENT ACCOUNTING

12.3 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:
1. Fixed costs or Standing charges
2. Variable costs or Operating expenses
3. Semi-variable costs or Maintenance expenses
Note: In the absence of information about semi-variable costs, the costs would be
shown under fixed and variable heads only.
Treatment of Depreciation- fixed or variable?
If related to effluxion of time or calculated on time basis, will be treated as fixed.
However, if the depreciation is calculated on the basis of activity level or usage, it
will be treated as variable cost.
Treatment of Interest:
Interest and finance charges shall be presented in the cost statement as a separate
item of cost of sales. In general, interest is treated as fixed cost, unless otherwise
given.

12.4 COSTING OF TRANSPORT SERVICES

Transport organizations can be divided into two categories viz. Goods transport
and Passenger transport.
The cost unit for Goods transport organization is Ton– Kilometer – that means cost
of carrying one Ton of goods over a distance of one kilometer.
Cost unit for Passenger transport organization is Passenger– Kilometer – that
means cost of carrying one Passenger over a distance of one kilometer.

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 SERVICE COSTING 12.9

The costs are shown under the suggestive following heads:

(i) Standing Charges or Fixed costs: These are the fixed costs that remain
constant irrespective of the distance travelled. These costs include the
following:
• Insurance
• License fees
• Salary to Driver, Conductor, Cleaners, etc if paid on monthly basis
• Garage costs, including garage rent
• Depreciation (if related to efflux of time)
• Taxes
• Administration expenses, etc.
(ii) Variable costs or Running costs: These costs are generally associated with
the distance travelled. These costs include the following:
• Petrol and Diesel
• Lubricant oils,
• Wages to Driver, Conductor, Cleaners, etc. if it is related to operations
• Depreciation (if related to activity)
• Any other variable costs identified.
(iii) Semi-variable costs or Maintenance costs: These costs include the
following:
• Repairs and maintenance
• Tyres
• Spares, etc.
The heads for a cost may change as per the situation or condition. For an example
salary of driver may be treated as standing charges or running cost depending on
the situation and nature of his employment.
ILLUSTRATION 2
AXA Passenger Transport Company is running 5 buses between two towns, which are
40 kms apart. Seating capacity of each bus is 40 passengers. Following details are
available from their books, for the month of April:

© The Institute of Chartered Accountants of India

 12.10 COST AND MANAGEMENT ACCOUNTING

Particulars Amount (`)

Salary of Drivers, Cleaners and Conductors 24,000
Salary to Supervisor 10,000
Diesel and other Oil 40,000
Repairs and Maintenance 8,000
Tax and Insurance 16,000
Depreciation 26,000
Interest 20,000
1,44,000
Actual passengers carried were 75% of the seating capacity. All the five buses run on
all days for the month. Each bus made one round trip per day. CALCULATE cost per
passenger – Kilometer.
SOLUTION:
Working Note:
Total Passenger Kilometres =
Number of Buses × Distance × Seating Capacity × Used Capacity × Number of days
in the month × Number of trips
= 5 Buses × 40 kms. × 40 Seats × 75% × 30 Days × 2 Single trips (1 Round Trip)
= 3,60,000 Passenger-Kms.
Cost per Passenger-Km = Total costs ÷ Total Passenger Kilometers
Statement of Cost per Passenger – Km

Particulars Cost Per Cost per

Month Passenger –
Km
A. Standing Charges:
Wages of Drivers, Cleaners and Conductors 24,000
Salary to Supervisor 10,000
Tax and Insurance 16,000
Depreciation 26,000
Interest 20,000
Total Standing Charges 96,000 0.267

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 SERVICE COSTING 12.11

B. Running Charges
Diesel and other Oil 40,000 0.111
C. Maintenance Charges
Repairs and Maintenance 8,000 0.022
Total 1,44,000 0.400

Cost per Passenger-Km = ` 0.40

ILLUSTRATION 3
ABC Transport Company has given a route 40 kilometers long to run bus.
(a) The bus costs the company a sum of ` 10,00,000
(b) It has been insured at 3% p.a. and
(c) The annual tax will amount to ` 20,000
(d) Garage rent is ` 20,000 per month.
(e) Annual repairs will be ` 2,04,000
(f) The bus is likely to last for 2.5 years
(g) The driver’s salary will be ` 30,000 per month and the conductor’s salary will
be ` 25,000 per month in addition to 10% of takings as commission [To be
shared by the driver and conductor equally].
(h) Cost of stationery will be ` 1,000 per month.
(i) Manager-cum-accountant’s salary is ` 17,000 per month.
(j) Petrol and oil will be ` 500 per 100 kilometers.
(k) The bus will make 3 up and down trips carrying on an average 40 passengers
on each trip.
(l) The bus will run on an average 25 days in a month.
Assuming 15% profit on takings, CALCULATE the bus fare to be charged from each
passenger.
SOLUTION:
Working Note:
(1) Total Kilometres run per annum:
= Number of Buses × Distance × Number of days in the Month × Number of
trips × 12 months

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 12.12 COST AND MANAGEMENT ACCOUNTING

= 1 Bus × 40 kms × 25 Days × 6 Single trips (3 Round Trips) × 12 months =

72,000 kms.
(2) Total Passenger Kilometres per annum:
Total Kilometres run per annum × Seating Capacity
= 72,000 Kms × 40 Seats = 28,80,000 Passenger-Kms.
(3) Petrol & oil Consumption per annum:
Total Kilometres run per annum × Petrol Consumption per KM
= 72,000 Kms × (`500 / 100 Kms) = ` 3,60,000
Statement of Cost per Passenger – Km

Particulars Per Annum Per Passenger -

Kilometer
A. Standing Charges:
Insurance @ 3% on `10,00,000 30,000
Annual Tax 20,000
Garage rent (`20,000 × 12) 2,40,000
Depreciation 4,00,000
Salary of Driver (fixed part) 3,60,000
Salary of Conductor (fixed part) 3,00,000
Stationary 12,000
Manager-cum-accountant’s salary 2,04,000
Total Standing Charges 15,66,000 0.5438
B. Running Charges:
Diesel and other Oil (WN-3) 3,60,000
Commission to Driver* 1,42,000
(10%×`28,40,000×1/2)
Commission to Conductor* 1,42,000
(10%×`28,40,000×1/2)
Total Running Charges 6,44,000 0.2236

© The Institute of Chartered Accountants of India

 SERVICE COSTING 12.13

C. Maintenance Charges:
Repairs 2,04,000 0.0708
Grand Total (A+B+C) 24,14,000 0.8382
Profit (15%×`28,40,000) 4,26,000 0.1479
Fare per Passenger Kilometer 0.9861

*Total takings = Standing Charges + (Running cost + Commission on takings)

+ Maintenance cost + Profit
Let Takings = X
Or, X = 15,66,000 + (3,60,000 + 0.1X) + 2,04,000 + 0.15X
Or, X – 0.25X = 21,30,000
Or, X = 28,40,000
ILLUSTRATION 4
SMC is a public school having five buses each plying in different directions for the
transport of its school students. In view of a larger number of students availing of the
bus service the buses work two shifts daily both in the morning and in the afternoon.
The buses are garaged in the school. The work-load of the students has been so
arranged that in the morning the first trip picks up senior students and the second
trip plying an hour later picks up the junior students. Similarly, in the afternoon the
first trip takes the junior students and an hour later the second trip takes the senior
students home.
The distance travelled by each bus one way is 8 km. The school works 25 days in a
month and remains closed for vacation in May, June and December. Bus fee, however,
is payable by the students for all 12 months in a year.
The details of expenses for a year are as under:

Driver’s salary ` 4,500 per month per driver

Cleaner’s salary ` 3,500 per month
(Salary payable for all 12 months)
(one cleaner employed for all the five buses)
Licence fee, taxes, etc. ` 8,600 per bus per annum
Insurance ` 10,000 per bus per annum
Repairs & maintenance ` 35,000 per bus per annum

© The Institute of Chartered Accountants of India

 12.14 COST AND MANAGEMENT ACCOUNTING

Purchase price of the bus ` 15,00,000 each

Life of each bus 12 years
Scrap value of buses at the end of life ` 3,00,000
Diesel cost ` 45.00 per litre
Each bus gives an average mileage of 4 km. per litre of diesel.
Seating capacity of each bus is 50 students.
The seating capacity is fully occupied during the whole year.
Students picked up and dropped within a range up to 4 km. of distance from the
school are charged half fare and fifty per cent of the students travelling in each trip
are in this category. Ignore interest. Since the charges are to be based on average
cost you are required to:
(i) PREPARE a statement showing the expenses of operating a single bus and the
fleet of five buses for a year.
(ii) WORK OUT the average cost per student per month in respect of –
(A) students coming from a distance of upto 4 km. from the school and
(B) students coming from a distance beyond 4 km. from the school.
SOLUTION:
(i) Statement of Expenses of operating bus/ buses for a year

Per Bus Fleet of 5

Particulars Rate (`) per buses p.a.
annum (`) (`)
(i) Standing Charges:
Driver’s salary 4,500 p.m 54,000 2,70,000
Cleaner’s salary 3,500 p.m 8,400 42,000
Licence fee, taxes etc. 8,600 p.a. 8,600 43,000
Insurance 10,000 p.a. 10,000 50,000
Depreciation (15,00,000 – 1,00,000 p.a. 1,00,000 5,00,000
3,00,000) ÷ 12 yrs
(ii) Maintenance Charges:
Repairs & maintenance 35,000 p.a. 35,000 1,75,000
(iii) Operating Charges:
Diesel (Working Note 1) 1,62,000 8,10,000

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 SERVICE COSTING 12.15

Total Cost [(i) + (ii) + (iii)] 3,78,000 18,90,000

Cost per month 31,500 1,57,500
Total no. of equivalent 150 750
students
Total Cost per half fare ` 210 ` 210
equivalent student

(ii) Average cost per student per month:

A. Students coming from distance of upto 4 km. from school
Total cost per month ` 31,500
= = = ` 210
Total no.of equivalent students 150 students
B. Students coming from a distance beyond 4 km. from school
= Cost of per half fare student × 2 = ` 210 × 2 = ` 420
Working Notes:
1. Calculation of Diesel cost per bus :
Distance travelled in a year:
(8 round trip × 8 km. × 25 days × 9 months)
Distance travelled p.a.: 14,400 km.
14, 400km.
Cost of diesel (per bus p.a.): ×` 45 = `1,62,000
4kmpl

2. Calculation of equivalent number of students per bus :

Seating capacity of a bus 50 students

Half fare students (50% of 50 students) 25 students
Full fare students (50% of 50 students) 25 students
Total number of students equivalent to half fare
students
Full fare students (25 students × 2) 50 students
Add: Half fare students 25 students
Total Equivalent number of students in a trip 75 students
Total number of equivalent students in two trips 150 students
(Senior + Junior)

© The Institute of Chartered Accountants of India

 12.16 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 5
GTC has a lorry of 6-ton carrying capacity. It operates lorry service from city A to city
B for a particular vendor. It charges ` 2,400 per ton from city ‘A’ to city ‘B’ and ` 2,200
per ton for the return journey from city ‘B’ to city ‘A’. Goods are also delivered to an
intermediate city ‘C’ but no extra charges are billed for unloading goods in-between
destination city and no concession in rates is given for reduced load after unloading
at intermediate city. Distance between the city ‘A’ to ‘B’ is 300 km and distance from
city ‘A’ to ‘C’ is 140 km.
In the month of January, the truck made 12 journeys between city ‘A’ and city ‘B’. The
details of journeys are as follows:

Outward journey No. of journeys Load (in ton)

‘A’ to ‘B’ 10 6
‘A’ to ‘C’ 2 6
‘C’ to ‘B’ 2 4
Return journey No. of journeys Load (in ton)
‘B’ to ‘A’ 5 8
‘B’ to ‘A’ 6 6
‘B’ to ‘C’ 1 6
‘C’ to ‘A’ 1 0

Annual fixed costs and maintenance charges are ` 6,00,000 and ` 1,20,000
respectively. Running charges spent during the month of January are ` 2,94,400
(includes ` 12,400 paid as penalty for overloading).
You are required to:
(i) CALCULATE the cost as per (a) Commercial ton-kilometre. (b) Absolute ton-
kilometre
(ii) CALCULATE Net Profit/ loss for the month of January.

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 SERVICE COSTING 12.17

SOLUTION:
(i) Calculation of total monthly cost for running truck:

Particulars Amount per Amount per

annum (`) month (`)
(i) Standing Charges:
Annual fixed costs 6,00,000 50,000
(ii) Maintenance Charges: 1,20,000 10,000
(iii) Running Cost:
Running charges 2,94,400
Less: Penalty paid for
overloading (12,400) 2,82,000
Total monthly cost 3,42,000

`3, 42,000
(a) Cost per commercial ton-km. = = ` 7.62
44,856ton-km.

(Refer to working note-1)

`3, 42,000
(b) Cost per absolute ton-km. = = ` 7.65
44,720ton-km.

(Refer to working note-2)

(ii) Calculation of Net Profit/Loss for the month of January:

Particulars (`) (`)

Truck hire charges received during the month:
From Outward journey [(10 + 2) trips × 6 ton × ` 1,72,800
2,400]
From return journey
{(5 trips × 8 ton × ` 2,200) + [(6 + 1) trips × 6 ton
× ` 2,200]} 1,80,400 3,53,200
Less: Monthly running cost {as per (i) above} (3,42,000)
Operating profit 11,200

© The Institute of Chartered Accountants of India

 12.18 COST AND MANAGEMENT ACCOUNTING

Less: Penalty paid for overloading (12,400)

Net Loss for the month (1,200)
Working Notes:
1. Calculation of Commercial Ton-km:

Particulars Ton-km.
A. Total Distance travelled
To and fro (300 km × 2× 12 trips) (in km) 7,200
B. Average weight carried:
Outward (12 journeys × 6 ton + 2 journeys × 4 ton) 80
Return (5 journeys × 8 ton + 6 journeys × 6 ton + 1 82
journey × 6 ton)
Total weight 162
No. of journeys 26
Average weight (in ton) (162÷26) 6.23
Total Commercial Ton-km (A×B) 44,856

2. Calculation of Absolute Ton-km:

Particulars Ton-km. Ton-km.

Outward journeys:
From city A to city B (10 journey × 300 km. × 6 18,000
ton)
From city A to city C (2 journeys × 140 km. × 6 1,680
ton)
From city C to city B (2 journeys × 160 km. × 4 1,280 20,960
ton)
Return journeys:
From city B to city A (5 journeys × 300 km. × 8 22,800
ton) + (6 journeys × 300 km. × 6 ton)
From city B to city C (1 journey × 160 km. × 6 ton) 960 23,760
Total Absolute Ton-km 44,720

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 SERVICE COSTING 12.19

Note: (i) While calculating absolute/commercial ton-km., actual load carried are
considered irrespective of the fact it attracts fines or penalty. (ii) Penalty paid for
overloading is an abnormal expenditure and is not included in the operating
cost of the bus. This amount will be debited to Costing Profit and Loss A/c and
hence deducted from operating profit to arrive at net profit/loss.

12.5 COSTING OF HOTELS AND LODGES

Service costing is an effective tool in respect if hotel industry. Hotels are run on
commercial basis. Hence it is necessary to compute the cost - to fix the price of
various services provided by the hotel and to find out the profit or loss at the end
of a particular period.
In this case, the costs associated with different services offered should be identified
and cost per unit should be worked out. The cost unit may be Guest-day or Room
day. For calculation of cost per Guest day or Room day, estimated occupancy rate
– at different point of time, for example – Peak season or lien season, are taken in
to account.
ILLUSTRATION 6
A company runs a holiday home. For this purpose, it has hired a building at a rent of
` 10,000 per month along with 5% of total taking. It has three types of suites for its
customers, viz., single room, double rooms and triple rooms.
Following information is given:

Type of suite Number Occupancy percentage

Single room 100 100%
Double rooms 50 80%
Triple rooms 30 60%

The rent of double rooms suite is to be fixed at 2.5 times of the single room suite and
that of triple rooms suite as twice of the double rooms suite.
The other expenses for the year 2020-21 are as follows:
(`)
Staff salaries 14,25,000
Room attendants’ wages 4,50,000
Lighting, heating and power 2,15,000

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 12.20 COST AND MANAGEMENT ACCOUNTING

Repairs and renovation 1,23,500

Laundry charges 80,500
Interior decoration 74,000
Sundries 1,53,000

Provide profit @ 20% on total taking and assume 360 days in a year.
You are required to CALCULATE the rent to be charged for each type of suite.
SOLUTION:
Working Notes:
(i) Total equivalent single room suites

Nature of suite Occupancy (Room-days) Equivalent single

room suites
(Room-days)
Single room suites 36,000 36,000
(100 rooms × 360 days × (36,000 × 1)
100%)
Double rooms suites 14,400 36,000
(50 rooms × 360 days × 80%) (14,400 × 2.5)
Triple rooms suites 6,480 32,400
(30 rooms × 360 days × 60%) (6,480 × 5)
1,04,400

(ii) Statement of total cost:

(`)
Staff salaries 14,25,000
Room attendant’s wages 4,50,000
Lighting, heating and power 2,15,000
Repairs and renovation 1,23,500
Laundry charges 80,500
Interior decoration 74,000
Sundries 1,53,000
25,21,000

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 SERVICE COSTING 12.21

Building rent {(`10,000 × 12 months) + 5% 1,20,000+ 5% on total takings

on total taking}
Total cost 26,41,000 + 5% on total takings
Profit is 20% of total takings
∴ Total takings = ` 26,41,000 + 25% (5% +20%) of total takings
Let R be rent for single room suite
Then 1,04,400 R = 26,41,000 + (0.25 × 1,04,400 R)
Or, 1,04,400 R = 26,41,000 + 26,100 R
Or, 78,300 R = 26,41,000
Or, R = `33.73
Alternatively
Let total takings be x
∴ X= 26,41,000 + .25X ( 5% + 20% )
∴ X = 35,21,333
Let the rent of single room be R
Then 1,04,400 R = 35,21,333
Or, R = `33.73
Rent to be charged:
Rent to be charged for single room suite = `33.73
Rent for double rooms suites ` 33.73 × 2.5 = `84.33
Rent for triple rooms suites `33.73 × 5 = `168.65
ILLUSTRATION 7
A lodging home is being run in a small hill station with 100 single rooms. The
home offers concessional rates during six off- season (Winter) months in a year
when numbers of visitor are limited. During this period, half of the full room
rent is charged. The management’s profit margin is targeted at 20% of the room
rent. The following are the cost estimates and other details for the year ending on
31st March. [Assume a month to be of 30 days].
(i) Occupancy during the season is 80% while in the off- season it is 40% only.

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 12.22 COST AND MANAGEMENT ACCOUNTING

(ii) Total investment in the home is ` 200 lakhs of which 80% relate to buildings
and balance for furniture and equipment.
(iii) Expenses:
o Staff salary [Excluding room attendants] : ` 5,50,000
o Repairs to building : ` 2,61,000
o Laundry charges : ` 80, 000
o Interior : ` 1,75,000
o Miscellaneous expenses : ` 1,90,800
(iv) Annual depreciation is to be provided for buildings @ 5% and on furniture and
equipment @ 15% on straight-line basis.
(v) Room attendants are paid ` 10 per room day on the basis of occupancy of the
rooms in a month.
(vi) Monthly lighting charges are ` 120 per room, except in four months in winter
when it is ` 30 per room.
You are required to WORK OUT the room rent chargeable per day both during the
season and the off-season months on the basis of the foregoing information.
SOLUTION:
Working Notes:
(i) Total Room days in a year

Season Occupancy (Room-days) Equivalent Full Room

charge days
Season – 80% 100 Rooms × 80% × 6 months 14,400 Room Days ×
Occupancy × 30 days in a month = 14,400 100% = 14,400
Room Days
Off-season – 40% 100 Rooms × 40% × 6 months 7,200 Room Days ×
Occupancy × 30 days in a month = 7,200 50% = 3,600
Room Days
Total Room Days 14,400 + 7,200 = 21,600 Room 18,000 Full Room days
Days

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 SERVICE COSTING 12.23

(ii) Lighting Charges:

It is given in the question that lighting charges for 8 months is `120 per
month and during winter season of 4 months it is `30 per month. Further it
is also given that peak season is 6 months and off season is 6 months.
It should be noted that – being Hill station, winter season is to be considered
as part of Off season. Hence, the non-winter season of 8 months include –
Peak season of 6 months and Off season of 2 months.
Accordingly, the lighting charges are calculated as follows:

Season Occupancy (Room-days)

Season & Non-winter – 80% 100 Rooms × 80% × 6 months × `120 per
Occupancy month = ` 57,600
Off- season & Non-winter – 100 Rooms × 40% × 2 months × `120 per
40% Occupancy (8 – 6 months) month = ` 9,600
Off- season & -winter – 40% 100 Rooms × 40% × 4 months × ` 30 per
Occupancy months) month = ` 4,800
Total Lighting charges ` 57,600+ 9,600 + 4,800 = ` 72,000

Statement of total cost:

(`)
Staff salary 5,50,000
Repairs to building 2,61,000
Laundry & Linen 80,000
Interior 1,75,000
Sundries Expenses 1,90,800
Depreciation on Building (` 200 Lakhs × 80% × 5%) 8,00,000
Depreciation on Furniture & Equipment (` 200 Lakhs × 20% × 15%) 6,00,000
Room attendant’s wages (` 10 per Room Day for 21,600 Room Days) 2,16,000
Lighting charges 72,000
Total cost 29,44,800
Add: Profit Margin (20% on Room rent or 25% on Cost) 7,36,200
Total Rent to be charged 36,81,000

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 12.24 COST AND MANAGEMENT ACCOUNTING

Calculation of Room Rent per day:

Total Cost / Equivalent Full Room days = ` 36,81,000/ 18,000 = `204.50
Room Rent during Season – `204.50
Room Rent during Off season = `204.50 × 50% = ` 102.25

12.6 COSTING OF HOSPITALS

A Hospital is providing various types of medical services to the patients. Hospital
costing is applied to decide the cost of these services.
A hospital may have different departments catering to varied services to the
patients – such as
• Out-Patient
• In Patient
• Medical services like X-Ray, Scanning, etc.
• General services like Catering, Laundry, Power house, etc.
• Miscellaneous services like Transport, Dispensary, etc.
12.6.1 Unit of Cost
Common unit of costs of various departments are as follows:
• Out Patient – Per Out-patient
• In Patient – Per Room Day
• Scanning – Per Case
• Laundry – Per 100 items laundered
12.6.2 Cost segregation
The cost of hospital can be divided in to fixed costs and variable costs
Fixed costs are based on timelines and irrespective of services provided. For
example, Staff salaries, Depreciation on Building and Equipment, etc.
Variable costs vary with the level of services rendered. For example, Laundry
charges, Cost of food supplied to patients, Power, etc.

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ILLUSTRATION 8
ABC Hospital runs a Critical Care Unit (CCU) in a hired building. CCU consists of 35
beds and 5 more beds can be added, if required.
Rent per month - ` 75,000
Supervisors – 2 persons – ` 25,000 Per month – each
Nurses – 4 persons – ` 20,000 per month – each
Ward Boys – 4 persons – ` 5,000 per month – each
Doctors paid ` 2,50,000 per month – paid on the basis of number of patients attended
and the time spent by them
Other expenses for the year are as follows:
Repairs (Fixed) – ` 81,000
Food to Patients (Variable) – ` 8,80,000
Other services to patients (Variable) – ` 3,00,000
Laundry charges (Variable) – ` 6,00,000
Medicines (Variable) – ` 7,50,000
Other fixed expenses – ` 10,80,000
Administration expenses allocated – ` 10,00,000
It was estimated that for 150 days in a year 35 beds are occupied and for 80 days
only 25 beds are occupied.
The hospital hired 750 beds at a charge of ` 100 per bed per day, to accommodate
the flow of patients. However, this does not exceed more than 5 extra beds over and
above the normal capacity of 35 beds on any day.
You are required to –
(1) CALCULATE contribution per Patient day, if the hospital recovers on an average
` 2,000 per day from each patient
(2) FIND OUT Breakeven point for the hospital.

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 12.26 COST AND MANAGEMENT ACCOUNTING

SOLUTION:
Working Notes:
(1) Calculation of number of Patient days
35 Beds × 150 days = 5,250
25 Beds × 80 days = 2,000
Extra beds = 750
Total = 8,000
Statement of Profitability

Particulars Amount Amount

Income for the year (` 2,000 per patient per 1,60,00,000
day × 8,000 patient days)
Variable Costs:
Doctor Fees (` 2,50,000 per month × 12) 30,00,000
Food to Patients (Variable) 8,80,000
Other services to patients (Variable) 3,00,000
Laundry charges (Variable) – (`) 6,00,000
Medicines (Variable) – (`) 7,50,000
Bed Hire Charges (`100 × 750 Beds) 75,000
Total Variable costs 56,05,000
Contribution 1,03,95,000
Fixed Costs:
Rent (` 75,000 per month × 12) 9,00,000
Supervisor (2 persons × `25,000 × 12) 6,00,000
Nurses (4 persons × ` 20,000 × 12) 9,60,000
Ward Boys (4 persons × ` 5,000 × 12) 2,40,000
Repairs (Fixed) 81,000
Other fixed expenses – (`) 10,80,000
Administration expenses allocated – (`) 10,00,000
Total Fixed Costs 48,61,000
Profit 55,34,000

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 SERVICE COSTING 12.27

(1) Calculation of Contribution per Patient day

Total Contribution – ` 1,03,95,000
Total Patient days – 8,000
Contribution per Patient day – ` 1,03,95,000 / 8,000 = ` 1,299.375
(2) Breakeven Point = Fixed Cost / Contribution per Patient day
= ` 48,61,000 / `1,299.375
= 3,741 patient days

12.7 COSTING OF IT & ITES

Information Technology (IT) and Information Technology Enabled Services (ITES)
organizations provide their customers with services or intangible products. These
organizations are highly labour intensive.
The services of IT and ITES organizations may be used for – provision of services to
outside customers or provision of services internally (captive consumption)
In this sector employee (labour) cost constitutes a significant portion of the total
operating costs. The direct employee cost is traceable to services rendered.
In addition to employee cost, significant overhead costs for offering the services
are incurred and are classified as service overhead. To arrive at the cost incurred
for rendering the services, it is necessary to allocate / apportion such overheads to
cost units.
12.7.1 Concept of Project
In general – IT & ITES industries, the jobs undertaken are considered as Project.
Each project is unique in nature and varies in size, functionality requirements,
duration and staffing requirements.
When a project is taken up, a detailed planning is done – by breaking down the
project into number of activities and their dependencies. Based on the above,
project scheduling are developed.
Then the skill level requirement for carrying out each of the activities is identified
and the duration of each and every activity would be ascertained. This process is
known as effort estimation.
Once the skill level and duration is identified, then required man-power is identified
for carrying out the activities.

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 12.28 COST AND MANAGEMENT ACCOUNTING

Normally, project scheduling and effort estimation is carried out together. The costs
of development are primarily the costs of the effort involved, so the effort
computation is used in both the cost and the schedule estimate
12.7.2 Effort involved
Direct Manpower
In a typical software implementation project, three to four levels of man-power
would be directly engaged, as mentioned below: -
- Software Engineers / Functional Consultants / Business Analysts
- Project Leaders
- Project Manager
- Program Manager, etc
Depending on the nature and complexities of the projects being implemented, the
number of persons engaged, their levels and duration of the engagement varies.
For example, in a multi-continental, multi-time zone software implementation
projects, in addition to the above man-power, Customer Account Manager,
Portfolio Manager, etc may be involved.
The costs incurred on the above listed man-power are traceable with a project and
hence forming part of direct costs of the project.
Support Man-power
In addition to the above persons, who are directly engaged in project, there could
be support persons or indirect manpower, who are indirectly involved in the
project.
For example, Quality Assurance Team, Testing team, Version Control team, Staffing
Manager, etc who are indirectly support the projects by providing required level of
support services over the life of the projects.
It is possible that the indirect manpower may be involved in more than one project,
simultaneously. Their time spent, may or may not be traced on any particular
project and will be used across multiple projects.
If their time can be identified with a project, they will be treated as direct
manpower. Accordingly, the cost incurred on them will be treated as direct cost.
However, if their time is not traceable with a single project, then it may either be
allocated or apportioned to various projects on some suitable basis. Accordingly,

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the cost incurred on them will be treated as overhead and the same will be
apportioned to various projects on some suitable basis.
Effort Cost in these types of organizations are calculated on the basis of cost per
Person day or cost per Person week or cost per Person month. That means cost
incurred for a person for rendering services per day or per week or per month.
Depending on the requirement of the customer, the periodicity will be defined. For
example, implementation of new software may require eight to twelve person
months. In such a case, the cost will be calculated on Per Person month basis. On
the other hand, implementation of one or two new functionality in already
implemented (existing) software may require one or two week’s efforts. In such a
case, the cost will be calculated on per Person week basis.
12.7.3 Parameters in computation of total cost
A. Hardware and software costs involved
- If they are identifiable with a project, then they are directly allocated
to the project
- If they are not directly identifiable with a project or not fully allocable
to a project, then they are treated as service overhead
B. Travel and training costs
- If they are incurred for a project, then they are directly allocated to
the project
- If they are not directly identifiable with a project or allocable over a
number of projects, then they are treated as service overhead. For
example, Java (software language) training provided to the software
engineers, may useful in multiple Java based projects. Hence treated
as overhead costs
C. Effort costs
- Effort costs are basically identified with a project. They can be
classified as direct cost, unless otherwise specified.
- Effort costs are not just the salaries of the software engineers or
programmers who are involved in the project. Organisations
compute effort costs in terms of overhead costs where they take the
total cost of running the organisation and divide this by the number
of productive staff. Therefore, the following costs are all part of the
total effort cost:

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 12.30 COST AND MANAGEMENT ACCOUNTING

1. Costs of providing, heating and lighting office space

2. Costs of support staff such as accountants, administrators, system
managers, cleaners and technicians
3. Costs of networking and communications
4. Costs of central facilities such as a library or recreational facilities
5. Costs of Social Security and employee benefits such as pensions
and health insurance, etc.
In short, effort cost includes Salary of the staff concerned and part
of common overhead.
ILLUSTRATION 9
Following are the data pertaining to Infotech Pvt. Ltd, for the year 2020-21:

Amount (`)
Salary to Software Engineers (5 persons) 15,00,000
Salary to Project Leaders (2 persons) 9,00,000
Salary to Project Manager 6,00,000
Repairs & maintenance 3,00,000
Administration overheads 12,00,000

The company executes a Project XYZ, the details of the same as are as follows:
Project duration – 6 months
One Project Leader and three Software Engineers were involved for the entire
duration of the project, whereas Project Manager spends 2 months’ efforts, during the
execution of the project.
Travel expenses incurred for the project – ` 1,87,500
Two Laptops were purchased at a cost of ` 50,000 each, for use in the project and the
life of the same is estimated to be 2 years
PREPARE Project cost sheet considering overheads are absorbed on the basis of
salary.

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 SERVICE COSTING 12.31

SOLUTION
Working Notes:
(1) Calculation of Cost per month and Overhead absorption rate

Particulars Total Per Per Person Per Person

Annum Per Annum Per Month
Salary to Software Engineer `15,00,000 ` 3,00,000 `25,000
(5 Persons)
Salary to Project Leaders ` 9,00,000 ` 4,50,000 ` 37,500
(2 persons)
Salary to Project Manager ` 6,00,000 ` 6,00,000 ` 50,000
Total ` 30,00,000 ` 1,12,500
(2) Total Overhead = Repairs & maintenance + Administration overheads
= ` 3,00,000 + `12,00,000 = `15,00,000
(3) Calculation of Overhead absorption rate
= Total Overhead / Total Salary = `15,00,000 / `30,00,000 = 50%
Project Cost Sheet

(`)
Salary Cost:
Salary of Software Engineers (3 × ` 25,000 × 6 months) 4,50,000
Salary of Project Leader (` 37,500 × 6 months) 2,25,000
Salary of Project Manager (` 50,000 × 2 months) 1,00,000
Total Salary 7,75,000
Overheads (50% of Salary) 3,87,500
Travel Expenses 1,87,500
Depreciation on Laptops (`1,00,000 / 2 years) × (6 25,000
months/12 months)
Total Project Cost 13,75,000

12.8 COSTING OF TOLL ROADS

The Construction of roads brings about a variety of benefits that are enjoyed
practically by all sectors of the economy. Highway economic analysis is a technique

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 12.32 COST AND MANAGEMENT ACCOUNTING

whereby the cost and benefit from a scheme are quantified over a selected time
horizon and evaluated by a common yardstick.
The economic analysis involves comparison of project costs and benefits under the
"with" and "without" project conditions.
The project is further subjected to sensitivity analysis by assessing the effects of
adverse changes in the key variables. In addition, the combined effect of these
changes is also assessed. This helps to gauge the economic strength of the project
to withstand future risks and uncertainties.
12.8.1 Cost Involved
The project cost consists of following two main components:
12.8.1.1 Capital Costs
The capital cost consists of cost incurred during the construction period. Generally,
this sort of road construction projects run across multiple financial years. The total
expenditure to be incurred during the construction period is termed as capital cost.
The total cost includes the cost of construction of road and other structures and
consultancy charges. In addition to this cost, it also includes the cost of
construction of tollbooths.
Construction expenses can be broadly classified as follows:
• Preliminary and pre-operative expenses
• Land Acquisition
• Materials
• Labour
• Overheads incurred in the course of actual construction
• Contingency allowance
• Interest during construction period
12.8.1.2 Operating and Maintenance Costs
Routine maintenance cost would be incurred once the Toll road is operational.
Routine maintenance involves Patching of potholes, sealing of cracks, Edge Repair,
Surface Renewal, Periodic maintenance for new highways would be met with in
accordance with the analysis of the life cycle model carried out for the project.

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 SERVICE COSTING 12.33

Annual operating cost includes the cost of operating tollbooths, administrative

expenses, emergency services, communications and security services and other
costs of operation.
Maintenance cost includes the cost of annual maintenance (routine) and periodic
maintenance.
• Annual maintenance cost includes primary maintenance of wearing surface,
railings, roadside furniture, etc.
• Periodic maintenance cost includes the cost of overlays (wearing coats),
painting of railings, etc.
Operating and Maintenance expenses can be broadly classified as follows:
• Toll collection expenses
• Administrative expenses for day-to-day operation.
• Maintenance expenses, which include routing and periodic maintenance.
• Interest expenses incurred for servicing term loans.
12.8.2 Build-Operate-Transfer (BOT) Approach
In recent years a growing trend emerged among Governments in many countries to
solicit investments for public projects from the private sector under BOT scheme. 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 to
the Government. Therefore, BOT can be seen as a developing technique for
infrastructure projects by making them amenable to private sector participation.
The fundamental principle in determining user levy is, 'if the price for a transport facility
is set at a level that reflects the benefit, each user gains from improvements in the
facility, it will result in traffic flow levels that equate social costs with user benefits.'
12.8.3 Toll Rate
In general, the toll rate should have a direct relation with the benefits that the road
users would gain from its improvements. The benefits to road users are likely to be
in terms of fuel savings, improvement in travel time and good riding quality.
To compute the toll rate, following formula may be used:
Total Cost + Profit
=
Number of Vehicles

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 12.34 COST AND MANAGEMENT ACCOUNTING

To compute the user fee, following formula with rounding off to nearest multiple
of five may be adopted:
User Fee = Total Distance × Toll Rate per km
ILLUSTRATION 10
BHG Toll Plaza Ltd built a 60 km. long highway and now operates a toll plaza to
collect tolls from passing vehicles using the highway. The company has estimated
that a total of 12 crore vehicles (only single type of vehicle) will be using the highway
during the 10 years toll collection tenure.
Toll Operating and Maintenance cost for the month of April are as follows:
(i) Salary to –
 Collection Personnel (3 Shifts and 4 persons per shift) - ` 550 per day
per person
 Supervisor (2 Shifts and 1 person per shift) - ` 750 per day per person
 Security Personnel (3 Shifts and 6 persons per shift) - ` 450 per day
per person
 Toll Booth Manager (2 Shifts and 1 person per shift) - ` 900 per day
per person
(ii) Electricity – ` 8,00,000
(iii) Telephone – ` 1,40,000
(iv) Maintenance cost – ` 30 Lakh
Monthly depreciation and amortisation expenses will be ` 1.50 crore. Further, the
company needs 25% profit over total cost to cover interest and other costs.
Required:
(i) CALCULATE cost per kilometer per month.
(ii) CALCULATE the toll rate per vehicle.
SOLUTION:
Calculation of cost for the month of April

Particulars (`)

Salary to Collection (3 Shifts × 4 persons per shift × 1,98,000

Personnel 30 days × ` 550 per day)

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 SERVICE COSTING 12.35

Salary to Supervisor (2 Shifts × 1 persons per shift × 45,000

30 days × ` 750 per day)
Salary to Security (3 Shifts × 6 persons per shift × 2,43,000
Personnel 30 days × ` 450 per day)
Salary to Toll Booth (2 Shifts × 1 persons per shift × 54,000
Manager 30 days × ` 900 per day)
Electricity 8,00,000
Telephone 1,40,000
Maintenance cost 30,00,000
Total operating cost (A) 44,80,000
Depreciation and amortisation expenses (B) 1,50,00,000
Total Cost (A + B) 1,94,80,000

(i) Calculation of cost per kilometer per month:

Total Cost ` 1,94,80,000
= = = ` 3,24,666.67
Total km. 60 km.

(ii) Calculation of toll rate per vehicle:

Total Cost+25% profit ` 1,94,80,000 + ` 48,70,000
= = = ` 24.35
Vehicles per month 10,00,000 vehicles

Working:
No. of vehicles using the highway per month
Total estimated vehicles 1 month 12 crore 1 month
× = × = 10 lakhs
10 years 12 months 10 years 12 months

12.9 COSTING OF EDUCATIONAL

INSTITUTIONS
Educational institutions like schools, colleges, technical institutes for education and
training, are run to impart education and training to students. The objective of
running these institutions may be ‘Not-for profit’ or ‘For profit’. Like other business
entities, cost and management accounting is also inevitable for this sector. The
Government, Local body of any other organisation which provides education and
training to students with an objective to benefit and upliftment of the society, are

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 12.36 COST AND MANAGEMENT ACCOUNTING

also need cost and management accounting system for cost-social benefit analysis,
allocation of funds and budgeting (zero-based budgeting), performance
measurement and evaluation etc.
12.9.1 Income of the Educational Institutions
The source of income of an institute may be classified on the basis of recurrence as
follows:
One-time fees: These are the fees which are collected once in a course period or
for a definite period like Admission fee, Development fee, Annual fee etc.
Recurring fees: Tuition fee, laboratory, computer and internet fee, library fee,
training fee, amenities fee, sports fee, extracurricular activities fee etc.
The Government and other aided institutes may not be permitted to collect various
fees like capitation fee and development fees etc. Further, unlike the trading and
manufacturing organizations, these are not free to determine fees beyond a
prescribed limit.
Other incomes: The indirect income like transport, hostel, mess and canteen for
the students and staff are provided by the educational institutions normally on no
profit no loss basis.
12.9.2 Expenditure of the Educational Institutions
(i) Operational Cost:
Following are the major operational costs incurred by an educational institution:
• The salary of the teaching and non-teaching staff
• Laboratory maintenance charges
• Computer maintenance and internet charges,
• Building maintenance,
• Repairs and maintenance of equipment,
• Administrative expenses,
• Finance charges etc.
Cost Centres and basis of cost allocation
Cost centres in educational institutions are classified as follows:
• Primary or Direct cost centres (like Civil Engineering department, Mechanical
Engineering department, etc.)

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 SERVICE COSTING 12.37

• Service cost centres (like Laboratory, Library, Sports, etc.)

• Student’s Self-Supporting Services (like Transport, Hostel & Mess, etc.)
• Administration Cost centres (like Research & Improvement, Examination)
Costs incurred are allocated to the respective cost centres, if they are identifiable
with a cost centre and apportioned to service and administration cost centres on
suitable basis.
(ii) Research and Development Cost
Educational institutions undertake academic research on various fields of
specialisations. The costs of such research including personal costs, books etc. are
to be collected through a cost centre approach. All costs incurred in that cost centre
are collected and set off against the revenue generated from such research
projects.
If any balance is left out as undistributed, then such balance costs can be
collectively distributed to all other course cost centre as a separate cost element
namely “Research costs“.
(iii) Cost of Publication of research and other materials
In an educational institution, there will be a separate department for conducting
research publication related exercise. The cost incurred would be directly allocated
to that department.
ILLUSTRATION 11
AD Higher Secondary School (AHSS) offers courses for 11 th & 12th standard in three
streams i.e. Arts, Commerce and Science. AHSS runs higher secondary classes along
with primary and secondary classes, but for accounting purpose it treats higher
secondary as a separate responsibility centre. The Managing committee of the school
wants to revise its fee structure for higher secondary students. The accountant of the
school has provided the following details for a year:

Amount (`)
Teachers’ salary (25 teachers × ` 35,000 × 12 months) 1,05,00,000
Principal’s salary 14,40,000
Lab attendants’ salary (2 attendants × ` 15,000 × 12 months) 3,60,000
Salary to library staff 1,44,000
Salary to peons (4 peons × ` 10,000 × 12 months) 4,80,000

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Salary to other staffs 4,80,000

Examinations expenditure 10,80,000
Office & Administration cost 15,20,000
Annual day expenses 4,50,000
Sports expenses 1,20,000

Other information:
(i)
Standard 11 & 12 Primary &
Arts Commerce Science Secondary

No. of students 120 360 180 840

Lab classes in a year 0 0 144 156
No. of examinations 2 2 2 2
in a year
Time spent at library 180 hours 120 hours 240 hours 60 hours
by students per year
Time spent by 208 hours 312 hours 480 hours 1,400 hours
principal for
administration
Teachers for 11 & 12 4 5 6 10
standard

(ii) One teacher who teaches economics for Arts stream students also teaches
commerce stream students. The teacher takes 1,040 classes in a year, it includes
208 classes for commerce students.
(iii) There is another teacher who teaches mathematics for Science stream students
also teaches business mathematics to commerce stream students. She takes
1,100 classes a year, it includes 160 classes for commerce students.
(iv) One peon is fully dedicated for higher secondary section. Other peons dedicate
their 15% time for higher secondary section.
(v) All school students irrespective of section and age participates in annual
functions and sports activities.
Required:
(a) CALCULATE cost per student per annum for all three streams.

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 SERVICE COSTING 12.39

(b) If the management decides to take uniform fee of ` 1,000 per month from all
higher secondary students, CALCULATE stream wise profitability.
(c) If management decides to take 10% profit on cost, COMPUTE fee to be charged
from the students of all three streams respectively.
SOLUTION:
Calculation of Cost per annum
Particulars Arts (`) Commerce Science Total (`)
(`) (`)
Teachers’ salary (W.N-1) 16,80,000 21,00,000 25,20,000 63,00,000
Re-apportionment of (84,000) 1,45,091 (61,091) -
Economics & Mathematics
teachers’ salary (W.N- 2)
Principal’s salary (W.N-3) 1,24,800 1,87,200 2,88,000 6,00,000
Lab assistants’ salary (W.N-4) - - 1,72,800 1,72,800
Salary to library staff (W.N-5) 43,200 28,800 57,600 1,29,600
Salary to peons (W.N-6) 31,636 94,909 47,455 1,74,000
Salary to other staffs (W.N-7) 38,400 1,15,200 57,600 2,11,200
Examination expenses (W.N- 8) 86,400 2,59,200 1,29,600 4,75,200
Office & Administration 1,21,600 3,64,800 1,82,400 6,68,800
expenses (W.N- 7)
Annual Day expenses (W.N-7) 36,000 1,08,000 54,000 1,98,000
Sports expenses (W.N- 7) 9,600 28,800 14,400 52,800
Total Cost per annum 20,87,636 34,32,000 34,62,764 89,82,400

(i) Calculation of cost per student per annum

Particulars Arts (`) Commerce Science Total (`)

(`) (`)
Total Cost per annum 20,87,636 34,32,000 34,62,764 89,82,400
No. of students 120 360 180 660
Cost per student per 17,397 9,533 19,238 13,610
annum

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(ii) Calculation of profitability

Particulars Arts Commer Science Total
(`) ce (`) (`) (`)
Total Fees per annum 12,000 12,000 12,000
Cost per student per 17,397 9,533 19,238
annum
Profit/ (Loss) per (5,397) 2,467 (7,238)
student per annum
No. of students 120 360 180
Total Profit/ (Loss) (6,47,640) 8,88,120 (13,02,840) (10,62,360)
(iii) Computation of fees to be charged to earn a 10% profit on cost
Particulars Arts Commerce Science
(`) (`) (`)
Cost per student per annum 17,397 9,533 19,238
Add: Profit @10% 1,740 953 1,924
Fees per annum 19,137 10,486 21,162
Fees per month 1,595 874 1,764
Working Notes:
(1) Teachers’ salary
Particulars Arts Commerce Science
No. of teachers 4 5 6
Salary per annum (`) 4,20,000 4,20,000 4,20,000
(` 35,000 x 12)
Total salary 16,80,000 21,00,000 25,20,000

(2) Re-apportionment of Economics and Mathematics teachers’ salary

Economics Mathematics
Particulars Arts Commerce Science Commerce
No. of classes 832 208 940 160
Salary re- (84,000) 84,000 (61,091) 61,091
apportionment (`)
 `4,20,000   `4,20,000 
 ×208   ×160 
 1,040   1,100 

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(3) Principal’s salary has been apportioned on the basis of time spent by
him for administration of classes.
(4) Lab attendants’ salary has been apportioned on the basis of lab
classes attended by the students.
(5) Salary of library staffs are apportioned on the basis of time spent by
the students in library.
(6) Salary of Peons are apportioned on the basis of number of students.
The peons’ salary allocable to higher secondary classes is calculated
as below:
Amount (`)
Peon dedicated for higher secondary 1,20,000
(1 peon × `10,000 × 12 months)
Add: 15% of other peons’ salary 54,000
{15% of (3 peons × `10,000 × 12 months)}
1,74,000

(7) Salary to other staffs, office & administration cost, Annual day
expenses and sports expenses are apportioned on the basis of
number of students.
(8) Examination expenditure has been apportioned taking number of
students into account (It may also be apportioned on the basis of
number of examinations).

12.10 COSTING IN INSURANCE COMPANIES

Insurance or assurance industry operates in providing social security to the persons
who subscribe for the policy. The Insurance companies are broadly classified as Life
insurer and Non-Life Insurer (General Insurance providers). Life insurers provide
assurance to the policy holders’ life for the insured value. The Non-life insurers are
providing insurance to the policyholder for actual loss upto insured value for the
policy.
The insurance companies are need to analyse it various insurance product for
profitability. The product offered by insurance companies may include:
(i) Life Insurance policies- with or without maturity benefits
(ii) General insurance- Health, Fire, Property, Travel Insurance etc.

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 12.42 COST AND MANAGEMENT ACCOUNTING

(iii) Others services- Re-insurance, Fund management- Pension, Gratuity and

other etc.
12.10.1 Income of Insurance companies
Income of insurance companies may include
(i) Premium on policy (periodic or onetime)
(ii) Commission on re-insurance
(iii) Fund administration fee and return on investment of funds etc.
12.10.2 Expenditure of Insurance companies
The Expenditure of an insurance company can be classified as direct and indirect
to a policy or product.
Direct- Commission paid to agents, claim settlement, cost of valuation, premium
for re-insurance, legal and other costs etc.
Indirect Cost- Actuarial fees, market and product development costs,
administration cost, asset management cost etc.
12.10.3 Method of Costing in an Insurance Company
The cost object in an insurance company may be a product, a policy, a department
or region, an agent etc.
Activity Based Costing in Insurance Companies
Activity based costing (ABC) is used for analysis of cost-benefit of a product (Direct
Product Profitability), policy profitability (Customer Profitability Analysis) etc.
Costs that occur in insurance companies are to be identified with appropriate
activities that have caused its occurrence. Then costs must be reassigned from
activities to cost objects (insurance contracts and policies, customers, delivery
channels) based on identified cost drivers.
Identification of activities and assignment of costs are the most critical for the
implementation of activity based costing. The activities can be divided into two part
i.e. (i) Pre-product development activities and (ii) Post product development
activities.
(i) Pre-product development activities: These are the activities which are
carried out before a product is made. It includes market research, product
development like specification of coverage, conditions, amount of premium,
insurance contract, policy forms and provision for sales channel etc.

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 SERVICE COSTING 12.43

(ii) Post product development activities: This activity is further divided into
parts i.e. (a) Selling of policy and (b) Processing of claims. (a) Selling of policy refers
to appointment of distribution of sales channel (direct selling or through agencies),
soliciting for policy, processing of applications etc. (b) Processing of claim includes
claim inception, claim estimation, claim settlement and legal actions.
The activities costs are assigned to the products on the basis of appropriate cost
drivers. The cost drivers may include no. of hours spent on processing of an
application and claim processing, no. of application, no. of policy, no. of claim etc.
ILLUSTATION 12
Sanziet Lifecare Ltd. operates in life insurance business. Last year it launched a new
term insurance policy for practicing professionals ‘Professionals Protection Plus’. The
company has incurred the following expenditures during the last year for the policy:
`
Policy development cost 11,25,000
Cost of marketing of the policy 45,20,000
Sales support expenses 11,45,000
Policy issuance cost 10,05,900
Policy servicing cost 35,20,700
Claims management cost 1,25,600
IT cost 74,32,000
Postage and logistics 10,25,000
Facilities cost 15,24,000
Employees cost 5,60,000
Office administration cost 16,20,400

Number of policy sold- 528

Total insured value of policies- ` 1,320 crore
Required:
(i) CALCULATE total cost for Professionals Protection Plus’ policy segregating the
costs into four main activities namely (a) Product development, Marketing and
Sales support, (b) Operations, (c) IT and (d) Support functions.
(ii) CALCULATE cost per policy.

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 12.44 COST AND MANAGEMENT ACCOUNTING

(iii) CALCULATE cost per rupee of insured value.

SOLUTION:
(i) Calculation of total cost for ‘Professionals Protection Plus’ policy

Particulars Amount (`) Amount (`)

1. Product Development, Marketing
and Sales Support:
- Policy development cost 11,25,000
- Cost of marketing 45,20,000
- Sales support expenses 11,45,000 67,90,000
2. Operations:
- Policy issuance cost 10,05,900
- Policy servicing cost 35,20,700
- Claims management cost 1,25,600 46,52,200
3. IT Cost 74,32,000
4. Support functions
- Postage and logistics 10,25,000
- Facilities cost 15,24,000
- Employees cost 5,60,000
- Office administration cost 16,20,400 47,29,400
Total Cost 2,36,03,600

Total cost `2,36,03,600

(ii) Calculation of cost per policy = =
No.of policies 528

= ` 44,703.79
Total cost ` 2.36 crore
(iii) Cost per rupee of insured value = =
Total insured value ` 1,320 crore

= ` 0.0018

12.11 COSTING IN FINANCIAL INSTITUTIONS

In the past two decade financial institutions have undergone major changes – in
terms to increased regulations, competition from new entrants from both locally

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 SERVICE COSTING 12.45

and globally, innovation of new products and services, technological advancement

and increased expectations of new generation customers, etc.
Over and above the challenges posed by the prevailing environment as described
above, financial institutions underwent considerable changes in terms of its high
quality, sensitive staffing requirements and its productivity.
Manpower cost, other than interest cost and finance charges, is one of the largest
single cost components in financial institutions. Hence, it is needless to say, that
financial institutions are more interested in understanding and discovering the
ways to more accurately allocate such costs to various product ranges offered by
them and its customers.
If the financial institution is to survive under the present challenging economic
conditions, it will have to add value to its products and services. It is imperative to
note that the financial institution needs to know the contribution of its products,
services and customers to value creation.
12.11.1 Cost measurement in financial institutions
The objectives of cost measurement includes –
- Understand the profitability by products offered and by customers
- Establishing a mechanism for pricing the products, by identifying the product
level and activity level unit costs
- Understanding productivity issues and their relationship with strategic goals
of the organization
In nutshell, financial institutions need to understand their position in various product
lines and to find out how they can stay in competing edge or becomes a leader.
12.11.2 Activity Based Costing in Financial Institutions
Activity based costing can be a useful tool in allocating the cost elements to various
products offered and the customers being serviced.
Activity based costing can help financial institutions to –
• Identify and analyze the profitability by product
• Analyze the profitability by customer
• Identify the activity level unit costs and build up product level costs, which in
turn forms basis for product level pricing / customer level pricing

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 12.46 COST AND MANAGEMENT ACCOUNTING

Financial institutions can improve their profitability by –

• Concentrating on products that are more profitable
• Focus on high margin customers
Costs that occur in financial institutions are to be identified with appropriate
activities that have caused its occurrence. Then costs must be reassigned from
activities to cost objects (various loan products offered by the organization,
customers, etc.) based on identified cost drivers.
The concepts on activity based costing as discussed under Costing of Insurance
Companies also applicable to financial institutions. Please refer the same.
ILLUSTRATION 13
The loan department of a bank performs several functions in addition to home loan
application processing task. It is estimated that 25% of the overhead costs of loan
department are applicable to the processing of home-loan application. The following
information is given concerning the processing of a loan application:
Direct professional labor:
(`)
Home Loan processor monthly salary: 2,40,000
(4 employees @ ` 60,000 each)
Loan department overhead costs (monthly)
Chief loan officer’s salary 75,000
Telephone expenses 7,500
Depreciation Building 28,000
Legal advice 24,000
Advertising 40,000
Miscellaneous 6,500
Total overhead costs 1,81,000

You are required to COMPUTE the cost of processing home loan application on the
assumption that five hundred home loan applications are processed each month.

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 SERVICE COSTING 12.47

SOLUTION:
Statement showing computation of the cost of processing
a typical home loan application
(`)
Direct professional labour cost 2,40,000
(4 employees @ ` 60,000 each)
Service overhead cost (25% of ` 1,81,000) 45,250
Total processing cost per month 2,85,250
No. of applications processed per month 500
Total processing cost per home loan application 570.5

12.12 OTHER SERVICES- COSTING FOR POWER

HOUSES
Power houses are engaged either in electricity generation or steam generation use
the concepts of service costing i.e. ‘Power House Costing.’ Service cost statement
can be prepared by identifying the costs associated with the power generation or
steam generation.
Cost unit is different for electricity generation and steam generation.
The cost unit for electricity generation organization is cost per kilowatt-hour (kWh)
– that means cost of generating one kilowatt of power per hour. Please note that
kWh is commonly known as a “Unit”.
The costs are shown under the following heads:
(i) Standing Charges or Fixed costs: These are the fixed costs that remain
constant irrespective of the power or stream generated. These costs include
the following:
 Rent, Rates & Taxes
 Insurance
 Depreciation
 Salaries, if paid on Time (Monthly) basis
 Administration expenses, etc.

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 12.48 COST AND MANAGEMENT ACCOUNTING

(ii) Variable costs or Running costs: These costs are generally associated with
the power or stream generated. These costs include the following:
 Fuel Charges
 Water Charges
 Wages / Labour charges, if paid on the basis of production
 Any other variable costs identified.
(iii) Semi-variable costs or Maintenance costs: These costs include the
following:
 Meters
 Furnaces
 Service materials
 Tools, etc.
ILLUSTRATION 14
PREPARE the cost statement of Ignus Thermal Power Station showing the cost of electricity
generated per kWh, from the data provided below pertaining to the year 2020-21.
Total units generated 20,00,000 kWh

Amount (`)
Operating labour 30,00,000
Repairs & maintenance 10,00,000
Lubricants, spares and stores 8,00,000
Plant supervision 6,00,000
Administration overheads 40,00,000
5 kWh. of electricity generated per kg of coal consumed @ ` 4.25 per kg. Depreciation
charges @ 5% on capital cost of ` 5,00,00,000.
SOLUTION:
Cost Statement of Ignus Thermal Power Station

Total units generated 20,00,000 kwh.

Per annum (`) Per kWh (`)
Fixed costs:
Plant supervision 6,00,000

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 SERVICE COSTING 12.49

Administration overheads 40,00,000

Depreciation (5% of ` 5,00,00,000 p.a.) 25,00,000
Total fixed cost: (A) 71,00,000 3.55
Variable costs:
Operating labour 30,00,000
Lubricants, spares and stores 8,00,000
Repairs & maintenance 10,00,000
Coal cost (Refer to working note) 17,00,000
Total variable cost: (B) 65,00,000 3.25
Total cost [(A) + (B)] 1,36,00,000 6.80

Working Note:
Coal cost (20,00,000 kwh. ÷ 5 kwh) × ` 4.25 per kg. = ` 17,00,000

SUMMARY
♦ Service Costing: - It is application of cost concepts in ascertainment of cost
or providing services. It is also known as operating costing as relates to
operating of a service.
♦ Composite Cost Unit: Unit of service cost consists of two different units.
♦ 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.
♦ Build-Operate-Transfer (BOT): With BOT, the private sector designs,
finances, constructs and operate the facility and eventually, after specified
concession period, the ownership is transferred to the Government.
Therefore, BOT can be seen as a developing technique for infrastructure
projects by making them amenable to private sector participation.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Composite cost unit for a hospital is:
(a) Per patient

© The Institute of Chartered Accountants of India

CHAPTER 10

PROCESS & OPERATION

COSTING
LEARNING OUTCOMES

 State the meaning of Process and Operation Costing

 Discuss the treatment of process loss and gains in cost
accounts
 Compute equivalent completed production units.
 Discuss the various methods of valuation of work in process.
 State the meaning and treatment of Inter-process profits.

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 10.2 COST AND MANAGEMENT ACCOUNTING

Meaning

Process & Operation Costing Costing Procedure

Normal
Treatment of
Process loss/ gain
Abnormal

Process Costing
Methods
Valuation of WIP
Equivalent Units
Inter-process Profit

Operation Costing

10.1 MEANING OF PROCESS COSTING

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.
This can be understood with the help of the following diagram:

Raw Finished
Process-I Process-II Process-III
Material Goods

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 PROCESS AND OPERATION COSTING 10.3

10.1.1 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.

10.2 COSTING PROCEDURE IN PROCESS COSTING

The Cost of each process comprises the cost of:
(i) Materials (ii) Employee Cost (Labour)
(iii) Direct expenses, and (iv) Overheads of production.
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.

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 10.4 COST AND MANAGEMENT ACCOUNTING

Direct expenses - Each process account should be debited with direct

expenses like depreciation, repairs, maintenance, insurance etc. associated with it.
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.
ILLUSTRATION 1
From the following data, PREPARE process accounts indicating the cost of each
process and the total cost. The total units that pass through each process were 240
for the period.

Process I (`) Process II (`) Process III (`)

Materials 1,50,000 50,000 20,000
Labour 80,000 2,00,000 60,000
Other expenses 26,000 72,000 25,000

Indirect expenses amounting to ` 85,000 may be apportioned on the basis of wages.

There was no opening or closing stock.
SOLUTION

Dr. Process- I Account Cr.

Particulars Per Total Particulars Per Total
unit (`) unit (`)
(`) (`)
To Material 625 1,50,000 By Process -II 1,150 2,76,000
A/c
” Labour 334 80,000 (Transfer to
Process-II)
” Other expenses 108 26,000
” Indirect expenses* 83 20,000
1,150 2,76,000 1,150 2,76,000

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 PROCESS AND OPERATION COSTING 10.5

Dr. Process- II Account Cr.

Particulars Per Total Particulars Per Total (`)
unit (`) unit
(`) (`)
To Process-I 1,150 2,76,000 By Process-III 2,700 6,48,000
A/c A/c
” Material 208 50,000 (Transfer to
Process-III)
” Labour 834 2,00,000
” Other 300 72,000
expenses
” Indirect 208 50,000
expenses*
2,700 6,48,000 2,700 6,48,000

Dr. Process- III Account Cr.

Particulars Per Total Particulars Per Total (`)
unit (`) unit
(`) (`)
To Process-II 2,700 6,48,000 By Finished 3,200 7,68,000
A/c Stock A/c
Material 83 20,000 (Transferred)
” Labour 250 60,000
” Other 104 25,000
expenses
” Indirect 63 15,000
expenses*
3,200 7,68,000 3,200 7,68,000

* Apportionment of Indirect expenses among Process-I, Process-II and Process-III

Total Wages to processes (I + II +III) = ` 80,000 + ` 2,00,000 + ` 60,000 =
` 3,40,000

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 10.6 COST AND MANAGEMENT ACCOUNTING

Apportionment to:
`85,000
Process- I = ×`80,000 = ` 20,000;
`3, 40,000
`85,000
Process- II = ×`2,00,000 = `50,000 and
`3, 40,000
`85,000
Process- III = ×`60,000 = `15,000
`3, 40,000

10.3TREATMENT OF NORMAL, ABNORMAL LOSS

AND ABNORMAL GAIN
10.3.1 Normal and abnormal loss:
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.
Example-1 (Normal loss with no realisable value)
A product passes through Process- I and Process- II. Materials issued to Process- I
amounted to ` 40,000, Wages ` 30,000 and manufacturing overheads were
` 27,000. Normal loss anticipated was 5% of input. 4,750 units of output were
produced and transferred-out from Process-I. There were no opening stocks. Input
raw material issued to Process I were 5,000 units. Scrap has no realisable value.
You are required to PREPARE Process- I account, value of normal loss and units
transferred to Process-II.

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 PROCESS AND OPERATION COSTING 10.7

Solution
Process- I Account

Particulars Units (`) Particulars Units (`)

To Material 5,000 40,000 By Normal loss 250 0
To Wages - 30,000
To Overhead - 27,000 By Process II 4,750 97,000
5,000 97,000 5,000 97,000

Value of Normal loss = Scrap realisable value less cost to sale

Since, scraps do not realise any value, hence, value of normal loss is zero.
Value of units transferred to Process-II:
Total Cost-Realisable value of normal loss
= ×Units transferred
Total inputunits-Normal lossunits

`97,000 − 0
= ×4,750 units = 97,000
5,000 units − 250 units

Example-2 (Normal loss with realisable value)

A product passes through Process- I and Process- II. Materials issued to Process-
I amounted to ` 40,000, Wages ` 30,000 and manufacturing overheads were
` 27,000. Normal loss anticipated was 5% of input. 4,750 units of output were
produced and transferred-out from Process-I. There were no opening stocks.
Input raw material issued to Process I were 5,000 units. Scrap has realisable value
of ` 2 per unit.
You are required to PREPARE Process- I account, value of normal loss and units
transferred to Process-II.
Solution
Process- I Account

Particulars Units (`) Particulars Units (`)

To Material 5,000 40,000 By Normal loss 250 500
To Wages - 30,000
To Overhead - 27,000 By Process II 4,750 96,500
5,000 97,000 5,000 97,000

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 10.8 COST AND MANAGEMENT ACCOUNTING

Value of Normal loss = Scrap realisable value less cost to sale

= 250 units × `2 = `500
Value of units transferred to Process-II:
Total Cost − Realisable value of normal loss
= ×Units transferred
Total input units − Normal loss units

`97,000 − `500
= ×4,750units = 96,500
5,000units − 250units

(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. In fact, the total cost of abnormal
process loss is debited to costing profit and loss account.
Example-3 (Abnormal loss with realisable value)
A product passes through Process- I and Process- II. Materials issued to Process-
I amounted to ` 40,000, Wages ` 30,000 and manufacturing overheads were
` 27,000. Normal loss anticipated was 5% of input. 4,550 units of output were
produced and transferred-out from Process-I. There were no opening stocks.
Input raw material issued to Process I were 5,000 units. Scrap has realisable value
of ` 2 per unit.
You are required to PREPARE Process- I account, value of normal loss, abnormal
loss and units transferred to Process-II.
Solution:
Process- I Account

Particulars Units (`) Particulars Units (`)

To Material 5,000 40,000 By Normal loss 250 500
To Wages - 30,000 By Abnormal Loss 200 4,063
To Overhead - 27,000 By Process II 4,550 92,437
5,000 97,000 5,000 97,000

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 PROCESS AND OPERATION COSTING 10.9

Value of Normal loss = Scrap realisable value less cost to sale

= 250 units × `2 = `500
Value of Abnormal loss:
Total Cost − Realisable value of normal loss
= ×Abnormal loss units
Total input units − Normal loss units

` 97,000- `500
= ×200units = `4,063
5,000units-250units

Value of units transferred to Process-II:

Total Cost-Realisable value of normal loss
= ×Units transferred
Total input units − Normal loss units

`97,000- `500
= ×4,550units = ` 92,437
5,000units-250units

10.3.2 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.
Example-4 (Abnormal gain/ yield with realisable value)
A product passes through Process- I and Process- II. Materials issued to Process- I
amounted to ` 40,000, Wages ` 30,000 and manufacturing overheads were ` 27,000.
Normal loss anticipated was 5% of input. 4,850 units of output were produced and
transferred-out from Process-I. There were no opening stocks. Input raw material
issued to Process I were 5,000 units. Scrap has realisable value of ` 2 per unit.
You are required to PREPARE Process- I account, value of normal loss, abnormal
loss/ gain and units transferred to Process-II.

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 10.10 COST AND MANAGEMENT ACCOUNTING

Solution
Process- I Account

Particulars Units (`) Particulars Units (`)

To Material 5,000 40,000 By Normal loss 250 500
To Wages - 30,000
To Overhead - 27,000 By Process II 4,850 98,532
To Abnormal Gain A/c 100 2,032
5,100 99,032 5,100 99,032

Value of Normal loss = Scrap realisable value less cost to sale

= 250 units × `2 = `500
(even though the actual loss is less than the expected loss (Normal loss), value of
the normal loss is calculated on the estimated figure)
Value of Abnormal Gain:
Total Cost − Realisable value of normal loss
= ×Abnormal Gain units
Total input units − Normal loss units

`97,000 − `500
= ×100 units = `2,032
5,000 units − 250 units

Value of units transferred to Process-II:

Total Cost − Realisable value of normal loss
= ×Units transferred
Total input units − Normal loss units

`97,000 − `500
= ×4,850units = ` 98,532
5,000units − 250units

(Process A/c is debited with the value of abnormal gain as calculated above but
the Costing Profit & Loss Account will only be credited with actual amount of
abnormal gain only considering the actual realisable value through Abnormal
Gain A/c, as shown below)
Abnormal Gain A/c

Particulars Units (`) Particulars Units (`)

To Normal Loss A/c 100 200 By Process-I 100 2,032
(100 units × `2) A/c

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 PROCESS AND OPERATION COSTING 10.11

To Costing P&L A/c - 1,832

100 2,032 100 2,032

(The Costing P&L Account is credited only for actual gain amount)
ILLUSTRATION 2
A product passes through three processes. The output of each process is treated as
the raw material of the next process to which it is transferred and output of the
third process is transferred to finished stock.

Process-I (`) Process-II (`) Process-III (`)

Materials issued 40,000 20,000 10,000
Labour 6,000 4,000 1,000
Manufacturing overhead 10,000 10,000 15,000

10,000 units have been issued to the Process-I and after processing, the output of
each process is as under:

Process Output Normal Loss

Process-I 9,750 units 2%
Process-II 9,400 units 5%
Process-III 8,000 units 10%

No stock of materials or of work-in-process was left at the end. CALCULATE the cost
of the finished articles.
SOLUTION
Dr. Process-I Account Cr.
Particulars Units Total Particulars Units Total
(`) (`)
To Material 10,000 40,000 By Normal Loss A/c 200 --
(2% of 10,000 units)
” Labour -- 6,000 ” Abnormal Loss A/c 50 286
(` 5.7142 × 50 units)
” Manufacturing -- 10,000 ” Process-II A/c 9,750 55,714
OH (` 5.7142 × 9,750 units)
10,000 56,000 10,000 56,000

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 10.12 COST AND MANAGEMENT ACCOUNTING

Cost per unit of completed units and abnormal loss:

Total Cost ` 56,000
= = ` 5.7142
Inputs − Normal loss 10,000units − 200units

Dr. Process-II Account Cr.

Particulars Units Total Particulars Units Total
(`) (`)
To Process-I A/c 9,750 55,714 By Normal Loss A/c 488 --
(5% of 9,750 units)
” Material -- 20,000 ” Process-III A/c 9,400 91,051
(` 9.6862 × 9,400
units)
” Labour -- 4,000
” Manufacturing -- 10,000
OH
” Abnormal Gain 138 1,337
A/c
(` 9.6862 × 138
units)
9,888 91,051 9,888 91,051

Cost per unit of completed units and abnormal gain:

Total Cost `89,714
= = ` 9.6862
Inputs − Normal loss 9,750units − 488units

Dr. Process-III Account Cr.

Particulars Units Total Particulars Units Total
(`) (`)
To Process-II A/c 9,400 91,051 By Normal Loss A/c 940 --
(10% of 9,400 units)
” Material -- 10,000 ” Abnormal Loss A/c 460 6,364
(`13.8358 × 460 units)
” Labour -- 1,000 ” Finished Stock A/c 8,000 1,10,687
(`13.8358 × 8,000
units)
” Manufacturing -- 15,000
OH
9,400 1,17,051 9,400 1,17,051

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 PROCESS AND OPERATION COSTING 10.13

Cost per unit of completed units and abnormal loss:

Total Cost ` 1,17,051
= = `13.8358
Inputs − Normal loss 9, 400units − 940units

ILLUSTRATION 3
RST Limited processes Product Z through two distinct processes – Process- I and Process-
II. On completion, it is transferred to finished stock. From the following information for
the current year, PREPARE Process- I, Process- II and Finished Stock A/c:

Particulars Process- I Process- II

Raw materials used 7,500 units --
Raw materials cost per unit ` 60 --
Transfer to next process/finished 7,050 units 6,525 units
stock
Normal loss (on inputs) 5% 10%
Direct wages ` 1,35,750 ` 1,29,250
Direct Expenses 60% of Direct wages 65% of Direct wages
Manufacturing overheads 20% of Direct wages 15% of Direct wages
Realisable value of scrap per unit ` 12.50 ` 37.50
6,000 units of finished goods were sold at a profit of 15% on cost. Assume that
there was no opening or closing stock of work-in-process.
SOLUTION
Process- I A/c
Particulars Units (`) Particulars Units (`)
To Raw material 7,500 4,50,000 By Normal 375 4,688
used loss
(`60 × 7,500 (5% of 7,500
units) units) × `12.5
To Direct wages -- 1,35,750 By Process- 7,050 6,82,403
II A/c
(`96.7947 ×
7,050 units)
To Direct -- 81,450 By 75 7,259
expenses Abnormal
loss

© The Institute of Chartered Accountants of India

 10.14 COST AND MANAGEMENT ACCOUNTING

(`96. 7947
× 75 units)
To 27,150
Manufacturing
overhead
7,500 6,94,350 7,500 6,94,350

Cost per unit of completed units and abnormal loss:

Total Cost − Realisable value from normal loss
Inputs units − Normal loss units
`6,94,350 − ` 4,688 `6,89,662
= = = `96.7947
7,500units − 375 units 7,125 units
Process- II A/c
Particulars Units (`) Particulars Units (`)
To Process- I A/c 7,050 6,82,403 By Normal loss 705 26,438
(10% of 7,050 units)
× ` 37.5
To Direct wages -- 1,29,250 By Finished Stock A/c 6,525 9,13,824
(` 140.0496 × 6,525
units)
To Direct expenses -- 84,013
To Manufacturing -- 19,387
overhead
To Abnormal gain 180 25,209
(` 140.0496 × 180
units)
7,230 9,40,262 7,230 9,40,262

Cost per unit of completed units and abnormal loss:

TotalCost-Realisable value fromnormalloss
Inputsunits-Normallossunits

`9,15,053 - `26, 438 `8,88,615

= = = `140.0496
7,050 units - 705 units 6,345 units

Finished Goods Stock A/c

Particulars Units (`) Particulars Units (`)
To Process II A/c 6,525 9,13,824 By Cost of Sales 6,000 8,40,298
(`140.0496 × 6,000

© The Institute of Chartered Accountants of India

 PROCESS AND OPERATION COSTING 10.15

units)
By Balance c/d 525 73,526
6,525 9,13,824 6,525 9,13,824

Income Statement
Particulars (`) Particulars (`)
To Cost of sales 8,40,298 By Abnormal gain 18,459
(`140.0496 × 6,000 units) {180 units × (`140.0496 – `37.50)}
To Abnormal loss 6,322 By Sales (`8,40,298 × 115%) 9,66,343
{75 units × (`96.7947 – `12.50)}
To Net Profit 1,38,182
9,84,802 9,84,802

10.4 VALUATION OF WORK IN PROCESS

In the case of process type of industries, it is possible to determine the average cost
per unit by dividing the total cost incurred during a given period of time by the total
number of units produced during the same period. But this is hardly the case in most
of the process type industries where manufacturing is a continuous activity. The
reason is that the cost incurred in such industries represents the cost of work carried
on opening work-in-process, closing work-in-process and completed units. Thus to
ascertain the cost of each completed unit, it is necessary to ascertain the cost of
work-in-process in the beginning and at the end of the process.
The valuation of work-in-process presents a good deal of difficulty because it has
units under different stages of completion from those in which work has just
begun to those which are only a step short of completion. 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.
10.4.1 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

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 10.16 COST AND MANAGEMENT ACCOUNTING

that the estimate of percentage of completion should be as accurate as possible.

The formula for computing equivalent completed units is:
 Actual number of units in   Percentage of 
Equivalent completed units =  × 
 the process of manufacture   Work completed 
For instance, if 25% of work has been done on the average of units still under
process, then 200 such units will be equal to 50 completed units and the cost of
work-in-process will be equal to the cost of 50 finished units.
The following table may be used to compute the equivalent units:
Input Details Unit Output Units Equivalent Units
s Particulars Material Labour Overhead
% Units % Units % Units
a b c= a×b d e=a×d f g=a×f
Opening W-I-P xxx Opening W-I- xxx xxx xxx xxx xxx xxx xxx
P*
Unit xxx Finished xxx xxx xxx xxx xxx xxx xxx
Introduced output**
Normal xxx - - - - - -
loss***
Abnormal xxx xxx xxx xxx xxx xxx xxx
loss/Gain****
Closing W-I-P xxx xxx xxx xxx xxx xxx xxx
Total xxx Total xxx xxx xxx xxx
* Equivalent units for Opening W-I-P is calculated only under FIFO method. Under
the Average method, it is not shown separately.
**Under the FIFO method, Finished Output = Units completed and transferred to
next process less Opening WIP. Under Average method, Finished Output = Units
completed and transferred.
***For normal loss, no equivalent unit is calculated.
****Abnormal Gain/ Yield is treated as 100% complete in respect of all cost elements
irrespective of percentage of completion.

10.5 STEPS IN PROCESS COSTING

For each production process, a Production Cost Report is prepared at the end of
each accounting period. The objective of preparing the report is to know physical
units and equivalent units in process, element wise cost of goods produced and
transferred, goods in process (work-in-process), units lost due to abnormal
reasons i.e. abnormal loss etc. To prepare the report, the following steps are
generally followed:

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 PROCESS AND OPERATION COSTING 10.17

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. For example, if there are 1,000
units in work-in-process at the end of the month. All materials are introduced at
the beginning of production process. For labour and overheads, 20% more work
is required to get it completed. In this example, the equivalent units of work-in-
process in respect of material would be 1,000 units (1,000 units × 100% complete)
and for labour and overheads 800 units (1,000 units × 80% complete).
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.

10.6 PROCESS COSTING METHODS

Mainly two methods for valuation of work-in-process are followed:
(i) First-in-First Out (FIFO) method.
(ii) Weighted Average(Average) method
(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

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 10.18 COST AND MANAGEMENT ACCOUNTING

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.
ILLUSTRATION 4
Opening work-in-process 1,000 units (60% complete); Cost ` 1,10,000. Units
introduced during the period 10,000 units; Cost ` 19,30,000. Transferred to next
process - 9,000 units.
Closing work-in-process - 800 units (75% complete). Normal loss is estimated at
10% of total input including units in process at the beginning. Scraps realise ` 10
per unit. Scraps are 100% complete.
Using FIFO method, COMPUTE equivalent production and cost per equivalent unit.
Also evaluate the output.
SOLUTION
Statement of Equivalent Production Units (Under FIFO Method)
Particulars Input Particulars Output Equivalent
units units Production
(%) Equivalent
units
Opening W-I-P 1,000 From opening W-I-P 1,000 40 400
Units introduced 10,000 From fresh inputs 8,000 100 8,000
Units completed 9,000
(Transferred to next
process)
Normal Loss 1,100 -- --
{10% (1,000 + 10,000
units)}
Closing W-I-P 800 75 600
Abnormal loss 100 100 100
(Balancing figure)
11,000 11,000 9,100

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 PROCESS AND OPERATION COSTING 10.19

Computation of cost per equivalent production unit:

Cost of the Process (for the period) `19,30,000
Less: Scrap value of normal loss (` 10 × 1,100 units) (`11,000)
Total process cost ` 19,19,000

`19,19,000
Cost per equivalent unit = = ` 210.88
9,100units

Statement of Evaluation
Particulars Equivalent Cost per Amount
Units (EU) EU (`) (`)
(i) Opening W-I-P completed 400 210.88 84,352
during the period
Add: Cost of W-I-P at beginning -- -- 1,10,000
Complete cost of 1,000 units of 1,000 194.35 1,94,352
opening W-I-P
(ii) Completely processed units 8,000 210.88 16,87,040
(iii) Abnormal Loss 100 210.88 21,088
(iv) Closing W-I-P 600 210.88 1,26,528
(The difference in total amount may arise due to rounding off error)

Process Explained:
(i) Total Units completed and Transferred is 9,000 units. Out of these 9,000 units,
1,000 units has been taken from opening WIP and the rest is from the fresh
units introduced.
(ii) The opening WIP is 60% complete in respect of costs, hence, 40% more work
is to be done during the period.

(iii) Total cost for cost elements for the period (current period only) is
accumulated.

(iv) The realisable value of scrap (i.e. normal loss) is deducted from the total cost
as accumulated above.

(v) Total cost less realisable value is divided by equivalent units to get cost per
equivalent unit.

(vi) The equivalent cost as calculated above is multiplied by the equivalent units of
completely processed goods, abnormal loss and closing WIP to get the value.

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 10.20 COST AND MANAGEMENT ACCOUNTING

(vii) Cost of units completed and transferred is calculated separately for Opening
WIP and fresh inputs.

(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.
ILLUSTRATION 5
Refer to information provided in Illustration 4 above and solve this by Weighted
Average Method:
SOLUTION
Statement of Equivalent Units (Under Weighted Average Method)
Particulars Input Particulars Output Equivalent
units units Production
(%) Equivalent
units
Opening W-I-P 1,000 Units completed 9,000 100 9,000
(Transferred to
next process)
Units introduced 10,000 Normal Loss 1,100 -- --
{10% (1,000 +
10,000 units)}
Closing W-I-P 800 75 600
Abnormal loss 100 100 100
(Balancing figure)
11,000 11,000 9,700

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 PROCESS AND OPERATION COSTING 10.21

Computation of cost per equivalent production unit :

Cost of Opening W-I-P ` 1,10,000
Cost of the Process (for the period) `19,30,000
Less: Scrap value of normal loss (` 10 × 1,100 units) (`11,000)
Total process cost `20,29,000

`20,29,000
Cost per equivalent unit = = ` 209.18
9,700units

Statement of Evaluation
Particulars Equivalent Cost per Amount
Units (EU) EU (`) (`)
(i) Units Completed and 9,000 209.18 18,82,620
transferred to next process
(ii) Abnormal Loss 100 209.18 20,918
(iii) Closing W-I-P 600 209.18 1,25,508
(The difference in total amount may arise due to rounding off error)

Process Explained:
(i) Total Units completed and Transferred is 9,000 units. All the 9,000 units has
been considered as equally complete in respected of cost.

(ii) Total cost for cost elements for the period and opening WIP is accumulated.

(iii) The realisable value of scrap (i.e. normal loss) is deducted from the total cost
as accumulated above.

(iv) Total cost less realisable value is divided by equivalent units to get cost per
equivalent unit.

(v) The equivalent cost as calculated above is multiplied by the equivalent units of
completely processed goods, abnormal loss and closing WIP to get the value.

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

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 10.22 COST AND MANAGEMENT ACCOUNTING

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.
ILLUSTRATION 6
A Ltd. produces product ‘AXE’ which passes through two processes before it is
completed and transferred to finished stock. The following data relate for the month
of October:

Process- I Process- Finished

(`) II (`) Stock (`)
Opening stock 7,500 9,000 22,500
Direct materials 15,000 15,750 --
Direct wages 11,200 11,250 --
Factory overheads 10,500 4,500 --
Closing stock 3,700 4,500 11,250
Inter-process profit included in -- 1,500 8,250
opening stock

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

Output of Process- II is transferred to finished stock at 20% profit on the transfer
price. Stock in processes is valued at prime cost. Finished stock is valued at the price
at which it is received from process II. Sales during the period are ` 1,40,000.
PREPARE Process cost accounts and finished goods account showing the profit
element at each stage.

© The Institute of Chartered Accountants of India

 PROCESS AND OPERATION COSTING 10.23

SOLUTION
Process- I Account

Particulars Total Cost Profit Particulars Total Cost Profit

(`) (`) (`) (`) (`) (`)
Opening 7,500 7,500 -- Process- II 54,000 40,500 13,500
stock A/c*
Direct 15,000 15,000 -- Closing Stock 3,700 3,700 --
materials
Direct 11,200 11,200 --
wages
Prime Cost 33,700 33,700
Overheads 10,500 10,500 --
Total Cost 44,200 44,200
Profit** 13,500 -- 13,500
57,700 44,200 13,500 57,700 44,200 13,500

Totalcost - Closingstock 44,200 - 3,700

*Transfer price = = =`54,000
75% 75%
**Profit on transfer = 54,000 × 25% = `13,500

Process- II Account
Particulars Total (`) Cost Profit Particulars Total (`) Cost Profit
(`) (`) (`) (`)
Opening 9,000 7,500 1,500 Finished 1,12,500 75,750 36,750
stock Stock A/c**
Transferred 54,000 40,500 13,500 Closing 4,500 3,750 750
from stock*
Process- I
Direct 15,750 15,750 --
materials
Direct wages 11,250 11,250 --
Prime cost 90,000 75,000 15,000
Overheads 4,500 4,500 --
Total cost 94,500 79,500 15,000

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 10.24 COST AND MANAGEMENT ACCOUNTING

Profit*** 22,500 -- 22,500

1,17,000 79,500 37,500 1,17,000 79,500 37,500

`75,000
* Cost of Closing Stock = ×` 4,500 = `3,750
`90,000

Totalcost - Closingstock 94,500 - 4,500

**Transfer price = = =`1,12,500
80% 80%

***Profit on transfer = 1,12,500 × 20% = `22,500

Finished Stock Account

Particulars Total (`) Cost (`) Profit Particulars Total Cost Profit
(`) (`) (`) (`)
Opening stock 22,500 14,250 8,250 Costing 1,40,000 82,425 57,575
P&L A/c
Process- II 1,12,500 75,750 36,750 Closing 11,250 7,575 3,675
stock*
Profit 16,250 -- 16,250
1,51,250 90,000 61,250 1,51,250 90,000 61,250

Cost of transfer fromProcess-II

* Cost of Closing Stock = ×Valueof closingstock
Transfer pricefromProcess-II

(As per instruction given in the question)

` 75,750
= × ` 11,250 = ` 7,575
`1,12,500

10.8 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.

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 PROCESS AND OPERATION COSTING 10.25

For example, a company is manufacturing two grades of products, Product-

Deluxe and Product- Regular. Both the products pass through a similar
production process but require different quality and quantities of raw materials.
The cost of raw material is accumulated on the basis of job or batches or units of
two variants of products. But the costs for the conversion activities need not to be
identified with the product variants as both the Products requires similar activities
for conversion. Hence, conversion activity costs are accumulated on the basis of
departments or processes only. Example of industries are ready made garments,
Shoe making, jewelry etc.

SUMMARY
♦ Process Costing: Used in industries where the material has to pass through
two or more processes for being converted into a final product.
♦ Operation Costing: It is the refinement of process costing. It is concerned with
the determination of the cost of each operation rather than the process.
♦ Treatment of Losses in process costing: -
(i) Normal process loss - The cost of normal process loss 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 - The total cost of abnormal process loss is
credited to the process account from which it arises. The total cost of
abnormal process loss is debited to costing profit and loss account.
♦ Abnormal gain - 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.
♦ Equivalent production units: This concept is used in the industries where
manufacturing is a continuous activity. Converting partly finished units into
equivalent finished units.
Equivalent production means converting the incomplete production units
into their equivalent completed units.
Equivalent completed units ={Actual number of units in the process of
manufacture} × {Percentage of work completed}
♦ Valuation of work-in-process: two main methods:
(1) First-in-First Out (FIFO) method.

© The Institute of Chartered Accountants of India

CHAPTER 13

STANDARD COSTING

LEARNING OUTCOMES

 Discuss the meaning of standard cost and variances.

 Differentiate between controllable and uncontrollable
variances.
 Analyse and compute variances related to material, labour
and overheads.

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 13.2 COST AND MANAGEMENT ACCOUNTING

Meaning of Standard cost

and Standard Costing

Types of Standards

The Process of Standard

Costing

Setting-up of Standard
Cost
Standard Costing

Types of Variances

Classification of Variances

Computation of Variance

Advantages and Criticism

of Standard Costing

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 STANDARD COSTING 13.3

13.1 INTRODUCTION
Cost control is one of the objectives of cost management. Management of an
organisation setups predetermined cost to compare the actual cost with the
predetermined cost. Predetermined costs are standardcosts used for cost control
and performance evaluation. Standard costing is a method of cost and
management accounting which starts with setting of standards and ends with
reporting of variances to management for taking corrective actions. The Official
Terminology of CIMA, London defines standard costing as “Control technique that
reports variances by comparing actual costs to pre-set standards so facilitating
action through management by exception.”
In this chapter we will learn how standards are set for each cost component i.e.
material, labour and overheads of a cost object.
13.1.1 What is a Standard or Standard Cost?
Standard cost is defined in the CIMA Official Terminology as “'the planned unit cost
of the product, component or service produced in a period. The standard cost may
be determined on a number of bases. The main use of standard costs is in
performance measurement, control, stock valuation and in the establishment of
selling prices.” From the above definition Standard costs can be said as
• Planned cost
• Determined on a base or number of bases.
13.1.2 Why Standard Costing is Needed?
Standards or Standard costs are established to evaluate performance of a
responsibility centre. Apart from performance evaluation and cost control, standard
costs are also used to value inventory where actual figures are not reliably available
and to determine selling prices particularly while preparing quotations.
Standard costing system is widely accepted as it serves different needs of an
organisation. 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

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 13.4 COST AND MANAGEMENT ACCOUNTING

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
used to 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 reporting and decision
making. To arrive at profit figure, standard costs are deducted from the revenue.

13.2 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.
These types of standards are criticised on three grounds:
(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.
(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, however, 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.

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 STANDARD COSTING 13.5

If the actual performance is found to be abnormal, large variances may result and
necessitate revision of standards.
(iii) Basic or Bogey Standards: These standards are used only when they are
likely to remain constant or unaltered over a long period. According to this
standard, a base year is chosen for comparison purposes in the same way as
statisticians use price indices. 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. Basic standards are, however, well suited to businesses having a
small range of products and long production runs. Basic standards are set, on a long-
term basis and are seldom revised. When basic standards are in use, variances are
not calculated. Instead, the actual cost is expressed as a percentage of basic cost.
The current cost is also similarly expressed and the two percentages are compared
to find out how much the actual cost has deviated from the current standard. The
percentages are next compared with those of the previous periods to establish the
trend of actual and current standard from 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 goods
and 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 efficiency
in usage of the factors of production, variation in prices paid for materials and
services and difference in the volume of production.

13.3 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 be
achieved, 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.

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 13.6 COST AND MANAGEMENT ACCOUNTING

(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.

13.4 SETTING UP OF STANDARD COST

Standard cost is set on the basis of management’s estimation. Cost is estimated on the
basis of technical specification provided by the engineering department or other
expert such as production engineer. Generally, while setting standards, consideration
is given to historical data, current production plan and expected conditions of future.
For the sake of detailed analysis and control, standard cost is set for each element of
cost i.e. material, labour, variable overheads and fixed overheads. Standard are also set
for the sales quantity and sales value; this is generally known as budgeted sales.
Standards are set in both quantity (units or hours) and in cost (price or rate). It is thus
measure in quantities, hours and value of the factors of production.
Standard costs are divided into three main cost components, such as
(a) Direct Material Cost
(b) Direct Employee (Labour) Cost and
(c) Overheads
Standards are set in both physical and monetary terms for each cost components.
Details are as follows:
13.4.1 Physical Standards
Physical standards refer to expression of standards in units or hours. At this
stage standard quantity and standard hours are determined for a particular product
or service. The purpose of setting standards is to secure economies in scale of
production and to set selling price for quotation purpose.
In manufacturing organisations, the task of setting physical standards is assigned
to the industrial engineering department. While setting standards consideration is
given to :
• Company’s operating plan i.e. budgets
• Final output to be produced
• Material specification, in both quantity and quality provided by the
engineering department.
• Proportion of material to be used in case of multiple inputs.

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 STANDARD COSTING 13.7

• Method of production i.e. fully automated, semi-automated or manual.

• Skill set of workers and availability of workers.
• Working conditions and internal factors.
• External factors (such as Labour Law, Factories Act, Govt. policy etc.).
PROCEDURE OF SETTING MATERIAL QUANTITY STANDARDS
The following procedure is usually followed for setting material quantity standards.
(a) Standardisation of products: At this phase, products to be produced are
decided based on production plan and customer’s order. Generally
following questions are answered at this stage: (i) What to be produced?
(ii) Which type to be produced and (iii) How much to be produced?
(b) Product study: Product to be produced is analysed and studied for
developments and production. Product study is carried out by the
engineering department or product consultants. At this phase answers to
the following questions are satisfied: (i) How can it be produced? (ii) What
are the pre-requisites? (iii) Which type of materials to be used? (iv) How
products can be accepted in the market? etc.
(c) Preparation of specification list: After the product study a list of material
is prepared. It specifies types (quality) and quantity of materials to be used,
substitute of the materials, quantity and proportion of materials to be
used, process to be followed, pre-requisites and condition required etc.
While preparing specification list consideration to expected amount of
wastage is given. It must be customised to adopt changes in the product.
(d) Test runs: Sample or test runs under specified conditions are carried out
and sample products are tested for the desired quality and quantity. Any
deviation from the specification is noted down and specification list is
updated.
PROCEDURE OF SETTING LABOUR TIME STANDARDS
The following are the steps involved in setting labour standards:
(a) Standardisation of product and product study is carried out as explained
above.
(b) Labour specification: Types of labour and labour time is specified. Labour
time specification is based on past records and it takes into account
normal wastage of time.

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(c) Standardisation of methods: Selection of proper machines to use proper

sequence and method of operations.
(d) Manufacturing layout: A plan of operation for each product listing the
operations to be performed is prepared.
(e) Time and motion study: It is conducted for selecting the best way of
completing the job or motions to be performed by workers and the
standard time which an average worker will take for each job. This also
takes into account the learning efficiency and learning effect.
(f) Training and trial: Workers are trained to do the work and time spent at
the time of trial run is noted down.
PROCEDURE OF SETTING OVERHEADS TIME/ QUANTITY STANDARDS
Variable overhead time/ quantity is estimated based on specification made by
the engineering departments. Variable overheads may either be based on direct
material quantity or labour hour. Generally, it is based on labour time worked.
Fixed overhead time is based on budgeted production volume.
13.4.1.1 Problems faced while setting physical standards
The problems involved while setting physical standards will vary from industry
to industry and may be illustrated as under:
(a) A situation may arise where the company is introducing the manufacture
of a new line of product. In such case, it may be necessary to employ
workers who have no experience in the job. This creates a problem of
setting standard time because it is necessary to make adjustment for the
inexperience of workers.
(b) Changes in technology may necessitate installation of sophisticated
machines. When such machines are installed, the precise estimation of
output and standard of efficiency achievable will pose a problem until after
a long time when the working conditions are settled. Thus, setting
standards for these machines and estimating the standard costs will need
considerable amount of work.
(c) Often manufacturers prefer to product diversification to improve
profitability. One of the most important problems that arise with the
proposed change in product is re-setting of production facilities. For
example, when an old copper part is to be changed into one made of
bronze to suit the new product, special care has to be taken to order new

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tools which in turn, pose the problem of setting up of standard time in

respect of the new tools.
(d) Standards of material specifications are established and if the materials
are not available as per specifications, the standards may not be
achievable.
(e) Very often the cost accountant is confronted with the problem of choosing
the type of standards to be adopted. For example, the industrial engineer
has furnished the standard time for all direct labour operations as under:
1. Standard time attainable by the best operations is 2 hours per unit
of product including allowances for personal fatigue and delay.
2. Attainable good performance for the average trained operator is 2.10
hours per unit of product.
3. Average past performance is 2.60 hours per unit.
The problem is, should direct labour standard hour be based on maximum
efficiency or attainable good performance or average past performance? If costs
are to represent maximum efficiency, the unit cost used in selling price will
relatively be low but a high debit variance may arise if the standard efficiency is
not achieved.
If, however, the standard cost is based on attainable good performance, the
variances may tend to be nil. If efficiency is to be gauged, maximum efficiency
standard will reflect the off standard performance, thereby enabling the
departmental head to exercise control.
Similar problems as those mentioned above, may also arise in setting of waste
standards. For example, the question may arise as to whether only absolutely
unavoidable wastage should be provided or the past average level of wastage
may be provided. This will again have different impact on the standard cost of
production.
13.4.2 Price or Rate Standards
Broadly, the price or rate standards can be set on either of the following bases:
(a) Actual average or mean price expected to prevail during the coming
period, say one year; or
(b) Normal prices expected to prevail during a cycle of seasons which may be
of a number of years.

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PROCEDURES OF SETTING MATERIAL PRICE STANDARDS

Material prices are not altogether within the control of the manufacturer; but
the purchasing department, on being apprised of production quantities
required, should be able, from its knowledge of current market conditions and
trends, to state with reasonable accuracy price for the constituent items. The
standards for prices of materials should be based on the following factors, if
price fluctuations are small and are not serious.

(a) Stock of materials on hand and the prices at which they are held;

(b) The prices at which orders for future deliveries of materials (agreement
entered into) have already been placed,

(c) Minimum support price fixed by the appropriate authority and

(d) Anticipated fluctuation in price levels

In case there are unsystematic fluctuations in the market price, it may be difficult
to determine standard costs of materials; fluctuations in the market price may
be of different sorts; prices may be different from month to month, from one
season to another or from one year to another. There may be a secular trend
which, on the whole, is pushing price upwards or downwards. The nature of
difficulties encountered in fixing standard costs of materials will naturally be
different in each case. In addition, the purchasing policy of the company and
the objective to be achieved (from cost accounting) will make a difference.

The difficulty in determining the standard cost of material in such a situation

can be resolved as follows:

(a) In case prices fluctuate from month to month, the average of prices of a
year corrected for the known secular changes and any other expected
change can very well serve as the standard price for the next year.

(b) If the fluctuations are seasonal, but the whole year’s requirements are
purchased at one time, the weighted average of the likely prices to be paid
should be treated as the standard price. But, if buying is also spread over
the whole year, the weighted average of the prices for the whole year
should be the standard price.

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(c) If prices fluctuate from one year to another, a careful estimate of the price
likely to prevail next year, based on a statistical study, should be adopted
as the standard price.

PROCEDURES OF SETTING WAGE RATE STANDARD

The type of labour required for performing a specific job would be the most
important factor for deciding the rate of wage to be paid to workers. Standard
wage rate for skilled and unskilled workers are set based on the following basis:

 Time taken by the workers to complete a unit of production.

 Time or piece rate prevailing in the industry. It can be known from the
peers.

 Wage agreement entered into between the management and workers’

union.

 Law prevailing in the area of operation, law like Payment of minimum

wages Act, Payment of bonus Act etc.

PROCEDURES OF SETTING OVERHEAD EXPENSE STANDARDS

In computing the overhead expense standards, consideration should be given

to the level of output and the budgeted expenses. A budgeted output is fixed
considering practical manufacturing capacity and anticipated sales demand.
Expenditures can be budgeted under different heads for the level of output
chosen. These expenditures are classified as fixed and variable. Thus, the
overhead expense standards are set by computing the optimum level of output
for a production departments followed by budgets for fixed and variable
overheads. If production is seasonal or it fluctuates during the year, a flexible
budget may be prepared to facilitate comparison between the set target and
actual expenditure for the period.

13.5 TYPES OF VARIANCES

Controllable and un-controllable variances: For effective cost control it is
necessary to investigate into the reasons for cost variances and to take corrective
actions. For this purpose variances are classified as controllable and uncontrollable
variances. Controllable variances are those which can be controlled under the

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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. Responsibility
centres are answerable for all adverse variances which could have been controlled.
Controllability is a subjective matter and varies from situation to situation. If the
uncontrollable variances are of significant nature and are persistent, the standard
may need revision.

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. On the other hand, adverse variance means
actual cost is exceeding standard cost. The situation will be reversed for sales
variance. Favourable variances mean actual is more than budgeted and adverse
when actual is less than budgeted. Favourable variance in short denoted by capital
‘F’ and adverse variances by capital ‘A’.

Students may note that signs of favourable and adverse variance may or may not match
exactly with mathematical signs i.e. (+) or (-).

13.6 CLASSIFICATION OF VARIANCES

Variances are broadly classified into two parts namely Revenue variance and Cost
variance. At Revenue side variances is calculated by comparing actual sales from
budgeted (standard) sales. On the other hand, Cost side reflects variances in cost
components. Cost variance classification is shown below with the help of a
structured diagram.

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Total Cost Variance

Material Cost Variance Labour Cost Variance Overhead Cost Variance

Material Material Labour Labour Idle

Price Usage Rate Efficiency Time
Variance Variance Variance Variance Variance

Material Material Labour Labour

Mix Yield Mix Yield
Variance Variance Variance Variance

Variable Overhead Cost Variance Fixed Overhead Cost Variance

Expenditure or Efficiency Expenditure or Volume

Budget Variance Variance
Budget Variance Variance

Efficiency Capacity Calendar

Variance Variance Variance

Fig 13.1. Classification of Variances

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 13.14 COST AND MANAGEMENT ACCOUNTING

13.7 COMPUTATION OF VARIANCES

As discussed earlier variances are classified into two parts. Here we will start from
cost side and discuss all cost components one by one with the help of appropriate
example and illustrations.

13.7.1 Material Cost Variance

Material cost variance is the difference between standard cost of materials
used and the actual cost of materials. Mathematically it is written as.

Material Cost Variance = [Standard Cost – Actual Cost]

Or
[(Std. Quantity × Std. Price) – (Actual Quantity × Actual Price)]

(The difference between the Standard Material Cost of the actual production
volume and the Actual Cost of Material)

Reasons for variance: Material cost variance arises mainly because of either
difference in material price from the standard price or difference in material
consumption from standard consumption or both the reasons. Analysis of material
cost variance is done dividing it into two parts namely Material Price variance and
Material Usage variance.

(A) Material Price Variance

It measures variance arises in the material cost due to difference in actual
material purchase price from standard material price. Mathematically it is
written as:

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 STANDARD COSTING 13.15

Material Price Variance = [Standard Cost of Actual Quantity* – Actual Cost]

Or
Actual Quantity (AQ) × {Std. Price (SP) – Actual Price(A)}
Or
[(SP × AQ) – (AP × AQ)]
(The difference between the Standard Price and Actual Price for the Actual
Quantity Purchased)

*Here actual quantity means actual quantity of material purchased. If in the

question material purchase is not given, it is taken as equal to material
consumed.

Explanation: Material price variance can also be calculated taking material used as
actual quantity instead of material purchased. This method is also correct but does
not serve the purpose of variance computation. Material price variance may arise from
variety of reasons out of which some may be controllable and some may be beyond
the control of the purchase department. If price variance arises due to inefficiency of
purchase department or any other reason within the control of the company, then it
is very important to report variance as early as possible and this can be done by taking
purchase quantity as actual quantity for price variance computation.

Responsibility for Material Price Variance: Generally, purchase department

purchases materials from the market. Purchase department is expected to perform
its function very prudently so that company never suffers loss due to its inefficiency.
Purchase department is held responsible for adverse price variance arises due to
the factors controllable by the department.
(B) Material Usage Variance
It measures variance in material cost due to usage/ consumption of materials. It
is computed as below:

Material Usage Variance = [Standard Cost of Standard Quantity for Actual

Production – Standard Cost of Actual Quantity*]
Or
Std. Price (SP)× {Std. Quantity (SQ) - Actual Quantity (AQ)}
Or
[(SQ × SP) – (AQ × SP)]

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 13.16 COST AND MANAGEMENT ACCOUNTING

(The difference between the Standard Quantity specified for actual production
and the Actual Quantity used, at Standard Price)

*Here actual quantity means actual quantity of material used.

Responsibility for material usage variance: Material usage is the responsibility

of production department and it is held responsible for adverse usage variance.
Reasons for variance: Actual material consumption may differ from the standard
quantity either due to difference in proportion used from standard proportion or
due to difference in actual yield from standard yield.
Material usage variance is divided into two parts (a) Material usage mix variance
and (b) Material yield variance.
(a) Material Mix Variance
Variance in material consumption may arise due to difference in proportion
actually used from the standard mix/ proportion. It only arises when two or
more inputs are used to produce a product. Mathematically,

Material Mix Variance = [Standard Cost of Actual Quantity in Standard

Proportion – Standard Cost of Actual Quantity]
Or
Std. Price (SP) × {Revised Std. Quantity (RSQ) – Actual Quantity (AQ)}
Or
[(RSQ × SP) – (AQ × SP)]
(The difference between the Actual Quantity in standard proportion and
Actual Quantity in actual proportion, at Standard Price)

(b) Material Yield Variance (Material Sub-usage Variance)

Variance in material consumption which arises due to yield or productivity of
the inputs. It may arise due to use of sub- standard quality of materials, inefficiency
of workers or due to wrong processing.

Material Yield Variance = [Standard Cost of Standard Quantity for Actual

Production – Standard Cost of Actual Quantity in
standard proportion]
Or
Std. Price (SP) × {Std. Quantity (SQ) – Revised Standard Quantity (RSQ)}

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Or
[(SQ × SP) – (RSQ × SP)]
(The difference between the Standard Quantity specified for actual production
and Actual Quantity in standard proportion, at Standard Purchase Price)

Verification of the formulae:

Material Cost Variance= Material Usage Variance + Material Price Variance*
Or, Material Cost Variance= (Material Mix Variance + Material Revised usage
Variance) + Material price variance

*If material purchased quantity and material consumed quantity is same

Meaning of the terms used in the formulae:

Term Meaning
Standard Quantity (SQ) Quantity of inputs to be used to produce actual
output.
Actual Quantity (AQ) Quantity of inputs actually used to produce actual
output.
Revised Standard If Actual total quantity of inputs were used in standard
Quantity (RSQ) proportion.

ILLUSTRATION 1
The standard and actual figures of product ‘Z’ are as under:
Standard Actual
Material quantity 50 units 45 units
Material price per unit ` 1.00 ` 0.80
CALCULATE material cost variances.
SOLUTION
The variances may be calculated as under:
(a) Standard cost = Std. Qty × Std. price = 50 units ×`1.00 = `50
(b) Actual cost = Actual qty. × Actual price = 45 units ×`0.80 = ` 36

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Variances:
(i) Price variance = Actual qty (Std. price – Actual price)
= 45 units (`1.00 – `0.80) = ` 9 (F)
(ii) Usage variance = Std. price (Std. qty – Actual qty.)
= `1 (50 units – 45 units) = ` 5 (F)
(iii) Material cost variance = Standard cost – Actual cost
(Total variance) = ` 50 – ` 36 = ` 14 (F)
ILLUSTRATION 2
NXE Manufacturing Concern furnishes the following information:
Standard: Material for 70 kg finished products 100 kg
Price of material ` 1 per kg
Actual: Output 2,10,000 kg
Material used 2,80,000 kg
Cost of Materials ` 2,52,000
CALCULATE: (a) Material usage variance, (b) Material price variance, (c) Material cost
variance.
SOLUTION
100 kg
Standard Quantity of input for actual output (SQ) = 2,10,000 kg ×
70 kg
= 3, 00,000 kg.
Actual Price (AP) = (`2,52,000 ÷ 2, 80,000 kg) = `0.90 per kg.
(a) Material Usage Variance = (SQ – AQ) × SP
= (3,00,000 – 2,80,000) × 1= ` 20,000 (F)
(b) Material Price Variance = (SP – AP) × AQ
= (1 – 0.90) × 2,80,000= ` 28, 000 (F)
(c) Material Cost Variance = (SQ × SP) – (AQ × AP)
= (3, 00,000 × 1) – (2, 80,000 × 0.90) = ` 48,000 (F)
Check MCV = MPV + MUV
` 48, 000 (F) = ` 28, 000 (F) + `20, 000 (F)

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ILLUSTRATION 3
The standard cost of a chemical mixture is as follows:
40% material A at ` 20 per kg
60% material B at ` 30 per kg
A standard loss of 10% of input is expected in production. The cost records for a
period showed the following usage:
90 kg material A at a cost of ` 18 per kg
110 kg material B at a cost of ` 34 per kg
The quantity produced was 182 kg of good product.
CALCULATE (a) Material cost variance, (b) Material price variance, (c) Material usage
variance.
SOLUTION
Basic Calculation
Material Standard for 180 kg. output Actual for 182 kg. output
Qty. Rate Amount Qty Rate Amount
Kg. (`) (`) Kg. (`) (`)
A 80 20 1,600 90 18 1,620
B 120 30 3,600 110 34 3,740
Total 200 5,200 200 5,360
Less: Loss 20 − − 18 − −
180 5,200 182 5,360
182
Std. cost of actual output = `5,200 × = ` 5, 257.78
180
Calculation of Variances
1. Material Cost Variance = (Std. cost of actual output – Actual cost)
= (5,257.78 – 5,360) = ` 102.22 (A)
2. Material Price Variance = (SP – AP) × AQ
Material A = (20 – 18) × 90 = ` 180.00 (F)
Material B = (30 – 34)) × 110 = ` 440.00 (A)
MPV =` 260.00 (A)

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3. Material Usage Variance = (Std. Quantity for actual output – Actual

Quantity) × Std. Price
 182 
Material A =  80 × − 90  × 20 = ` 182.22 (A)
 180 
 182 
Material B = 120 × − 110  × 30 = `340.00 (F)
 180 
MUV = `157.78 (F)
Check
MCV `102.22 (A)

MPV `260 (A) MUV `157.78 (F)

ILLUSTRATION 4
ABC Ltd. produces an article by lending two basic raw materials. It operates a
standard costing system and the following standards have been set for raw materials:
Material Standard mix Standard price (` per kg)
A 40% 4
B 60% 3
The standard loss in processing is 15%. During April 2021, the company produced
1,700 kgs. of finished output.

The position of stock and purchases for the month of April 2021 are as under:
Material Stock on Stock on Purchased during
01.04.2021 30.04.2021 April 2021
(Kg.) (Kg.) (Kg.) (` )
A 35 5 800 3,400
B 40 50 1,200 3,000

Opening stock of material is valued at standard price.

CALCULATE the following variances:
(i) Material price variance
(ii) Material usage variance

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(iii) Material yield variance

(iv) Material mix variance
(v) Total Material cost variance
SOLUTION

Types of material Standard Actual

Qty. Rate Amount Qty. Rate Amount

(Kg.) (`) (`) (Kg.) (`) (`)
A 800 4 3,200 35 4 140.00
795 4.25 3,378.75
B 1200 3 3,600 40 3 120.00
1,150 2.50 2,875.00
Total 2,000 6,800 2,020 6,513.75
(i) Material price variance
= Actual qty. (Std. price – Actual price)

Material A: Since the actual price and standard price in respect of 35 kg. of
raw materials A are same i.e. ` 4, there will be no price variance in respect of
this quantity. Price variance will be in respect of only 795 kg. as given below:
= 795 kg. (` 4 – ` 4.25) = ` 198.75 (A)
Material B: For Material B also, price variance will only be in respect of 1,150
kg. as given below:
= 1,150 kg. (` 3 – ` 2.50) = ` 575 (F)
Total = ` 198.75 (A) + 575 (F) = ` 376.25(F)
(ii) Material usage variance
= (Std. qty. for actual output – Actual qty.) × Std. price
Material A = (800 – 830) × 4 = 120 (A)
Material B = (1,200 – 1,190) × 3 = 30 (F)
` 90 (A)
(iii) Material yield variance
= (Std. qty. - Revised Std. qty.) × Std. Price

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Material A = (800 – 808) × 4 = 32 (A)

Material B = (1,200 – 1,212) ×3 = 36 (A)
` 68 (A)

Check
MUV = MMV + MYV
90 (A) = 22 (A) + 68 (A)
(iv) Material mix variance
= (Revised std. qty. – Actual qty.) × Std. Price
Material A = (808 – 830) × 4 = 88 (A)
Material B = (1,212 – 1,190) × 3 = 66 (F)
` 22 (A)

(v) Total material cost variance

= Std. cost for actual output – Actual cost = 6,800 – 6,513.75 = 286.25 (F)
Check
MCV = MPV + MUV
286.25 (F) = 376.25 (F) + 90 (A)
Working Notes:
1. Standard quantity for actual output
The standard loss being 15%. It means to produce, 1,700 kg. of the article,
standard quantity of material required is:
100
= ×1,700 kgs. = 2,000 kg.
85
Out of 2,000 kg. of material used, 40% is of type A and 60% is of type B, i.e.,
Standard quantity for actual output for:

40
Material A = 2,000× = 800 kg.
100
60
Material B = 2,000× = 1,200 kg.
100

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2. Actual quantity of material

= Opening stock + Purchases – Closing stock
Material A = 35 + 800 – 5 = 830 kg.
Material B = 40 + 1,200 – 50 = 1,190 kg.

3. Standard cost per unit

Total sandard cost
=
Total standard output of std. mix
` 6,800
= = ` 4 per kg.
1,700 kg.

4. Revised Standard Quantity

2,020
Material A = × 800 = 808 kg.
2,000
2,020
Material B = ×1,200 = 1,212 kg.
2,000

13.7.2 Labour Cost Variance

Amount paid to employees for their labour is generally known as employee or
labour cost. In this chapter labour cost is used to denote employees cost. Labour
(employee) cost variance is the difference between actual labour cost and
standard cost. Mathematically it can be written as:

Labour Cost Variance = [Standard Cost – Actual Cost]

Or
[(SH × SR) – (AH* × AR)]
(The difference between the Standard Labour Cost and the Actual Labour Cost
incurred for the production achieved)
* Actual hours paid.

Reasons for variance: Difference in labour cost arises either due to difference in
the actual labour rate from the standard rate or difference in numbers of hours
worked from standard hours. Labour cost variance can be divided into three parts
namely (i) Labour Rate Variance (ii) Labour Efficiency Variance and (iii) Labour Idle
time Variance.

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Labour Cost Variance

Labour Rate Labour Efficiency Labour Idle Time

Variance Variance Variance

Labour Mix
Variance

Labour Yield
Variance

(A) Labour Rate Variance:

Labour rate variance arises due to difference in actual rate paid from standard
rate. It is very similar to material price variance. It is calculated as below:

Labour Rate Variance = [Standard Cost of Actual Time – Actual Cost]

Or
Actual Hours (AH*) × {Std. Rate (SR) – Actual Rate (AR)}
Or
[(SR×AH*) – (AR × AH*)]
(The difference between the Standard Rate per hour and Actual Rate per hour
for the Actual Hours paid)
* Actual hours paid.
Responsibility for labour rate variance: Generally labour rates are influenced by
the external factors which are beyond the control of the organisation. However,
personnel manager is responsible for labour rate negotiation.
(B) Labour Efficiency Variance:
Labour efficiency variance arises due to deviation in the working hours from
the standard working hours.

Labour Efficiency Variance =

[Standard Cost of Standard Time for Actual Production – Standard Cost of
Actual Time]
Or

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 STANDARD COSTING 13.25

Std. Rate (SR) × {Std. Hours (SH) – Actual Hours (AH*)}

Or
[(SH × SR) – (AH# × SR)]
(The difference between the Standard Hours specified for actual production and
Actual Hours worked at Standard Rate).
# Actual Hours worked
Responsibility for labour efficiency variance: Efficiency variance may arise due
to ability of the workers, inappropriate team of workers, inefficiency of production
manager or foreman etc. However, production manager or foreman can be held
responsible for the adverse variance which otherwise can be controlled.
Labour efficiency variance is further divided into the following variances:
(a) Labour Mix Variance or Gang variance
(b) Labour Yield Variance (or Labour Revised-efficiency Variance)
(a) Labour Mix Variance:
Labour efficiency variance which arises due to change in the mix or
combination of different skill set i.e. number of skilled workers, semi-skilled
workers and un-skilled workers. Mathematically,
Labour Mix Variance Or Gang Variance =
[Standard Cost of Actual Time Worked in Standard Proportion – Standard Cost
of Actual Time Worked]
Or
Std. Rate (SR) × {Revised Std. Hours (RSH) – Actual HoursWorked (AH)}
Or
[(RSH × SR) – (AH# × SR)]
(The difference between the Actual Hours worked in standard proportion and
Actual Hours worked in actual proportion, at Standard Rate).
# Actual Hours worked

© The Institute of Chartered Accountants of India

 13.26 COST AND MANAGEMENT ACCOUNTING

(b) Labour Yield Variance:

Labour efficiency variance which arises due to productivity of workers.
Labour Yield Variance Or Sub-Efficiency Variance =
[Standard Cost of Standard Time for Actual Production – Standard Cost of
Actual Time Worked in Standard Proportion]
Or
Std. Rate (SR) × {Std. Hours (SH) – Revised Std. Hours (RSH)}
Or
[(SH × SR) – (RSH × SR)]
(The difference between the Standard Hours specified for actual production and
Actual Hours worked in standard proportion, at Standard Rate).

(C) Idle Time Variance:

It is calculated for the idle hours. It is difference between paid and worked hours.
It is calculated as below:

Labour Idle Time Variance = [Standard Rate per Hour × Actual Idle Hours]
Or
Std. Rate (SR) {Actual HoursPaid – Actual HoursWorked}
Or
[(AH × SR) – (AH# ×SR)]
*

(The difference between the Actual Hours paid and Actual Hours worked at
Standard Rate)

* Actual hours paid; # Actual Hours worked

Verification of formulae:
Labour Cost Variance = Labour Rate Variance + Labour Efficiency Variance (if hours
paid and hours worked is same)
OR
Labour Cost Variance = Labour Rate Variance + Idle Time Variance + Labour
Efficiency Variance
OR
Labour Efficiency Variance = Labour Mix Variance + Labour Yield Variance

© The Institute of Chartered Accountants of India

 STANDARD COSTING 13.27

ILLUSTRATION 5
The standard and actual figures of a firm are as under
Standard time for the job 1,000 hours
Standard rate per hour ` 50
Actual time taken 900 hours
Actual wages paid ` 36,000
CALCULATE variances.
SOLUTION
(a) Std. labour cost (`)
(1,000 hours × `50) 50,000
(b) Actual wages paid 36,000
(c) Actual rate per hour: ` 36,000/900 hours = `40
Variances
(i) Labour Rate variance = Actual time (Std. rate – Actual rate)
= 900 hours (`50 – `40) = `9,000 (F)
(ii) Efficiency variance = Std. rate per hr. (Std. time – Actual time)
= `50 (1,000 hrs. – 900 hrs.) = `5,000 (F)
(iii) Total labour cost variance = Std. labour cost – Actual labour cost
= {(`50 × 1,000 hours) – `36,000}
= (`50,000 – `36,000) = `14,000 (F)
ILLUSTRATION 6
The standard output of product ‘EXE’ is 25 units per hour in manufacturing
department of a company employing 100 workers. The standard wage rate per labour
hour is ` 6.
In a 42 hours week, the department produced 1,040 units of ‘EXE’ despite 5% of the
time paid being lost due to an abnormal reason. The hourly wages actually paid were
` 6.20, ` 6 and ` 5.70 respectively to 10, 30 and 60 of the workers.
CALCULATE relevant labour variances.

© The Institute of Chartered Accountants of India

 13.28 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Working Notes:
1. Calculation of standard man hours

When 100 worker works for 1 hr., then the std. output is 25 units.

Std. man hour per unit = 100 hrs. = 4 hrs.

25 units
2. Calculation of std. man hours for actual output
Total std. man hours = 1,040 units × 4 hrs. = 4,160 hrs.
Standard for actual Actual

Actual Idle Amount

Rate Amount No. of Production Rate paid
Hours hours time
(`) (`) workers hours (`) (`)
paid hrs.

4,160 6 24,960 10 420 21 399 6.20 2,604

30 1,260 63 1,197 6.00 7,560

60 2,520 126 2,394 5.70 14,364

4,160 6 24,960 100 4,200 210 3,990 24,528

1. Labour cost variance

= Std. labour cost – Actual labour cost

= 24,960 – 24,528 = ` 432 (F)

2. Labour rate variance
= (SR – AR) × AHPaid
= (6 – 6.20) × 420 = 84 (A)
= (6 - 6) × 1260 = NIL
= (6 - 5.70) × 2,520 = 756 (F)
= 672 (F)
3. Labour efficiency variance
= (SH – AH) × SR
= (4,160 – 3,990) × 6 = 1,020 (F)

© The Institute of Chartered Accountants of India

 STANDARD COSTING 13.29

4. Labour Idle time variance

= Idle Hours × SR
= 210 × 6 = 1,260 (A)

ILLUSTRATION 7
NPX Ltd. uses standard costing system for manufacturing of its product X. Following
is the budget data given in relation to labour hours for manufacture of 1 unit of
Product X :
Labour Hours Rate (`)
Skilled 2 6
Semi-Skilled 3 4
Un- Skilled 5 3
Total 10

In the month of January, total 10,000 units were produced following are the details:

Labour Hours Rate (`) Amount (`)

Skilled 18,000 7 1,26,000
Semi-Skilled 33,000 3.5 1,15,500
Un- Skilled 58,000 4 2,32,000
Total 1,09,000 4,73,500

Actual Idle hours (abnormal) during the month:

Skilled: 500
Semi- Skilled: 700
Unskilled: 800
Total 2,000
CALCULATE:
(a) Labour Variances.
(b) Also show the effect on Labour Rate Variance if 5,000 hours of Skilled Labour
are paid @ ` 5.5 per hour and balance were paid @ ` 7 per hour.

© The Institute of Chartered Accountants of India

 13.30 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Working Notes:

Budget Standard for actual Actual

Rate Amount Rate Amount Rate Amount
Hours (`) (`) Hours (`) (`) Hours (`) (`)
Skilled 2 6 12 20,000 6 1,20,000 18,000 7 1,26,000
Semi-
skilled 3 4 12 30,000 4 1,20,000 33,000 3.5 1,15,500
Unskilled 5 3 15 50,000 3 1,50,000 58,000 4 2,32,000
10 39 1,00,000 3,90,000 1,09,000 4,73,500

Idle Hours Hours worked

Skilled 500 17,500
Semi-skilled 700 32,300
Unskilled 800 57,200
2,000 1,07,000
(a) (i) Labour Cost Variance= (SH×SR – AH×AR)
Skilled 20,000 × 6 – 18,000× 7 = ` 6,000 (A)
Semi-Skilled 30,000 ×4 – 33,000 × 3.5 = ` 4,500 (F)
Unskilled 50,000× 3 – 58,000 × 4 = ` 82,000 (A)
Total ` 83,500 (A)
(ii) Labour Rate Variance = (SR – AR )×AHPaid
Skilled (6 – 7) × 18,000 = ` 18,000 (A)
Semi-Skilled (4 – 3.5) × 33,000 = ` 16,500 (F)
Unskilled (3 – 4) × 58,000 = ` 58,000 (A)
Total ` 59,500 (A)
(iii) Labour Efficiency Variance = (SH – AH) × SR
Skilled (20,000 –17,500) ×6 = ` 15,000 (F)
Semi- Skilled (30,000 –32,300) ×4 = ` 9,200 (A)
Unskilled (50,000 –57,200)×3 = ` 21,600 (A)
Total ` 15,800 (A)

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 STANDARD COSTING 13.31

(iv) Labour Idle Time Variance = (Idle Hours × SR)

Skilled 500 × 6 = ` 3,000 (A)
Semi- Skilled 700 × 4 = ` 2,800 (A)
Unskilled 800 × 3 = ` 2,400 (A)
Total ` 8,200 (A)
(v) Labour Mix Variance = (RSH – AHWorked )×SR
Std.Hours
Revised Std. hours (RSH) = ×TotalActual Hours
TotalStd.hours
20,000
Skilled ( ×1,07,000 – 17,500) × 6 = ` 23,400 (F)
1,00,000
30,000
Semi- Skilled ( ×1,07,000 – 32,300) × 4 = ` 800 (A)
1,00,000
50,000
Unskilled ( ×1,07,000 - 57,200) × 3 = ` 11,100 (A)
1,00,000
Total ` 11,500 (F)
(vi) Labour Yield Variance = (SH – RSH) × SR
20,000
Skilled (20,000 – ×1,07,000 ) × 6 =` 8,400 (A)
1,00,000
30,000
Semi- Skilled (30,000 – ×1,07,000 ) × 4 = ` 8,400 (A)
1,00,000
50,000
Unskilled (50,000 - ×1,07,000 ) × 3 = ` 10,500 (A)
1,00,000
Total ` 27,300 (A)
(b) Labour Rate Variance = (SR – AR) ×AHPaid
Skilled (6 – 5.5) ×5,000
(6 – 7) ×13,000 = ` 10,500 (A)
Semi- Skilled (4 – 3.5) ×33,000 = ` 16,500 (F)
Unskilled (3 – 4) × 58,000 = ` 58,000 (A)
Total ` 52,000 (A)

© The Institute of Chartered Accountants of India

 13.32 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 8
The standard labour employment and the actual labour engaged in a week for a job
are as under:
Skilled Semi-skilled Unskilled
workers workers workers
Standard no. of workers in the gang 32 12 6
Actual no. of workers employed 28 18 4
Standard wage rate per hour 3 2 1
Actual wage rate per hour 4 3 2
During the 40 hours working week, the gang may produce 1,800 labour hours of
work. CALCULATE:
(a) Labour Cost Variance (b) Labour Rate Variance
(c) Labour Efficiency Variance (d) Labour Mix Variance
(e) Labour Yield Variance
SOLUTION
Workings:
1. Standard hours (SH)for actual hours produced are calculated as below:
1,800
Skilled = × 1,280 = 1,152 hrs.
2,000
1,800
Semi-skilled = × 480 = 432 hrs.
2,000
1,800
Unskilled = × 240 = 215 hrs.
2,000
2. Actual hours (AH) paid are calculated as below:

Category No. of Worker Hours in a week Total Hours

Skilled 28 40 1,120
Semi-skilled 18 40 720
Unskilled 4 40 160
2,000

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 STANDARD COSTING 13.33

3. For 40 hours week total Revised standard hours (RSH) will be calculated as
below:

Category No. of Worker Hours in a week Total Hours

Skilled 32 40 1,280
Semi-skilled 12 40 480
Unskilled 6 40 240
2,000

Calculations
Category of SH × SR AH × SR AH × AR RSH × SR
workers

Skilled 1,152 × 3 = 3,456 1,120 × 3 = 3,360 1,120 × 4 = 4,480 1,280 × 3 = 3,840

Semi-skilled 432 × 2 = 864 720 × 2 = 1,440 720 × 3 = 2,160 480 × 2 = 960

Unskilled 216 × 1 = 216 160 × 1 = 160 160 × 2 = 320 240 × 1 = 240

Total ` 4,536 ` 4,960 ` 6,960 ` 5,040

(i) Labour Cost Variance = Std. Cost for hours worked – Actual cost paid
= (SH × SR) – (AH × AR)
= `4,536 – 6,960 = `2,424 (A)
(ii) Labour Rate Variance = AH (SR – AR) or (AH × SR) – (AH × AR)
Skilled = 3,360 – 4,480 = `1,120 (A)
Semi-skilled = 1,440 – 2,160 = `720 (A)
Unskilled = 160 - 320 = `160 (A) 2,000 (A)

(iii) Labour Efficiency Variance = SR (SH – AH) or (SR × SH) – (SR × AH)
Skilled = 3,456 – 3,360 = `96 (F)
Semi-skilled = 864 – 1,440 = `576 (A)

Unskilled = 216 – 160 = `56 (F) `424 (A)

© The Institute of Chartered Accountants of India

 13.34 COST AND MANAGEMENT ACCOUNTING

(iv) Labour Mix Variance = SR (RSH – AH) or (SR × RSH) – (SR × AH)
Skilled = 3,840 – 3,360 = `480 (F)
Semi-skilled = 960 – 1,440 = `480 (A)
Unskilled = 240 - 160 = ` 80 (F) `80 (F)
(v) Labour Yield Variance = SR (SH – RSH) or (SR × SH – SR × RSH)
Skilled = 3,456 - 3,840 = `384 (A)
Semi-skilled = 864 - 960 = `96 (A)
Unskilled = 216 - 240 = ` 24 (A) `504 (A)
Check
(i) LCV = LRV + LEV
`2,424 (A) = `2,000 (A) + `424 (A)
(ii) LEV = LMV + LYV
`424 (A) = `80 (F) + `504 (A)

13.7.3 Variable Overheads Cost Variance

Variable Overhead Cost Variance

Variable Overhead Expenditure Variable Overhead Efficiency

Variance Variance

Variable overheads consist of expenses other than direct material and direct labour
which vary with the level of production. If variable overhead consist of indirect
materials, then in this case it varies with the direct material used. On the other hand,
if variable overhead is depending on number of hours worked then in this case it
will vary with labour hour or machine hours. If nothing is mentioned specifically
then we take labour hour as basis. Variable overhead cost variance calculation is
similar to labour cost variance. Variable overhead cost variance is divided into two
parts (i) Variable Overhead Expenditure Variance and (ii) Variable Overhead
Efficiency Variance.

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 STANDARD COSTING 13.35

Variable Overhead Cost Variance

(Standard Variable Overheads for Actual Production – Actual Variable
Overheads)

Variable Overhead Variable Overhead

Expenditure (Spending) Variance Efficiency Variance
(Standard Variable Overheads for (Standard Variable Overheads for
Actual Hours#) Production)
Less Less
(Actual Variable Overheads) (Standard Variable Overheads for
[(SR – AR) × AH#] Actual Hours#)

Or [(SH – AH#) × SR]

[(SR × AH#) – (AR × AH#)] Or

[(SH × SR) – (AH# × SR)]
#
Actual Hours (Worked)
Meaning of the terms used in the formulae:
Term Meaning

Standard Hours (SH) Hours required

producing actual
output.
Actual Hours (AH) Actual Hours taken to
produce actual output.
Revised Standard Hours (RSH) If actual labour hours
worked were worked by
standard mix
(combination) of labour.
Actual Yield (AY) Actual Hours worked
Standard Yield (SY) Actual hours if labour
worked in standard ratio
Standard Labour Cost (SLC) Standard labour cost for
actual output

© The Institute of Chartered Accountants of India

 13.36 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 9
From the following information of G Ltd., CALCULATE (i) Variable Overhead Cost
Variance; (ii) Variable Overhead Expenditure Variance and (iii) Variable Overhead
Efficiency Variance:

Budgeted production 6,000 units

Budgeted variable overhead ` 1,20,000
Standard time for one unit of output 2 hours
Actual production 5,900 units
Actual overhead incurred ` 1,22,000
Actual hours worked 11,600 hours

SOLUTION
Workings:
`1,20,000
1. Standard cost per unit = = `20
6,000units

`1,20,000
2. Standard cost per hour = = `10
6,000units×2hours

(i) Variable Overhead Cost Variance:

= Std. Overhead for actual production – Actual overhead incurred

= `20 × 5,900 units – `1,22,000 = `4,000 (A)

(ii) Variable Overhead Expenditure Variance:

= Std. overhead for Actual hours – Actual Overhead

= `10 ×11,600 hours - `1,22,000 = `6,000 (A)

(iii) Variable Overhead Efficiency Variance:

= Std.rate per hour × (Std. hours for actual production – Actual hours)

= `10 (2 hours × 5,900 units – 11,600 hours) = `2,000 (F)

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 STANDARD COSTING 13.37

13.7.4 Fixed Overhead Cost Variance

The recovery of the fixed components of the estimated overheads depends upon
capacity utilization.
In case a company produces less than the projected utilization it shall not be able to
recover all the budgeted fixed overheads. This unrecovered portion is known as
production volume variance.
The other variance is because of variations in actual spending when compared with
both estimated fixed and estimated variable overheads. Such a variance is known
as Overhead expenses variance.
The following detailed discussion shall help you have a clear understanding of these
two variances.
(1) Production Volume Variance: The term fixed overheads implies that the
element of cost does not vary directly in proportion to the output. In other words, fixed
overheads do not change within a given range of activity.
However, the unit cost changes even though the fixed overheads are constant in total
within the given range of output. So, higher the level of activity, the lower will be the
unit cost or vice versa.
The management is, therefore, faced with a costing difficulty because it requires a
representative rate for charging fixed overheads irrespective of changes in volume
of output. For example, if the fixed overheads are ` 10,000 and the output varies
from 8,000 to 11,000 units, the cost per unit of output would be as under:

Fixed Overheads Output in units Cost per unit of output (`)

10,000 8,000 1.25

10,000 9,000 1.11
10,000 10,000 1.00
10,000 11,000 0.91

We have, however, seen that in standard costing, a predetermined rate of overhead

recovery is established for costing purposes. This involves the establishment of a
predetermined capacity.
If we take, for example; 10,000 units as predetermine volume/capacity, the pre-
determined rate will be `1 per unit. If the factory produces only 8,000 units, there
will be a loss due to under-recovery which can be explained in two-ways:

© The Institute of Chartered Accountants of India

 13.38 COST AND MANAGEMENT ACCOUNTING

(a) The actual cost will be `10,000 ÷ 8,000 units = `1.25 per unit whereas the
absorbed cost is `1 per hour. Since the cost is more by `0.25 per unit, the
total loss is 8,000 units × ` 0.25 or ` 2,000.

(b) Since the factory has produced only 8,000 units, the amount of overheads
recovered is 8,000 units × `1 or ` 8,000. Since fixed overheads are
constant, the amount which should have been ideally incurred for the
department is `10,000. Hence there is a difference of `2,000 between the
overheads recovered and the overheads estimated. This variance is known
as production volume variance.

This shows the cost of failure on the part of the factory to produce at the planned activity
of 10,000 units. If the company produces 11,000 units, the variance will show the benefits
of operating at a level above the budgeted activity. If, however, the factory has produced
10,000 units, there will be no production volume variance because the actual activity
equals what was budgeted i.e. the production of 10,000 units.

(2) Overhead Expenses Variance: As discussed above, the Production Volume

Variance analyses the unrecovered fixed overheads. Apart from this, there can be
variations in the actual spending of both fixed and variable overheads when compared
to what was established as a standard. Such variations can be accounted for by
analyzing an overhead expenses variance.

The analysis of overhead variances is different from that of material and labour
variances. As overhead is the aggregate of indirect materials, indirect labour and
indirect expenses, this variance is considered to be a difficult part of variance
analysis. It is important to understand that overhead variance is nothing but under
or over-absorption of overhead.

Fixed Overhead Cost Variance: Fixed overhead cost variance is the difference
between actual fixed overhead and absorbed fixed overhead. Fixed overhead
variance is divided into two parts (A) Fixed Overhead Expenditure Variance and (B)
Fixed Overhead Volume Variance.
(A) Fixed Overhead Expenditure Variance: This is the difference between the
actual fixed overhead incurred and budgeted fixed overhead.
(B) Fixed Overhead Volume Variance: Variance in fixed overhead which arise
due to the volume of production is called fixed overhead volume variance.

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 STANDARD COSTING 13.39

Fixed overhead volume variance is further divided into the three variances:
(a) Efficiency Variance
(b) Capacity Variance and
(c) Calendar Variance

Fixed Overhead Cost Variance

Fixed OH Expenditure Variance Fixed OH Volume Variance

FOH Efficiency FOH Capacity FOH Calender

Variance Variance Variance

Mathematically these can be written as follows:

Fixed Overhead Cost Variance

(Absorbed Fixed Overheads) Less (Actual Fixed Overheads)
(SH × SR) –(AH × AR)

Fixed Overhead Expenditure Fixed Overhead Volume

Variance Variance
(Budgeted Fixed Overheads) (Absorbed Fixed Overheads)
Less Less
(Actual Fixed Overheads) (Budgeted Fixed Overheads)
Or Or
(BH × SR) – (AH × AR) (SH × SR) – (BH × SR)

Fixed Overhead Fixed Overhead Fixed Overhead

Capacity Variance Calendar Variance Efficiency Variance
SR (AH – BH) Std. Fixed Overhead rate SR(SH – AH)
Or per day (Actual no. of Or
(AH × SR) – (BH × SR) Working days – (SH × SR) – (AH × SR)
Budgeted Working days)

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 13.40 COST AND MANAGEMENT ACCOUNTING

(a) Fixed Overhead Efficiency Variance: This is the difference between fixed
overhead absorbed and standard fixed overhead.
(b) Fixed Overhead Capacity Variance: This is the difference between standard
fixed overhead and budgeted overhead.
(c) Fixed Overhead Calendar Variance: This variance arises due to difference in
number of actual working days and the standard working days.

Note: When calendar variance is computed, there will be a modification in the

capacity variance. In that case revised capacity variance will be calculated and the
formula is:
Revised Capacity Variance = (Actual hours – Revised budgeted hours) × Std. fixed
rate per hour

Verification of formulae:
F.O. Cost Variance = F.O. Expenditure Variance + F.O. Volume Variance
F.O. Volume Variance = Efficiency Variance + Capacity Variance + Calendar
Variance
Basic terms used in the computation of overhead variance
Budgeted Overhead
Standard overhead rate (per hour) =
Budgeted hours

Or
Budgeted Overhead
Standard overhead rate (per unit) =
Budgeted output in units

Note: Separate overhead rates will be computed for fixed and variable overheads.
Basic calculations before the computation of overhead variances:
The following basic calculation should be made before computing variances.
(i) When overhead rate per hour is used:
(a) Standard hours for actual output (SHAO)
Budgeted Hours
SHAO = ×Actual Output
Budgeted Output

(b) Absorbed (or Recovered) overhead = Std. hours for actual output × Std.
overhead rate per hour

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 STANDARD COSTING 13.41

(c) Standard overhead = Actual hours × Std. overhead rate per hour
(d) Budgeted overhead = Budgeted hours × Std. overhead rate per hour
(e) Actual overhead = Actual hours × Actual overhead rate per hour
(ii) When overhead rate per unit is used
(a) Standard output for actual hours (SOAH)
Budgeted Output
SOAH = ×Actual Hours
Budgeted Hours

(b) Absorbed overhead = Actual output × Std. overhead rate per unit
(c) Standard overhead = Std. output for actual time × Std. overhead
rate per unit
(d) Budgeted overhead = Budgeted output × Std. overhead rate per unit
(e) Actual overhead = Actual output × Actual overhead rate per unit
(f) Overhead cost variance = Absorbed overhead – Actual overhead
(g) OCV = (Std. hours for actual output × Std. overhead
rate) – Actual overhead
ILLUSTRATION 10
The cost detail of J&G Ltd. for the month of September is as follows:

Budgeted Actual
Fixed overhead ` 15,00,000 ` 15,60,000
Units of production 7,500 7,800
Standard time for one unit 2 hours -
Actual hours worked - 16,000 hours

Required:
CALCULATE (i) Fixed Overhead Cost Variance (ii) Fixed Overhead Expenditure
Variance (iii) Fixed Overhead Volume Variance (iv) Fixed Overhead Efficiency
Variance and (v) Fixed Overhead Capacity Variance.
SOLUTION
(i) Fixed Overhead Cost Variance:
= Overhead absorbed for actual production – Actual overhead incurred

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 13.42 COST AND MANAGEMENT ACCOUNTING

 `15,00,000 
 7,500 × 7,800  − `15,60,000
=   =0
(ii) Fixed Overhead Expenditure Variance:
= Budgeted overhead – Actual overhead
= `15,00,000 - `15,60,000 = `60,000 (A)
(iii) Fixed Overhead Volume Variance:
= Absorbed overhead – Budgeted overhead
 `15,00,000 
=  × 7,800  − `15,00,000 = `60,000 (F)
 7,500 
(iv) Fixed Overhead Efficiency Variance:
= Std. Rate (Std. hours for actual production - Actual hours)
`15,00,000
= × {(2 hours × 7,800 hours) -16,000 hours}
7,500×2
= `100 (15,600 -16,000) = ` 40,000 (A)
(v) Fixed Overhead Capacity Variance:
= Std. Rate (Actual hours - Budgeted hours)
`15,00,000
= × (16,000 hours -15,000 hours}
7,500×2
= `100 (16,000- 15,000) = `1,00,000 (F)
ILLUSTRATION 11
A company has a normal capacity of 120 machines, working 8 hours per day of 25
days in a month. The fixed overheads are budgeted at ` 1,44,000 per month. The
standard time required to manufacture one unit of product is 4 hours.
In April 2021, the company worked 24 days of 840 machine hours per day and
produced 5,305 units of output. The actual fixed overheads were ` 1,42,000.
COMPUTE the following Fixed Overhead variance:
1. Efficiency variance
2. Capacity variance
3. Calendar variance
4. Expenditure variance

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 STANDARD COSTING 13.43

5. Volume variance
6. Total Fixed overhead variance

SOLUTION
Working Notes:
Budget Actual

(1) Fixed overheads for the month 1,44,000 1,42,000

(2) Working days per month 25 24

(3) Working hours per month (120 machines × 8 (840 machines

hrs. × 25 days) hours × 24 days) =
= 24,000 20,160

(4) Production units per month 24,000 hrs. = 6,000 5,305

4 hrs.

(5) Standard hours for actual production

= Actual production units × Std. hours per unit
= 5,305 × 4 = 21,220 hrs.
` 1, 44,000
(6) Standard fixed overhead rate per unit = = ` 24
6000 units
` 1, 44,000
(7) Standard fixed overhead rate per hour = =`6
24,000 hrs.
(8) Standard fixed overhead per day = ` 1, 44,000 = ` 5,760
25 days

1. Efficiency variance
= Std. rate per hr. (Std. hrs. for actual production – Actual hrs.)
= 6 × (21,220 – 20,160) = ` 6,360 (F)
2. Capacity variance
= Std. Rate (Actual hours - Budgeted hours)
= 6 × {20,160 – (24 days × 120 machine × 8 hrs.)} = ` 17,280 (A)

© The Institute of Chartered Accountants of India

 13.44 COST AND MANAGEMENT ACCOUNTING

3. Calendar variance
= (Actual No. of days – Budgeted No. of days) × Std. rate per day
= (24 – 25) × 5,760 = ` 5,760 (A)
4. Expenditure variance
= Budgeted overhead – Actual overhead
= 1,44,000 – 1,42,000 = ` 2,000 (F)
5. Volume variance
= Absorbed overhead – Budgeted overhead
= (5,305 × 24) – 1,44,000 = ` 16,680 (A)
6. Total fixed overhead Variance
= Absorbed overhead – Actual overhead incurred
= (5,305 × 24) – 1,42,000 = ` 14,680 (A)
ILLUSTRATION 12
The overhead expense budget for a factory producing to a capacity of 200 units per
month is as follows:

Description of overhead Fixed cost Variable cost per Total cost

per unit in ` unit in ` per unit in `
Power and fuel 1,000 500 1,500
Repair and maintenance 500 250 750
Printing and stationary 500 250 750
Other overheads 1,000 500 1,500
` 3,000 ` 1,500 4,500

The factory has actually produced only 100 units in a particular month. Details of
overheads actually incurred have been provided by the accounts department and are
as follows:

Description of overhead Actual cost

Power and fuel ` 4,00,000
Repair and maintenance ` 2,00,000
Printing and stationary ` 1,75,000
Other overheads ` 3,75,000

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 STANDARD COSTING 13.45

You are required to CALCULATE the Overhead volume variance and the overhead
expense variances.
SOLUTION
Overheads volume variance (in case of fixed overhead):
Standard fixed overheads per unit (SR): `3,000 (Given)
Actual production : 100 units
Standard production (capacity) : 200 units
Fixed Overhead Volume Variance:
= Absorbed overhead – Budgeted Overhead
= (`3,000× 100 units) – (`3,000× 200 units)
= `3,00,000 - `6,00,000 = `3,00,000 (Adverse)
Overhead expense variances
For variable overhead:
= AQ (SR – AR)
= 100 units (`1,500 - `1,500) = Nil
For fixed overhead:
= Budgeted Overhead – Actual Overhead
= (`3,000 × 200 units) – (Total overhead – Variable overhead)
= (`3,000 × 200 units) – (`11,50,000 - `1,500×100 units)
= `6,00,000 – (`11,50,000 - `1,50,000)
= `6,00,000 –`10,00,000 = `4,00,000 (Adverse)
ILLUSTRATION 13
The following information was obtained from the records of a manufacturing unit
using standard costing system.

Standard Actual
Production 4,000 units 3,800 units
Working days 20 21
Machine hours 8,000 hours 7,800 hours

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 13.46 COST AND MANAGEMENT ACCOUNTING

Fixed Overhead ` 4,00,000 ` 3,90,000

Variable Overhead `1,20,000 `1,20,000
You are required to CALCULATE the following overhead variance:
(a) Variable overhead variances
(b) Fixed overhead variances
SOLUTION
(a) Variable Overhead Variances
(i) Variable Overhead Variance:
= Std. overhead for actual production – Actual overhead

�4,000 units ×3,800 units� - `1,20,000

`1,20,000
=

= `1,14,000 – `1,20,000 = `6,000 (A)

(ii) Variable Overhead Expenditure Variance:
= Std. overhead for actual hours – Actual overhead
` 1,20,000
= �8,000 hours ×7,800 hours�- `1,20,000
= `15 × 7,800 hours - `1,20,000 = `3,000 (A)
(iii) Variable Overhead Efficiency Variance:
= Std. Rate per hour (Std. hours for actual production – Actual hours)

` 1,20,000  8,000hours  
= ×  ×3,800units  -7,800hours 
8,000 hours  4,000units  
= `15 × (7,600 hours – 7,800 hours) = `3,000 (A)
(b) Fixed Overhead Variance:
(i) Fixed Overhead Variance:
= Absorbed overhead – Actual overhead
= {(SR × SH) – (AR × AH)}
 ` 4,00,000 
=  ×3,800units  - `3,90,000
 4,000units 

= `3,80,000 - `3,90,000 = 10,000 (A)

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 STANDARD COSTING 13.47

(ii) Fixed Overhead Expenditure Variance:

= Budgeted Overhead – Actual Overhead
= `4,00,000 - `3,90,000 = `10,000 (F)
(iii) Fixed Overhead Volume Variance:
= Absorbed overhead – Budgeted Overhead
 ` 4,00,000 
=  ×3,800 units  - `4,00,000
 4,000 units 

= ` 3,80,000 - `4,00,000 = `20,000 (A)

(iv) Fixed Overhead Efficiency Variance:
= SR × (Std. hours for actual production – Actual hours)
= `50 × {(2 hours × 3,800 units) – 7,800 hours}
= `3,80,000 - `3,90,000 = `10,000 (A)
(v) Fixed Overhead Capacity Variance:
= SR × (Actual hours – Revised budgeted hours)
 8,000 
= `50 × 7,800 hours - ×21 days 
 20 days 
= `50 × (7,800 hours – 8,400 hours) = `30,000 (A)
(vi) Fixed Overhead Calendar Variance:
= Rate per day (Budgeted days – Actual days)
`4,00,000
= ×(20 days – 21 days) = 20,000 (F)
20 days

13.8ADVANTAGES AND CRITICISM OF

STANDARD COSTING
13.8.1Advantages of Standard Costing
Following are the advantages of standard costing.
(i) It serves as a basis for measuring operating performance and cost
control. It is possible by setting standards, proper classification and

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determination of variances. 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.
Although actual cost may vary from day to day, standard costs will remain
stable over a period of time and, where demand for a product is elastic,
this information can be used as a basis for fixing the selling price.
(iii) Introduction of standard costing facilitates evaluation of jobs and
introduction of incentives. Job values can be determined by the use of
evaluation and scale of wages fixed according to the responsibility
involved in each job.
(iv) Standard costing facilitates the estimation of the cost of new products
with greater accuracy.
(v) It serves as a basis for inventory valuation. Standard costs are used 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. The question
of correct approach of calculating profit is very much related to methods of
stock valuation and absorption of fixed overheads. 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) It provides objectives and targets to be achieved by each level of
management and defines the responsibilities of departmental managers.
Thus, 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. Since care is taken in setting standards, the standards become
unchanging units of comparison. The standard hour may be used as a basic
unit to compare dissimilar products or processes.

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(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.

13.8.2 Criticism of Standard Costing

The following are some of the criticism which may be leveled against the
standard costing system. The arguments have been suitably answered as stated
against each by advocates of the standard costing and hence they do not
invalidate the usefulness of the system to business enterprises.
(i) Variation in price: One of the chief 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.
(ii) 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.
(iii) Changing standard of technology: In case of industries that have frequent
technological changes affecting the conditions of production, standard costing
may not be suitable. This criticism does not affect the system of standard costing.
Cost reduction and cost control is a cardinal feature of standard costing because
standards once set do not always remain stable. They have to be revised.
(iv) Attitude of technical people: Technical people are accustomed to think of
standards as physical standards and, therefore, they will be misled by standard
costs. Since technical people can be educated to adopt themselves to the system
through orientation courses, it is not an insurmountable difficulty.
(v) Mix of products: Standard costing presupposes a pre-determined
combination 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

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 13.50 COST AND MANAGEMENT ACCOUNTING

set normally for a short period, such changes can be taken care of by revision of
standards.
(vi) 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.
(vii) 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, however,
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.
(viii) 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.

SUMMARY
♦ Standard Costing: A technique which uses standards for costs and revenues
for the purposes of control through variance analysis.
♦ Standard Price: A predetermined price fixed on the basis of a specification
of a product or service and of all factors affecting that price.
♦ Standard Time: The total time in which task should be completed at standard
performance.
♦ Variance: A divergence from the predetermined rates, expressed ultimately
in money value, generally used in standard costing and budgetary control
systems.
♦ Variance Analysis: The analysis of variances arising in standard costing
system into their constituent parts.
♦ Revision Variance: It is the difference between the original standard cost and
the revised standard cost of actual production.
♦ Basic Standard: A standard fixed for a fairly long period.

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♦ Current Standard: A standard fixed for a short period.

♦ Estimated Cost: An estimate of what the cost is likely to be during a given period
of time.
♦ Ideal Cost: A cost which should be incurred during a period under ideal
conditions.
Important Formulas
♦ Material Variance:
Material Costs Variance = (Std. qty × Std. Price) – (Actual qty × Actual price)
Material Usage Variance = Std. price (Std. Qty. – Actual qty.)
Material Price Variance = Actual qty. (Std. price – Actual price)
Material Cost Variance = Material usage variance + Material price variance
Material Mix Variance = SP (RSQ – AQ)
Material Yield Variance = SP (SQ – RSQ)
♦ Labour Variance:
Labour Cost Variance = (Std. time × Std. Rate) – (Actual time × Actual rate)
Labour Efficiency Variance = Std. rate (Std. time – Actual time)
Labour Rate Variance = Actual time (Std. rate – Actual rate)
Labour Idle Time Variance = Idle time x Std. rate
Labour Cost Variance = Labour Efficiency Variance + Labour Rate Variance
Labour Mix Variance = SR (RSH – AH)
Labour Yield Variance = SR (SH – RSH)
♦ Fixed Overhead Variances:
F.O. Cost Variance = Recovered Overhead – Actual Overhead
F.O. Expenditure Variance = Budgeted Overhead – Actual Overhead
F.O. Volume Variance = Recovered Overhead – Budgeted Overhead
F.O. Efficiency Variance = Recovered Overhead – Standard Overhead
F.O. Capacity Variance = Standard Overhead – Budgeted Overhead
F.O. Calendar Variance = SR (Actual no. of working days – Std. no. working days)

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♦ Variable Overhead Variances

V.O. Cost variance = Recovered Overhead – Actual Overhead
V.O. Expenditure Variance = Standard Overhead – Actual Overhead
V.O. Efficiency Variance = Recovered Overhead – Standard Overhead

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Under standard cost system the cost of the product determined at the
beginning of production is its:
(a) Direct cost
(b) Pre-determined cost
(c) Historical cost
(d) Actual cost
2. The deviations between actual and standard cost is known as:
(a) Multiple analysis
(b) Variable cost analysis
(c) Variance analysis
(d) Linear trend analysis
3. The standard which is attainable under favourable conditions is:
(a) Theoretical standard
(b) Expected standard
(c) Normal standard
(d) Basic standard
4. The standard most suitable from cost control point of view is:
(a) Normal standard
(b) Theoretical standard
(c) Expected standard
(d) Basic standard

© The Institute of Chartered Accountants of India

CHAPTER 14

MARGINAL COSTING
LEARNING OUTCOMES

 Explain the meaning and characteristics of Marginal Costing.

 Describe the meaning of CVP Analysis and apply the same in
making short-term managerial decisions.
 Describe the meaning and application of Break-even point,
Margin of safety, Angle of incidence etc. and apply the same
in making computations.
 Calculate and explain the various formulae used in CVP
analysis.
 Apply the concepts of marginal costing and CVP analysis in
short-term decision making.
 Differentiate between Marginal Costing and Absorption
Costing.

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 14.2 COST AND MANAGEMENT ACCOUNTING

Meaning of Marginal Cost

and Marginal Costing
Break-even Analysis
Marginal Costing

Characteristics of Marginal
Costing
Marginal of Safety
Cost-Volume-Profit (CVP)
Analysis
Angle of Incidence
Short-term Decision
making
Contribution Ratio

14.1 INTRODUCTION
As discussed in the first chapter ‘Introduction to Cost and Management
Accounting’, the cost and management accounting system, by provision of
information, enables management to take various decisions. Marginal Costing is a
technique of cost and management accounting which is used to analyse
relationship between cost, volume and profit.
In order to appreciate the concept of marginal costing, it is necessary to study the
definition of marginal costing and certain other terms associated with this
technique. The important terms have been defined as follows:
1. Marginal Cost: Marginal cost as understood in economics is the incremental
cost of production which arises due to one-unit increase in the production
quantity. As we understood, variable costs have direct relationship with volume of
output and fixed costs remains constant irrespective of volume of production.
Hence, marginal cost is measured by the total variable cost attributable to one unit.
For example, the total cost of producing 10 units and 11 units of a product is
`10,000 and `10,500 respectively. The marginal cost for 11th unit i.e. 1 unit extra
from 10 units is `500.

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Marginal cost can precisely be the sum of prime cost and variable overhead.
Example 1: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost
of ` 3,50,000. Break-up of costs are as follows:
(i) Direct Material @ ` 10 per unit, ` 1,00,000,
(ii) Direct employee (labour) cost @ ` 8 per unit, ` 80,000
(iii) Variable overheads @ `2 per unit, ` 20,000
(iv) Fixed overheads ` 1,50,000 (upto a volume of 50,000 units)
In this example, if Arnav Ltd. wants to know marginal cost of producing one extra
unit from the current production i.e. 10,001st unit. The marginal cost would be the
change in the total cost due production of this 10,001st extra unit. The extra cost
would be `20, as calculated below:
10,000 10,001 units Change in
units Cost
(A) (B) (c) = (B) - (A)

(i) Direct Material @ `10 per unit 1,00,000 1,00,010 10

(ii) Direct employee (labour) cost 80,000 80,008 8
@ `8 per unit
(iii)Variable overheads @ `2 per 20,000 20,002 2
unit
(iv) Fixed overheads 1,50,000 1,50,000 0
Total Cost 3,50,000 3,50,020 20

2. 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. Costs are classified on the basis
of behavior of cost (i.e. fixed and variable) rather functions as done in absorption
costing method.
3. 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.

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Example 2: Arnav Ltd. produces 10,000 units of product Z by incurring a total cost
of `4,80,000. Break-up of costs are as follows:
(i) Direct Material @ `10 per unit, `1,00,000,
(ii) Direct employee (labour) cost @ `8 per unit, `80,000
(iii) Variable overheads @ `2 per unit, `20,000
(iv) Machine set up cost @ `1,200 for a production run (100 units can be
manufactured in a run)
(v) Depreciation of a machine specifically used for production of Z `10,000
(iv) Apportioned fixed overheads `1,50,000.
Analysis of the costs:
10,000 10,001 Change in Direct Cost
units units Cost
(A) (B) (c) = (B) - (A)
(i) Direct Material 1,00,000 1,00,010 10 Unit level Direct
@ ` 10 per unit Cost.
(ii) Direct employee 80,000 80,008 8 Unit level Direct
(labour) cost @ Cost.
` 8 per unit
(iii) Variable 20,000 20,002 2 Unit level Direct
overheads @ `2 Cost.
per unit
(iv) Machine set up 1,20,000 1,21,200 1,200 Batch level Direct
cost Cost
(v) Depreciation of 10,000 10,000 0 Product level Direct
a machine Cost.
(vi) Apportioned 1,50,000 1,50,000 0 Department level
fixed overheads Direct Cost
Total Cost 4,80,000 4,81,220 1,220
In the example, the direct cost of producing 10,001st unit is 1,220 but it is not the
marginal cost of producing one extra unit rather marginal cost of running one extra
production run (batch).

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 MARGINAL COSTING 14.5

4. 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 costs due 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. In the Example 2 above, ` 1,220 is the incremental cost of producing one
extra unit but not marginal cost for producing one extra unit.

14.2 CHARACTERISTICS OF MARGINAL COSTING

The technique of marginal costing is based on the distinction between product
costs and period costs. Only the variables costs are treated as the costs of the
products while the fixed costs are treated as period costs which will be incurred
during the period regardless of the volume of output. The main characteristics of
marginal costing are as follows:
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–progress
is also comprised only of marginal costs. Variable selling and distribution
are excluded for valuing these inventories. Fixed costs are not considered for
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 to
their contribution margin.

14.3 FACTS ABOUT MARGINAL COSTING

Some of the facts about marginal costing are depicted below:
Not a distinct method: Marginal costing is not a distinct method of costing like

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 14.6 COST AND MANAGEMENT ACCOUNTING

job costing, process costing, operating costing, etc., but a special technique used
for managerial decision making. Marginal costing is used to provide a basis for the
interpretation of cost data to measure the profitability of different products,
processes and cost centres in the course of decision making. It can, therefore, be
used in conjunction with the different methods of costing such as job costing,
process costing, etc., or even with other techniques such as standard costing or
budgetary control.
Cost Ascertainment: In marginal costing, cost ascertainment is made on the basis of
the nature of cost. It gives consideration to behaviour of costs. In other words, the
technique has developed from a particular conception and expression of the nature
and behaviour of costs and their effect upon the profitability of an undertaking.
Decision Making: According to traditional or total cost method, as opposed to
marginal costing, the classification of costs is based on functional basis. Under this
method the total cost is the sum total of the cost of direct material, direct labour,
direct expenses, manufacturing overheads, administration overheads, selling and
distribution overheads. In this system, other things being equal, the total cost per
unit will remain constant only when the level of output or mixture is the same from
period to period. Since these factors are continually fluctuating, the actual total
cost will vary from one period to another. Thus, it is possible for the costing
department to say one day that an item costs ` 20 and the next day it costs ` 18.
This situation arises because of changes in volume of output and the peculiar
behavior of fixed expenses included in the total cost. Such fluctuating
manufacturing activity, and consequently the variations in the total cost from
period to period or even from day to day, poses a serious problem to the
management in taking sound decisions. Hence, the application of marginal costing
has been given wide recognition in the field of decision making.

14.4 DETERMINATION OF COST AND PROFIT

UNDER MARGINAL COSTING
For the determination of cost of a product or service under marginal costing, costs
are classified into variable and fixed. All the variable costs are part of product and
services while fixed costs are charged against contribution margin.

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 MARGINAL COSTING 14.7

Cost and Profit Statement under Marginal Costing

Amount Amount (`)

(`)
Revenue (A) xxx
Product Cost:
- Direct Materials xxx
- Direct employee (labour) xxx
- Direct expenses xxx
- Variable manufacturing overheads xxx
Product (Inventoriable) Costs: (B) xxx xxx
Product Contribution Margin {A – B} xxx
- Variable Administration overheads xxx
- Variable Selling & Distribution overheads xxx xxx
Contribution Margin: (C) xxx
Period Cost: (D)
Fixed Manufacturing expenses xxx
Fixed non-manufacturing expenses 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 (Please
refer Process & Operation costing chapter)
(ii) Contribution: Contribution or contribution margin is the difference between
sales revenue and total variable costs irrespective of manufacturing or non-
manufacturing.

Contribution (C) = Sales Revenue (S) – Total Variable Cost (V)

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 14.8 COST AND MANAGEMENT ACCOUNTING

It is obtained by subtracting variable costs from sales revenue. It can also be

defined as excess of sales revenue over the variable costs. The contribution concept
is based on the theory that the profit and fixed expenses of a business is a ‘joint
cost’ which cannot be equitably apportioned to different segments of the business.
In view of this difficulty the contribution serves as a measure of efficiency of
operations of various segments of the business. The contribution forms a fund for
fixed expenses and profit as illustrated below:
Example:
Variable Cost = `50,000, Fixed Cost = ` 20,000,
Selling Price = ` 80,000
Contribution = Selling Price – Variable Cost
= ` 80,000 – ` 50,000 = ` 30,000
Profit = Contribution – Fixed Cost
= ` 30,000 – ` 20,000 = `10,000
Since, contribution exceeds fixed cost; the profit is of the magnitude of ` 10,000.
Suppose the fixed cost is ` 40,000 then the position shall be:
Contribution – Fixed cost = Profit or,
= ` 30,000 – ` 40,000 = - ` 10,000
The amount of ` 10,000 represent extent of loss since the fixed costs are more than
the contribution. At the level of fixed cost of ` 30,000, there shall be no profit and
no loss.
(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 they
are incurred. All fixed costs either manufacturing or non-manufacturing are
recognised as period costs in marginal costing.

14.5 ABSORPTION COSTING

Absorption Costing is the practice of charging all costs, both variable and
fixed to operations, processes or product.
In absorption costing the classification of expenses is based on functional basis
whereas in marginal costing it is based on the nature of expenses. In absorption
costing, the fixed expenses are distributed over products on absorption costing basis

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 MARGINAL COSTING 14.9

that is, based on a pre-determined level of output. Since fixed expenses are constant,
such a method of recovery will lead to over or under-recovery of expenses depending
on the actual output being greater or lesser than the estimate used for recovery. This
difficulty will not arise in marginal costing because the contribution is used as a fund
for meeting fixed expenses.
(For understanding the difference between marginal and absorption costing
along with the presentation of information to management under the said two
costing techniques, students are advised to refer Para 14.14)

14.6 ADVANTAGES AND LIMITATIONS OF

MARGINAL COSTING
ADVANTAGES
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. 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 basis
of 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

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 14.10 COST AND MANAGEMENT ACCOUNTING

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 taking
a 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.
LIMITATIONS
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. For example, various
amenities provided to workers may have no relation either to volume of
production or time factor.
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, sales
staff 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 longer

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 MARGINAL COSTING 14.11

time 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.

14.7 COST-VOLUME-PROFIT (CVP) ANALYSIS

Meaning: It is a managerial tool showing the relationship between various ingredients
of 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. Such an analysis explores the relationship between costs, revenue, activity levels
and 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 – for
example, the number of television sets produced and sold by Sony
Corporation or the number of packages delivered by Overnight Express. The
number of output units is the only revenue driver and the only cost driver.
Just as a cost driver is any factor that affects costs, a revenue driver is a
variable, such as volume, that causally affects revenues.
2. Total costs can be separated into two components; a fixed component that
does not vary with output level and a variable component that changes with
respect to output level. Furthermore, variable costs include both direct
variable costs and indirect variable costs of a product. Similarly, fixed costs
include both direct fixed costs and indirect fixed costs of a product
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 without
taking into account the time value of money. (Refer to the FM study
material for a clear understanding of time value of money).

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 14.12 COST AND MANAGEMENT ACCOUNTING

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 budgeting
and 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.
14.7.1 Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and
selling price. It tells us that selling price minus variable cost of the units sold is the
contribution towards fixed expenses and profit. If the contribution is equal to fixed
expenses, there will be no profit or loss and if it is less than fixed expenses, loss is
incurred. Since the variable cost varies in direct proportion to output, therefore if
the firm does not produce any unit, the loss will be there to the extent of fixed
expenses. These points can be described with the help of following marginal cost
equation:

Marginal Cost Equation = S -V = C = F ± P

Where,
S = Selling price per unit, V = Variable cost per unit, C = Contribution,
F = Fixed Cost,
Marginal Cost Statement
(`)

Sales xxxx

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 MARGINAL COSTING 14.13

Less: Variable Cost xxxx

Contribution xxxx
Less: Fixed Cost xxxx
Profit xxxx

14.7.2 Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio)

This ratio shows the proportion of sales available to cover fixed costs and profit.
Contribution represent the sales revenue after deducting variable costs. This ratio
is usually expressed in percentage.

Contribution Change in contribution / Profit

P / V Ratio = ×100 or, P/V Ratio = ×100
Sales Change in sales

A higher contribution to sales ratio implies that the rate of growth of contribution
is faster than that of sales. This is because, once the breakeven point is reached,
profits shall grow at a faster rate when compared to a product with a lesser
contribution to sales ratio.
By transposition, we have derived the following equations:
(i) C = S × P/V ratio
C
(ii) S=
P / VRatio

14.7.3 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.

14.8 METHODS OF BREAK -EVEN ANALYSIS

Break even analysis may be conducted by the following two methods:
(A) Algebraic computations
(B) Graphic presentations

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 14.14 COST AND MANAGEMENT ACCOUNTING

(A) ALGEBRAIC CALCULATIONS

14.8.1 Breakeven Point
The word contribution has been given its name because of the fact that it literally
contributes towards the recovery of fixed costs and the making of profits. The
contribution grows along with the sales revenue till the time it just covers the fixed cost.
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. Hence, if we know how
much contribution is generated from each unit sold we shall have sufficient information
for computing the number of units to be sold in order to break even. Mathematically,
Fixed costs
Break-even point in units =
Contributi on per unit

Example 3: ABC Ltd. manufacturing a single product, incurring variable costs of `

300 per unit and fixed costs of ` 2,00,000 per month. If the product sells for
` 500 per unit, the breakeven point shall be calculated as follows;
Fixed costs ` 2,00,000
Break- even point in units = = = 1,000 units
Contribution per unit `200

Total fixed cost

Break- even points (in Value) = × Sales
Contribution
Total fixed cost
Break- even point (in Value) =
P / V Ratio
14.8.2 Cash Break-even point
When break-even point is calculated only with those fixed costs which are payable
in 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 unit

ILLUSTRATION 1
MNP Ltd sold 2,75,000 units of its product at ` 37.50 per unit. Variable costs are
` 17.50 per unit (manufacturing costs of ` 14 and selling cost ` 3.50 per unit). Fixed

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 MARGINAL COSTING 14.15

costs are incurred uniformly throughout the year and amounting to ` 35,00,000
(including depreciation of ` 15,00,000). There are no beginning or ending inventories.
Required:
COMPUTE breakeven sales level quantity and cash breakeven sales level quantity.
SOLUTION
Fixed cost ` 35,00,000
Break even Sales Quantity = =
Contribution margin per unit `20

= 1,75,000 units
Cash Fixed Cost ` 20,00,000
Cash Break-even Sales Quantity = =
Contribution margin per unit `20
=1,00,000 units.
14.8.3 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. The calculation of Multi-Product
Break-even analysis can be understood with the help of the following example.
Example 4: Arnav Ltd. sells two products, J and K. The sales mix is 4 units of J and
3 units of K. The contribution margins per unit are ` 40 for J and ` 20 for K. Fixed
costs are ` 6,16,000 per month.
Sales mix (in quantity) is 4 units of Product- J and 3 units of Product- K
i.e. Sales ratio is 4 : 3
Composite contribution per unit by taking weights for the product sales quantity
4 3
=Product J- ` 40 × + Product K- `20 × = `22.86 + `8.57 = `31.43
7 7
Common Fixed Cost `6,16,000
Composite Break-even point = =
Composite Contribution per unit `31.43
= 19,600 units
4
Break-even units of Product-J = 19,600 × = 11,200 units
7
3
Break-even units of Product- K = 19,600 × = 8,400 units
7

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 14.16 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 2

You are given the following particulars

i. Fixed cost ` 1,50,000
ii. Variable cost ` 15 per unit
iii. Selling price is ` 30 per unit

CALCULATE:
(a) Break-even point
(b) Sales to earn a profit of ` 20,000

SOLUTION
Fixed cost `1,50,000
(a) Break-even point (BEP) = = = 10,000 Units
Contribution per unit * `15

* (Contribution per unit = Sales per unit – Variable cost per unit = ` 30 - `15)

(b) Sales to earn a Profit of ` 20,000:

Fixed cost+Desired profit
= ×Selling price per unit
Contribution per unit

`1,50,000+ `20,000
= ×`30 = ` 3,40,000
`15
Or
Fixed cost+Desired profit `1,70,000 `1,70,000
= = = ` 3, 40,000
P / V Ratio P / V Ratio 50%
Contributi on
PV Ratio = × 100
Sales

ILLUSTRATION 3

A company has a P/V ratio of 40%. COMPUTE by what percentage must sales be
increased to offset: 20% reduction in selling price?

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 MARGINAL COSTING 14.17

SOLUTION
Desired Contribution 0.40
Revised Sales Value = = = 1.6
Revised P / VRatio * 0.25

This means sales value to be increased by 60% of the existing sales.

Revised Contribution 0.80- 0.60
*Revised P/V Ratio = = = 0.25
Revised Selling Price 0.80

Desired Contribution 0.40

Required Sales Quantity = = =2
Revised P / VRatio *×Revised Selling Price 0.25×0.80

Therefore, Sales value to be increased by 60% and sales quantity to be doubled to

offset the reduction in selling price.
Proof:
Let selling price per unit is `10 and sales quantity is 100 units.
Data before change in selling price:
(`)
Sales (`10 × 100 units) 1,000
Contribution (40% of 1,000) 400
Variable cost (balancing figure) 600
Data after the change in selling price:
Selling price is reduced by 20% that means it became `8 per unit. Since, we have
to maintain the earlier contribution margin i.e. `400 by increasing the sales quantity
only. Therefore, the target contribution will be `400.
The new P/V Ratio will be
(`)
Sales 8.00
Variable cost 6.00
Contribution per unit 2.00
P/V Ratio 25%
DesiredContribution `400
Sales Value = = = `1,600
Revised P / VRatio 0.25
Sales value `1,600
Sales quantity = = = 200 units
Selling price per unit `8

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 14.18 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 4
PQR Ltd. has furnished the following data for the two years:

2019-20 2020-21

Sales ` 8,00,000 ?
Profit/Volume Ratio (P/V ratio) 50% 37.5%
Margin of Safety sales as a % of total sales 40% 21.875%

There has been substantial savings in the fixed cost in the year 2020-21 due to the
restructuring process. The company could maintain its sales quantity level of 2019-
20 in 2020-21 by reducing selling price.
You are required to CALCULATE the following:
(i) Sales for 2020-21 in Value,
(ii) Fixed cost for 2020-21 in Value,
(iii) Break-even sales for 2020-21 in Value.
SOLUTION
In 2019-20, PV ratio = 50%
Variable cost ratio = 100% - 50% = 50%
Variable cost in 2019-20 = ` 8,00,000 × 50% = ` 4,00,000
In 2020-21, sales quantity has not changed. Thus, variable cost in 2020-21 is `
4,00,000.
In 2020-21, P/V ratio = 37.50%
Thus, Variable cost ratio = 100% − 37.5% = 62.5%
4,00,000
(i) Thus, sales in 2020-21 = = `6,40,000
62.5%
In 2020-21, Break-even sales = 100% − 21.875% (Margin of safety) = 78.125%
(ii) Break-even sales = 6,40,000 × 78.125% = ` 5,00,000
(iii) Fixed cost = B.E. sales × P/V ratio
= 5,00,000 × 37.50% = `1,87,500.

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 MARGINAL COSTING 14.19

(B) GRAPHICAL PRESENTATION OF BREAK EVEN CHART

14.8.4 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 require
you to 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 (horizontal line at ` 2,00,000 for ABC Ltd), (ii) Total costs
at maximum level of activity (joined to the Y-axis where the Fixed cost of ` 2,00,000
is marked) and (iii) Revenue at maximum level of activity (joined to the origin) shall
be 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.
The breakeven chart for ABC Ltd (Example-3) is drawn below.

` 000

14.8.5 Contribution Breakeven chart

It is not possible to use a breakeven chart as described above to measure
contribution. This is one of its major limitations especially so because contribution
analysis is literally the backbone of marginal costing. To overcome such a limitation,
accountants frequently resort to the making of a contribution breakeven chart
which 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 off
in the same way as with a conventional chart. However, it is also possible to read
the contribution for any level of activity.

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 14.20 COST AND MANAGEMENT ACCOUNTING

Using the same example of ABC Ltd as for the conventional chart, the total variable
cost for an output of 1,700 units is 1,700 × `300 = `5,10,000. This point can be
joined to the origin since the variable cost is nil at zero activity.
` 000

The contribution can be read as the difference between the sales revenue line and
the variable cost line.
14.8.6 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. A
profit-volume graph for our example (ABC Ltd) will be as follows,

` 000

Loss

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 MARGINAL COSTING 14.21

The loss at a nil activity level is equal to ` 2,00,000, i.e. the amount of fixed costs.
The second point used to draw the line could be the calculated breakeven point or
the calculated profit for sales of 1,700 units.
Advantages of the profit-volume chart
1. 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,
Example 5:
A manufacturing company incurs fixed costs of `3,00,000 per annum. It is a single
product company with annual sales budgeted to be 70,000 units at a sales price of
`300 per unit. Variable costs are ` 285 per unit.
(i) Draw a profit volume graph, and use it to determine the breakeven point.
The company is deliberating upon an increase in the selling price of the
product to ` 350 per unit. This shall be required in order to improve the
quality of the product. It is anticipated that despite increase in the selling
price the sales volume shall remain unaffected, however, the fixed costs shall
increase to ` 4,50,000 per annum and the variable costs to ` 330 per unit.
(ii) Draw on the same graph as for part (a) a second profit volume graph and give
your comments.
Solution
Figure showing changes with a profit-volume chart
` 000

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 14.22 COST AND MANAGEMENT ACCOUNTING

Working notes (i)

The profit for sales of 70,000 units is ` 7,50,000.
(`’000)
Contribution 70,000 × (`300 – `285) 1050
Fixed costs 300
Profit 750

This point is joined to the loss at zero activity, ` 3,00,000 i.e., the fixed costs.
Working notes (ii)
The profit for sales of 70,000 units is ` 9,50,000.
(`’000)
Contribution 70,000 × (`350 – `330) 1400
Fixed costs 450
Profit 950

This point is joined to the loss at zero activity, ` 4,50,000 i.e., the fixed costs.
Comments:
It is clear from the graph that there are larger profits available from option (ii). It
also shows an increase in the break-even point from 20,000 units to 22,500 units,
however, the increase of 2,500 units may not be considered large in view of the
projected sales volume. It is also possible to see that for sales volumes above
30,000 units the profit achieved will be higher with option (ii). For sales volumes
below 30,000 units option (i) will yield higher profits (or lower losses).
ILLUSTRATION 5
You are given the following data for the current financial year of Rio Co. Ltd:

Variable cost 60,000 60%

Fixed cost 30,000 30%
Net profit 10,000 10%
Sales 1,00,000 100%

FIND OUT (a) Break-even point, (b) P/V ratio, and (c) Margin of safety. Also DRAW
a break-even chart showing contribution and profit.

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 MARGINAL COSTING 14.23

SOLUTION
Sales - Variable Cost 1,00,000 - 60,000
P / V ratio = = = 40%
Sales 1,00,000
Fixed Cost 30,000
Break Even Point = = = ` 75,000
P / V ratio 40%
Margin of safety = Actual Sales – BE point = 1,00,000 – 75,000 = ` 25,000
Break even chart showing contribution is shown below:
Cost and Revenue (` thousands)

Break-even chart

ILLUSTRATION 6
PREPARE a profit graph for products A, B and C and find break-even point from the
following data:

Products A B C Total
Sales (`) 7,500 7,500 3,750 18,750
Variable cost (`) 1,500 5,250 4,500 11,250
Fixed cost (`) --- --- --- 5,000

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 14.24 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Statement Showing Cumulative Sales & Profit

Sales Cumulative Variable Contributio Cumulative Cumulative

Sales Cost n Contribution Profit
(`) (`) (`) (`) (`) (`)
A 7,500 7,500 1,500 6,000 6,000 1,000
B 7,500 15,000 5,250 2,250 8,250 3,250
C 3,750 18,750 4,500 (750) 7,500 2,500

Profit in `
(+) 5,000
`3,250
(+) 2,500 `2,500
`1,000

0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000

BEP Sales in `
(-) 2,500
Profit Line
(-) 5,000
Loss in `
Break Even Point (BEP) = ` 12,500

14.9 LIMITATIONS OF BREAK-EVEN ANALYSIS

The limitations of the practical applicability of breakeven analysis and
breakeven charts stem mostly from the assumptions underlying CVP which
have been mentioned above. Assumptions like costs behaving in a linear fashion
or 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.

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 MARGINAL COSTING 14.25

14.10 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. In the Example-3 if the forecast sale is 1,700 units per
month, the margin of safety can be calculated as follows,
Margin of Safety = Projected sales – Breakeven sales
= 1,700 units – 1,000 units
= 700 units or 41% of sales.
The Margin of Safety can also be calculated by identifying the difference between
the 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. It also can
be calculated as:
Profit
Margin of Safety =
P / V Ratio

ILLUSTRATION 7
A company earned a profit of ` 30,000 during the year. If the marginal cost and
selling price of the product are ` 8 and ` 10 per unit respectively, FIND OUT the
amount of margin of safety.
SOLUTION
Selling price- Variable cost per unit `10- `8
P/V ratio = = = 20%
Selling price `10

Profit 30,000
Margin of safety = = = ` 1,50,000
P/V ratio 20%

ILLUSTRATION 8
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio
of 40%. Its fixed costs amount to ` 5 lakhs.
CALCULATE the following:
i. Break-even sales

ii. Total sales

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 14.26 COST AND MANAGEMENT ACCOUNTING

iii. Total variable cost

iv. Current profit
v. New ‘margin of safety’ if the sales volume is increased by 7 ½ %.
SOLUTION

(i) We know that: Break- even Sales (BES) × P/V Ratio = Fixed Cost
Break-even Sales (BES) × 40% = ` 5,00,000
Break- even Sales (BES) = ` 12,50,000

(ii) Total Sales (S) = Break Even Sales + Margin of Safety

S = ` 12,50,000 + 0.375S

Or, S – 0.375S = ` 12,50,000

Or, S = ` 20,00,000

(iii) Contribution to Sales Ratio = 40%

Therefore, Variable cost to Sales Ratio = 60%

Variable cost = 60% of sales = 60% of 20,00,000

Variable cost = 12,00,000

(iv) Current Profit = Sales – (Variable Cost + Fixed Cost)

= ` 20,00,000 – (12,00,000 + 5,00,000) = ` 3,00,000

(v) If sales value is increased by 7 ½ %

New Sales value = ` 20,00,000 × 1.075 = ` 21,50,000

New Margin of Safety = New Sales value – BES

= ` 21,50,000 – ` 12,50,000 = ` 9,00,000

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 MARGINAL COSTING 14.27

14.11 VARIATIONS OF BASIC MARGINAL COST

EQUATION AND OTHER FORMULAE
i. Sales – Variable cost = Fixed cost ± Profit/ Loss
By multiplying and dividing L.H.S. by S
S(S − V)
ii. = F+P
S
 S−V
iii. S × P/V Ratio = F + P or Contribution  P/V Ratio = 
 S 
iv BES × P/V Ratio = F ( at BEP profit is zero)

Fixed Cost
v BES =
P / V Ratio
Fixedcost
vi P/V Ratio =
BES
vii S × P/V Ratio = Contribution (Refer to iii)
Contributi on
viii P/V Ratio =
Sales
ix (BES + MS) × P/V Ratio = Contribution (Total sales = BES + MS)
x (BES × P/V Ratio) + (MS × P/V Ratio) = F + P
By deducting (BES × P/V Ratio) from L.H.S. and F from R.H.S. in (x) above,
we get:
xi M.S. × P/V Ratio = P
Change in profit
xii P/V Ratio =
Change in sales

Change in contribution
xiii P/V Ratio =
Change in sales
Contributi on
xiv Profitability =
Key factor

Profit
xv Margin of Safety = Total Sales – BES or .
P / V ratio

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 14.28 COST AND MANAGEMENT ACCOUNTING

Xvi BES = Total Sales – MS

Total sales - BES
Margin of Safety Ratio =
Total sales

ILLUSTRATION 9
By noting “P/V will increase or P/V will decrease or P/V will not change”, as the case
may be, STATE how the following independent situations will affect the P/V ratio:
(i) An increase in the physical sales volume;
(ii) An increase in the fixed cost;
(iii) A decrease in the variable cost per unit;
(iv) A decrease in the contribution margin;
(v) An increase in selling price per unit;
(vi) A decrease in the fixed cost;
(vii) A 10% increase in both selling price and variable cost per unit;
(viii) A 10% increase in the selling price per unit and 10% decrease in the physical
sales volume;
(ix) A 50% increase in the variable cost per unit and 50% decrease in the fixed cost.
(x) An increase in the angle of incidence.
SOLUTION

Item no. P/V Ratio Reason

(i) Will not change
(ii) Will not change
(iii) Will increase
(iv) Will decrease
(v) Will increase
(vi) Will not change
(vii) Will not change Reasoning 1
(viii) Will increase Reasoning 2
(ix) Will decrease Reasoning 3
(x) Will increase Reasoning 4

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A 10% increase in both selling price and variable cost per unit.
Reasoning 1. Assumptions: a) Variable cost is less than selling price.
b) Selling price `100 variable cost ` 90 per unit.
100 − 90
c) P/V ratio = = 10%
100
10% increase in S.P. = `110
10% increase in variable cost = `99
110 − 99
P/V ratio = = 10% i.e. P/v ratio will not change
10
Reasoning 2. Increase or decrease in physical sales volume will not change P/V
ratio. Hence 10% increase in selling price per unit will increase P/V
ratio.
Reasoning 3. Increase or decrease in fixed cost will not change P/V ratio. Hence
50% increase in the variable cost per unit will decrease P/V ratio.
Reasoning 4. Angle of incidence is the angle at which sales line cuts the total cost
line. If it is large, it indicates that the profits are being made at higher
rate. Hence increase in the angle of incidence will increase the P/V
ratio.

14.12 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.

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 14.30 COST AND MANAGEMENT ACCOUNTING

280

L ine
les
260
Sa
240

220

200
ea
it Ar
180 of
Pr Line
Cost and Sales (Rs. ‘ 000)

C ost
Margin Angle of Total
Cost and Sales (` '000)

160 of incidence
Safety Break even point
140

120 Variable cost

100

80
ea
Ar
60 oss
L

40 Margin
of Fixed cost
20 Safety

0
2 4 6 8 10 12 14 16 18 20 22 24 26 28

B.E.sales Actual sales

Volume of sales (Unit ‘000)

14.13 APPLICATION OF CVP ANALYSIS IN

DECISION MAKING
As discussed earlier CVP analysis is used as an evaluation tool for managerial decisions.
In this chapter we will discuss the use of CVP Analysis for short term decision making.
Before going into illustration, let us discuss the decision making framework.
14.13.1 Framework for Decision Making

Step 1: Identification of Problem

Step 2: Indentification of Options

Step 3: Evaluation of the Options

Step 4: Selection of the Option

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 MARGINAL COSTING 14.31

Step-1: Identification of Problem

Every organisation has its own objectives, and goals are set to achieve these
objectives. To reach at the goal, actions are to be taken. For example, if an
organisation wants to be a cost leader in the industry it operates in, it has to achieve
3Es in its all activities. 3Es means economy in inputs, efficiency in process and
operations and effectiveness in output. An entity that exists for profit may identify
few areas (problem areas) which if worked on can add to the profit or wealth
maximisation. For example, Arnav Ltd. a manufacturer of Steel products, has
identified that it can be leader in the industry if it can produce steel 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). Every possible options need to be
explored. In the above example, the Arnav Ltd. may have the 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
(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 basis
of 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 options
(ii) Estimation of amount of each options

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 14.32 COST AND MANAGEMENT ACCOUNTING

Step-4: Selection of option:

After evaluation of the options, the best option is selected and implemented.
14.13.2 Principles for Identification of Cost and Benefits for
measurement
The cost and benefit of an option is identified for measurement if it passes the
principles of Controllability and Relevance.
(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.
For Example, Arnav Ltd. wants to manufacture 1,000 additional units of Product X.
It is considering either to manufacture in its own factory or to outsource to job
workers. In this example cost of raw materials to manufacture additional 1,000 units
is controllable as it arises due to management’s decision to make additional units.
But it is not relevant for making choice between manufacturing in-house and
outsource to job workers, as under the both options, the raw materials cost would
be same.
Hence, for decision making purpose only those cost and benefits are identified for
measurement which are both Controllable and Relevant.
Below is an analysis of few costs for its relevance:

Cost Relevance Reason

(i) Historical Irrelevant The cost has already been incurred and do
Cost not affect the decision. Example: Book value
of machinery etc.
(ii) Sunk Cost Irrelevant The cost which are already paid either for
goods or services availed or to be availed.
Example: Raw material purchased and held
in store without having replacement cost,
Cost of drawing, blueprint etc.

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 MARGINAL COSTING 14.33

(iii) Committed Irrelevant The committed costs are the pre-agreed

Cost 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 Relevant The opportunity cost is represented by the
Cost 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
Imputed Cost making only if company is actually 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 only
if company could earn interest from it.
(vi) Shut-down Relevant When an organization suspends its
Cost manufacturing operations, certain fixed
expenses can be avoided and certain extra
fixed expenses may be incurred depending
upon the nature of the industry. 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.

14.13.3 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.

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 14.34 COST AND MANAGEMENT ACCOUNTING

(ii) Traceability: Traceability of cost means degree of relationship between the

cost and the choice of the option. Direct costs are directly assigned to the option
on the other hand indirect costs needs to be apportioned to the option on some
reasonable basis.
For Example, Arnav Ltd. wants to manufacture 1,000 units of Product X. It is
considering to manufacture the same in its own factory. To manufacture in its own
factory it requires 1,000 hours of employees and a specialised machine. In this
example, employee cost for labour of 1,000 hours is variable cost for in-house
manufacturing and it is directly traceable. Cost of machinery is also direct cost but
so far as traceability of the machinery cost is concerned it is direct cost for 1,000
units as a whole but indirect cost for a unit.
Hence, the cost and benefits of an option is measured at directly traceable and
variable costs.
14.13.4 Short-term Decision-Making using concepts of CVP Analysis
Management uses marginal costing and CVP concepts for making various
decisions. In this chapter, we will learn how the concepts of marginal costing and
CVP is applied for analysis of identified options for short-term decision making.
Generally, short-term decisions are related with temporary gaps between demand
and supply for available resources. The areas of short-term decisions may be
classified into two broad categories:
(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.

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 MARGINAL COSTING 14.35

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 it
is 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 demand
for 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.

ILLUSTRATION 10
Moon Ltd. produces products 'X', 'Y' and 'Z' and has decided to analyse its production
mix in respect of these three products - 'X', 'Y' and 'Z'.
You have the following information:
X Y Z
Direct Materials ` (per unit) 160 120 80
Variable Overheads ` (per unit) 8 20 12
Direct labour:
Departments: Rate per Hour Hours per unit Hours per Hours per
(` ) unit unit
X Y Z
Department-A 4 6 10 5
Department-B 8 6 15 11

From the current budget, further details are as below :

X Y Z
Annual Production at present (in units) 10,000 12,000 20,000
Estimated Selling Price per unit (` ) 312 400 240
Sales departments estimate of possible sales in the coming 12,000 16,000 24,000
year (in units)

There is a constraint on supply of labour in Department-A and its manpower cannot

be increased beyond its present level.
Required:
(i) IDENTIFY the best possible product mix of Moon Ltd.
(ii) CALCULATE the total contribution from the best possible product mix.

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 14.36 COST AND MANAGEMENT ACCOUNTING

SOLUTION
(i) Statement Showing “Calculation of Contribution/ unit”

Particulars X Y Z
(`) (`) (`)
Selling Price (A) 312 400 240
Variable Cost:
Direct Material 160 120 80
Direct Labour
Dept. A (Rate x Hours) 24 40 20
Dept. B (Rate x Hours) 48 120 88
Variable Overheads 8 20 12
Total Variable Cost (B) 240 300 200
Contribution per unit (A - B) 72 100 40
Hours in Dept. A 6 10 5
Contribution per hour 12 10 8
Rank I II III

Existing Hours = 10,000 x 6hrs. + 12,000 x 10 hrs. + 20,000 x 5 hrs. = 2,80,000 hrs.
Best possible product mix (Allocation of Hours on the basis of ranking)
Produce ‘X’ = 12,000 units
Hours Required = 72,000 hrs (12,000 units × 6 hrs.)
Balance Hours Available = 2,08,000 hrs (2,80,000 hrs. – 72,000 hrs.)
Produce ‘Y’ (the Next Best) = 16,000 units
Hours Required = 1,60,000 hrs (16,000 units × 10 hrs.)
Balance Hours Available = 48,000 hrs (2,08,000 hrs. – 1,60,000 hrs.)
Produce ‘Z’ (balance) = 9,600 units (48,000 hrs./ 5 hrs.)
(ii) Statement Showing “Contribution”

Product Units Contribution/ Unit (`) Total Contribution (`)

X 12,000 72 8,64,000

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 MARGINAL COSTING 14.37

Y 16,000 100 16,00,000

Z 9,600 40 3,84,000
Total 28,48,000

ILLUSTRATION 11
ABC Limited produces and sells two product- X and Y. The product is highly
demanded in the market. Following information relating to both the products are
given as under :
Per Unit (`)
X Y
Direct Materials 140 180
Direct Wages 60 100
Variable Overheads (` 5 per machine hour) 20 40
Selling price 300 450
The company is facing scarcity of machine hours for working. The availability of
machine hours are limited to 60,000 hrs in a month. At present, the monthly demand
of product X and product Y is 8,000 units and 6,000 units respectively. The fixed
expenses of the company are ` 2,25,000 per month.
You are required to:
DETERMINE the product mix that generates maximum profit to the company in the
given situation and also CALCULATE the profit of the company.
SOLUTION
Workings -
Calculation of contribution (per unit)
X (`) Y (`)
Selling price (A) 300 450
Variable cost:
Direct materials 140 180
Direct wages 60 100
Variable overheads 20 40
Total Variable Cost (B) 220 320

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 14.38 COST AND MANAGEMENT ACCOUNTING

Contribution per unit (A-B) 80 130

Machine hours (MH) 4 8
Contribution per MH 20 16.25
Ranking I II

(i) Product mix to maximise the profit

Produce ‘X’ = 8,000 units
Hours Required = 32,000 hrs (8,000 units × 4 hrs.)
Balance Hours Available = 28,000 hrs (60,000 hrs. – 32,000 hrs.)
Produce ‘Y’ (balance) = 3,500 units (28,000 hrs./ 8 hrs.)
(ii) Profitability of the concern in the best Product mix
X (`) Y (`) Total (`)
Sales (in units) 8,000 units 3,500 units
Contribution per unit 80 130
Contribution 6,40,000 4,55,000 10,95,000
Less: Fixed cost 2,25,000
Profit 8,70,000

Short-term Decisions: Processing of Special Order

When the resources for production are excess in supply, demand for the products
becomes the limiting factor. Any additional demand for the product can earn an
additional contribution to recover fixed costs. Special orders are the orders which
are non-repetitive. Offers for special orders are accepted even if the offered price
covers the marginal cost (incremental cost) as it utilises the resources and can earn
additional profit. Some qualitative factors like the effect of the decision on the
existing customers or market, long term customer relationship, ethical and legal
impact etc. shall also be given due consideration.
ILLUSTRATION 12: Processing of Special Order
PQR Ltd. manufactures medals for winners of athletic events and other contests. Its
manufacturing plant has the capacity to produce 10,000 medals each month. The
company has current production and sales level of 7,500 medals per month. The
current domestic market price of the medal is ` 150.
The cost data for the month of August 2021 is as under:

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 MARGINAL COSTING 14.39

(` )

Variable costs:
- Direct materials 2,62,500
- Direct labour cost 3,00,000
- Overhead 75,000
Fixed manufacturing costs 2,75,000
Fixed marketing costs 1,75,000
10,87,500

PQR Ltd. has received a special one-time only order for 2,500 medals at ` 120 per
medal.
Required:
(i) Should PQR Ltd. accept the special order? Why? EXPLAIN briefly.
(ii) Suppose the plant capacity was 9,000 medals instead of 10,000 medals each
month. The special order must be taken either in full or rejected totally.
ANALYSE whether PQR Ltd. should accept the special order or not.
SOLUTION
In this question, the existing demand for the medals is 7,500 units per month
against the 10,000 units capacity. There is an idle capacity for 2,500 medals in a
month. Since, the capacity of the plant (supply) is more than the demand, any
additional order could increase the existing profit provided the offered price is
more than the marginal cost.
The existing cost and profit structure is as under:

Particulars Amount (`) Amount (`)

A. Selling price per unit 150.00
B. Variable Cost per unit:
- Direct material (` 2,62,500 ÷ 7,500 units) 35.00
- Direct labour (` 3,00,000 ÷ 7,500 units) 40.00
- Overhead (` 75,000 ÷ 7,500 units) 10.00 85.00
C. Contribution per unit (A-B) 65.00
D. Total Contribution (` 85 × 7,500 units) 4,87,500

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 14.40 COST AND MANAGEMENT ACCOUNTING

E. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
F. Profit (D-E) 37,500
(i) The offered price for the additional demand of 2,500 medals is more than the
variable cost per unit. Any additional demand will contribute towards fixed
costs and profit.

Particulars Amount Amount

(`) (`)
A. Sales Value {(` 150 × 7,500) + (` 120 × 2,500)} 14,25,000
B. Variable Cost (` 85 × 10,000) 8,50,000
C. Contribution (A-B) 5,75,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 1,25,000
The offer for 2,500 unit be accepted as it increases the profit by ` 87,500
(` 1,25,000 – ` 37,500).
(ii) In this instant case, the capacity to produce medals is decreased by 1,000 unit
per month and the existing demand for the medals is 7,500. The spare
capacity is for 1,500 medals only but the special demand is for 2,500 medals.
By accepting the offer, the company has to lose contribution on 1,000 medals
from existing customers. The offer will only be acceptable if the gain from the
new offer supersedes the loss from the existing customers.

Particulars Amount Amount

(`) (`)
A. Sales Value {(` 150 × 6,500) + (` 120 × 2,500)} 12,75,000
B. Variable Cost (` 85 × 9,000) 7,65,000
C. Contribution (A-B) 5,10,000
D. Fixed Costs:
- Fixed manufacturing costs 2,75,000
- Fixed marketing costs 1,75,000 4,50,000
E. Profit (C-D) 60,000

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 MARGINAL COSTING 14.41

By accepting the special order at ` 120 per unit, the total profit of the company is
increased by ` 22,500 (` 60,000 – ` 37,500) hence the order may be accepted,
however, other qualitative factors may also be taken care-off.
Short-term Decisions: Make or Buy
Make or Buy is a situation of decision making where it is to be decided whether the
product should be made using the own production facility or to be produced
outside by outsourcing or to buy from the market instead of making. This type of
situation arises when Demand for the product is more than the supply of resources
(material, men, machine etc.). The resource is limiting or key factor and decision is
made keeping optimum utilization of the key resource and the maximization of
profitability into consideration. However, as discussed earlier the qualitative factors
shall also be kept into consideration.
ILLUSTRATION 13: Make or Buy Decision
NN Ltd. manufactures automobiles accessories and parts. The following are the total
cost of processing 2,00,000 units:
Direct materials cost ` 375 per unit
Direct labour cost ` 80 per unit
Variable factory overhead ` 16 per unit
Fixed factory overhead ` 500 lakhs
The purchase price of the component is ` 485. The fixed overhead would continue to
be incurred even when the component is bought from outside.
REQUIRED:
(a) Should the part be made or bought from outside considering that the present
facility when released following a buying decision would remain idle?
(b) In case the released capacity can be rented out to another manufacturer for
` 32,00,000 having good demand. What should be the decision?
SOLUTION
The present cost structure is as follows:
Variable cost per unit is:

Direct materials cost ` 375

Direct labour cost ` 80

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 14.42 COST AND MANAGEMENT ACCOUNTING

Variable factory overhead ` 16

Total variable cost per unit ` 471
The fixed cost of ` 500 lakhs is irrelevant for decision making as it would incur in
either case.
(a) The decision shall be made comparing the marginal cost of making and
buying the component.
Here the variable cost of making the component is ` 471 as compared to
buying cost of ` 485. The component shall be made by using own production
facility as it would save the company ` 14 per unit.
(b) If by releasing the production facility the company can earn a rental income
of ` 32,00,000, then the additional cost of buying from outside and the rental
income from releasing the capacity shall be compared for making decision.

(i) Rental income ` 32,00,000

(ii) Additional cost of buying (` 14 × 2,00,000 units) ` 28,00,000
Additional Income {(i)-(ii)} ` 4,00,000
The component should be bought from outside as it would save the company
` 4,00,000 in fixed cost.
ILLUSTRATION 14
A company can make any one of the 3 products X, Y or Z in a year. It can exercise its
option only at the beginning of each year.
Relevant information about the products for the next year is given below.
X Y Z
Selling Price (` / unit) 10 12 12
Variable Costs (` / unit) 6 9 7
Market Demand (unit) 3,000 2,000 1,000
Production Capacity (unit) 2,000 3,000 900
Fixed Costs (`) 30,000

Required
COMPUTE the opportunity costs for each of the products.

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 MARGINAL COSTING 14.43

SOLUTION

X Y Z

I. Contribution per unit (`) 4 3 5

II. Units (Lower of Production / Market Demand) 2,000 2,000 900
III. Possible Contribution (`) [ I × II ] 8,000 6,000 4,500
IV. Opportunity Cost* (`) 6,000 8,000 8,000

(*) Opportunity cost is the maximum possible contribution forgone by not producing
alternative product i.e. if Product X is produced then opportunity cost will be maximum of
(` 6,000 from Y, ` 4,500 from Z).

ILLUSTRATION 15
M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per
unit and the variable cost is ` 16 per unit.
(i) If the Fixed Costs for this year are ` 4,80,000 and the annual sales are at 60%
margin of safety, CALCULATE the rate of net return on sales, assuming an
income tax level of 40%
(ii) For the next year, it is proposed to add another product line Y whose selling
price would be ` 50 per unit and the variable cost ` 10 per unit. The total fixed
costs are estimated at ` 6,66,600. The sales mix values of X : Y would be 7 : 3.
DETERMINE at what level of sales next year, would M.K. Ltd. break even? Give
separately for both X and Y the break-even sales in rupee and quantities.
SOLUTION
(i) Contribution per unit = Selling price – Variable cost
= `40 – `16 = `24
` 4,80,000
Break-even Point = = 20,000 units
`24
Actual Sales – Break - even Sales
Percentage Margin of Safety =
Actual Sales

Actual Sales – 20,000units

Or, 60% =
Actual Sales

∴ Actual Sales = 50,000 units

© The Institute of Chartered Accountants of India

 14.44 COST AND MANAGEMENT ACCOUNTING

(`)
Sales Value (50,000 units × `40) 20,00,000
Less: Variable Cost (50,000 units × `16) 8,00,000
Contribution 12,00,000
Less: Fixed Cost 4,80,000
Profit 7,20,000
Less: Income Tax @ 40% 2,88,000
Net Return 4,32,000
 ` 4,32,000 
Rate of Net Return on Sales = 21.6%  ×100 
 `20,00,000 

(ii) Products

X Y
(`) (`)
Selling Price 40 50
Less: Variable Cost 16 10
Contribution per unit 24 40
Sales Ratio 7 3
Contribution in sales Ratio 168 120

Based on Weighted Contribution

24 ×7 + 40 ×3
Weighted Contribution = = ` 28.8 per unit
10
Total Fixed Cost 6,66,600
Total Break-even Point = = = 23,145.80 units
Weighted Cost 28.80

Break-even Point
7
X = ×23,145.80 = 16,202 units
10
or 16,202 × ` 40 = ` 6,48,080
3
Y = ×23,145.80 = 6,944 units or 6,944 × ` 50 =` 3, 47,200
10

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Based on distributing fixed cost in the weighted Contribution Ratio

Fixed Cost
168
X = ×6,66,600 = ` 3,88,850
288
120
Y = ×6,66,600 = ` 2,77,750
288
Break-even Point
Fixed Cost 3,88,850
X = = = 16,202 units or ` 6, 48,000
Contribution per unit 24
Fixed Cost 2,77,750
Y = = = 6,944 units or ` 3, 47,200
Contribution per unit 40
ILLUSTRATION 16
X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of
X Ltd. facilitates production of any one spare part for a particular period of time. The
following are the cost and other information for the production of the two different
spare parts A and B:
Part A Part B
Per unit
Alloy usage 1.6 kgs. 1.6 kgs.
Machine Time: Machine P 0.6 hrs 0.25 hrs.
Machine Time: Machine Q 0.5 hrs. 0.55 hrs.
Target Price (`) 145 115
Total hours available Machine P 4,000 hours
Machine Q 4,500 hours

Alloy available is 13,000 kgs. @ ` 12.50 per kg.

Variable overheads per machine hours Machine P: ` 80
Machine Q: ` 100
Required
(i) IDENTIFY the spare part which will optimize contribution at the offered price.
(ii) If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine
hour, CALCULATE the total contribution from the spare part identified above?

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 14.46 COST AND MANAGEMENT ACCOUNTING

SOLUTION
(i)

Part A Part B
Machine “P” (4,000 hrs) 6,666 16,000
Machine “Q” (4,500 hrs) 9,000 8,181
Alloy Available (13,000 kg.) 8,125 8,125
Maximum Number of Parts to be manufactured 6,666 8,125
(Minimum of the above three)

(`) (`)
Material (`12.5 × 1.6 kg.) 20.00 20.00
Variable Overhead: Machine “P” 48.00 20.00
Variable Overhead: Machine “Q” 50.00 55.00
Total Variable Cost per unit 118.00 95.00
Price Offered 145.00 115.00
Contribution per unit 27.00 20.00
Total Contribution for units produced …(I) 1,79,982 1,62,500
Spare Part A will optimize the contribution.
(ii)
Part A
Parts to be manufactured numbers 6,666
Machine P : to be used 4,000
Machine Q : to be used 3,333
Underutilized Machine Hours (4,500 hrs. – 3,333 hrs.) 1,167
Compensation for unutilized machine hours (1,167hrs. × `60) (II) 70,020
Reduction in Price by 10%, Causing fall in Contribution of `14.50 96,657
per unit (6,666 units × `14.5) (III)
Total Contribution (I + II – III) 1,53,345

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ILLUSTRATION 17
The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the
relevant figures are as under:
Sales……………………………………………………………… ` 5,00,000
Direct Materials………………………………………………… ` 2,50,000
Direct Labour…………………………………………………….. ` 1,00,000
Variable Overheads…………………………………………… ` 40,000
Capital Employed……………………………………………… ` 4,00,000
The new Sales Manager who has joined the company recently estimates for next year
a profit of about 23% on capital employed, provided the volume of sales is increased
by 10% and simultaneously there is an increase in Selling Price of 4% and an overall
cost reduction in all the elements of cost by 2%.
Required
FIND OUT by computing in detail the cost and profit for next year, whether the
proposal of Sales Manager can be adopted.
SOLUTION
Statement Showing “Cost and Profit for the Next Year”
Particulars Existing Volume, Costs, Estimated Sale,
Volume, etc. after 10% Cost, Profit,
etc. Increase etc.*
(`) (`) (`)
Sales 5,00,000 5,50,000 5,72,000
Less: Direct Materials 2,50,000 2,75,000 2,69,500
Direct Labour 1,00,000 1,10,000 1,07,800
Variable Overheads 40,000 44,000 43,120
Contribution 1,10,000 1,21,000 1,51,580
Less: Fixed Cost# 60,000 60,000 58,800
Profit 50,000 61,000 92,780
(*) for the next year after increase in selling price @ 4% and overall cost reduction by 2%.
(#) Fixed Cost = Existing Sales – Existing Marginal Cost – 12.5% on `4,00,000
= `5,00,000 – `3,90,000 – `50,000 =
`60,000
 `92,780 
Percentage Profit on Capital Employed equals to 23.19%  x 100 
 ` 4,00,000 
Since the Profit of `92,780 is more than 23% of capital employed, the proposal of
the Sales Manager can be adopted.

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 14.48 COST AND MANAGEMENT ACCOUNTING

14.14 DISTINCTION BETWEEN MARGINAL AND

ABSORPTION COSTING
The distinctions in these two techniques are illustrated by the following diagrams:

Absorption Costing Approach

Marginal Costing Approach

14.14.1 The main points of distinction between marginal costing and
absorption costing are as below:

Marginal costing Absorption costing

1. Only variable costs are Both fixed and variable costs are
considered for product costing considered for product costing and
and inventory valuation. inventory valuation.
2. Fixed costs are regarded as Fixed costs are charged to the cost of
period costs. The Profitability production. Each product bears a

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 MARGINAL COSTING 14.49

of different products is judged reasonable share of fixed cost and thus the
by their P/V ratio. profitability of a product is influenced by the
apportionment of fixed costs.
3. Cost data presented highlight Cost data are presented in conventional
the total contribution of each pattern. Net profit of each product is
product. determined after subtracting fixed cost
along with their variable costs.
4. The difference in the magnitude The difference in the magnitude of
of opening stock and closing opening stock and closing stock affects
stock does not affect the unit the unit cost of production due to the
cost of production. impact of related fixed cost.
5. In case of marginal costing the In case of absorption costing the cost per
cost per unit remains the same, unit reduces, as the production increases
irrespective of the production as it is fixed cost which reduces, whereas,
as it is valued at variable cost the variable cost remains the same per
unit.

14.14.2 Difference in profit under Marginal and Absorption costing

The above two approaches will compute the different profit because of the
difference in the stock valuation. This difference is explained as follows in different
circumstances.
1. No opening and closing stock: In this case, profit / loss under absorption
and 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 both
the 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 value
is 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 goods
sold in the form of opening stock.

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 14.50 COST AND MANAGEMENT ACCOUNTING

The presentation of information to management under the two costing techniques

is as under:
Income Statement (Absorption costing)

(` )
Sales XXXXX
Production Costs:
Direct material consumed XXXXX
Direct labour cost XXXXX
Variable manufacturing overhead XXXXX
Fixed manufacturing overhead XXXXX
Cost of Production XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period’s production)
XXXXX
Less: Closing stock of finished goods XXXXX
(Value at production cost of current period) .
Cost of Goods Sold XXXXX
Add: (or less) Under (or over) absorption of fixed
Manufacturing overhead XXXXX
Add: Administration costs XXXXX
Selling and distribution costs XXXXX XXXXX
Total Cost XXXXX
Profit (Sales – Total cost) XXXXX
Income Statement (Marginal costing)

(` )
Sales XXXXX
Variable manufacturing costs:
– Direct material consumed XXXXX
– Direct labour XXXXX

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 MARGINAL COSTING 14.51

– Variable manufacturing overhead XXXXX

Cost of Goods Produced XXXXX
Add: Opening stock of finished goods XXXXX
(Value at cost of previous period)
Less: Closing stock of finished goods (Value at current variable
cost)
Cost of Goods Sold XXXXX
Add: Variable administration, selling and dist. overhead XXXXX
Total Variable Cost XXXXX
Add: Selling and distribution costs
Contribution (Sales – Total variable costs) XXXXX
Less: Fixed costs (Production, admin., selling and dist.) XXXXX
Net Profit XXXXX

It is evident from the above that under marginal costing technique the
contributions of various products are pooled together and the fixed overheads are
met out of such total contribution. The total contribution is also known as gross
margin. The contribution minus fixed expenses yields net profit. In absorption
costing technique cost includes fixed overheads as well.
ILLUSTRATION 18
Wonder Ltd. manufactures a single product, ZEST. The following figures relate to ZEST
for a one-year period:

Activity Level 50% 100%

Sales and production (units) 400 800
(`) (`)
Sales 8,00,000 16,00,000
Production costs:
- Variable 3,20,000 6,40,000
- Fixed 1,60,000 1,60,000
Selling and distribution costs:
- Variable 1,60,000 3,20,000
- Fixed 2,40,000 2,40,000

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 14.52 COST AND MANAGEMENT ACCOUNTING

The normal level of activity for the year is 800 units. Fixed costs are incurred evenly
throughout the year, and actual fixed costs are the same as budgeted. There were no
stocks of ZEST at the beginning of the year.
In the first quarter, 220 units were produced and 160 units were sold.
Required:
(a) COMPUTE the fixed production costs absorbed by ZEST if absorption costing is
used?
(b) CALCULATE the under/over-recovery of overheads during the period?
(c) CALCULATE the profit using absorption costing?
(d) CALCULATE the profit using marginal costing?
SOLUTION
(a) Fixed production costs absorbed: (` )
Budgeted fixed production costs 1,60,000
Budgeted output (normal level of activity 800 units)
Therefore, the absorption rate: 1,60,000/800 = ` 200 per unit
During the first quarter, the fixed production
cost absorbed by ZEST would be (220 units × ` 200) 44,000
(b) Under /over-recovery of overheads during the period: (` )
Actual fixed production overhead 40,000
(1/4 of ` 1,60,000)
Absorbed fixed production overhead 44,000
Over-recovery of overheads 4,000
(c) Profit for the Quarter (Absorption Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
- Fixed overheads absorbed (220 units × ` 200) 44,000 2,20,000
Add: Opening stock --

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 MARGINAL COSTING 14.53

 `2,20,000  (60,000)
Less: Closing Stock  ×60units 
 220units 
Cost of Goods sold 1,60,000
Less: Adjustment for over-absorption of fixed (4,000)
production overheads
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
- Fixed (1/4 of ` 2,40,000)
th
60,000 1,24,000
Cost of Sales (B) 2,80,000
Profit {(A) – (B)} 40,000

(d) Profit for the Quarter (Marginal Costing)

(`) (`)
Sales revenue (160 units × ` 2,000): (A) 3,20,000
Less: Production costs:
- Variable cost (220 units × ` 800) 1,76,000
Add: Opening stock --
 `1,76,000  (48,000)
Less: Closing Stock  ×60units 
 220units 
Variable cost of goods sold 1,28,000
Add: Selling & Distribution Overheads:
- Variable (160 units × `400) 64,000
Cost of Sales (B) 1,92,000
Contribution {(C) = (A) – (B)} 1,28,000
Less: Fixed Costs:
- Production cost (40,000)
- Selling & distribution cost (60,000) (1,00,000)
Profit 28,000

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 14.54 COST AND MANAGEMENT ACCOUNTING

SUMMARY
♦ Marginal Cost: Marginal cost as understood in economics is the incremental
cost of production which arises due to one-unit increase in the production
quantity. Marginal cost is measured by the total variable cost attributable to
one unit.
♦ 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.
♦ Absorption Costing: A method of costing by which all direct cost and
applicable overheads are charged to products or cost centers for finding out
the total cost of production. Absorbed cost includes production cost as well as
administrative and other cost.
♦ Contribution: Contribution or contribution margin is the difference between
sales revenue and total variable costs irrespective of manufacturing or non-
manufacturing.
♦ Cost-Volume-Profit (CVP) Analysis: It is an analysis of reciprocal effect of
changes in cost, volume and profitability. Such an analysis explores the
relationship between costs, revenue, activity levels and the resulting profit. It
aims at measuring variations in cost and volume.
♦ Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio): This ratio
shows the proportion of sales available to cover fixed costs and profit.
Contribution represent the sales revenue after deducting variable costs.
♦ Break-even Point (BEP): The level of sales where an entity neither earns profit
nor incurs loss. BEP is indicated in both quantity and monetary value terms.
♦ Margin of Safety (MOS): The margin between sales and the break-even sales
is known as margin of safety. It can either be indicated in quantitative or
monetary terms.
♦ 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
profits is earned once the break-even point is reached.
♦ Limiting (Key) 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
it is also known as Key factor.

© The Institute of Chartered Accountants of India

CHAPTER 15

BUDGETS & BUDGETARY

CONTROL
LEARNING OUTCOMES
 State the meaning of budget and budgetary control
 Essentials of budget.
 Discuss the objectives and importance of budget and
budgetary control.
 Describe the process of preparing budgets.
 List the different types of budgets.
 Differentiate between fixed and flexible budget.
 Prepare fixed and flexible budget.

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 15.2 COST AND MANAGEMENT ACCOUNTING

Essentials of Budget
Capacity-wise
Objectives of
Budget & Budgetary Control Budgeting
Functions-wise
Types of Budgets
Period-wise
Zero-based
Budgeting (ZBB)
Master Budget
Performance
Budgeting

Budget Ratio

15.1
15 INTRODUCTION
Budget, budgeting, budgetary control and standard costing are essential tools
frequently used by business executives for the purpose of planning, execution and
control of business activities. In the case of budgetary control, the exercise starts
with the setting up of budgets or targets, measuring achievements, comparing
actual achievements with budget and ends with the taking remedial actions, in case
the actual figures differ with the budgetary ones.
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. The Chartered Institute of
Management Accountants (CIMA) UK defines budget as “A financial and/or
quantitative statement, prepared and approved prior to a defined period of time
of 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 and 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.

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 BUDGETS AND BUDGETARY CONTROL 15.3

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.

15.2 ESSENTIAL CHARACTERISTICS OF BUDGET

15.
The main characteristics of budget are as follows:
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
preparation of a business budget.
5. Budget is a mean to achieve business objectives and it is not an end in
itself.
6. Budget needs to be updated, corrected and controlled every time
circumstances change. Therefore, it is a continuous process.
7. Budget helps in planning, coordination and control.
8. Different types of budgets are prepared by industries according to
business requirements.
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.

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 15.4 COST AND MANAGEMENT ACCOUNTING

15.3 ESSENTIAL STEPS FOR PREPARING BUDGET

15.
Essential steps for preparing a budget are as follows:
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 down
into 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.

15.4 OBJECTIVES OF BUDGETING

Planning:
Planning is the beginning of any activity. Planning establishes the objectives of the
firm and decides the course of action to achieve it. It is concerned with formulating
short-term and long-term plans to achieve a particular end. Planning is a statement
of what should be done, how it should be done and when it should be done. The
process of preparing budget begins with the establishment of specific targets of
performance and is followed by devising plans to achieve such desired goals.
These targets include both the overall business targets as well as the specific
targets for the individual units within the business. Establishing specific targets for
future operations is part of the planning function of management, while executing

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 BUDGETS AND BUDGETARY CONTROL 15.5

actions to meet the goals is the directing function of management. It may be

explained as
• 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
companies to reduce expenses during business recession.
• Planning not only motivates employees to attain goals but also improves
overall decision making. During the planning phase of the budget process,
all viewpoints are considered, options identified, and cost reduction
opportunities assessed. This process may reveal opportunities or threats that
were not known prior to the budget planning process.
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
actual results to ensure that a firm’s goals and plans are achieved. Control is
achieved through the process of feedback.

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 15.6 COST AND MANAGEMENT ACCOUNTING

• 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 centre
is 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 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.
The main objective of Budgeting is to help in achieving the overall objective
of the organization.

15.5 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.
15.5.1 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.
15.5.2 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 will

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 BUDGETS AND BUDGETARY CONTROL 15.7

be 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.
15.5.3 The steps for establishing budgetary control
The following steps are necessary for establishing a good budgetary control
system:
1. Determining the objectives to be achieved, over the budget period, and
the policy or policies that might be adopted for the achievement of these
objectives.
2. Determining the activities that should be undertaken for the achievement
of 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,
or department with the relevant budget and determination of causes for the
variation, if any.

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 15.8 COST AND MANAGEMENT ACCOUNTING

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.
In brief, it is a system to assist management in the allocation of responsibility and
authority, to provide it with aid for making, estimating and planning for the future
and to facilitate the analysis of the variation between estimated and actual per-
formance.
In order to ensure effective functioning of budgetary control, it is necessary that
the firm should develop a proper basis of measurement or standards with which
to evaluate the efficiency of operations, i.e., the firm should have in operation, a
system of standard costing.
The organisation should be so integrated that all lines of authority and
responsibility are properly defined. This is essential since the system of budgetary
control postulates separation of functions and division of responsibilities and thus
requires that the organisation shall be planned in such a manner that everyone,
from the Managing Director down to the Shop Foreman, will have his duties
properly defined.
15.5.4 Budget Committee and Budget Officer
The budget committee is a group of representatives of various functions in an
organisation. As all functions are inter-related and as any change in one’s target
will have its impact on that of the other, it is necessary to discuss the targets so
that a mutually agreed programme is finally decided. 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 responsibility for successfully introducing and implementing Budgetary
Control System rests with the Budget Committee acting through the Budget
Officer. The Budget Committee would be composed of all functional heads and a
member from the Board to preside over and guide the deliberations.
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

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 BUDGETS AND BUDGETARY CONTROL 15.9

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 them
in 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 Budget
Committee 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.
It is necessary that every budget should be thoroughly discussed with the
functional heads before it is finalised.
It is the duty of the Budget Officer to see that the periodical budget reports are
supplied to the recipients at regular intervals so as to enable them to take remedial
action.
The efficiency of the Budget Officer, and through him of the Budget Committee,
will be judged more by the smooth working of the system and the agreement
between the actual figures and the budgeted figures.
Budgets provides basis for giving an incentive for better performance, ; It is up to
the Budget Officer to see that attention of the different functional heads is drawn
to the deviations so as to face the challenge in a successful manner.
15.5.5 Advantages of Budgetary Control System
Points Description
1. Efficiency The use of budgetary control system enables
the management of a business entity to
conduct its business activities in an efficient
manner.
2. Control on expenditure It is a powerful instrument used by business
entity for the control of their expenditure. It
provides a yardstick for measuring and

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 15.10 COST AND MANAGEMENT ACCOUNTING

evaluating the performance of individuals and

their departments.
3. Finding deviations Budget reveals the deviations of the actual
from the budgeted figures after making a
comparison and communicating the deviation
to management.
4. Effective utilisation of Effective utilisation of various resources like—
resources 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
and framing of future policies.
6. Implementation of Budget creates suitable conditions for the
Standard Costing implementation of standard costing system in
system a business organisation.
7. Cost Consciousness Budgetary control system encourages cost
consciousness and maximum utilisation of
available resources.
8. Credit Rating Management which have developed a well
ordered budget plans and which operate
accordingly, receive greater favour from credit
agencies.

15.5.6 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 expected
at the time budget is established. It requires
revision in plan if conditions change.
2. Time factor Budgets cannot be executed automatically. Some
preliminary steps are required to be accomplished
before budgets are implemented. It requires
proper attention and time of management.
Management must not expect too much during the
initial development period.

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 BUDGETS AND BUDGETARY CONTROL 15.11

3. Co-operation Staff co-operation is usually not available during

Required the initial budgetary control exercise. In a
decentralised organisation, each unit has its own
objective and these units enjoy some degree of
discretion. In this type of organisation structure,
coordination among different units is required. The
success of the budgetary control depends upon
willing co-operation and teamwork,
4. Expensive The implementation of budget is somewhat
expensive. For successful implementation of the
budgetary control, proper organisation structure
with responsibility is prerequisite. Budgeting
process start from the collection of information to
for 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
management intelligently applied for management to get
benefited. Budgets are not a substitute for good
management.
6. Rigid document Budgets are sometime considered as rigid
documents. But in reality, an organisation is exposed
to various uncertain internal and external factors.
Budget should be flexible enough to incorporate
ongoing developments in the internal and external
factors affecting the very purpose of the budget.

15.5.7 Components of Budgetary Control System

The policy of a business for a defined period is represented by the master
budget, the detailed components of which are given in a number of individual
budgets called functional budgets. These functional budgets are broadly
grouped under the following heads:
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.

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 15.12 COST AND MANAGEMENT ACCOUNTING

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.

15.6 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 should
be 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 production
on 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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 BUDGETS AND BUDGETARY CONTROL 15.13

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.”
Effective budgetary planning relies on the provision of adequate information
to the individuals involved in the planning process. Many of these
information needs are contained in the budget manual. A budget manual is
a collection of 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 late
preparation of one budget holding up the preparation of all others.

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 15.14 COST AND MANAGEMENT ACCOUNTING

(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 how
to use them.
(xiv) Information concerning key assumptions to be made by managers in
their 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-terminus with 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 changes
on sales, the provision for advertisement campaign plan capacity etc.

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 BUDGETS AND BUDGETARY CONTROL 15.15

15.7 DIFFERENT TYPES OF BUDGETS

15.7.1 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: A budget prepared on the basis of standard or fixed level of
activity is known as fixed budget. It does not change with a change in the level of
activities. 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.

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 15.16 COST AND MANAGEMENT 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 in
respect of service export, where fairly regular export orders are received
6. There is no need of special labour or material in the production of the
products.
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 not
suitable 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
2. Less time consuming and may give misleading results. A poor
or 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: A flexible budget is a budget which, by recognising the

difference in behaviour between fixed and variable costs in relation to fluctuations in
output, turnover, or other variable factors, is designed to change appropriately with
such fluctuations. According to CIMA, “a flexible budget is defined as a budget
which, by recognizing the difference between fixed, semi-variable and

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 BUDGETS AND BUDGETARY CONTROL 15.17

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:
(i) In the case of new business venture, due to its typical nature, it may be
difficult to forecast the demand of a product accurately.
(ii) 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 the
weather is relatively warm.
(iii) 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 in
the 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.

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 15.18 COST AND MANAGEMENT ACCOUNTING

Merits and Demerits of flexible budgets are tabulated below:

Merits Demerits
1. With the help of flexible budget, the 1. The formulation of flexible
sales, costs and profit may be budget is possible only when
calculated easily by the business at there is proper accounting
various levels of production capacity. system maintained, perfect
2. In flexible budget, adjustment is very knowledge about the factors of
simple according to change in production and various
business conditions. business circumstances is
3. It also helps in determination of available.
production level as it shows 2. Flexible Budget also requires
budgeted costs with classification at the system of standard costing
various levels of activity along with in business.
sales. Hence the management can 3. It is very expensive and labour
easily select the level of production oriented.
which shows the profit
predetermined by the owners of the
business.
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 actual It can be re-casted on the basis of
volume of activity achieved. activity level to be achieved. Thus it is
Thus it is known as rigid or not rigid.
inflexible budget.
2. It operates on one level of It consists of various budgets for
activity and under one set of different levels of activity.
conditions. It assumes that
there will be no change in the
prevailing conditions, which
is unrealistic.
3. Here as all costs like - fixed, Here analysis of variance provides
variable and semi-variable useful information as each cost is
are related to only one level analysed according to its behaviour.

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 BUDGETS AND BUDGETARY CONTROL 15.19

of activity so variance analysis

does not give useful
information.
4. If the budgeted and actual Flexible budgeting at different levels
activity levels differ of activity facilitates the
significantly, then the aspects ascertainment of cost, fixation of
like cost ascertainment and selling price and tendering of
price fixation do not give a quotations.
correct picture.
5. Comparison of actual It provides a meaningful basis of
performance with budgeted comparison of the actual
targets will be meaningless performance with the budgeted
specially when there is a targets.
difference between the two
activity levels.

ILLUSTRATION 1
A factory which expects to operate 7,000 hours, i.e., at 70% level of activity, furnishes
details of expenses as under:
Variable expenses `1,260
Semi-variable expenses `1,200
Fixed expenses `1,800
The semi-variable expenses go up by 10% between 85% and 95% activity and by
20% above 95% activity. PREPARE a flexible budget for 80, 90 and 100 per cent
activities.
SOLUTION

Head of Account Control basis 70% 80% 90% 100%

Budgeted hours 7,000 8,000 9,000 10,000

(`) (`) (`) (`)
Variable expenses Variable 1,260 1,440 1,620 1,800
Semi-variable expenses Semi-variable 1,200 1,200 1,320 1,440
Fixed expenses Fixed 1,800 1,800 1,800 1,800
Total expenses 4,260 4,440 4,740 5,040

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 15.20 COST AND MANAGEMENT ACCOUNTING

Recovery rate per hour:

Total expenses/Bud hours 0.61 0.55 0.53 0.50

Conclusion:
We notice that the recovery rate at 70% activity is ` 0.61 per hour. If in a particular
month the factory works 8,000 hours, it will be incorrect to estimate the allowance
as `4,880 @ `0.61. The correct allowance will be `4,440 as shown in the table. If
the actual expenses are `4,500 for this level of activity, the company has not saved
any money but has over-spent by `60 (`4,500 – `4,440).
ILLUSTRATION 2:
A department of Company X attains sale of ` 6,00,000 at 80 per cent of its normal
capacity and its expenses are given below:
Administration costs: (`)
Office salaries 90,000
General expenses 2 per cent of sales
Depreciation 7,500
Rates and taxes 8,750
Selling costs:
Salaries 8 per cent of sales
Travelling expenses 2 per cent of sales
Sales office expenses 1 per cent of sales
General expenses 1 per cent of sales
Distribution costs:
Wages 15,000
Rent 1 per cent of sales
Other expenses 4 per cent of sales
PREPARE flexible administration, selling and distribution costs budget, operating at
90 per cent, 100 per cent and 110 per cent of normal capacity.

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 BUDGETS AND BUDGETARY CONTROL 15.21

SOLUTION
Flexible Budget of Department....of Company ‘X’
80% (`) 90% (`) 100%(`) 110%(`)

Sales 6,00,000 6,75,000 7,50,000 8,25,000

Administration Costs:
Office Salaries (fixed) 90,000 90,000 90,000 90,000
General expenses (2% of Sales) 12,000 13,500 15,000 16,500
Depreciation (fixed) 7,500 7,500 7,500 7,500
Rent and rates (fixed) 8,750 8,750 8,750 8,750
(A) Total Adm. Costs 1,18,250 1,19,750 1,21,250 1,22,750
Selling Costs:
Salaries (8% of sales) 48,000 54,000 60,000 66,000
Travelling expenses (2% of sales) 12,000 13,500 15,000 16,500
Sales office (1% of sales) 6,000 6,750 7,500 8,250
General expenses (1% of sales) 6,000 6,750 7,500 8,250
(B) Total Selling Costs 72,000 81,000 90,000 99,000
Distribution Costs:
Wages (fixed) 15,000 15,000 15,000 15,000
Rent (1% of sales) 6,000 6,750 7,500 8,250
Other expenses (4% of sales) 24,000 27,000 30,000 33,000
(C) Total Distribution Costs 45,000 48,750 52,500 56,250
Total Costs (A + B + C) 2,35,250 2,49,500 2,63,750 2,78,000

Note: In the absence of information it has been assumed that office salaries,
depreciation, rates and taxes and wages remain the same at 110% level of activity
also. However, in practice some of these costs may change if present capacity is
exceeded.
ILLUSTRATION 3
Action Plan Manufacturers normally produce 8,000 units of their product in a month,
in their Machine Shop. For the month of January, they had planned for a production
of 10,000 units. Owing to a sudden cancellation of a contract in the middle of
January, they could only produce 6,000 units in January.

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 15.22 COST AND MANAGEMENT ACCOUNTING

Indirect manufacturing costs are carefully planned and monitored in the Machine
Shop and the Foreman of the shop is paid a 10% of the savings as bonus when in
any month the indirect manufacturing cost incurred is less than the budgeted
provision.
The Foreman has put in a claim that he should be paid a bonus of ` 88.50 for the
month of January. The Works Manager wonders how anyone can claim a bonus when
the Company has lost a sizeable contract. The relevant figures are as under:

Indirect manufacturing Expenses for a Planned for Actual in costs

normal month January January
(` ) (` ) (` )
Salary of foreman 1,000 1,000 1,000
Indirect labour 720 900 600
Indirect material 800 1,000 700
Repairs and maintenance 600 650 600
Power 800 875 740
Tools consumed 320 400 300
Rates and taxes 150 150 150
Depreciation 800 800 800
Insurance 100 100 100
5,290 5,875 4,990

Do you agree with the Works Manager? Is the Foreman entitled to any bonus for the
performance in January? Substantiate your answer with facts and figures. EXPLAIN.
SOLUTION
Flexible Budget of “Action Plan Manufacturers”
(for the month of January)
Indirect Nature Expenses Planned Expenses Actual Difference
manufacturing of cost for a expenses as per expenses
cost normal flexible
month budget
(`) (`) (`) (`) (`)
(1) (2) (3) (4) (5) (6)=(5)–
(4)
Salary of foreman Fixed 1,000 1,000 1,000 1,000 Nil

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 BUDGETS AND BUDGETARY CONTROL 15.23

Indirect labour Variable 720 900 540 600 60

(WN 1)
Indirect material Variable 800 1,000 600 700 100
(WN 2)
Repair and Semi- 600 650 550 600 50
maintenance variable
(WN 3)
Power (WN 4) Semi- 800 875 725 740 15
variable
Tools consumed Variable 320 400 240 300 60
(WN 5)
Rates and taxes Fixed 150 150 150 150 Nil
Depreciation Fixed 800 800 800 800 Nil
Insurance Fixed 100 100 100 100 Nil
5,290 5,875 4,705 4,990 285

Conclusion: The above statement of flexible budget shows that the concern’s
expenses in the month of January have increased by `285 as compared to flexible
budget. Under such circumstances, assuming the expenses are controllable and
based on the financial perspective the Foreman of the company should not be
entitled for any performance bonus for the month of January.
Working notes:
` 720
1. Indirect labour cost per unit = ` 0.09
8,000
Indirect labour for 6,000 units = 6,000 × ` 0.09 = `540.
`800
2. Indirect material cost per unit = `0.10
8,000
Indirect material for 6,000 units = 6,000 × `0.10 = `600
3. According to high and low point method of segregating semi-variable cost
into fixed and variable components, following formulae may be used.
Change in expense level
Variable cost of repair and maintenance per unit=
Change in output level

`650 -` 600
= = ` 0.025
2,000

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 15.24 COST AND MANAGEMENT ACCOUNTING

For 8,000 units

Total Variable cost of repair and maintenance = `200
Fixed repair & maintenance cost = `400
Hence at 6,000 units output level, total cost of repair and maintenance
should be
= ` 400 + ` 0.025 × 6,000 units= `400 + ` 150 = ` 550
`875-`800
4. Variable cost of power per unit = = 0.0375
2,000 units
For 8,000 units
Total variable cost of power = `300
Fixed cost = `500
Hence, at 6,000 units output level, total cost of power should be
= `500 + `0.0375 × 6,000 units = `500 + `225 =`725
5. Tools consumed cost for 8,000 units = `320
Hence, tools consumed cost for 6,000 units = (`320/8,000 units) × 6,000 units
= `240
15.7.2 Classification on the basis of Function
A functional budget is one which is related to function of the business as
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 types of functional budgets to be prepared will vary according to
the size and nature 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

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 BUDGETS AND BUDGETARY CONTROL 15.25

(vi) Direct-labour (personnel) budget

(vii) 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. In
any 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:
1. the quantity of estimated sales and
2. 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

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 15.26 COST AND MANAGEMENT ACCOUNTING

(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 sales budget represents the total sales
in physical quantities and values for a future budget period. Sales
managers are constantly faced with problems like anticipation of
customer requirements, new product needs, competitor strategies and
various changes in distribution methods or promotional techniques.
• 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 competitive
situation.
• A good budget hinges on aggressive management control rather than
on 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.
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)
Home sales, (iv) Retail depots.

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 BUDGETS AND BUDGETARY CONTROL 15.27

4. Period—months, weeks, etc.

The illustrative format of a sales budget is as under :
Last Year Budgeted Northern Southern Central
Total Year Total Region Region Region
Qty. Value Qty. Value Qty. Value Qty. Value Qty. Value
Product X
1st 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
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. Production budget shows the production for
the budget period based upon:
1. Sales budget,
2. Production capacity of the factory,
3. Planned increase or decrease in finished stocks, and

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 15.28 COST AND MANAGEMENT ACCOUNTING

4. Policy governing outside purchase.

Production budget is normally stated in units of output. Production
should be carefully coordinated with the sales budget to ensure that pro-
duction and sales are kept in balance during the period. 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
season to cater to the peak season,
2. A steady and uniform level of production to utilise the plant fully and
to avoid retrenchment or lay-off of the workers, and
3. To produce in such a way that minimum stocks are maintained at any
time to avoid locking up of funds in inventory.
• 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.

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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:
1. To determine the load on each process, cost or groups of machines for
the budget period.
2. 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.
3. To dovetail the sales production budgets where it is not possible to
increase the capacity of any of the overloaded processes.
4. 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:
1. The quality standards for each item of material have to be specified. In
this connection, standardisation of size, quality, colour, etc., may be
considered.
2. Standard requirement of each item of materials required should also
be set. While setting the standard quality, consideration should be

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 15.30 COST AND MANAGEMENT ACCOUNTING

given to normal loss in process. The standard allowance for normal loss
may be given on the basis of past performance, test runs, technical
estimates etc.
3. 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.
Example of direct material usage budget is as under:
XYZ COMPANY
Direct material usage in units and in amount
for the year ending March 31, 20...
Direct Materials
Type of material Product A Product B Total direct Material Total cost

(4,000 units) (9,000 units) material cost per of material

usage (Units) unit (`) used (`)

X (12 units per

finished product) 48,000 1,08,000 1,56,000 1.50 2,34,000

Y (4 units per

product A & 2

units per product B) 16,000 18,000 34,000 2.50 85,000

Total 3,19,000

(v) Purchase Budget:

• The production budget is the starting point for determining the
estimated quantities of direct materials to be purchased.
• Multiplying these quantities by the expected unit purchase price
determines 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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 BUDGETS AND BUDGETARY CONTROL 15.31

• 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.
An example of material purchase budget is as under:
XYZ Company
Direct material purchase budget
for the year ending March 31, 20.....
Material X Material Y Total
Desired closing stock (units) 3,000 500
Units required for production 1,56,000 34,000
Add:
Total Requirement 1,59,000 34,500
Less: Opening stock (units) 4,000 300
Units to be purchased 1,55,000 34,200
Unit price (`) 1.50 2.50
Purchase cost (`) 2,32,500 85,500 3,18,000

(vi) Personnel (or Labour cost) 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.
From this, the standard hours required to be worked can be calculated. The
total labour component thus budgeted can be divided into direct and indirect
labour. Standard rates of wages for each grade of labour can be introduced
and then the direct and indirect labour cost budget can be prepared.
Merits/advantages:
1. It defines the direct and indirect labour force required.
2. It enables the personnel department to plan ahead in recruitment and
training of workers so that labour turnover can be reduced to the
minimum.
3. 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.

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 15.32 COST AND MANAGEMENT ACCOUNTING

Example of direct-labour cost budget:

XYZ COMPANY
Direct-labour cost budget
for the year ending March 31, 20...
Units to be Direct labour Total Total budget cost (` )
produced hour, per unit hours @ ` 2 per hour
Product A 4,000 7 28,000 56,000
Product B 9,000 10 90,000 1,80,000
1,18,000 2,36,000
(vii) Production or Factory overhead Budget:
• Production overheads consist of all items such as indirect materials,
indirect labour and indirect expenses. 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 which
the factory overhead costs are separated into their fixed and variable
cost elements. Such schedules enable department managers to direct
their attention to those costs for which they are responsible and to
evaluate performance of each department.
• A careful study and determination of the behaviour of different types
of costs will be essential in preparation of overhead budget.
• A few examples are given below to show how the expenses are
estimated.
1. Fixed expenses are normally policy costs and hence they are
based on policy matters.
2. 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 supervisor
for every twenty direct workers.

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 BUDGETS AND BUDGETARY CONTROL 15.33

3. In regard to the estimate of consumption of indirect materials,

the age and condition of the plant and machinery are taken into
consideration.
Example of factory overhead budget:
XYZ COMPANY
Factory overhead budget for the year ending March 31, 20....
(Anticipated activity of 1,18,000 direct labour hours)
(` ) (` )
Supplies 12,000
Indirect labour 30,000
Cost of fringe benefits 10,000
Power (variable portion) 22,000
Maintenance cost (variable portion) 15,000
Total variable overheads 89,000
Depreciation 10,000
Property taxes 2,000
Property insurance 1,000
Supervision 12,000
Power (Fixed portion) 800
Maintenance (Fixed portion) 3,200
Total fixed overheads 29,000
Total factory overheads 1,18,000
Factory overhead recovery rate is:
`1,18,000
= `1 per direct labour hour
1,18,000 labour hours

(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.
Production cost budget covers direct material cost, direct labour cost and
manufacturing expenses. After preparing direct material, direct labour and
production overhead cost budget, one can prepare production cost
budget.

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 15.34 COST AND MANAGEMENT ACCOUNTING

(ix) End of the year (or closing) 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
information is required to prepare cost-of-goods-sold budget and
budgeted financial statements i.e., budgeted income statement and
budgeted balance sheet.
Example of end of the year (or closing) inventory budget:
XYZ Company end of the year inventory budget March 31, 20....
Units Unit cost Amount Total
(` ) (` ) (` )
Direct material
X 3,000 1.50 4,500
Y 500 2.50 1,250 5,750
Finished goods
A 500 49.00* 24,500
B 1,000 53.00* 53,000 77,500
Total 83,250
* Unit cost of finished goods have been computed as below:
Unit cost Product A Product B
of input Units Amount Units Amount
(` ) (` ) (` )
Material X 1.50 12 18.00 12.00 18.00
Material Y 2.50 4 10.00 2.00 5.00
Direct labour 2.00 7 14.00 10.00 20.00
Factory overhead 1.00 7 7.00 10.00 10.00
49.00 53.00
(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.
We present below the cost-of-goods-sold budget on the basis of the data
taken from the various budgets already illustrated:

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 BUDGETS AND BUDGETARY CONTROL 15.35

XYZ Company cost-of-goods-sold budget for the year ending

March 31, 20....
Amount
(` )
Direct materials used 3,19,000
Direct labour 2,36,000
Factory overhead 1,18,000
Total manufacturing costs 6,73,000
Add : Finished goods (opening) 1,79,500*
8,52,500
Less : Finished goods (closing) 77,500*
Total cost of goods sold 7,75,000
*Assumed figure
In the above budget if adjustments for opening and closing inventory of finished
goods are not shown. The budget will be called production cost budget.

(xi) Selling and Distribution Cost Budget:

Selling and distribution are the essential aspects of the profit earning
function. At the same time, the pre-determination of these costs is very
difficult. Selling & Distribution Cost Budget is a forecast of the cost of selling
& distribution of goods during the budget period. 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 serv-
ice, etc. are generally grouped together to form part of the responsibility
of the sales manager.
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:
1. 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
2. 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.

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 15.36 COST AND MANAGEMENT ACCOUNTING

3. 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.
Using the past experience as a guide, consideration should be given to the
future trend of sales, possible changes in competition etc., in pre-
determination of selling costs.
• 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 return
of 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:
1. The best method of advertisement must be selected; costs will
vary according to the method selected.
2. The maximum amount to be spent in a period, say one year, has
to be decided.
3. Advertising and sales should be co-ordinated. It means that
money should be spent on advertisement only when sufficient
quantities of the product advertised are ready for sale.
4. An effective control over advertisement expenditure should be
exercised and the effectiveness of the advertisement should be
measured.
5. 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 on
the expected profit may be fixed on the basis of past experience.
2. A sum which is expected to be incurred by the competitors may
be fixed to be spent during the budget period.

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 BUDGETS AND BUDGETARY CONTROL 15.37

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 to
spend on advertising.
5. An advertisement plan is decided upon and the amount to be
spent 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.
Example of selling and distribution cost budget:
XYZ Company selling and distribution cost budget
for the year ending March 31, 20....
Amount
Direct selling expenses: (` )
Salesmen’s salaries 14,500
Salesmen’s commission 7,000
Travelling expenses 19,000
40,500
Distribution expenses:
Warehouse wages 6,000
Warehouse rent, rates, electricity 4,500
Lorry expenses 11,000
21,500
Sales office expenses:
Salaries 16,000
Rent, rates, electricity 12,000
Depreciation 2,000
Stationery, postage and telephone 12,500
General expenses 3,000
45,500
Advertising:
Press 4,500
Radio and television 18,500
Shop window displays 4,000
27,000
Total 1,34,500

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 15.38 COST AND MANAGEMENT ACCOUNTING

(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 antic-
ipated changes either in general policy or the volume of business. To
bring such expenses under control, it is necessary to review them frequently
and to determine at regular intervals whether or not these expenses continue
to be adjusted. 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.
XYZ Company administrative expenses budget
for the year ending March 31, 20...
(` )
Salaries of clerical staff 28,000
Executives’ salaries 8,000
Audit fee 600
Depreciation on office equipment 800
Insurance 250
Stationery 1,250
Postage and telegrams 950
Telephones 850
Miscellaneous 5,300
Total administrative expenses 46,000
(xiii) Research and Development expense Budget:
Research and development expenditure is to be incurred so that the products or
methods of production do not become obsolete. The research and development
budget is the forecast of all such expenses. 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. After
development, formal production can commence on commercial scale and then
production function starts. Since the areas of research and development cannot
be precisely defined, the costs incurred under both the functions are clubbed
together as research and development costs. Research and Development (R &
D) plays a vital role in maintaining the business. For example, automobile

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 BUDGETS AND BUDGETARY CONTROL 15.39

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.
1. A percentage based on total sales value. This method is good if
sales value is steady from year to year.
2. A percentage based on net profit.
3. A total sum is estimated on the basis of past experience and
future R & D plans and policies.
4. A sum is fixed on the basis of cash resources available with the
company.
All factors which affect the importance of R & D are considered. For
example, factors like demand for existing products, competition,
economic conditions, etc., are considered carefully and a sum is set
aside as R& D budget.
(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.
This budget is subject to strict management control because it entails large
amount of expenditure. The budget is prepared to cover a long period of
years 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:
1. 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.
2. Future development plans to increase output by expansion of plant
facilities.

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 15.40 COST AND MANAGEMENT ACCOUNTING

3. Replacement requests from the concerned departments.

4. Factors like sales potential to absorb the increased output, possibility
of price reductions, increased costs of advertising and sales promotion
to absorb increased output, etc.
5. 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 and
estimated capital expenditure during the budget period.
2. It enables the company to establish a system of priorities. When there
is 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 be
considered for the completion of the budget.
6. It facilitates cost reduction programme, particularly when
modernisation and renovation is covered by this budget.
ILLUSTRATION 4
A single product company estimated its quarter-wise sales for the next year as
under:
Quarter Sales (Units)
I 30,000
II 37,500
III 41,250
IV 45,000
The opening stock of finished goods is 6,000 units and the company expects to
maintain the closing stock of finished goods at 12,250 units at the end of the
year. The production pattern in each quarter is based on 80% of the sales of
the current quarter and 20% of the sales of the next quarter. The company
maintains this 20% of sales of next quarter as closing stock of current quarter.

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 BUDGETS AND BUDGETARY CONTROL 15.41

The opening stock of raw materials in the beginning of the year is 10,000 kg.
and the closing stock at the end of the year is required to be maintained at
5,000 kg. Each unit of finished output requires 2 kg. of raw materials.
The company proposes to purchase the entire annual requirement of raw
materials in the first three quarters in the proportion and at the prices given below:
Quarter Purchase of raw materials % to total annual Price per
requirement in quantity kg. ( ` )
I 30% 2
II 50% 3
III 20% 4
The value of the opening stock of raw materials in the beginning of the year is
` 20,000. You are required to PREPARE the following for the next year, quarter
wise:
(i) Production budget (in units).
(ii) Raw material consumption budget (in quantity).
(iii) Raw material purchase budget (in quantity and value).
(iv) Priced stores ledger card of the raw material using First in First out method.
SOLUTION
Working Note:
Calculation of total annual production
(Units)
Sales in 4 quarters 1,53,750
Add: Closing balance 12,250
1,66,000
Less: Opening balance (6,000)
Total number of units to be produced in the next year 1,60,000
(i) Production Budget (in units)
Quarters I II III IV Total
Units Units Units Units Units
Sales 30,000 37,500 41,250 45,000 1,53,750
Production in current 24,000 30,000 33,000 36,000
quarter
(80% of the sale of current
quarter)

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 15.42 COST AND MANAGEMENT ACCOUNTING

Production for next 7,500 8,250 9,000 12,250

quarter
(20% of the sale of next
quarter)
Total production 31,500 38,250 42,000 48,250 1,60,000

(ii) Raw material consumption budget in quantity

Quarters I II III IV Total
Units to be 31,500 38,250 42,000 48,250 1,60,000
produced in each
quarter: (A)
Raw material 2 2 2 2
consumption p.u.
(kg.): (B)
Total raw material 63,000 76,500 84,000 96,500 3,20,000
consumption (Kg.)
: (A × B)
(iii) Raw material purchase budget (in quantity)
Qty. (kg.)
Raw material required for production 3,20,000
Add : Closing balance of raw material 5,000
3,25,000
Less : Opening balance (10,000)
Material to be purchased 3,15,000
Raw material purchase budget (in value)
Quarters % of annual Qty. of material Rate Amount (`)
requirement per
kg. (`)
(1) (2) (3) (4) (5)=(3×4)
I 30 94,500 2 1,89,000
(3,15,000 kg. ×
30%)
II 50 1,57,500 3 4,72,500
(3,15,000 kg. ×
50%)
III 20 63,000 4 2,52,000
(3,15,000 kg. ×
20%)
Total 3,15,000 9,13,500

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 (iv) Priced Stores Ledger Card
(of the raw material using FIFO method)

Quarters
I II III IV
Kg. Rate Value Kg. Rate Value Kg. Rate Value Kg. Rate Value
(`) (`) (`) (`) (`) (`) (`) (`)
Opening 10,000 2 20,000 41,500 2 83,000 1,22,500 3 3,67,500 38,500 3 1,15,500
balance
(A) 63,000 4 2,52,000
Purchases: (B) 94,500 2 1,89,000 1,57,500 3 4,72,500 63,000 4 2,52,000 – – –
Consumption: 63,000 2 1,26,000 41,500 2 83,000 84,000 3 2,52,000 38,500 3 1,15,500

© The Institute of Chartered Accountants of India

(C)
35,000 3 1,05,000 58,000 4 2,32,000
Balance: (D) 41,500 2 83,000 1,22,500 3 3,67,500 38,500 3 1,15,500 5,000 4 20,000
(D) = (A) +(B)– 63,000 4 2,52,000
(C)
BUDGETS AND BUDGETARY CONTROL
15.43
 BUDGETS AND BUDGETARY CONTROL 15.44

ILLUSTRATION 5
A company is engaged in the manufacture of specialised sub-assemblies
required for certain electronic equipment. The company envisages that in
the forthcoming month, December, the sales will be in the ratio of 3 : 4 : 2
respectively of sub-assemblies, ACB, MCB and DP.
The following is the schedule of components required for manufacture:

Component requirements

Sub-assembly Selling Price Base board IC08 IC12 IC26

ACB 520 1 8 4 2
MCB 500 1 2 10 6
DP 350 1 2 4 8
Purchase price (`) 60 20 12 8
The direct labour time and variable overheads required for each of the sub-
assemblies are:
Labour hours Variable overheads (`)

Grade A Grade B

ACB 8 16 36
MCB 6 12 24
DP 4 8 24
Direct wage rate per hour (`) 5 4 —
The labourers work 8 hours a day for 25 days a month.
The opening stocks of sub-assemblies and components for December are as
under:
Sub-assemblies Components

ACB 800 Base Board 1,600

MCB 1,200 IC08 1,200
DP 2,800 IC12 6,000
IC26 4,000
Fixed overheads amount to ` 7,57,200 for the month and a monthly profit
target of ` 12 lacs has been set.

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 BUDGETS AND BUDGETARY CONTROL 15.45

The company is eager for a reduction of closing inventories for the month
of December of sub-assemblies and components by 10% of quantity as
compared to the opening stock. PREPARE the following budgets for the
month of December:
(a) Sales budget in quantity and value.
(b) Production budget in quantity
(c) Component usage budget in quantity.
(d) Component purchase budget in quantity and value.
(e) Manpower budget showing the number of workers and the amount of
wages payable.
SOLUTION
Working Note:
1. Statement showing contribution:
Sub- assemblies ABC MCB DP Total
(`) (`) (`) (`)
Selling price per unit (p.u.) : (A) 520 500 350
Marginal Cost per unit.
Components
- Base board 60 60 60
- IC08 160 40 40
- IC12 48 120 48
- IC26 16 48 64
Labour
- Grade A 40 30 20
- Grade B 64 48 32
Variable production overhead 36 24 24
Total marginal cost per unit. : (B) 424 370 288
Contribution per unit. : (C) = (A) – 96 130 62
(B)
Sales ratio : (D) 3 4 2
Contribution × Sales ratio: [(E) = 288 520 124 932
(C) × (D)]

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 15.46 COST AND MANAGEMENT ACCOUNTING

2. Desired Contribution for the forthcoming month December

( `)
Fixed overheads 7,57,200
Desired profit 12,00,000
Desired contribution 19,57,200
3. Sales mix required i.e. number of batches for the forthcoming month
December
Sales mix required = Desired contribution/contribution × Sales ratio
= `19,57,200/932 (Refer to Working notes 1 and 2)
= 2,100 batches
Budgets for the month of December
(a) Sales budget in quantity and value

Sub-assemblies ACB MCB DP Total

Sales (Qty.) 6,300 8,400 6,300
(2,100×3) (2,100×4) (2,100×3)
Selling price p.u. (`) 520 500 350
Sales value (`) 32,76,000 42,00,000 14,70,000 89,46,000

(b) Production budget in quantity

Sub-assemblies ACB MCB DP

Sales 6,300 8,400 4,200
Add : Closing stock 720 1,080 2,520
(Opening stock less 10%) ____ ____ ____
Total quantity required 7,020 9,480 6,720
Less : Opening stock (800) (1,200) (2,800)
Production 6,220 8,280 3,920

(c) Component usage budget in quantity

Sub-assemblies ACB MCB DP Total
Production 6,220 8,280 3,920 —
Base board (1 each) 6,220 8,280 3,920 18,420

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 BUDGETS AND BUDGETARY CONTROL 15.47

Component IC08 (8:2:2) 49,760 16,560 7,840 74,160

(6,220 × 8) (8,280 × 2) (3,920 × 2)
Component IC12 24,880 82,800 15,680 1,23,360
(4:10:4) (6,220× 4) (8,280 × 10) (3,920 × 4)
Component IC26 (2:6:8) 12,440 49,680 31,360 93,480
(6,220× 2) (8,280 × 6) (3,920 × 8)
(d) Component Purchase budget in quantity and value

Sub- Base IC08 IC12 IC26 Total

assemblies board
Usage in 18,420 74,160 1,23,360 93,480
production
Add :Closing 1,440 1,080 5,400 3,600
stock
(Opening
stock less
10%)
19,860 75,240 1,28,760 97,080
Less (1,600) (1,200) (6,000) (4,000)
:Opening
stock
Purchase 18,260 74,040 1,22,760 93,080
(Qty.)
Purchase 60 20 12 8
price (`)
Purchase 10,95,600 14,80,800 14,73,120 7,44,640 47,94,160
value (`)
(e) Manpower budget showing the number of workers and the amount
of wages payable

Sub- Budgeted Direct labour Total

assemblies Production Grade A Grade B
Hours Total Hours Total
p.u. hours p.u. hours
ACB 6,220 8 49,760 16 99,520

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 15.48 COST AND MANAGEMENT ACCOUNTING

MCB 8,280 6 49,680 12 99,360

DP 3,920 4 15,680 8 31,360
(A) Total hours 1,15,120 2,30,240
(B) Hours per man per month 200 200
(C) Number of workers per 576 1,152
month : (A/B)
(D) Wage rate per month (`) 1,000 800
(E) Wages payable (`) : (C × D) 5,76,000 9,21,600 14,97,600

(xv) Cash Budget:

Cash Budget is a detailed budget of cash receipts and cash payments
incorporating both revenue and capital items for the budget period. This
budget is usually of two parts giving detailed estimates of (i) cash receipts
and (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.
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.
The cash budget is one of the most important elements of the budgeted
balance sheet. Information from the various operating budgets, such as
the sales budget, the direct materials purchases budget, and the selling
and administrative expenses budget, affects the cash budget.
In addition, the capital expenditures budget, dividend policies, and plans
for equity or long-term debt financing also affect the cash budget.
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 making investments when cash is in
excess.

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 BUDGETS AND BUDGETARY CONTROL 15.49

(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 of
the 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
15.7.3 Master Budget
CIMA, London, defines it as “the summary budget, incorporating its component
functional budgets, which is finally approved, adopted and employed.” When all
the 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. When the
master budget is approved by the board of directors, it represents a standard for
the achievement of which all the departments will work. On the basis of the various
budgets (schedules) prepared earlier in this study, we prepare below budgeted
income statement and budgeted balance sheet.
Example of budgeted income statement:
XYZ Company Budgeted Income Statement
For the Year Ending March 31, 20....
Amount
(` ) (` )
Sales 11,75,000
Less: Cost of goods sold 7,75,000
Gross margin 4,00,000
Less: Selling and distribution expenses 1,36,500
Less: Administrative expenses 46,000 1,82,500

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 15.50 COST AND MANAGEMENT ACCOUNTING

Profit before interest and taxes 2,17,500

Interest expenses (assumed) 50,000
Profit before tax 1,67,500
Income-tax (30% assumed) 50,250
Net profit 1,17,250
Example of budgeted balance sheet:
XYZ Company Budgeted Balance Sheet
March 31, 20....
(` ) (` ) (` )
Share capital 3,50,000
Retained income 1,29,000 4,79,000
Represented by:
Plant and machinery 3,40,000
Less: Provision for depreciation 60,000 2,80,000
Raw materials 5,750
Finished goods 77,500
Debtors 1,10,000
Cash 37,750 2,31,000
Less: Creditors 32,000 1,99,000
4,79,000
Note: Information not available in respect of share capital, opening balance of retained
earnings, current assets and current liabilities, etc., has been assumed to complete the above
balance sheet.

ILLUSTRATION 6
Float glass Manufacturing Company requires you to PREPARE the Master budget for
the next year from the following information:

Sales:
Toughened Glass ` 6,00,000
Bent Glass ` 2,00,000
Direct material cost 60% of sales
Direct wages 20 workers @ ` 150 per month
Factory overheads:
Indirect labour –

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 BUDGETS AND BUDGETARY CONTROL 15.51

Works manager ` 500 per month

Foreman ` 400 per month
Stores and spares 2.5% on sales
Depreciation on machinery ` 12,600
Light and power ` 3,000
Repairs and maintenance ` 8,000
Others sundries 10% on direct wages
Administration, selling and distribution ` 36,000 per year
expenses

SOLUTION
Master Budget for the year ending _____

Sales: (`)
Toughened Glass 6,00,000
Bent Glass 2,00,000
Total Sales 8,00,000
Less: Cost of production:
Direct materials (60% of `8,00,000) 4,80,000
Direct wages (20 workers × `150 × 12months) 36,000
Prime Cost 5,16,000
Fixed Factory Overhead:
Works manager’s salary (500 × 12) 6,000
Foreman’s salary (400 × 12) 4,800
Depreciation 12,600
Light and power (assumed fixed) 3,000 26,400
Variable Factory Overhead:
Stores and spares 20,000
Repairs and maintenance 8,000
Sundry expenses 3,600 31,600
Works Cost 5,74,000
Gross Profit (Sales – Works cost) 2,26,000
Less: Adm., selling and distribution expenses 36,000
Net Profit 1,90,000

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 15.52 COST AND MANAGEMENT ACCOUNTING

15.7.4 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.
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.
1. Short term Budget: - These budgets are generally for one or two years and are
in the form of monetary terms. The consumer’s good industries like Sugar,
Cotton, and textile use short term budgets.
2. 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 which is
established for use over a short period of time and is related to current
conditions”.

15.8 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.
Zero based budgeting differs from the conventional system of budgeting because
it mainly starts from scratch or zero and not on the basis of trends or historical
levels of expenditure. In the customary budgeting system, the last year’s figures are
accepted as they are, or cut back or increases are granted. Zero based budgeting
on the other hand, starts with the premise that the budget for next period is zero
so long the demand for a function, process, project or activity is not justified for
each rupee from the first rupee spent.
Zero-based Budgeting (ZBB) is an emergent form of budgeting which arises to
overcome the limitations of incremental (traditional) budgeting system.
ZBB is an activity based budgeting system where budgets are prepared for
each activities rather than functional department. Justification in the form of
cost benefits for the activity is required to be given. The activities are then
evaluated and prioritized by the management on the basis of factors like

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synchronisation with organisational objectives, availability of funds, regulatory

requirement etc.
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.
15.8.1 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
(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 like environmental, 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. Because of
this prioritization feature ZBB is also known as Priority-based Budgeting.
(iv) Allocation of resources: After ranking of the decision packages, resources
are allocated for decision packages. Budgets are prepared like it is done
first time without taking reference to previous budgets.
15.8.2 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.

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 15.54 COST AND MANAGEMENT ACCOUNTING

• 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.
15.8.3 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,

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 BUDGETS AND BUDGETARY CONTROL 15.55

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 to
be 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 is.
• 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.
• Traditional budgeting makes a routine approach. Zero-based budgeting
makes a very straightforward approach and immediately spotlights the
decision packages enjoying priority over others.
15.8.4 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 tedious
to 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.

15.9 PERFORMANCE BUDGETING (PB)

Performance budgeting (PB) involves evaluation of the performance of an organisation
in the context of both specific as well as overall objectives of the organisation. This
requires complete clarity about both the short-term as well as long-term
organisational objectives. The responsibility of the various levels of management
should be predetermined in terms of results expected from them and the authority
vested in them. In other words, performance budgeting requires fixing of the
responsibility of each executive in organisation and the continuous appraisal of his
performance. It is, therefore, considered to be synonymous with responsibility
accounting.

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 15.56 COST AND MANAGEMENT ACCOUNTING

Performance Budgeting provide a meaningful relationship between estimated

inputs and expected outputs as an integral part of the budgeting system. ‘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.
15.9.1 Traditional budgeting vs. Performance budgeting
• The traditional budgeting gives more emphasis on the financial aspect than
the 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 and so on. In the
PB emphasis is more on the functions of the organisation, the programmes to
discharge these function and the activities which will be involved in
undertaking these programmes.
15.9.2 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:

Functions Programme Activity 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

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 BUDGETS AND BUDGETARY CONTROL 15.57

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 information
for purposes of control and planning.
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 used
if 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 else
jointly interested?

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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 the
recipient?
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 progress of
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

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- 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 summarized
as departmental average;
- Labour utilization report and causes of lost time and controllable
time;
- Indirect shop expenses against the standard allowed; and
- Scrap report.
(iii) To Works Managers:
- Departmental operating statement;
- General works operating statements (Expenses relating to all works
expenses 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
at the initiative of the management accountants. The necessity for them
may, in some cases, arise on account of the need for more detailed
information on matters of interest first revealed; by the routine, reports.
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.

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 15.60 COST AND MANAGEMENT ACCOUNTING

(v) Special pricing analysis

(vi) Make or buy certain components
(vii) Statement of surplus available for payment of bonus under the labour
appellate tribunal formula.

15.10 BUDGET RATIO

Ratio is a mathematical relationship between two or more related figures. Budget
ratios provide information about the performance level, i.e., the extent of deviation
of actual performance from the budgeted performance and whether the actual
performance is favourable or unfavorable. If the ratio is 100% or more, the
performance is considered as favourable and if ratio is less than 100% the
performance is considered as unfavourable.
The following ratios are usually used by the management to measure development
from budget.
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 number
of working days in a period and the number of working as in the relative budget
period.

Budget Ratios:
Standard Hours
(i) Efficiency Ratio = ×100
Actual Hours

Standard Hours
(ii) Activity Ratio = ×100
Budgeted Hours

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 BUDGETS AND BUDGETARY CONTROL 15.61

Available working days

(iii) Calendar Ratio = ×100
Budgeted working days

Budgeted Hours
(iv) Standard Capacity Usage Ratio = ×100
Max. possible hours in the budgeted period

Actual Hours worked

(v) Actual Capacity Usage Ratio = ×100
Max. possible working hours in a period

Actual working Hours

(vi) Actual Usage of Budgeted Capacity Ratio = ×100
Budgeted Hours

ILLUSTRATION 7
Following data is available for DKG and Co:
Standard working hours 8 hours per day of 5 days per week
Maximum capacity 50 employees
Actual working 40 employees
Actual hours expected to be worked per four week 6,400 hours
Std. hours expected to be earned per four weeks 8,000 hours
Actual hours worked in the four- week period 6,000 hours
Standard hours earned in the four- week period 7,000 hours.
The related period is of 4 weeks. In this period there was a one special day holiday
due to national event. CALCULATE the following ratios:
(1) Efficiency Ratio, (2) Activity Ratio, (3) Calendar Ratio, (4) Standard Capacity Usage
Ratio, (5) Actual Capacity Usage Ratio. (6) Actual Usage of Budgeted Capacity Ratio.
SOLUTION
Maximum Capacity in a budget period
= 50 Employees × 8 Hrs. × 5 Days × 4 Weeks = 8,000 Hrs.
Budgeted Hours

40 Employees × 8 Hrs. × 5 Days × 4 Weeks = 6,400 Hrs.

Actual Hrs. = 6,000 Hrs. (given)

Standard Hrs. for Actual Output = 7,000 Hrs.

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 15.62 COST AND MANAGEMENT ACCOUNTING

Budget No. of Days = 20 Days = 20 Days (4 Weeks x 5 Days)

Actual No. of Days = 20 – 1 = 19 Days

Standard Hrs 7,000 hours
1. Efficiency Ratio = ×100 = ×100 = 116.67%
Actual Hrs 6,000 hours

Standard Hrs 7,000 hours

2. Activity Ratio = ×100 = ×100 = 109.375%
Budgeted Hrs 6, 400 hours

Available working days 19days

3. Calendar Ratio = ×100 = ×100 = 95%
Budgeted working days 20days

Budgeted Hours
4. Standard Capacity Usage Ratio = ×100
Max. possible hours in the budgeted period

6, 400 hours
= ×100 = 80%
8,000 hours

Actual Hours worked

5. Actual Capacity Usage Ratio = ×100
Max. possible working hours in a period

6,000 hours
= ×100 = 75%
8,000 hours

Actual working Hours

6. Actual Usage of Budgeted Capacity Ratio = ×100
Budgeted Hours

6,000 hours
= ×100 = 93.75%
6, 400 hours

SUMMARY
♦ Budget: Budget is a quantitative expression of a plan of action to be
pursued over a defined period of time. It is statement of an estimated
performance to be achieved in given time, expressed in monetary or quantitative
or both terms.
♦ Budget Centre: A Budget Centre is a section of an organisation developed
for the purpose of budgetary control, and is intended to facilitate
formulation of various budgets with the help of head of the department. .
♦ Budgetary Control: Budgetary Control is the establishment of budgets,
relating the responsibilities of executives to the requirements of a policy,

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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.
♦ Budget Manual: The Budget manual is a document or booklet which Contain
guidelines for the preparation of budget in an organization.
♦ Budget Period: The period of time for which a budget is prepared and used. It
may be a year, quarter or a month.
♦ Classification of Budgets:
Capacity based - Fixed and Flexible
Content based - Monetary and Physical/quantitative
Functional based - Purchase, Sale, Production Cost, Administrative,
Selling & Distribution, Research & Development,
Plant Capital Expenditure, Cash, Plant Utilization.
♦ Fixed Budget: a fixed budget, is a budget designed to remain unchanged
irrespective of the level of activity actually attained.
♦ Flexible Budget: 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.
♦ Zero-based Budgeting (ZBB): Zero- based Budgeting (ZBB) is defined as ‘a
method of budgeting which requires each cost element to be specifically
justified, although the activities to which the budget relates are not being
undertaken for the first time, without approval, the budget allowance is zero.
♦ Performance Budgeting (PB): Performance Budgeting: Performance
Budgeting means that budget in which the responsibility of various levels
of management is predetermined in terms of output or result keeping in
view the authority vested with them.
♦ Budget Ratios: Ratio is a mathematical relationship between two or more
related figures. Budget ratios provide information about the performance level,
i.e., the extent of deviation of actual performance from the budgeted
performance and whether the actual performance is favourable or unfavorable.

© The Institute of Chartered Accountants of India