Costing Syllabus Mapping Remark

Chapter 1 - Overview of Cost and

Overview of Cost and Management Management Accounting
Accounting - Introduction to Cost and Chapter 2 - Material Cost
Management Accounting, Not directly mentioned in
Chapter 3 - Labour Cost
Objectives and Scope of Cost and syllabus but forms the base
Chapter 4 - Overhead Costing
Management Accounting for Costing
Chapter 5 - Activity Based Costing
Chapter 6 - Output or Unit Cost
Chapter 8 is covered under
Chapter 7 - Job Costing & Batch Costing
Chapter 7
Methods of Costing - Single Output/ Unit
Chapter 9 Contract Costing
Costing, Job Costing, Batch Costing, Contract
Chapter 10 - Process or Operating
Costing, Process/Operation Costing, Costing
Costing
of Service Sectors.
Chapter 11 - Joint and By Product
Costing
Chapter 12 - Service Costing
Chapter 13 - Marginal Costing
Basics of Cost Control and Analysis - (i)
Chapter 14 - Standard Costing and
Standard Costing, (ii) Marginal Costing, (iii)
Variance Costing
Budget and Budgetary Control.
Chapter 15 - Budgeting
Lean System and Innovation:-
a) Introduction to Lean System
b) Just-in-Time (JIT)
c) Kaizen Costing
d) 5 Ss
Chapter 16 - Lean System and
e) Total Productive Maintenance (TPM)
Innovation
f) Cellular Manufacturing/ One-Piece Flow
Production Systems
g) Six Sigma (SS)
h) Introduction to Process Innovation and
Business Process Re-engineering (BPR).
 Summary Sheet
–
Overview of Cost and Management
Accounting

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 1 Various types of Accounting
Basically, accounting means that we get Timely and accurate financial information concerning
the activities of an enterprise to a diverse group of people such as shareholders, managers,
creditors, tax authorities, etc.

Accounting can be categorized as the following:

2 Costing and Cost Accounting and Cost Accountancy

Normally, people use both these terms interchangeably considering there meaning as same.
But both these terms have different meaning:

Costing is concerned with determining the costs of products/services and also planning
and controlling such costs. In simple words, we can say that costing means finding of cost
by any process or technique. Example- Cost of manufacturing a product.; Cost of providing
a service.

Cost Accounting is the process of accounting for cost which begins with the recording of the
expenditure and ends with the preparation of statistical data which helps in creation of
reports and analysis. It is a wider process than costing.

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

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 ascertainment of profitability. In simple words, we can say that Cost Accountancy is the
practice of Costing and Cost Accounting.

3 Scope of Cost Accounting

Firstly, refer to the below image. Then we will discuss each scope in detail.

1. Costing—It is concerned with ascertainment of cost of products, processes, jobs. services,

etc. In fact, ascertainment of cost is the most important function of cost accounting.

2. Cost bookkeeping—It involves maintaining complete record of all costs incurred from
their incurrence up to the charging to final products/services.

3. Cost analysis—Costs recorded in the books are analyzed according to categories such as
direct and indirect costs, fixed and variable costs, controllable and uncontrollable costs,
etc.

4. Cost control—Cost accounting includes the comparison of actual cost incurred with the
predetermined standard cost so that the difference between the two can be analyzed
and used for cost control purpose.

5. Cost reports—Cost accounting includes the presentation of periodical cost reports such
as weekly, monthly reports for use by management at different levels. These reports form
the basis of planning and control, performance appraisal and managerial decision
making.

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 6. Cost audit—Cost audit is the verification of cost accounts and a check on the adherence
to the cost accounting plan.

4 Objectives of Cost Accounting

The main objectives of Cost and Management accounting are explained as below:

1. 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.

2. Cost Control and Cost Reduction- 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. This is known as Cost Control. Cost reduction is an approach
of management where cost of an object is believed to have a scope of further reduction.

3. Guide to business policy- Cost and Management Accounting by providing relevant

information, assist management in planning, implementing, measuring, controlling and
evaluating of various activities.

5 Difference between Financial Accounting and Cost Accounting

Let us see some major differences between the two from the following image:

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 6 Meaning of Cost
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 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.

From the following image, we can see that expenses and loss are part of cost:

Expense- An expired cost resulting from a productive usage of an asset.” Example can be use
of raw material or depreciation of machine.

Loss: Expired cost which no compensating value has been received.” Example can be loss of
raw material due to fire.

Note- Expired cost is the cost which has been already incurred, unexpired cost are those cost
which has to be paid in future.

7 Cost Center
For the purpose of finding cost, the whole organization is divided into small parts or sections.
These are called Cost Centers. For example-, if you want to find a cost of different

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 department then department will be the cost center, if you want to find the cost of running
different machines then the equipment will be the cost center.

Cost Center can be categorized as Personal cost Center and Impersonal cost Center.

Personal cost Center- When the cost center consists of persons or a group of persons it is
known as Personal cost Centers.

Impersonal cost Center- Cost Centers apart from persons or group of persons are termed as
Impersonal cost Centers.

8 Cost Unit
Cost Unit is a unit of product or service in relation to which costs are ascertained. Example-

9 Cost Object
Cost Object is “anything for which a separate measurement of cost may be desired”. A cost
object ‘includes a product, service, cost center, activity, sub-activity, project, contract,
customer or distribution channel or any other unit in relation to which costs are ascertained’.
Example-

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 In simple words, A cost object is any item for which costs are being separately measured.
Keep in mind that anything that generates costs or has expenses associated with it can be
considered as a cost object.

Now we will discuss a very important part of Costing.

10 Methods of Costing
There are two main types of methods of costing- Job costing and Process Costing. All other
methods are kind of subcategories of these two main types.

Now we will discuss them one by one. However, we will be discussing all these methods in
detail in the upcoming chapters.

10.1 Job Costing

Job Costing is used when work is taken as per the special requirements of the customer. Job
costing involves the accumulation of the costs of materials, labor, and overhead for a specific
job. Example: Printing, Interior Decoration, Painting, etc.

Cost unit in job order costing is taken to be a job or work order for which costs are separately
collected and computed.

10.1.1 Batch Costing

In this method, the cost of a batch or group of identical products is ascertained . Each batch
of products is a cost unit for which costs are ascertained. Example – Shoes, Tyres etc.

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 10.1.2 Contract Costing
The difference between job and contract is that job is small, and contract is big. The cost
unit here is a ‘contract’ which is of a long duration and may continue over more than one
financial year. Example – Building of Dam, Bridges, etc.

10.2 Process Costing

Process Costing method is used in mass production industries manufacturing standardized
products in continuous processes of manufacturing. Example: Manufacture of erasers,
Chemicals or processed foods.

Costs are accumulated for each process or department. Here raw material has to pass
through a number of processes in a particular sequence to completion stage. In order to
arrive at cost per unit, the total cost of a process is divided by the number of units produced,
etc.

10.2.1 Single, Unit or Output Costing

When production is uniform and consists of a single or two or three varieties of the same
product or where the product is produced in different grades, costs are ascertained grade-
wise. As the units of output are identical, the cost per unit is found by dividing the total cost
by the number of units produced. Example: mines, quarries, brick kilns, steel production,
flour mills, etc.

10.2.2 Operations Costing

It is a refinement and a more detailed application of process costing. A process may consist
of several operations and operation costing involves cost ascertainment for each operation
instead of a process. This method provides minute analysis of costs and ensures greater
accuracy and better control.

10.2.3 Operating Costing

This method should not be confused with operation costing. It is used in undertakings which
provide services instead of manufacturing products. For example, transport undertakings
(road transport, railways, airlines, shipping companies), electricity companies, hotels,
hospitals.

So, from the above information, we can say that the difference between job costing and
process costing is that job costing is used for custom products, and process costing is used
for mass-produced items that are the same or similar.

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 11 Techniques of Costing
These techniques are those which help a company to present the cost data in a particular
manner to facilitate achievement of a special purpose like cost control, decision making, etc:

11.1 Standard Costing

This is a very valuable technique of controlling cost. In this technique, standard cost is pre-
determined actual performance is measured against the standard. The difference between
standard and actual costs are analyzed to know the reasons for the difference so that
corrective actions may be taken.

11.2 Marginal Costing

In this technique, separation of costs into fixed and variable (marginal) is of special interest
and importance. This is so because marginal costing regards only variable costs as the cost of
the products.

11.3 Budgetary Control

This technique is similar to Standard Costing. A budget is an expression of a firm’s business
plan in financial form and budgetary control is a technique applied to the control of total
expenditure on materials, wages and overheads by comparing actual performance with
planned performance.

Note: We will be discussing all these techniques in detail in the upcoming chapters.

12 Classification of Costs
There are various ways by which the costs are classified.

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 Now we will discuss the above elements one by one.

Direct Costs- These are those costs which can be easily and conveniently identified with a
unit of product. Example: Cost of raw material or labor, Cost of steel used in manufacturing
a machine can be easily known, wages paid to a tailor in a readymade garments company for
stitching a pair of trousers.

Indirect Costs- These are general costs and are incurred for the benefit of a number of cost
units, processes or departments. These costs cannot be easily and conveniently identified
with a unit of product. Example: Rent of building, Salaries of Managers, Lighting, etc.

Note: Direct costs of a product can be conveniently determined while the indirect costs have
to be arbitrarily apportioned to various cost units.

Fixed Costs- These remain constant and do not increase of decrease when volume of
production changes. Example: Rent of Building , Salaries of Managers etc.

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 The characteristics of fixed cost are:

(a) fixed total amount within a relevant range of output;

(b) increase or decrease in per unit fixed cost when quantity of production changes;

(c) apportioned to departments on some arbitrary basis;

(d) such cost can be controlled mostly by top level management.

Variable Costs- In other words, when volume of output increases, total variable cost also
increases, and vice versa, when volume of output decreases, total variable cost also
decreases, but the variable cost per unit remains fixed. Example : Cost of cloth required to
produce a shirt, Direct Material, Direct Wages, Commissions.

Variable costs show the following characteristics:

(a) variability of the total amount in direct proportion to the volume of output;

(b) fixed amount per unit in the face of changing volume;

(c) easy and reasonably accurate allocation and apportionment to departments;

(d) such costs can be controlled by functional managers.

Now. Let’s discuss a point where you may get confused:

Is Variable Cost same as Direct Cost – Answer is NO

Direct costs can also be fixed costs, such as rent payments that are directly tied to a
production facility. Also, salaries of mangers or supervisors might also be included in direct
costs, particularly if they're tied to a specific project.

Also, variable costs do not need to be directly related to the product. In other words,
a variable cost can be an indirect cost. For example, a company produces mobile phones and
has several production machines to produce their devices. The factory
machinery needs electricity to function. The cost of electricity is an indirect cost since it can't
be tied back to the product or the specific machine. However, the cost of electricity is a
variable cost since electricity usage increases with the number of products that are produced
or manufactured.

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 Fixed cost can be of two types:

Committed Cost- This refers to that part of fixed cost that cannot be reduced. Example-
Salary of CEO.

Discretionary Cost- This refers to that part of fixed cost that can be reduced. Example- Salary
of low-level managers.

Product Cost- These are those costs which are necessary for production and which will not
be incurred if there is no production. Example: These consist of direct materials, direct labour
and some of the factory overheads. Also called inventoried Costs.

Period Cost- These are those costs which are not necessary for production and are incurred
even if there is no production. These are written off as expenses in the period in which these
are incurred. Example: Showroom rent. Salary, Municipal taxes.

Controllable Cost- These are the costs which may be directly regulated at a given level of
management authority. Variable costs are generally controllable by department heads. For
example, cost of raw material may be controlled by purchasing in larger quantities.

Non-Controllable Cost- These are those costs which cannot be influenced by the action of a
specified member of an enterprise. For example, it is very difficult to control costs like factory
rent, Showroom rent, Municipal taxes.

Historical Cost- These are the costs which are ascertained after these have been incurred.
Historical costs are thus, nothing but actual costs.

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 Pre-determined Cost- These are future costs which are ascertained in advance of production
on the basis of a specification of all the factors affecting cost. These costs are extensively used
for the purpose of planning and control.

Normal Cost- Normal cost may be defined as a cost which is normally incurred on expected
lines at a given level of output. In another words, 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.

Abnormal Cost- Abnormal cost is that which is not normally incurred at a given level of
output. Such cost is over and above the normal cost. In another words, 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.

Now we will discuss various types of costs for Management Decision Making.

13 Costs for Management Decision Making

There are various costs for Management Decision Making:

Now, we will discuss the above costs one by one.

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 Relevant Costs- A relevant cost is a cost whose magnitude will be affected by a decision being
made. In decision-making, management should consider only future costs and revenues.

Irrelevant Costs- Irrelevant cost is one which is not impacted by decision making. Example:
The cost of car insurance will not be impacted irrespective of you travel by car or bus whereas
cost of petrol will be impacted depending on you travel by bus or own car.

A sunk cost is an expenditure made in the past that cannot be changed and over which
management no longer has control. 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.

You must understand the difference between sunk costs and irrelevant costs. Not all
irrelevant costs are sunk costs, but all sunk costs are irrelevant. This can be understood with
the following example, in choosing from the two alternative methods of production, if direct
material cost is the same under the two alternatives, it is an irrelevant cost. But direct
material cost is not a sunk cost because it will be incurred in future and is a future cost.

Differential cost is the increase or decrease in total cost that results from an alternative
course of action. It is ascertained by subtracting the cost of one alternative from the cost of
another alternative.

Marginal cost is the additional cost of producing one additional unit. Marginal cost is the
same thing as variable cost. Marginal costing (or variable costing) is a technique of charging
only variable costs to products.

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 An imputed cost is an invisible cost that is not incurred directly, as opposed to an
explicit cost, which is incurred directly. - 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. Imputed cost is also known as
Notional or Implicit Cost

Opportunity cost is the sacrifice involved in accepting an alternative under consideration. In

another words, this cost refers to the value of sacrifice made or benefit of opportunity
foregone in accepting an alternative course of action. For example, company invests in
debentures at 17% rather than in FD at 10%. In this case investing in FD at 10% is an
opportunity Cost.

This is the cost at which there could be purchased an asset identical to that which is being
replaced. In simple words, replacement cost is the current market cost of replacing an asset.

For example, a machinery purchased in 1990 at `10,000 is discarded in 1998 and a new
machinery of the same type is purchased for `15,000. So the replacement cost of the
machinery is `15,000.

Out-of-pocket costs, also known as explicit costs, are those costs that involve cash outlays
or require the utilization of current resources. Examples of these costs are wages, material
cost, insurance, power cost, etc. Out-of-pocket cost may be either fixed (manager’s salary)
or variable (raw materials and direct wages).

Implicit Costs are does not involve any immediate cash outlay. They are not recorded in the
books of account. They are also known as economic costs.

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 14 Elements of Cost
Elements of Cost can be classified as:

We have already discussed Direct Cost and Indirect Cost. Now, we will discuss the subheads.

Materials Cost- The substance from which the finished product is made is known as material.
Material cost includes cost of procurement, freight inwards, taxes, insurance.

Labor Cost- The cost of remuneration (wages, salaries, commissions, bonuses, etc.) of the
employees/labor of an undertaking. It includes all fringe benefits like P.F. contribution,
gratuity, ESI, overtime, incentive bonus, wages for holidays, idle time etc.

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 Expenses- All costs other than material and labor are termed as expenses.

15 Prime cost and Overhead Cost

For better understanding, refer to the formula:

Prime Cost= Direct Material + Direct Labour + Direct Expenses

Overhead= Indirect Material + Indirect Labour + Indirect Expenses

Overheads are further divided into three types:

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 Note- Formula for Prime Cost will be used throughout the costing module.

16 Components of Total Cost

The following flowchart is the summarized view of what we have discussed till now.

So, from the flowchart we can see that:

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 Apart from the above-mentioned formulas, the following formulae are also important:

Prime Cost = Direct material + Direct labour + Direct expenses

Works Cost or Factory Cost = Prime cost + Factory overhead.

Cost of Production = Works cost + Administration overhead.

Total Cost or Cost of Sales = Cost of production + Selling and distribution overhead.

Conversion cost= Factory Cost – Direct Material Cost

Conversion cost is the total cost of converting a raw material into finished product.

Note: Production Overhead is also known as Factory Overhead.

17 Cost Sheet
A Cost Sheet or Cost Statement is “a document which provides a detailed cost information.

Format:

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 Advantages of Cost Accounting

There are various advantages of Cost Accounting:

1. Reveals what is profitable or not profitable

2. Cost control and Analysis
3. Decision making
4. Deciding on Selling prices
5. Formulating policies
6. Prevents frauds
Note: The above points are generic in nature. So, we are not explaining the above points.

18 Cost Audit
Cost audit is the specific application of auditing principles and procedures in the field of
cost accounting .

Cost Accounting Standards (CAS) are a set of standards that are designed “to achieve
uniformity and consistency in cost accounting practices.”

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 Previous Year Questions (PYQs)
on
Overview of Cost and Management Accounting

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Imputed Cost is also known as ___________ SEBI Grade A – Phase 1 - 2022

A. Sunk Cost
B. Historical Cost
C. Notional Cost
D. Process Cost
E. None of the above
Question 2 – Which of the following is an example of an Indirect Cost? SEBI Grade A – Phase 1 - 2022

A. Store Services for Canteen

B. Starch Powder for Dressing Yarn
C. 2 Batteries for Radio Transistor
D. Packaging Material like Carton
E. Jute for Bag
Question 3 – Which of the following is a notional cost? SEBI Grade A – Phase 1 - 2022

A. Absorption Costing
B. Historical Costing
C. Standard Costing
D. Lean Costing
E. None of the above
Question 4 – Calculate the Prime Cost using the information given below: SEBI Grade A – Phase 2 - 2022

Direct Material Cost– Rs 1,00,000

Direct Labour Cost– Rs 68,000

Fixed Overheads – Rs 1,50,000

Variable Overheads – Rs 24,000

A. Rs 1,58,000
B. Rs 1,68,000
C. Rs 1,78,000

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D. Rs 1,88,000
E. Rs 1,98,000

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1– Which of the following is not included in the scope of cost accounting? PFRDA Grade A – Phase 2
- 2021

A. Cost Ascertainment
B. Cost Reports
C. Cost Audit
D. Tax Planning
E. Cost Control

Question 2– __________ is the process of accounting for cost which begins with recording of expenditure and
ends with the preparation of statistical data. PFRDA Grade A – Phase 2 - 2021

A. Cost Accounting
B. Costing
C. Cost Accountancy
D. Both A and B
E. All of the above

Question 3– In the modern world, which type of accounting is best suited for decision-making? PFRDA Grade
A – Phase 2 - 2021

A. Financial Accounting
B. Management Accounting
C. Cost Accounting
D. Either A or B
E. All of the above

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 Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option A
Question 3 Option C
Question 4 Option B

PFRDA Grade A questions

Question Number Answer

Question 1 Option D
Question 2 Option A
Question 3 Option B

Section C

Explanation
SEBI Grade A questions

Question 1 – Imputed Cost is also known as ___________ SEBI Grade A – Phase 1 - 2022

A. Sunk Cost
B. Historical Cost
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C. Notional Cost
D. Process Cost
E. None of the above

Answer – Option C

Explanation -

An imputed cost is an invisible cost that is not incurred directly. Imputed Cost is also known as implicit cost,
notional cost. Hence, Option C is the correct answer.

For Example: A company owns its place and still shows rent in its books, that will be regarded as an imputed or
notional cost, as this is an invisible cost.

Additional Information:

• Sunk Cost: It is an expenditure made in the past that cannot be changed and over which management
no longer has control. These costs are not relevant for decision-making about the future. Hence, Option
A is incorrect.
• Historical Cost: These are the costs that are ascertained after these have been incurred. Historical Costs
are thus nothing but actual costs. Hence, Option B is incorrect.
• Process Cost: Process costing is a method of costing used mainly in manufacturing where units are
continuously mass-produced through one or more processes. Examples of this include the manufacture
of erasers, chemicals or processed food. Hence, Option D is incorrect.

Therefore, Option C is the correct answer.

Question 2 – Which of the following is an example of an Indirect Cost? SEBI Grade A – Phase 1 - 2022

A. Store Services for Canteen

B. Starch Powder for Dressing Yarn
C. 2 Batteries for Radio Transistor
D. Packaging Material like Carton
E. Jute for Bag
Answer – Option A

Explanation –

• Indirect Costs are general costs and are incurred for the benefit of a number of cost units, processes or
departments.
• These costs cannot be easily and conveniently identified with a unit of product.

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 • Indirect costs represent the expenses of doing business that are not readily identified with a particular
grant, contract, project function or activity, but are necessary for the general operation of the
organization and the conduct of activities it performs.
• In this question Store services for canteen is the indirect cost. As, store services for a canteen cannot be
identified with a particular service. Hence, Option A is the correct answer.

All other options are incorrect.

Additional Information:

• A direct cost is a price that can be directly tied to the production of specific goods or services. A direct
cost can be traced to the cost object, which can be a service, product, or department.
• Starch Powder for dressing yarn can be tied to the production and can be traced. Hence, Option B is
incorrect.
• 2 Batteries for Radio Transistor is specific that 2 Batteries will be used for a Radio Transistor. Hence,
Option C is incorrect.
• Packaging Material like Carton can be traced to the cost object. Like for example for 12 units of a product
one carton will be used. Hence, Option D is incorrect.
• Jute for bag can also be traced to a product. Hence, Option E is incorrect.

Hence, Option B is the correct answer. All other options are incorrect.

Question 3 – Which of the following is a notional cost? SEBI Grade A – Phase 1 - 2022

A. Absorption Costing
B. Historical Costing
C. Standard Costing
D. Lean Costing
E. None of the above
Answer – Option C

Explanation –

• A standard cost is the budgeted cost of a regular manufacturing process against which actual costs are
compared. So standard cost is not the actual cost.
• Notional cost is the opportunity cost of something which firm is using but not paying for it because it
belongs to the firm. For example, a firm is using the car of the owner but not paying rent for it because
the car belongs to the owner of the firm. Here cost of car is the notional cost.
• Now you can see that both in Standard cost and Notional cost there is a similarity that both are not the
actual costs. Hence, Option C is the correct answer.

All other options are incorrect.

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Additional Information:

• Absorption Costing: It is a managerial accounting method for capturing all costs associated with
manufacturing a particular product. The direct and indirect costs, such as direct materials, direct labor,
rent, and insurance, are accounted for by using this method. Hence, Option A is incorrect.
• Historical Costing: The historical cost principle states that a company or business must account for and
record all assets at the original cost or purchase price on their balance sheet. Hence, Option B is
incorrect.
• Lean Costing: Lean accounting is a term that describes the application of the Lean philosophy principles,
such as a focus on delivering value to the customer and striving to waste elimination to managing
financial practices and processes. Hence, Option D is incorrect.
•

Question 4 – Calculate the Prime Cost using the information given below: SEBI Grade A – Phase 2 - 2022

Direct Material Cost– Rs 1,00,000

Direct Labour Cost– Rs 68,000

Fixed Overheads – Rs 1,50,000

Variable Overheads – Rs 24,000

A. Rs 1,58,000
B. Rs 1,68,000
C. Rs 1,78,000
D. Rs 1,88,000
E. Rs 1,98,000
Answer – Option B

Explanation –

Prime Cost = Direct Material Cost + Direct Labour Cost

= 1,00,000 + 68,000

= 1,68,000

Explanation
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 PFRDA Grade A questions

Question 1– Which of the following is not included in the scope of cost accounting? PFRDA Grade A – Phase 2
- 2021

A. Cost Ascertainment
B. Cost Reports
C. Cost Audit
D. Tax Planning
E. Cost Control
Answer – Option D

Explanation –

• The scope of Cost Accountancy includes – Cost Ascertainment, Cost Accounting, Analysis of Cost, Cost
Control, Cost Reports, Cost Audit.
• Tax Planning is not included in the scope of Cost Accounting.
• Tax planning means reduction of tax liability by the way of exemptions, deductions and benefits.
• Tax planning in India allows a taxpayer to make the best use of the various tax exemptions, deductions
and benefits to minimize his tax liability every financial year.

Therefore, Option D is the correct answer. All other options are incorrect.

Additional Information:

• Cost Ascertainment refers to methods and processes involved in calculating cost actually incurred on
the basis of actual data shown in cost records. It involves computation of historical cost i.e. the cost
which has already been incurred. Hence, Option A is incorrect.
• Cost Report means the department-approved form for reporting costs, statistical data, and other
relevant information to the department. Hence, Option B is incorrect.
• Cost Audit accounts for the complete verification of the cost records of the company. Hence, Option C
is incorrect.
• Cost control is the practice of identifying and reducing business expenses to increase profits, and it starts
with the budgeting process. Cost control is an important factor in maintaining and growing profitability.
Hence, Option E is incorrect.

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Question 2– __________ is the process of accounting for cost which begins with recording of expenditure and
ends with the preparation of statistical data. PFRDA Grade A – Phase 2 - 2021

A. Cost Accounting
B. Costing
C. Cost Accountancy
D. Both A and B
E. All of the above
Answer – Option A

Explanation –

• Cost Accounting is the process of accounting for cost which begins with the recording of the expenditure
and ends with the preparation of statistical data.
• It is a method of accounting that records, classifies, allocate, summarize, analyse, interpret and controls
the cost incurred on any product, process, service or activity.
• It is formal mechanism by means of which costs of products or services are ascertained and controlled.

Hence, Option A is the correct answer. All other options are incorrect.

Additional Information:

• Costing refers to the practice of identifying costs of any product, service or activity, at various times and
stages of production. Hence, Option B is incorrect.
• The Institute of Cost and Management Accountants (ICMA) defines cost accountancy as follows:
o 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 therefrom for the purpose of managerial decision-making.
Hence, Option C is incorrect.

Question 3– In the modern world, which type of accounting is best suited for decision-making? PFRDA Grade
A – Phase 2 - 2021

A. Financial Accounting
B. Management Accounting
C. Cost Accounting
D. Either A or B
E. All of the above
Answer – Option B

Explanation –
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In the Modern world, Management Accounting is best suited for decision-making.

Management Accounting is primarily concerned with management. It involves the application of appropriate
techniques and concepts, which help management in establishing a plan for reasonable economic objective. It
helps in making rational decisions for accomplishment of these objectives.

Hence, Option B is the correct answer. All other options are incorrect.

Additional Information:

• Financial accounting is a specific branch of accounting involving a process of recording, summarizing,

and reporting the myriad of transactions resulting from business operations over a period of time.
Hence, Option A is incorrect.
• Cost Accounting is a method of accounting that records, classifies, allocate, summarize, analyse,
interpret and controls the cost incurred on any product, process, service or activity. Hence, Option C is
incorrect.

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 Summary Sheet
–
Material Cost

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 1 What is Material?
The general meaning of material is all commodities/ physical objects used to make the final
product. In simple words, Material is any substance which is used for the purpose of
production of goods or services. 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. For example, piece of cloth for
manufacturing a shirt.

(ii) Indirect Materials: Those materials which are not directly attributable to a particular final
product. For example, grease and oil used in the machines.

The above image depicts the classification of material costs. We will not be discussing the
above classification as the points are generic in nature.

2 Inventory
The inventory consists of direct material inventory, work-in-progress inventory and finished
goods.

Direct material inventory includes the stock of raw material which the company has
purchased for its use in production;

Work-in-progress inventory is the cost accumulated to the goods that are partially completed

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 Finished goods inventory is the stock that has finished all stages of production and is now
available for sale.

Let’s discuss the type of inventories with an example, Assume a company is in the business
of producing shirts. So, if the company has acquired the fabric for further processing. The
fabric will be considered raw material. And when this fabric is in the process of becoming a
finished product (shirt), it is considered work in progress, and when the shirt is finished, it is
considered a finished product.

3 Inventory Control
“The function of ensuring that sufficient goods are retained in stock to meet all requirements
without carrying unnecessarily large stocks” is known as inventory control. The main
objective of inventory control is to make a balance between sufficient stock and over-stock.

Inventory Control is must so that there is no wastage. Inventory Control can be at various
stages:

1. Regulating of Purchase (Buying at the right price).

2. Storage of Inventory (Minimum storage cost and no wastage).
3. Usage of Inventory (No wastage during manufacturing).
4. Avoiding excessive Investment in inventories as it will lead to storage cost and block the
money.
So, we can say that Inventory control is the systematic control and regulation of purchase,
storage and usage of materials in such a way as to maintain an even flow of production and
at the same time avoiding excessive investment in materials.

Objectives of Inventory Control:

The following are the objectives of Inventory Control:

1. No Understocking (It can lead to Production blockage)

2. No Overstocking (Storage Cost gets increased)
3. Economy in purchasing
4. Proper Quality
5. Minimum wastage

So, from the above points, we can understand that Inventory Control helps to control the
stock keeping while ensuring proper quality and minimum wastage.

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 4 Techniques of Inventory Control
Firstly, let’s see the different techniques, then we will discuss the techniques in detail:

4.1 ABC Technique

The “ABC Analysis” is an analytical method of stock control that aims at concentrating efforts
on those items where attention is needed most. It is a kind of selective control.

Example, In the below table, the point of classifying stock into A, B and C categories is to
ensure that material management focuses on A items where sophisticated controls should
be installed. B items may be given less attention and C items least attention. So, we can see
that there is a strict control when the there is high percentage value and vice versa.

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 Now let us discuss the advantages and disadvantages of the ABC Technique:

Advantages-
1. Closer and stricter control can be exercised on those items which represent large amounts
of capital invested.
2. Investment in inventory is regulated and funds can be utilized in the best possible way.
Disadvantages-
1. However, a limitation of ABC analysis is that it does not stress on items which are less
costly but may be vital.

4.2 Stock Level Technique

Under this technique, to prevent overstocking or understocking, most companies fix the
following levels:

1. Maximum Level
2. Minimum Level
3. Reorder Level
4. Reorder Quantity
We will discuss the above points in detail.

Some of the factors which influence stock levels are:

i. Anticipated rate of consumption

ii. Amount of capital available
iii. Availability of storage space
iv. Storage/warehousing costs
v. Procurement costs
vi. Reliability of suppliers
vii. Minimum order quantities imposed by suppliers
viii. Risk of loss due to: (a) obsolescence; (b) deterioration; (c) evaporation; and (d) fall in
market prices

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 Now, let us discuss, Maximum level, Minimum Level, Reorder Level, Danger Level and
Average Stock Level in detail:

Maximum Level- This is that level above which stocks should not normally be allowed to rise.
The idea of setting maximum stock level is to ensure that capital is not unnecessarily
blocked in stores and to avoid loss due to obsolescence and deterioration.

Minimum Level- It is that level below which stock should not normally be allowed to fall. It is
kind of safety stock. Falling below this level can lead to stoppage in production.

Reorder Level- This is that level of material at which purchase requisition is initiated for fresh
supplies. This level is fixed somewhere above minimum level. This is fixed in such a way that
by reordering when materials fall to this level, then in the normal course of events, new
supplies will be received just before the minimum level is reached.

Danger Level- Sometimes purchased materials are not received in time and stock level goes
below the minimum level. In order to meet such a situation a danger level is fixed. Danger
level is a level at which normal issues are stopped and materials are issued for important
jobs only. This level is generally fixed somewhat below the minimum level. When stock
reaches danger level, urgent action is needed for the replenishment of stock so that stoppage
in production can be avoided. Purchasing materials on an urgent basis results in higher
purchasing cost.

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 Average Stock Level-

Average stock level = ½ (Minimum level + Maximum level)

Alternatively, Average stock level = Minimum level + ½ (Reorder quantity)

Till now, we have discussed all the formulas related to Stock. Now let us see the implication
of such formulas in the following example:

4.3 Economic Order Quantity

Reorder quantity is the quantity for which order is placed when stock reaches reorder level.
By fixing this quantity, the purchaser doesn’t have to recalculate the quantity to be
purchased each time he orders for materials.

Two things must be considered:

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 1. Ordering Cost : Order making, Receiving and Inspecting Orders
2. Cost of Carrying Stock: Storage cost, Interest on Capital , Wastage
The above two types of costs are of opposing nature. If we try to reduce one, then other will
increase and vice-versa. EOQ should be such that sum of these costs is minimum. It is the
quantity when ordering cost and Cost of carrying are equal.

This can be understood from the following graph:

The optimum ordering quantity, i.e., the quantity for which the cost of holding plus the cost
of purchasing is the minimum is known as Economic ordering Quantity and is calculated by
the following formula:

Where, EOQ = Economic Order Quantity; A = Annual consumption in units ; B = Buying or

ordering cost per order ; S = Storage cost per unit per annum

Let’s discuss a question:

Question- Estimated requirement for the year 600 units. Calculate the EOQ with the help of
below data:

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 Solution-

S = 20 * Carrying Cost in %

= 20 * .2 = 4

4.4 Just-in-time Purchasing

Purchasing is the function of buying raw materials, general supplies, tools, office stationery
and other items. The essentials of efficient purchasing are right quantity, right quality, right
time, right price, right source and delivery at the right place.

Just-in-time purchasing is the purchase of materials immediately before these are required
for use in production. Raw materials are reduced to near zero.

4.5 Proper Purchase Procedure

There shall be a proper purchase procedure. Let’s discuss the process:

1. Purchase Requisition- A purchase requisition is a formal request by the head of a

department or an authorized officer to the purchase manager to purchase the specified
materials

2. Selection of Suppliers- Suppliers are selected from which the material will be purchased.

3. Purchase Order and Follow-up- When the supplier has been selected, the most common
procedure is the preparation of a purchase order.

4. Receipt of Materials- This department performs the functions of unpacking the goods
received and verifying their quantities and conditions.

5. Inspection of Quality- After receiving the materials, the quality is checked.

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 6. Return of Rejected Material- If there is any defect then such material is rejected or
returned.

7. Passing Invoice for Payment- When the purchase manager is satisfied, he can pass the
invoice for making payment to the supplier.

8. Purchase Price: The purchase price shall be decided considering following discounts

a. Quantity Discount: if you buy in large quantity then they shall give you discount.
b. Cash Discount: If you give money in cash they shall give you discount.
c. Trade Discount: If you buy directly from a wholesaler then they might give you
discount.

4.6 Proper Storage of Materials

In inventory control, proper storage of materials helps to ensure that materials are protected
from damage, deterioration or obsolescence. Here are some guidelines for proper storage of
materials under inventory control:

1. Proper storage to keep the material.

2. Proper storekeeper to manage the store.
3. Proper naming conventions to track the inventory.

4.7 Inventory Turnover Ratio

Inventory or stock turnover ratio tells us how many times in a year stock is used up and
replaced. The greater the stock turnover, the more efficient is the stock policy.

Let’s discuss a numerical,

Question- Refer to the following image:

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 Solution-

Now, calculating the stock turnover ratio expressed in number of days:

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 Thus, from the above solution, we can interpret that material A is fast moving as compared
to material B as it takes only 37 days to consume the average stock, whereas in the case of
B, it takes 183 days to consume the average stock. Considering the low turnover ratio of B,
its stock level should be refixed and if its rate of consumption does not change, its purchases
may be reduced.

SLOW, NON-MOVING AND OBSOLETE MATERIALS:

1. Slow moving materials are those which have a low turnover ratio, i.e., their rate of
consumption or sale is low compared to their stock-holding.

2. Dormant materials or non-moving materials are those which have no demand at

present, say, due to seasonal demand. Such materials may be required in future.

3. Obsolete materials represent those materials that have become useless with the
passage of time, say, due to changes in the design of the product or methods of
manufacture. These materials are no longer in demand because a better substitute
has been found or the product.

4.8 Perpetual Inventory System

Perpetual Inventory System is basically a type of inventory system to maintain Store Records.
There are two types of inventory systems to maintain store records:

1. Periodic Inventory System: Under this system, stock-taking is undertaken at the end of
the accounting year. As stock-taking involves verifying the physical quantities of stores in
hand, some firms temporarily suspend plant operations when this is done.

2. Perpetual Inventory Records: The method of recording stores balances after each receipt
and issue to facilitate regular checking. These records show the movement of stores, i.e.,
the receipt of materials, issues of materials to the production department and balance in
stock. Bin card and stores ledger are maintained under Perpetual Inventory Records.

Bin Cards: A bin card is a quantitative record of receipts, issues and closing balances of
material items in store.

Two Bin System: Two bins are maintained for each item of material. One bin constitutes
the main or the regular bin from which materials are issued and the other bin contains
the minimum stock from which issues are made only when stock in the regular bin is
exhausted.

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 Store Ledger: Gives same information as Bin card but also gives monetary value of
material along with number. Unlike Bin card which is kept by storekeeper Store ledger is
maintained by Cost department.

4.9 Fixation of Material Cost

When materials are issued from stores to production department, a question arises regarding
the price at which materials issued are to be charged

The question is important because the pricing directly affects the amount of profit or loss
reported for the accounting period. If the method chosen puts higher value to closing stock,
it will result in higher profit, and vice versa, lower valuation of closing stock will result in
lower profits.

There are various methods that can be used by the companies for the fixation of material
cost.

Let’s start with FIFO Method,

4.9.1 FIFO Method

This method is based on the assumption that materials which are purchased first are issued
first. 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.

Let’s calculate the closing stock for the following data with the help of FIFO Method:

So price for issuing 900 units would be

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 (200*5 + 500*6 + 200*6.5) = 5300
Closing stock = 600* 6.5 = 3900

Characteristics of FIFO Method:

1. Materials are priced at the actual cost.

2. Charge to production for material cost is at the oldest prices of materials in stock .
3. Closing stock is valued at the latest price paid.

4.9.2 LIFO Method

This method is based on the assumption that the last materials purchased are the first
materials 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.

Let’s calculate the closing stock for the following data with the help of LIFO Method:

So price for issuing 900 units would be

(800*6.5 + 100*6) = 5800

Closing stock = 400* 6 + 200* 5 = 3400

Characteristics of LIFO Method:

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 1. Materials are priced at the actual cost.

2. Charge to production for material cost is at the latest prices of materials in stock.

3. Closing stock is valued at the old prices paid and may not be in line with current prices.

FIFO and LIFO Method Comparison

1. In periods of rising prices, profit and tax liability under LIFO would be lower than under
FIFO method because cost will be charged at current prices which are at higher level.

2. Conversely, in periods of falling prices, in LIFO the closing stock is valued at old prices
which are at higher level and thus, profit would also be higher resulting in higher tax
liability.

4.9.3 Simple Average Method

Simple average price is calculated by adding all the different prices of materials in stock,
from which the materials to be priced could be drawn, by the number of prices used in that
total. The simple average is the average of prices ignoring the quantities involved. It can be
used when the prices are normally stable and the stocks purchased are in equal quantities or
the stock value is small. It is calculated by dividing the total rates of materials by the number
of rates of prices.

For Example:

Periodic Simple Average Method- This method is similar to simple average method except
that the issue price here is computed periodically (normally at the month-end) and not at
the time of each issue of material.

Moving Simple Average Method- In this method, the periodic simple average is further
averaged. For this purpose, a number of periods (or months) is decided first and then the
total of the periodic average prices of the given periods is divided by the number of periods
taken.

Let’s take an example,

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 Question- Compute simple moving average rates in a paint industry which purchased double
boiled oil at different monthly rates as given below. Six-monthly moving rate is to be
computed from June.

Solution-

Now, let us discuss the method which overcomes the flaw of simple average method.

4.9.4 Weighted Average Method

This method gives due weightage to the quantities held at each price when calculating the
average price. In this method, the total quantities and total costs are taken into account
while calculating the average price. It is calculated after every purchase by adding the
quantity received to the stock in hand and the cost of this purchase to the cost of stock in
hand. The total cost is divided by the total quantity to arrive at the value. This method avoids

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 price fluctuations and reduces the number of calculations and gives an acceptable figure for
stock. Example:

Now, let us discuss the advantages and disadvantages of Weighted Average Method:

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 4.9.5 Replacement Price Method
Replacement price is the price at which materials would be replaced, i.e., the market price
on the date of issue. This method is used when it is desired to reflect the current prices in
cost.

It is most suitable for businesses that buy large quantities of materials well in advance of
requirements to take advantage of cheap prices the benefit of which is not desired to be
passed on to the customer. For Example:

Now, let us discuss the advantages and disadvantages of Replacement Price Method:

Advantages: The main advantages of this method is that it is simple to operate as no

calculations are required to be made of the issue prices as is done in average, LIFO, FIFO
methods, etc. Secondly, material cost is charged at the current market prices.

Disadvantages:

1. Sometimes, replacement price is not easily available or not available at all. In such
cases, it has to be estimated, which may not be quite reliable.
2. As issues are not priced at actual cost, it results in unrealized profit or loss.

4.9.6 NIFO (Next in First Out) Method

Here materials are not charged at a price which has been paid, but rather at a price at which
an order has been placed, i.e., the price of materials that will be next received. This method
is same as Replacement Price Method.

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 For example, in stock there are two batches of materials, one at `15 and the other at `16.
There is a further batch of materials on order at `16.50 which has not yet been received. If
materials were to be issued now, these will be charged at `16.50.

4.9.7 Specific Price or Identifiable Cost Method

Special materials purchased exclusively for specific jobs or work orders should be charged to
those specific jobs at the specific (actual) price. This method can always be used where
materials are purchased and set aside for a job or work order until required for production.

4.9.8 Base Stock Method

This method assumes that minimum (base) stock is always held in stock and is not issued.
This is a fixed asset and is carried at original cost. Any quantity in excess of base stock is
valued according to one of the other methods, i.e., FIFO, LIFO, Average, etc. Thus, base stock
method is not an independent method and has to be used along with some other method.

For Example: Refer to the following image:

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 4.9.9 Inflated Price Method
This method is used where materials are subject to some inevitable losses that may arise
from evaporation, breaking the bulk, etc. The issue price is slightly inflated to ensure that
the loss is covered, and the full cost of the material concerned is recovered.

For example, let us assume 100 gallons of a liquid are purchased at `9 per gallon and a loss
of 5% is expected. This means only 95 gallons would be available for issues to production.
In order to recover the original cost of `900 (i.e., 100 × `9), the issue price must be `900 ÷ 95
gallons = `9.47.

Some important points under this method:

1. Normal Loss is that loss which has necessarily to be incurred and thus is unavoidable.
Examples are:

(i) Loss by evaporation in case of liquid materials.

(ii) Loss due to loading and unloading of material,
Normal losses of material cannot be eliminated but may be controlled to a limited extent.

2. Abnormal Loss: This is that loss which arises due to inefficiency in operations, bad luck,
mischief, etc. Examples are:

(i) Theft or pilferage

(ii) Breakage
(iii) Fire, accident, flood, etc.
(iv) Use of inaccurate weighing instruments
(v) Improper storage resulting in deterioration of materials

3. It is a principle of costing that all normal losses which are necessarily to be incurred are
treated as a part of the cost and abnormal losses which are avoidable should not be included
in the cost. Therefore, in order to absorb normal material losses in cost, the rates of usable
materials in stock are inflated so that such losses are covered.

Note: Preparation of Material Budgets (used in Budgetary Control) will be discussed in the
Budgetary Control Chapter.

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 Previous Year Questions (PYQs)
on
Material Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Which of the following is a technique of Inventory Management? SEBI Grade A – Phase 2 - 2020

A. ABC Analysis
B. Standard Costing
C. Marginal Costing
D. Process Costing
E. None of the above
Question 2 – Calculate the value of closing stock using Simple price moving average method.

1st December - purchased 100 units @ Rs. 20

2nd December - purchased 200 units @ Rs 22

5th December - Issued 250 units to department X. SEBI Grade A – Phase 2 - 2022

A. 1050
B. 1100
C. 900
D. 500
E. None of the above

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic.

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 Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option A
Question 2 Option A

Section C

Explanation
SEBI Grade A questions

Question 1 – Which of the following is a technique of Inventory Management? SEBI Grade A – Phase 2 - 2020

A. ABC Analysis
B. Standard Costing
C. Marginal Costing
D. Process Costing
E. None of the above

Answer – Option A

Explanation -

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ABC Analysis inventory categorization technique splits subjects into three categories to identify items that have
a heavy impact on overall inventory cost.

• Category A serves as your most valuable products that contribute the most to overall profit.

• Category B is the products that fall somewhere in between the most and least valuable.

• Category C is for the small transactions that are vital for overall profit but don’t matter much individually
to the company altogether.

Hence, Option A is the correct answer. All other options are incorrect.

Additional Information:

• Standard Costing: It is the practice of substituting an expected cost for an actual cost in the accounting
records. It involves the creation of estimated (i.e., standard) costs for some or all activities within a
company. Hence, Option B is incorrect.
• Marginal Costing: It refers to an increase or decrease in the total cost of production due to a change in
the quantity of the desired output. It is variable, depending on the inclusion of resources required to
produce or deliver additional unit(s) of a product or service. Hence, Option C is incorrect.
• Process Costing: It is an accounting method typically used by companies that mass produce very similar
or identical products or units of output. Hence, Option D is incorrect.

Question 2 – Calculate the value of closing stock using Simple price moving average method.

1st December - purchased 100 units @ Rs. 20

2nd December - purchased 200 units @ Rs 22

5th December - Issued 250 units to department X. SEBI Grade A – Phase 2 - 2022

A. 1050
B. 1100
C. 900
D. 500
E. None of the above
Answer – Option A

Explanation –

Simple average is an average of price without considering the quantities involved.

Average price = (20+22)/2 = 21

Closing Balance = Average Price x Closing Inventory

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Closing inventory, also referred to as ending inventory, refers to the amount of inventory a business has left on
the shelves and in stock at the end of the accounting year.

Closing Inventory = 100+200 – 250 (Issued to Department X)

= 50

Therefore, Closing Balance = Average Price x Closing Inventory = 21 x 50 = 1050

Hence, Option A is the correct answer. All other options are incorrect.

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 Summary Sheet
–
Labor Cost

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 1 What is Labor Cost/Employee Cost?
Labor or manpower represents human resources used in production. After material cost,
labor cost is the second major element of cost.

According to Cost Accounting Standard-7 (CAS-7) issued by ICAI, employee cost is

1. the aggregate of all kinds of consideration paid, payable, and provision made for
future payments

2. for the services rendered by employees of an enterprise (including temporary, part-

time and contract employees)

3. Consideration includes wages, salaries, contractual payments, and benefits, as

applicable, or any payment made on behalf of the employee. This is also known as
labor cost.’

The purpose of CAS-7 is to bring uniformity and consistency in the principles and methods of
determining Employee Cost with reasonable accuracy.

2 Reasons for Excessive Labor Cost

Labor Costs can be excessive due to many factors-

1. Inefficiency of the Labor Force- When there is inefficiency in the labor force, it can lead to
a decrease in productivity, increased costs, and reduced profits for businesses. This can be
due to a range of factors, such as inadequate training, poor working conditions, low morale
or motivation, or lack of appropriate tools and resources.

2. High Idle Time- High idle time in relation to labor cost refers to the period of time during
which employees are being paid for being at work, but they are not actively engaged in
productive activities. This can happen due to a lack of work, poor scheduling, equipment
breakdowns, or other factors that prevent employees from performing their duties.

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 3. Waste and Defective Production due to lack of supervision-

• Waste refers to any type of material or resources that are not utilized or consumed
efficiently during the production process. This can include raw materials, energy, or
labor that is used unnecessarily or excessively. Waste can occur due to poor planning,
inefficient processes, or lack of oversight and supervision.
• Defective production occurs when the output of the production process fails to meet
the required standards of quality or functionality. This can lead to additional costs for
the company, such as reworking the product or replacing it altogether. Defective
production can be caused by a variety of factors, including poor training or
supervision, faulty equipment, or errors in the production process.

4. High Labor Turnover- High labor turnover refers to a situation where a company has a high
rate of employee turnover or staff attrition. This means that employees are leaving the
company at a faster rate than new employees are being hired. High labor turnover can result
in significant labor costs for a company, as they have to spend money on recruiting, training,
and onboarding new staff to replace those who have left. Additionally, the loss of
experienced employees can lead to a loss of productivity and quality, further increasing labor
costs. High labor turnover can also indicate issues with employee satisfaction, retention, or
management, which can impact the company's bottom line.

3 Various Aspects of Labor Cost Control

Now, refer to the following information:

3.1 Classification of Labor Cost

Employee costs are broadly classified as direct and indirect employee costs.

Direct Labor Cost- Direct labor cost is ‘the cost of employees which can be attributed to a
cost object in an economically feasible way.’ Direct labor is expended in altering the
construction, composition or condition of the product. Example- In a factory of readymade
garments, wages paid to a tailor are direct wages.

Indirect Labor Cost- It is the wages paid to those workers who are not directly engaged in
converting raw materials into finished products. Such costs cannot be conveniently identified
with a cost object. Example- Supervisors, inspectors, clerks, instructors, peons, watchmen,
and cleaners are examples of indirect workers.

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 3.2 Production Planning
Effective control over Labor Cost can be achieved through proper production planning.
Production planning includes activities like planning, scheduling, routing, machine loading,
product and process engineering, work-study etc. With the help of work-study, time and
motion study can be conducted which will help in the fixation of standard time for a job. The
variance between actual time and standard time can then be monitored and if the actual time
is continuously more than standard time then corrective action can be taken.

3.3 Labor Budget

A Labor budget can be prepared which will set the target for the Labor Cost which will again
facilitate a comparison between the Budgeted Labor Cost and the Actual Labor Cost.

3.4 Labour Performance Report

There should be a system of periodic Labour efficiency and utilization reports. These reports
will give an idea about the efficiency and productivity of Labour.

3.5 Incentive Schemes

Improving Labour productivity is one of the important ways to reduce Labour Costs per unit.
Productivity can be improved by motivating the workers. Offering monetary and
nonmonetary incentives can help to improve productivity substantially.

3.6 Labour Cost Accounting

There should be a proper cost accounting system, which will identify the Direct and Indirect
Labour Costs. Similarly, the cost accounting department should be able to generate and
maintain records for timekeeping, time booking, idle and overtime, the impact of incentive
schemes, per unit of Labour, cost due to Labour Turnover and other relevant records.

Now, let us discuss about the various departments in Control of Labour Cost.

4 Various Departments in Control of Labour Cost

There are mainly five departments in an organization which deal with labour:

1. Personnel or HR department- Execution of policies related to Recruitment, training,

discharge and transfer, attendance, leave records, overtime, allowances, and incentives.
Reports concerning labour turnover, recruitment, productivity, utilization, and absenteeism
as well as reports on labour cost, idle time, various cost ratios etc., are prepared here for
submission to higher authorities for necessary action.

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 2. Engineering department- This department prepares and plans specifications of jobs makes
job analysis, provisions for safe working conditions, and supervises production activities.

3. Time-Keeping department- The function of this department is mainly to keep, and

maintain the time for which each and every worker has worked including the check-in and
check-out time. The entire correctness of the calculation of payroll, overtime payments,
incentive payments, and overhead allocation depend on the records maintained by this
department

4. Payroll Department- This department is responsible for the preparation of payroll and also
basically to maintain records of job classification, and department wage rates to prepare each
man’s earnings.

5. Cost-Accounting Department- This department is responsible for the accumulation and

compilation of all cost data relating to the element of Labour which is used by higher
management.

The above departments work in sync for labor cost control. This can be understood with the
flowchart below:

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 Hence, we can say that the departments work in sync to achieve control in respect to labor
turnover, idle time, overtime, payment by results. From the above image we can also
interpret the important factors of controlling labour cost.

Important Factors of Controlling Labour Cost:

5 Assessing Manpower Requirements

Assessing manpower requirement in Labour cost refers to the process of determining the
number of employees required to complete a task or project and calculating the associated
costs of Labour for the organization.

This involves identifying the skills and experience needed to perform the task, estimating the
time required to complete it, and evaluating the potential productivity of the workforce.

The cost of Labour includes wages, benefits, and any other expenses associated with
employing workers, such as training and development costs. Also, existing manpower is
trained as per the changing needs of the company.

By accurately assessing manpower requirements, organizations can manage labour costs

effectively, ensure that they have the right number of employees to complete tasks
efficiently.

6 Control Over Timekeeping and Time-Booking

Now, let us discuss the meaning of Timekeeping:

Time Keeping-

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 1. Plays an important role in Labour cost control through maintaining record of each
worker’s time in and time out during regular working period and reporting the time of each
worker for each department.

2. This will ensure punctuality and discipline in the company and will have a positive impact
on the morale of each worker.

3. It shows the total number of hours worked by each workman and so the calculation of his
wage becomes possible. This is applicable where the workers are paid wages as per the time
rate.

There are various methods of Time Keeping:

1. Attendance Records: In this method, every worker signs in an attendance register against
his name. Leaves taken by workers as well as late reporting is marked on the attendance
register itself. The main limitation of this system is that in case there is a large number of
workers, there may be large queues for signing the muster.

2. Disc Method: This is one of the older methods of recording time. A disc, which bears the
identification number of each worker, is given to each one. When the worker comes in, he
picks up his disc from the tray kept near the gate of the factory and drops in the box or hooks
it on a board against his number. The same procedure is followed at the time of leaving the
factory. The box is removed at starting time, and the timekeeper becomes aware of late
arrivals by requiring the workers concerned to report him before starting. The timekeeper
will record in an Attendance Register any late arrivals and workers leaving early.

3. Time Recording clocks: This is a mechanized method of time recording. Each worker
punches the card given to him when he comes in and goes out. The time and date is
automatically recorded in the card.

4. Biometric Machines: Marking attendance using an employee’s unique identity like finger
print, face and retina image etc.

Time Booking-

Timekeeping aims at keeping a check on the number of hours spent by a worker in the
factory. However, it does not record the productive time of the workers. It means the time
keeping methods do not provide information about how the time is spent by the workers in
the factory.

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 For example, the time keeping record will show that the worker has reported for duty at 8
am and left at 6 pm, thus, he has spent 10 hours in the company. But the analysis of these 10
hours is not provided by the timekeeping. In view of this there is a need to have a system,
which will tell about the productive time spent by the workers in the factory.

The method, which supplies this information, is known as ‘Time Booking Methods’ and the
recording the time spent by a worker in each job, process or operation is known as ‘Time
Booking’.

Time booking helps in

1. To determine the productive time spent by the worker on the job or operation. This helps
in finding out the idle time and controls the same.
2. To determine quantity of work done and hence the efficiency of workers.
3. To determine earnings like wages and bonus.
There are various methods of Time Booking:

1. Daily Time Sheet: In this method, each worker records the time spent by him on the work
during the day, for which a sheet is provided to each worker.

2. Weekly Timesheet: In this method, each worker records the time spent by him on the
work during the week, for which a sheet is provided to each worker.

3. Job Ticket: Job tickets are given to all workers where the time for commencing the job is
recorded as well as the time when the job is completed. The job tickets are given for each
job and the recording of the time as mentioned above helps to ascertain the time taken
for each job.

4. Labor Cost Card: This card is meant for a job, which involves several operations or stages
of completion. Instead of giving one card to each worker, only one card is passed on to all
workers, and the time taken on the job is recorded by each one of them. This card shows
the aggregate labor cost of the job or the product.

5. Time and Job Card: This card is a combined record, which shows both, the time is taken
for completion of the job as well as the attendance time. Therefore, there is no need to
keep a separate record of both, time is taken and attendance time.

7 Time and Motion Study

The study of time and motion is essential for designing an incentive system.

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 Motion Study -→ Time Study → Standard Time is arrived.

Time Study determines the time to be spent on the job. Standard time is the time that should
be taken for completing a particular job under standard or normal working conditions. For
fixation of standard time, Motion Study is necessary. Thus, the Motion Study precedes the
Time Study.

Motion Study means dividing the job into fundamental elements or basic operations of the
job or process and studying them in detail to eliminate the unnecessary elements or motions.
After investigation all movements in a job, process or operation, the Motion Study aims at
finding out the most scientific and systematic way of performing the job.

After eliminating unnecessary motions, the time that should be taken to perform these
motions is decided with the help of a stopwatch. In the time so fixed, some allowance is
added in the same for normal idle time, which is due to fatigue, change of job, change of
tools, and preventive maintenance of machines and so on. Thus standard time for a job or
process is arrived at.

Now, let us discuss another method known as Work Study and Method Study

Work Study-

Bonus is very important to motivate workers but the bonus can be given after comparing the
performance with some standard performance. A bonus is paid if the actual performance is
higher than the standard one.

However, for deciding the standard performance, standard time, i.e. time that is allowed
doing a particular job should be fixed against which the actual time taken should be
compared.

The Work Study which includes, Job Study, and the Method Study ensures the fixation of
standard time to do a particular job.

Method Study is done to improve the methods of production and to achieve the most
efficient use of the resources like, manpower, machines and materials. In method study
basically all the processes are studied and they are improved by:

1. Changing the location of certain job

2. Changing the sequence of certain job
3. Using modern methods to do certain jobs

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 Work Measurement: It aims at determining the effective time required to perform a job. The
ineffective, wasteful or avoidable time is separated from required time to complete the work.

Note- Method Study is similar to Motion Study and Work Measurement is similar to Time
Study.

8 Job Evaluation and Merit Rating

Firstly, we will discuss Job Evaluation and then we will discuss Merit Rating.

Job Evaluation:

It is necessary for the management of any organization to establish proper wage and salary
structure for various jobs. For doing this in a scientific manner, it is necessary to determine
the relative value of jobs and hence a job evaluation is done.

Job Evaluation is a technique of analysis and assessment of jobs to determine their relative
value within the firm.

Various Methods of Job Evaluation:

1. Point Ranking Method

2. Ranking Method
3. Grading Method

Merit Rating:

Job Evaluation is the rating of the job in order to bring rationality in the wage and salary
structure in the organization. On the other hand, Merit Rating is the comparative evaluation
and analysis of the individual merits of the employees.

The Merit Rating aims at evaluating and ranking the individual employees in order to plan
and implement rational promotional policies in the organization.

Difference between Job Evaluation and Merit Rating:

Job Evaluation is the assessment of the relative worth of jobs within a business enterprise
and Merit Rating is the assessment of the employees with respect to a job.

Job Evaluation helps in establishing a rational wage and salary structure. On the other hand,
Merit Rating helps in fixing fair wages for each worker in terms of his competence and
performance.

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 Job Evaluation brings uniformity in wages and salaries while Merit Rating aims at providing a
fair rate of pay for different workers on the basis of their performance.

9 Control over Idle Time and Overtime

Firstly, let us discuss Overtime.

Overtime:

Payment of overtime consists of two elements, viz., the normal (i.e., usual) amount and the
extra payment, i.e., the premium.

As per CAS-7, the overtime. Overtime premium is defined as ‘Overtime is the time spent
beyond the normal working hours which is usually paid at a higher rate than the normal time
rate. The extra amount payable beyond the normal wages & salaries for beyond the normal
working hours is called Overtime Premium’.

Overtime may result in excess cost, decrease in productivity, defective work, strain on
machinery. Therefore

1. Overtime shall only be done only if cannot be dispensed with.

2. Regular overtime means either more workers or more machines need to be installed.

Treatment of overtime in Accounts:

1. When overtime is worked due to exigencies or urgencies of the work, the basic / normal
payment is treated as Direct Labour Cost and charged to Production or cost unit on which
the worker is employed. Whereas the amount of premium (extra amount) is treated as
overhead

2. If overtime is spent at the request of the customer, then the entire amount (including
overtime premium) is treated as direct wages and should be charged to the job.

Idle Time:

Idle Time Cost represents the wages paid for the time lost during which the worker does not
work, i.e. time for which wages are paid, but no work is done.

As per CAS-7 Idle Time is ‘The difference between the time for which the employees are
paid/payable to employees and the employees time booked against the cost object’.

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 1. Inherent or unavoidable idle time: Time lost between the gate and place of work, break
for tea, time interval between one job and another, time for tool setting, adjustment of
machine, etc.
2. Normal idle time such as waits for jobs, tools, materials or instructions, small power
failures, small breakdown of machines and tools, and atmospheric conditions
3. Abnormal idle time such as those arising due to breakdown for considerable period, non-
availability of raw materials, slack supervision, strikes or lock-outs, fire flood, storm, etc.
4. Concealed idle time such as unnecessary work like cleaning, grass cutting and gardening
to employ idle men.
Treatment in Accounts:

1. Unavoidable idle time would be for insignificant periods and it is booked as direct cost.
2. Normal Idle Time is booked to factory or works overhead.
3. Abnormal Idle Time would usually be heavy in amount involves longer periods and would
mostly be beyond the control of the management. Payment for such idle time is not included
in cost and is adjusted through the Costing Profit and Loss Account or included in Profit and
Loss Account, when the accounts are integrated.
Now, let us discuss the very important factor that is Wage and Incentive System.

10 Wage and Incentive System

Before going further, we must understand the following terms:

Remuneration: Payment made to employees/labor

1. Time-Related Remuneration: Time-Related (How much time you work)

2. Piece-Related Remuneration: Result Related (How much quantity you produce)

Remuneration can be in form of salary, wage or Incentive.

10.1 Methods of Wages

Before discussing the methods, you must know that Higher wages does not necessarily mean
higher labor cost as higher wages may result in higher productivity.

Let us discuss the above statement, When workers are paid more, they may be more
motivated to work harder, produce higher-quality work, and be more committed to their
jobs. They may also feel more valued and appreciated by their employers, which can improve
morale and reduce turnover.

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 In turn, higher productivity can lead to increased revenue, which can offset the higher labour
costs. Additionally, when workers are more productive, they may require less supervision
or training, which can further reduce costs.

However, it's worth noting that the relationship between wages and productivity is complex,
and there are many factors that can impact productivity beyond wages alone.

Now let us discuss the various methods of wages:

10.1.1 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 Rate System is further categorized as:

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 1. At ordinary levels:

Under this method, rate of payment of wages per hour is fixed and payment is made
accordingly on the basis of time worked irrespective of the output produced. However,
overtime is paid as per the statutory provisions. The main benefit of this method for the
workers is that they get guarantee of minimum income irrespective of the output produced
by them.

This is used where:

1. High Skill is required

2. Output is not quantifiable
3. Work done is dependent on another person
4. Speed of production depends is governed by speed of machine
5. Workers are learners and they can’t be given wages on the basis of results

2. At high wage levels:

This system is a variation of time rate at ordinary levels in the sense that in this system,
workers are paid at time rate but the rate is much higher than that is normally paid in the
industry or area. In this method, the workers are paid according to the time taken and
overtime is not normally allowed .

This method is useful to attract talented workers.

3. Graduated Time Rate:

Under this method payment is made at time rate, which varies according to personal
qualities of the workers. The rate also changes with the official cost of living index.

10.1.2 Piece Rate System

This method is also called as payment by results where the workers are paid as per the
production achieved by them. Thus if a worker produces higher output, he can earn higher
wages

Advantages of Piece Rate:

A. Workers feel motivated to produce more.
B. Efficiency is rewarded.
C. Reduction of overhead expenses in overtime and idle time shall be reduced.
Disadvantages of Piece Rate:
A. Quantity may increase but not quality.

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 B. Materials and Machines may be used carelessly in order to produce more and hence
leading to wastage.
C. Dissatisfaction among those who are slow.
Piece Rate system can be of three types:
1. Straight Piece Rate:

In this method, rate per unit is fixed and the worker is paid according to this rate. For
example, if the rate per unit is fixed at `10, and the output produced is 300 units, the
remuneration to the worker will be `10 X 300 units = `3, 000.

This method is a very simple method in terms of calculation.

2. Piece Rate with Guaranteed Day Rates:

Under this system, Emerson’s Efficiency System is considered.

Emerson’s Efficiency System:

Under this system minimum time wages are guaranteed. Bonus in addition to minimum day
wages is given to the worker beyond a certain efficiency level. A worker who can attain
efficiency measured by his output which is equal to 2/3rd of this standard efficiency or
above, is deemed to be an efficient worker who deserves encouragement.

The scheme provides for payment of bonus at various levels of efficiency ranging from
66.67% to 150% in the following manner:

(i) for a performance below 66.67% efficiency, only time rate wages is paid without any bonus

(ii) for a performance between 66.67% and 100% efficiency, bonus varies between 0.01% and
20%

(iii) above 100% efficiency level, bonus of 20% of basic wages + 1% for each 1% increase in
efficiency is admissible

3. Differential Piece Rates:

Under these methods, the remuneration is increased as the output level rises. In other words,
a worker is paid higher wages for higher productivity as an incentive.

Comparison is made between the standard production and actual production of the worker.
If the actual production is more, the worker qualifies for higher rate of wages.

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 The Differential Piece Rate methods will be useful when the production is of repetitive type,
methods of production are standardized, and the output can be identified with individual
workers

Three types of Differential Piece rates:

(i) Taylor (ii) Merrick (iii) Gantt Task and Bonus

Now, we will discuss the above methods in detail.

(i) Taylor:

Taylor is regarded as father of scientific management, and he has recommended a system of

Differential Piece Rate.

He suggests that while efficient workers should be encouraged to the maximum possible
extent, the inefficient workers should be penalized.

Each worker will be given a standard production quantity to be produced in the time allowed
and the actual production should be compared with the same. If a worker exceeds the
standard, he will be regarded as efficient while if he fails to do so, he will be regarded as
inefficient.

If the workers are efficient, they should be paid @ 120% of the normal piece rate and if
they are inefficient, they should be paid @ 80% of the normal piece rate.

Merits and Demerits of Taylor Differential Piece Rate System:

(ii) Merrick:

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 Merrick’s system is modification of Taylor’s system and is comparatively less harsh on the
workers. The scale of remunerations is as follows:-

Production Rates of Payment

Up to 83% of production - Normal piece rate

83% to 100% of production - 110% of ordinary piece rate
Above 100% of production - 120% of ordinary piece rate
As mentioned earlier, this method is less harsh on the workers as compared to Taylor’s
system. It is particularly useful to beginners and offers an incentive who have potential of
higher productivity.

(iii) Gantt Task Bonus:

In this method, there is a combination of time rate, bonus and piece rate plan. The
remuneration is computed as shown below:

Production below standard - Guaranteed time rate

Production at standard - Bonus of 20% [normally] of time rate
Production above standard - High piece rate for the entire output
Advantage: This method assures minimum wages for even too less efficient workers and
hence is a preferred method of payment of wages. It also offers reasonably good incentive to
efficient workers.

Disadvantage: However, the main limitation is that the method is complicated to understand
by the workers and hence may create confusion amongst them.

10.1.3 Bonus Systems

Bonus Systems can be of three types:

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 1. Individual Bonus for Direct Workers:

The bonus to be paid to the workers is computed on the basis of savings in the hours, i.e. the
difference between the time allowed and time taken. The time allowed is the standard time,
which is fixed by conducting a time and motion study by the work-study engineers. The actual
time taken is compared with this standard time and bonus is payable to the worker if the
time taken is less than the standard time.

The individual bonus schemes commonly used are as follows.

(a) Halsey Premium Plan

This plan was introduced by F.A. Halsey, an American engineer.

In this plan, bonus is paid equal to wages of 50% of the time saved as compared to standard
time .

A worker is assured of time wages if he takes longer time than the allowed time. The formula
for computing the total wages is as follows.

Total Earnings = H X R + 50% [S – H] R

Where, H = Hours worked, R = Rate per hour, S = Standard time

(b) Halsey-Weir Premium Plan

Under this method, there is only one difference as compared to the Halsey Plan and that is
instead of 50% bonus for the time saved, it is 33.3% of the time saved. Accordingly the
formula for this method is modified as follows:

Total Earnings = H × R + 33+1/3 [S-H]R

H = Hours worked. R = Rate per hour, S = Standard time

(c) Rowan Plan

It is similar to that of Halsey Plan in respect of time saved, but bonus hours are calculated as
the proportion of the time saved to time allowed and they are paid for at time rate. The
formula for computation of total earnings is as follows:-

Total Earnings = H × R + [S – H]/S × H × R

Where H = Hours worked, R = Rate per hour, S = Standard time

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 (d) Barth Variable Sharing Plan

In this system, the total earnings are calculated as follows:

Total Earnings= R* √𝑺 ∗ 𝑯

H= Hours worked, R= Rate per hour, S= Standard Time

2. Group Bonus for Direct Workers

Many times, output of individuals cannot be measured. Similarly, the output of individual is
dependent on the performance of the group. In such cases, rather than implementing
individual bonus systems, group bonus system is implemented. The main objects of group
bonus system are as follows:

(a) Creation of team spirit

(b) Recognition of group efforts
(c) Improving productivity
Various Group Bonus Plans are:

Budgeted Expenses Bonus: Under this system, bonus is based on the savings in actual total
expenditure compared with the budgeted expenditure.

Pristman System: In this method, production standards are set in units or points and actual
production is compared with the standards. If the actual production exceeds the standard,
the workers are paid additional wages equal to the percentage of output over standard.

Towne Profit Sharing Plan: In this method standards are set for costs [mainly labour cost]
and the actual cost is compared with the standards. If there is a saving in the costs, the saving
is shared by workers and supervisory staff in agreed proportion. The principle behind this
method is that if there is a saving in the cost, not only the workers but the supervisory staff
should also get the reward because the cost reduction is the joint efforts of both the types of
staff. Hence both, workers and supervisors share it.

Waste Reduction Bonus: This system of bonus is based on savings in the material cost. If
there is a saving in the material cost, the workers share the same in the agreed proportion.
This system is generally used in industries where cost of material is very high.

3. Bonus for Indirect Workers

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 Indirect workers do not take part in the production process directly, but they play important
role in the production process. It is difficult to chalk out a bonus system for indirect workers,
as there is a difficulty in measuring their output.

However, it is advisable to plan a bonus system for indirect workers in order to motivate them
for better productivity.

Bonus to indirect workers is paid on the basis of output of the department, saving in time
or expenditure against the budgeted, product quality, reduction of waste and scrap and
reduction of labour turnover.

10.1.4 Indirect Monetary Incentives

Indirect Monetary Incentives are of two types:

(a) Profit Sharing- In this system, the profits of the organization are shared by workers in an
agreed proportion. The Payment of Bonus Act 1965 in India makes it mandatory to pay
minimum bonus of 8.33% of salary and maximum bonus of 20% of salary to the workers.

(b) Co-Partnerships- In this system, the workers get an opportunity to participate in the
ownership of the organization and to receive the part of the share of profits. The employees
are given assistance to purchase shares of the company. Thus the employees get dividend
and bonus also. These schemes help to boost the morale of workers to a great extent.

10.1.5 Non-Monetary Incentives

These incentives are given in addition to monetary incentives for further boosting the morale
of the employees. Though these benefits do not result in additional remuneration, they help
to improve productivity by boosting the morale of the employees. Some of the examples are:

(a) Free education and training.

(b) Medical benefits.
(d) Superannuation benefits like pensions, gratuity, life assurance schemes etc.
(e) Sports and recreation facilities, housing facilities, long service awards.
(f) Job security, promotion schemes.
(g) Benevolent funds and welfare fund.

11 Treatment of Wage/ Employee Costing in Accounts

There are various type of wage/employee cost. But how will we treat such cost in accounts?

Let’s discuss the treatment with regard to cost:

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 Supervisor Salary: The foreman is mainly concerned with the supervision of man and
machines in the workshop and so his salary is ‘indirect expenses’ under works or factory
overhead.

Bonus Under Payment of Bonus Act, 1965: The portion till minimum bonus is charged to
Direct or indirect labor cost depending on whether it is given to worker or supervisor. The
portion of bonus over and above the minimum is based on profit and should be charged off
to Costing Profit and Loss Account and not taken into the cost at all.

Leave Travel Assistance: Depending whether the assistance is payable to direct labour,
indirect labour or staff the expenditure should be treated as Direct Labour Cost, Production
Overhead Cost or Administrative Selling Overhead Cost and should be appropriately
charged.

Night Shift Allowance: It is a customary practice that the persons working in night shifts are
paid some extra and such an allowance is known as night shift allowance. Such additional
expenditure caused by general pressure of work in excess of normal capacity are charged to
general production overhead because otherwise job performed during days will be cheaper
than the jobs completed during night which by no means a fair proposition. If the additional
expenditure is incurred extremely as a result of pressing demands from customers such
expenditure should directly be charged to the job concerned.

Fringe Benefits: These may be treated as overheads.

Work on Holidays and Weekly off Day : Usually work on such days is to be paid at a higher
rate than the normal days’ grace. Normal wage is treated as direct cost whereas additional
wage is treated as production overhead.

Attendance Bonus: This is paid to workers based on satisfactory attendance. This is charged
to Production Overhead.

Employer’s contribution to Employees’ Provident Fund : Since this is mandatory, so this

should be treated as part of direct wages of workers.

12 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.
Hence, we can say that Labour turnover is defined as ‘the rate of change in the composition
of the Labour force in an organization.’

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 Causes of Labour Turnover-

There are various causes of Labor Turnover. Following are the causes of Labour Turnover:
1. Personnel Causes
(a)Dislike for the job, locality or environments
(b) Domestic troubles and family responsibilities
(c) Change of line for betterment
(d) Retirement due to old age and ill health
(e) Death
2. Unavoidable Causes
(a) Retrenchment due to recession
(b) Firing on Disciplinary grounds
3. Avoidable Causes
(a) Low Pay
(b) Lack of Interest in Job
(c) Bad working conditions
(d) Dispute with managers
(e) Lack of welfare activities

Methods-
There are various alternative methods by which this rate is computed:

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 Cost of Labour Turnover-

1. Preventive Cost: Preventive Costs refer to all those items of expenditure which are
incurred in order to keep the workers satisfied
I. Personnel Administration: Listening and solving labor grievances
II. Medical Service
III. Welfare services such as schools, canteens, laundry etc.
IV. Miscellaneous Schemes such as Pension or Provident Fund Schemes, Bonus

2. Replacement Cost: Replacement Costs are those costs which are incurred for the
recruitment and training of new hands and the resulting losses, wastages and lowering of
productivity due to the inexperience and inefficiency of the new labour force.
I. Loss of output due to delay in obtaining new workers
II. Recruitment Expenses
III. Induction training for new workers
IV. Cost of Machine breakage by inexperienced workers
V. Cost of Defective work

13 Employee Cost (CAS-7)

CAS-7 standard deals with the principles and methods of determining the Employee cost.
The objective of this standard is to bring uniformity and consistency in the principles and
methods of determining the Employee cost with reasonable accuracy.

For calculating employee cost, certain items are included and some are not. So let us discuss
which items are included and what items are not included.

The following items are to be ‘included’ for the purpose of measuring employee cost:

(i) Any payment made to an employee either in cash or kind

(ii) Gross payments including all allowances payable and includes all benefits . The cost of
free housing, free conveyance and any other similar benefits provided to an employee shall
be determined at the total cost of all resources consumed in providing such benefits.

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 (iii) Bonus, ex-gratia, sharing of surplus, remuneration payable to Managerial personnel
including Executive Directors and other officers

(iv) Any amount of amortization arising out of voluntary retirement, retrenchment,

termination, etc.

(vi) Any perquisites provided to an employee by the employer

The following items are to be ‘excluded’ for the purpose of measuring employee cost:

(i) Remuneration paid to Non-Executive Director

(ii) Cost of idle time [ = Hours spent as idle time x hourly rate]

(iii) Any abnormal payment to an employee – which are material and quantifiable

(iv) Penalties, damages paid to statutory authorities or third parties

(v) Recoveries from employees towards benefits provided – this should be adjusted/reduced
from the employee cost

(vi) Cost related to labour turnover – recruitment cost, training cost and etc.

(vii) Unamortized amount related to discontinued operations.

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 Previous Year Questions (PYQs)
on
Labor Cost

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Labour Turnover= __________ SEBI Grade A – Phase 1 - 2020

A. The number of people working in the current period

B. The number of people who left the organisation in the previous period
C. Rate of change of labour force
D. The rate of the change in the wages of the labour force
E. None of the above
Question 2 – Which of the following does not classify semi-variable costs into fixed and variable costs? SEBI
Grade A – Phase 2 - 2022

A. Graphical Method
B. Simultaneous Equations
C. High and Low Method
D. Least Square Method
E. Straight Piece Method

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic

Section B

Answer Key

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 SEBI Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option E

Section C

Explanation
SEBI Grade A questions

Question 1 – Labour Turnover= __________ SEBI Grade A – Phase 1 - 2020

A. The number of people working in the current period

B. The number of people who left the organisation in the previous period
C. Rate of change of labour force
D. The rate of the change in the wages of the labour force
E. None of the above

Answer – Option C

Explanation -
• Labour turnover may be defined as the number of workers replaced during a given period relative to the
average labour force during the period.
• It is the number of workers who left the job during a period relative to the average labour force during
the period.
• So, Labour Turnover is the rate of change of the labour force. Hence, Option C is the correct answer.

All other options are incorrect.

Question 2 – Which of the following does not classify semi-variable costs into fixed and variable costs? SEBI
Grade A – Phase 2 - 2022

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A. Graphical Method
B. Simultaneous Equations
C. High and Low Method
D. Least Square Method
E. Straight Piece Method

Answer – Option E

Explanation –

Sometimes, a business will need to use cost estimation techniques, particularly in the case of mixed costs, so
that they can separate the fixed and variable components, since only the variable components change in the
short run. Estimation is also useful for using current data to predict the effects of future changes in production
on total costs. Different estimation techniques that can be used include:

1) The scatter graph (Graphical Method)

2) The high-low method

3) Simulation Equations

4) Least Square Method

5) Regression analysis

Hence Option A, B, C and D are the techniques that help to classify semi-variable costs into fixed and variable
costs. Therefore, Option E is the correct answer.

Straight piece rate system is the simplest method of payment by result in which payment is made according to
the number of units produced at a fixed rate per unit.

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 Summary Sheet
-
Overhead Costing

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 1 Introduction
First thing which you should note is that, "Overheads costing" is covered under Cost Accounting
Standard (CAS- 3). So basically, CAS-3 explains the methodology that is used for collecting, allocating,
apportioning, and absorbing overheads.

The analysis and collection of overheads, their allocation and apportionment to different cost centres,
and absorption to products or services all play important roles in cost determination and control. A
better overhead distribution system can only ensure greater accuracy in determining the cost of
products or services.

As a result, standard practices for overhead allocation, apportionment, and absorption, are required
for the preparation of cost statements.

1.1 What is overhead?

To define, Overheads are an aggregate of indirect materials, indirect employee costs, and indirect
expenses that are not directly identifiable or economically allocable to a cost object.

Examples of overhead expenses are rent, taxes, depreciation, maintenance, repairs, supervision,
selling and distribution expenses, marketing expenses, factory lighting, printing stationery etc.

In simple terms, overhead is the cost which cannot be identified with a particular product or service.

For example, if there is a building on rent in a company and in that building various departments are
working where various kinds of products are being made, then can this rent be distributed among the
products? Can we determine that which product is taking how much rent? No, this is very difficult to
quantify. So that is why rent is called a kind of an overhead.

One more example can be the salary of a CEO. Can we quantify the amount of salary that is
apportioned to each of the products that are being produced? No, because it is very difficult without
proper calculations to say that a certain amount of salary of this CEO is apportioned to a particular
product.

2 Steps involved in Overhead Accounting

As overheads are all indirect costs, it is difficult to charge them to product units. In view of this, it
becomes necessary to charge them on some equitably basis which is called as ‘Absorption of
overheads’.

This equitable basis means a set of logically based criteria that we need to follow, in order to assign
overheads cost to different products or services.

The important steps involved in overhead accounting are as follows-

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 (a) Collection, classification and codification of overheads- Collection of overheads means the pooling
of expenses from books of account with the help of some supportive/ corroborative records.

(b) Allocation, apportionment and reapportionment of overheads- Allocation of overheads is

assigning a whole item of cost directly to a cost centre whereas Apportionment of overhead is
distribution of overheads to more than one cost centre on some equitable basis. And The process of
assigning service department overheads to production department is called reassignment or re-
apportionment.

(c) Absorption of overheads- After completing allocation, apportionment and reapportionment,

overheads charged to department are to be recovered from the output produced in respective
departments. This process of recovering of overheads of a department or any other cost centre from
its output is called recovery or absorption.

For, higher conceptual clarity, you can refer to the following image, which we will be using for
understanding purpose.

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2.1 Collection of overheads
Overheads collection is the process of recording each item of cost in the records maintained for the
purpose of ascertainment of cost of each cost center or unit.

To make overhead apportionment more rational and scientific, the cost pools must be kept as
homogeneous as possible. A cost center for maintenance expenses will aid in allocating them to the
various cost centres that use the maintenance service.

2.1.1 Sources of collection of overheads

Collection of overheads is done with the help of certain documents that are issued on the day-to-day
basis in the course of any business.

This list of documents is not exhaustive, there can be various other sources of collection of
information about overheads, and these are just some of the many examples.

1. Stores issue notes: Stores issue notes, which show standing order numbers, are used to obtain
indirect materials such as brushes, brooms, etc.
2. Purchase Vouchers or Invoices: Payments to outside parties for stores and other services are
made on the basis of vouchers or invoices that are entered in the Purchase Journal for cash
payment.
3. Payroll Sheet or time sheets: are basically maintained by payroll department where the record
that which work has worked for what time and what is the salary that is being given to them.
Wages and salaries with other benefits that are being given to indirect labour are recorded, which
is the indirect cost that is also an overhead. So using payroll sheet can classify that what salaries
are being given in which department, and which of them are direct or indirect labour.
4. Cash Book: Where transactions for petty expenses occur more frequently, the cash book is
thoroughly scrutinized, and indirect expenses are properly collected against each department's
standing order number. It is basically a register in which we record everything we spend to buy
something. So, in this document, we can see the expenditure on indirect material, indirect labour,
and other indirect expenses.

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 2.2 Classification of overheads
The determination of categories, classes, or groups into which overhead costs can be subdivided is
referred to as classification. CIMA defines classification as "the arrangement of items in logical groups
based on their nature (subjective classification) or the purpose to be fulfilled (objective
classification)".

The process of grouping costs based on their common characteristics is referred to as overhead
classification.

2.2.1 Classification on the basis of elements

This classification method is based on the definition of overheads. Overheads are divided into three
categories in this method: (a) Indirect Materials (b) Indirect Labor (c) Indirect Expenses.

(a) Indirect Materials: They are material costs that cannot be allocated to a specific job or production
but are absorbed indirectly by cost centres or cost units. Examples include fuel, lubricating oil, stores
used for repair and maintenance, cotton waste, and so on.

(b) Indirect Labour: This includes wages that cannot be allocated and must instead be apportioned to
cost centres or cost units. Examples - Wages for maintenance workers, storekeeper and foreman
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 salaries, overtime and night shift bonuses, employer contributions to funds, holiday pay, leave pay,
and so on are some examples.

(c) Indirect Costs: Indirect expenses are those that cannot be allocated directly but must be
apportioned to or absorbed by cost centres or cost units. The typical examples are—rent, insurance,
taxes, telephone expenses, canteen and welfare expenses, lighting and heating, depreciation, etc.

It should be noted that this method of classification is usually followed for classifying factory
overheads but not overheads in general.

2.2.2 Classification on the basis of Functions

Overheads can be classified on the basis of type of functions in which a particular overhead is incurred.
Overheads are divided into three categories: Production overheads, office and administrative
overheads, and selling and distribution overheads.

Each of these overheads is again sub-divided into three categories-Indirect material, indirect labour,
and indirect expenses.

Note – We have already covered the basics of this classification of overhead in the very first chapter of
costing, therefore here we will understand them in a very brief manner.

1. Production overhead- Also known as factory overhead, works overhead or manufacturing overhead,
these are those overheads which are concerned with the production function. They include indirect
materials, indirect wages and indirect expenses in producing goods or services.

(a) Indirect Material-Examples: Coal, oil, grease, etc.; stationery in factory office, cotton waste,
brush, sweeping broom, etc.

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 (b) Indirect Labour-Examples: Works manager's salary, salary of factory office staff, salary of
inspector and supervisor, wages of factory sweeper, wages of factory watchman.

(c) Indirect Expenses-Examples: Factory rent, depreciation of plant, repair and maintenance of plant,
insurance of factory building, factory lighting and power, internal transport expenses.

2. Office and administration overhead- This is the indirect expenditure incurred in general
administrative function, i.e., in formulating policies, planning and controlling the functions, directing
and motivating the personnel of an organization in the attainment of its objectives.

These overheads are of general character and have no direct connection with production or sales
activities. This category of overhead is also classified into indirect material, indirect labour and indirect
expenses.

(a) Indirect Material-Examples: Stationery used in general administrative office, postage, sweeping
broom and brush, etc.

(b) Indirect Labour-Examples: Salary of office staff, salary of managing director, remuneration of
directors of the company.

(c) Indirect Expenses-Examples: Rent of office building, legal expenses, office lighting and power,
telephone expenses, depreciation of office furniture and equipment’s, office air-conditioning, sundry
office expenses.

3. Selling and distribution overhead- Selling overhead is the cost of promoting sales and retaining
customers. It is defined as "the cost of seeking to create and stimulate demand and of securing
orders." Examples are advertisements, samples and free gifts, salaries of salesmen, etc.

Selling and distribution overhead are also grouped into indirect material, indirect labour and indirect
expenses.

(a) Indirect Material-Examples: Packing material; stationery used in sales office, cost of samples,
price list; catalogues, oil, grease etc., for delivery vans, etc.

(b) Indirect Labour-Examples: Salary of sales manager, salary of sales office staff, salary of
warehouse staff, salary of drivers of delivery vans, etc.

(c) Indirect Expenses-Examples: Advertising, travelling expenses, showroom expenses, carriage

outwards, rent of warehouse, bad debts, insurance of goods in transit, etc.

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 2.2.3 Classification on the basis of behavior

1. Variable Overheads: Variable overhead is a term used to describe the fluctuating manufacturing
costs associated with operating businesses. As production output increases or decreases, variable
overhead expenses move in kind. Examples are indirect materials, indirect labor, salesmen’s
commission, power, light, fuel, etc.

2. Fixed Overheads: Fixed overhead is a set of costs that do not vary as a result of changes in
activity. Examples are rent and rates, managerial salaries, building depreciation, postage,
stationery and legal expenses

3. Semi-Variable Overheads - These overheads are partly fixed and partly variable. In other words,
semi-variable overhead costs vary in part with the volume of production and in part they are
constant, whenever there is a change in volume of production. Examples are supervisory salaries,
depreciation, repairs and maintenance, etc.

After understanding how classification of various overheads are done, now we should also
understand the importance of codification of these overheads, as this process brings clarity for such
classification of overheads.

2.2.4 Codification of overheads

After overheads are classified, it is found useful to allot a number or symbol to each group of
expenses so that each such group is easily distinguished from others.

Such numbers or symbols that are codes for overheads are called standing order numbers. Each
standing order number denotes a particular type of expenditure so that items of expenses of similar
nature, as and when they are incurred, are appropriately classified into one of these.

In the below image, there is an example where a certain code indicates a particular department of the
production process.

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 2.3 Allocation and Apportionment of Overheads (Primary distribution)
Departmentalization of overheads is the process of allocation and apportionment of overheads to
different departments or cost centres. Instead of directly assigning overheads to each product unit,
departmentalization distributes them among different departments.

For smooth and efficient working, a factory is sub-divided into several departments, each of which
denotes an activity of the factory, e.g., purchase department, stores department, timekeeping
department, personnel department, crushing department and melting shop.

Departmentalization is a process in basically we divide the over it into various departments write a
company has various departments, and those department can be categorized into production
departments and Service Department.

• Production departments are the departments which are engaged in production of something. For
example, in a firm which is manufacturing something there can be a weaving department, crushing
department, polishing Department, melting shop, etc. and such other departments depending
upon what kind of production is taking place.
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 • Service Department would not be directly engaged into producing something but it is engaged in
providing services to the production department. For example, HR department is providing service
to this production department by managing the workforce involved in production.

Some, examples of production departments and service departments are shown in the image below.

So, departmentalization is the process of dividing the overhead expenses in production and service
departments and this division of overheads in production department and service departments is
called as primary distribution or allocation and apportionment.

2.3.1 Allocation of overheads

Certain items of overhead costs can be directly identified with a particular department or cost center
as having been incurred for that cost center. Allotment of such costs to departments or cost centres is
known as allocation. Thus, allocation may be defined as ‘the assignment of whole items of cost directly
to a cost centre.’

Whenever we know that a particular overhead is fully included in some single department only then
we can directly allocate that overhead to that department that is called as allocation. For example,
there are wages of supervisor which is an indirect cost. If a supervisor is working in only in the grinding
department then it becomes easier for us to allocate that wage of supervisor which is an indirect cost
to the grinding department.

2.3.2 Apportionment of overheads

Certain overhead costs cannot be directly charged to a department or cost centre. Such costs are
common to several cost centres or departments and do not originate from any specific department.

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 Distribution of such overhead costs to various departments is known as apportionment. Thus,
apportionment may be defined as ‘the distribution of overheads to more than one cost centre, on
some equitable basis.

Difference between Allocation and Apportionment: -

1. The purpose of both cost allocation and cost apportionment is the identification or allotment of
items of cost to cost centres or cost units.

2. Allocation deals with whole items of costs, apportionment deals with proportions of the items
of cost.

3. Overheads should always be allocated, as far as possible. If an overhead cost cannot be

allocated, then it is apportioned

Principles of apportionment

There are 3 major principles of apportionment-

1. Service of Use: This method is based on the usage pattern of certain service or function of different
departments in a particular organization. Larger the use by department, larger the apportionment
to that department

2. Survey Method: This method is used for those overhead costs that are not directly related to
departments and whose remoteness necessitates an arbitrary distribution. For example, salary of a
general manager of a company may be apportioned on the basis of the results of a survey which
may reveal that 30% of his salary should be apportioned to sales, 10% to administration and 60% to
various producing departments.

3. Ability-to-pay method: This is based on the theory of taxation which holds that those who have the
largest income should bear the highest proportion of the tax burden. In overhead cost distribution,
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 those departments which have the largest income may be charged with the largest amount of
overheads.

Please note that no method is right or wrong or no method is the best method amongst the above
three. But mostly used method is of service of use where larger the used by the department, larger the
proportion of cost apportioned to the department because this is the most logical among these
principles of apportionment.

Basis of apportionment
First have a look on the below table, if talk regarding first point (Rent), then rent overheads can be
apportioned on basis of floor area. Like we can apportioned the supervision overheads on the basis of
Number of workers and so on.

S.No. Overhead Cost Basis of apportionment

(1) (i) Rent and other building expenses Floor area or volume of department
(ii) Lighting and heating
(iii) Fire precaution service
(iv) Air-conditioning

(2) (i) Fringe benefits 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

(4) (i) Power/steam consumption Technical estimates

(ii) Internal transport
(iii) Managerial salaries

(5) Lighting expenses No. of light points, or Area

(6) Electric power Horse power of machines, or Number of

machine hours, or Value of machines

(7) (i) Material handling Weight of materials, or Volume of materials, or

(ii) Stores overheads Value of materials

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2.4 Reapportionment (Secondary Distribution)
Under primary distribution we distributed the overhead cost to all the departments- production and
service department, but the ultimate objective is to find out the cost per unit, that is, the cost of each
unit or product.

So, we need to distribute all cost of different departments to Production department so that we can
find out the cost of each unit. To meet this objective, we need to use secondary distribution, in which
all the overheads that has been distributed to Service Department using primary distribution now
needs to be redistributed to Production department. After secondary distribution we can successfully
find out the cost per unit of a particular product.

Now, for apportionment of service department overheads to production departments, there can be
two cases.

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 First one is that all the service departments are providing services only to Production department, that
is, for example- if Service Department C and D are providing service to production departments A and
B.

C and D not providing service to any other Service Department, which means that service
departments are just providing services to production departments, they are not providing services
to other Service Department.

Second case is where the service departments are providing services to production departments as
well as also to other service departments. In such a case there can be again two categories- where the
service department is not taking services from such other service department to which it gives its
services, which will be termed as non-reciprocal basis. And the other one is where a service
department not only gives its services to such other departments but also take certain services from
them, which will be termed as reciprocal basis.

For example, if service department C is providing its services to service department D, but not taking
any services from D, this is a case of non-reciprocal. Whereas, if department C was providing services
to department D and D was also provides some services to C, then this is a case of reciprocal basis.

2.4.1 Apportionment of Service Department Overheads to Production Departments Only

Direct Distribution: In this case, cost of each service department is apportioned only to production
departments without apportioning it to other service departments.

It is assumed that service departments are not providing service to other service departments.

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 2.4.2 Apportionment of Service Department Overheads to Production Departments and
Service Departments
Quite often, a service department renders services not only to production department but also to
other service departments.

For Example: Powerhouse supplies electricity not only to production departments but also to service
departments like canteen, maintenance departments, etc.

Personnel department not only takes care of employees of production department but also of
employees in purchase or canteen department. Now first let’s discuss the case of Non-Reciprocal basis.

Non-Reciprocal basis (Step Distribution Method or Ladder Method):

1. This method is used when a service department renders services to other service departments but
does not receive services of the other service departments, i.e., when service departments are not
inter-dependent.

2. In this method, the service departments are arranged in descending order of their serviceability.
The cost of the most serviceable department, i.e., the department which serves the largest number
of departments is first apportioned to other service departments.

3. The service department which serves the next largest number of departments is taken up next
and its cost (including the prorated cost of the first service department) is apportioned to other
service and production departments excepting the first service department.

In the above method, overhead cost of first Service Department was apportioned among all the
production departments and all other Service Department, but the second Service Department is not
providing service to First Service Department.

That is why, it is non-reciprocal which means that the cost of second Service Department shall be
reapportioned among other production departments and other service departments except the first
service department.

The important thing to remember is that in primary distribution the second Service Department would
have apportioned some cost which needs to be redistributed, apart from that under this method
itself certain overhead has been redistributed from first Service Department to second Service
Department so while we are reapportioning the overhead to the second Service Department, we shall
also add that overhead which has been reapportioned from first Service Department to second Service
Department.

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 Reciprocal basis
This method takes cognizance of the fact that service departments may give as well as receive services
from and to the other service departments on reciprocal basis.

Such inter-departmental exchange of service is given due weight in the distribution of the
overheads. There are two methods used for distribution under this logic.

1. Repeated Distribution Method : This is a continuous distribution of overhead costs over all
departments. The decided ratios are used to distribute the costs of service departments to the
production and other service departments. This is continued till the figures of service
departments become ‘nil’ or ‘negligible’.

2. Other Simultaneous Equation Method: Under this method, simultaneous equations are formed
using relationship the service departments’ share with each other. (Complex method which we
shall not study here)

3. Trial and Error Method: when there is circular relationship and its not possible to use either of
the above then trial and error method is used

The method that we will be focusing on as per our curriculum is repeated distribution method.
Please note that the other two methods are outside the purview of the course, just memorize that
these two come under reciprocal basis of overhead distribution, do not bother to study them in more
detail.

2.5 Absorption of overheads

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 Once the apportionment and Re-apportionment has happened, the total cost of each production
department comprises the following:

1) Costs allocated and apportioned to production departments.

2) Costs of service departments re-apportioned to production departments.
The total overhead cost pertaining to a production department or cost centre is then charged to or
absorbed in the cost of the products or cost units passing through that centre. This is known as
absorption.

The absorption of overheads is the last step in the distribution plan of overheads. It is defined as
charging of overheads to cost units. In other words, overhead absorption is the apportionment of
overheads of the cost centres over cost units. Absorption of overheads is also known as levy, recovery
or application of overheads.

What do we mean by charging of overheads in cost unit?

Cost unit is simply the cost per unit. For example, for steel it would be per metric ton, for a soap
it will be a case of soap which consists of 24 soaps. So, this will depend upon how or in what
terms this particular unit is being maintained.

There are two steps in the absorption of overheads:

1. Computation of overheads absorption rate

2. Application of these rates to cost units.

2.5.1 Computation of overhead absorption rate

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 1. Direct Material Cost
Under this method, the amount of overheads to be absorbed by a cost unit is determined by the cost
of direct materials consumed in producing it. This rate is computed by dividing the total overheads by
the total cost of direct materials consumed in the department.

𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝𝐬
𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝𝐬 𝐫𝐚𝐭𝐞 = × 100
𝐃𝐢𝐫𝐞𝐜𝐭 𝐦𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐜𝐨𝐬𝐭

2. Direct Labour Cost Percentage Rate

The overhead rate under this method is computed by dividing the production overheads by the direct
labour cost.

𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝𝐬
𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝𝐬 𝐫𝐚𝐭𝐞 = × 100
𝐃𝐢𝐫𝐞𝐜𝐭 𝐥𝐚𝐛𝐨𝐮𝐫 𝐜𝐨𝐬𝐭

3. Prime Cost Percentage Rate

This method is based on the premise that both materials and labor give rise to factory overheads and
thus the total of the two, i.e., prime cost should be taken as the base for absorption of factory
overheads. In a way, this is a combination of the material cost and labor cost methods.

𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝
𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝 𝐫𝐚𝐭𝐞 = × 100
𝐏𝐫𝐢𝐦𝐞 𝐜𝐨𝐬𝐭

4. Direct Labor Hour Rate:

It is obtained by dividing the total production overheads by the total number of direct labor hours for
the period.

𝑷𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒐𝒏 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅
𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝 𝐫𝐚𝐭𝐞 =
𝑫𝒊𝒓𝒆𝒄𝒕 𝒍𝒂𝒃𝒐𝒖𝒓 𝒉𝒐𝒖𝒓𝒔

5. Machine Hour Rate

Machine hour rate is the overhead cost of running a machine for one hour. This rate is obtained by
dividing the amount of factory overheads apportioned to a machine by the number of machine hours
for the period under consideration.

When budgeted hours are used, they are taken at average capacity at which a factory normally
operates. You cannot take full capacity hours as the factory may not operate at that level and then the
absorption rate may be unnecessarily fixed at a lower level.

A machine hour rate may be calculated using only those overheads which are directly related to the
machine e.g. power, fuel, repairs, maintenance, depreciation etc. These expenses are totaled and then
divided by the hours to compute the rate. This is called as Ordinary Machine Hour Rate. Whereas, if

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 costs not related to machine are also included (e.g. supervision, rent, lighting, heating etc.) for the rate
calculation, such rate is called as Composite Machine Hour Rate

For example: Production overhead of machine 1= Rs. 25000

No. of machine hours = 2000

𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝 25000

Machine hour rate = = = 12.5
𝐍𝐨.𝐨𝐟 𝐦𝐚𝐜𝐡𝐢𝐧𝐞 𝐡𝐨𝐮𝐫𝐬 2000

If machine 1 has been used for a job for 30 hours, overheads to be absorbed by that job will amount to
Rs. 375, i.e., 30 hrs × 12.5

Ideally it does not make sense to use overhead costs that are not related to machine while
calculating machine hour rate and therefore we use ordinary machine hour rate more often than
composite machine hour rate.

6. Rate per Unit of Output

Here Overhead Absorption rate is calculated by number of units being produced.

This method can only be used if the units produced are uniform because if these units have different
features and attributes, it is also likely that they incur different cost of overheads. For example, for a
shoe designing company, it would incur more overheads on the shoe of larger size and complex design
as compared to the shoes that are smaller in size and do not have complex designs.

Example :- Production overhead = 22000

No. of units produced = 1000

𝐀𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐨𝐯𝐞𝐫𝐡𝐞𝐚𝐝𝐬 22000

Therefore, overhead rate = = = Rs.22 per unit
𝐍𝐨.𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 1000

2.5.2 Categorization of overhead rates

The methods of calculating overhead rate can be categorized into two major heads- blanket overhead
rate or multiple overhead rate.

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 Blanket overhead rate
A single overhead rate for the entire factory may be computed for the entire factory. So this is known
as factory wide or Blanket Overhead Rate Method.

Blanket Rate = Overhead Cost for the factory / Total Quantum of the base.

Blanket Rate of overheads may be applied suitable in a small size concerns. Blanket Rates are easy to
compute. The use of Blanket Rate of overheads gives erroneous and misleading results, where several
products passing through number of different departments.

Multiple overhead rate

This method is most used to determine the multiple overhead rates, i.e. separate rates:

(a) For each producing department;

(b) For each product line

Overhead Rate = Overhead cost allocated & apportioned to each product, dept / Corresponding
Base.

Multiple overhead rates simply means when we find different absorption rate for different
departments or different products.

Actual or pre-determined overhead rate

Actual Overhead Rate is obtained by dividing the overhead expenses incurred during the accounting
period by actual quantum on the base selected. Assuming that the rates are worked out on a monthly
basis the formula is:-

Actual Overhead Rate = Actual overhead during the month ÷ Value/Quantity of the base during the
month

Absorption of overheads based on actual rates may not be adopted due to the following reasons:-
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 (a) Actual overhead rate can be computed only after the accounting period is over.

(b) The incidence of some of the items of expenses like repairs, overhauling, etc. is not uniformly
spread over all the accounting periods.

Predetermined Rate is computed by dividing the budgeted overhead expenses for the accounting
period by the budgeted base (quantity, hours, etc.)

Predetermined Overhead Rate= Budgeted overhead expenses for the period / Budgeted Base for the
period

Advantages of Predetermined Overhead Rate

(a) Enables prompt preparation of cost estimates, quotations and fixation of selling prices.

(b) Cost data is available to management along with financial data.

2.5.3 Features of a satisfactory overhead rate

(a) Simple, easy to operate, practical and accurate:- The overhead rate calculated should be easily
applicable so that apportionment of overheads could be done in a practical or logical manner, which
will give accurate results.

(b) Economic in application:- It should not be the case that while applying such rates we are incurring
unnecessary losses that could have been avoided if the correct method was followed to apportion such
overheads.

(c) Departmental rates are preferable to blanket rates; because departmental rates are more accurate
and give the most correct results as compared to blanket rates which assign the same rate to different
departments of production.

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2.6 Under-absorption or Over-absorption of Cost
Sometimes if we use Budgeted Overhead Cost then it may not be same as actual overhead cost. So the
overheads absorbed may be less than or more than the actual overheads.

If the amount absorbed is less than the amount incurred then it is called under-absorption.

If the amount absorbed is more than the amount incurred then it is called over-absorption.

2.6.1 Factors for Under-absorption or Over-absorption of Cost

(a) Error in estimating overhead expenses – it might happen that during valuation of overheads, some
error was made.

(b) Error in estimating the level of production, i.e. the base – there may be a case of error in choosing
the correct or accurate base for calculation of overhead rates.

(c) Major unanticipated changes in the methods of production- due to which there is a change in the
production cost, or overhead costs, or both.

(d) Unforeseen changes in the production capacity

(e) Seasonal fluctuations in the overhead expenses from period to period

Adjustments that need to be made - Write-off (in case of under absorption) or write back (in case of
over-absorption) to the P & L Account.

Writing off means, deducting the under-absorbed overheads from the profit. Whereas writing back
means, adding back the overheads which were over-absorbed to the profit as arrived by P&L account.

2.7 Reporting of Overhead Costs

1. Overheads shall be presented as separate cost heads like production, administration and
marketing.

2. Element wise and behavior wise details of the overheads shall be presented, if material.

3. Any under-absorption or over-absorption of overheads shall be presented in the reconciliation

statement.

3 General and Administrative Overhead

These are indirect expenditures incurred in formulating the policy, directing the organization and
controlling the operations of an undertaking. These overheads are of a general character and are
incurred for the business as a whole.

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 These overheads are generally constant in nature and are not affected by any fluctuations in the
volume of production or sales.

These overhead costs are then allocated and apportioned to various administrative departments,
like general office, law department, accounts department and secretarial department.

Absorption of General and Administrative overhead can be done in the following manner:

1. Percentage of works cost- Administration overhead cost is generally absorbed as a percentage of

works cost. Such a rate is computed by the following formula:

Overhead rate = (Administration Overheads/ works cost) × 100

2. Percentage of sales:- Sometimes office and administration overheads are absorbed as a percentage
of sales. Its formula is:

Overhead rate = (Administration overheads/ Sales) × 100

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 Previous Year Questions (PYQs)
on
Overhead Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Over and Under Absorption of Overheads due to Normal Factors are ___________ SEBI Grade A
– Phase 2 - 2020

A. Charged to Financial Profit and Loss Account

B. Charged to Costing Profit and Loss Account
C. Treated using Supplementary Rate
D. They are not rectified
E. None of the above

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 - In an organisation, there are 4 employees receiving Rs. 20,000 each for a specific job. Moreover,
the overall overheads were valued at Rs. 40,000 but only 25% of the total overheads were allocated to this
concerned job and a total of 125 units of the production was produced and finalized. You are required to
calculate the per unit cost. PFRDA Grade A – Phase 2 - 2022

A. Rs. 350
B. Rs. 125
C. Rs. 720
D. Rs. 600
E. Rs. 650

Question 2 – In the field of costing, which of the following type of cost is/are categorized on behavioral basis.
PFRDA Grade A – Phase 2 - 2022

A. Manufacturing Cost
B. Total Cost
C. Marginal Cost
D. Variable cost
E. None of the above

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 Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option C

PFRDA Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option D

Section C

Explanation
SEBI Grade A questions

Question 1 – Over and Under Absorption of Overheads due to Normal Factors are ___________ SEBI Grade A
– Phase 2 - 2020

A. Charged to Financial Profit and Loss Account

B. Charged to Costing Profit and Loss Account
C. Treated using Supplementary Rate
D. They are not rectified
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E. None of the above

Answer – Option C

Explanation -
• Under Normal Factors, a supplementary rate can be used to adjust the amount of under-or over-
absorption. Hence, Option C is the correct answer.
• The supplementary rate is determined by dividing the amount of under – or over-absorption by the
actual absorption base.
• Under-absorption is adjusted by using a plus supplementary rate while a minus supplementary rate in
used to correct over-absorption.
• The amount of under-or over-absorption can be transferred to the costing profit and loss account to
arrive at the accurate net profit for an accounting period.
• When over-or under absorption has been due to abnormal factors, the amount of under- or over-
absorption is necessarily transferred to the costing profit and loss account.

All other options are incorrect.

Explanation
PFRDA Grade A questions

Question 1 - In an organisation, there are 4 employees receiving Rs. 20,000 each for a specific job. Moreover,
the overall overheads were valued at Rs. 40,000 but only 25% of the total overheads were allocated to this
concerned job and a total of 125 units of the production was produced and finalized. You are required to
calculate the per unit cost. PFRDA Grade A – Phase 2 - 2022

A. Rs. 350
B. Rs. 125
C. Rs. 720
D. Rs. 600
E. Rs. 650

Answer – Option C

Explanation

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This question is based on the concept of allocation of overhead, its clearly given in the question that out of total
overheads (40,000) only 25% is allocated to the concerned job, which means only 10,000 will be allocated as
overheads.

Moreover, there are total of 4 employees who are receiving 20,000 each, which total amount paid to the
employees will be 20,000*4 = 80,000

Which means your total cost including overhead will be 90,000 (80,000 + 10,000)

Now, to calculate per unit cost we will be using following formula

Per unit cost = Total Cost/Number of units

Total cost = 90,000 and Number of Units = 125

Per Unit Cost = 90000/125 = 720

Hence the correct answer will be option C

Question 2– In the field of costing, which of the following type of cost is/are categorized on behavioral basis.
PFRDA Grade A – Phase 2 - 2022

A. Manufacturing Cost
B. Total Cost
C. Marginal Cost
D. Variable cost
E. None of the above
Answer – Option D
Explanation
A variable cost is a corporate expense that changes in proportion to how much a company produces or sells.
Variable costs increase or decrease depending on a company's production or sales volume—they rise as
production increases and fall as production decreases.

Examples of variable costs include a manufacturing company's costs of raw materials and packaging—or a retail
company's credit card transaction fees or shipping expenses, which rise or fall with sales. A variable cost can be
contrasted with a fixed cost .

A variable cost is an expense that changes in proportion to production output or sales.

When production or sales increase, variable costs increase; when production or sales decrease, variable costs
decrease.

Hence the correct answer will be option D

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 Summary Sheet
–
Activity Based Costing

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 1 Traditional Approach
This is traditional approach of overhead distribution which assumes that products consume
resources in proportion to the production volume. This assumption may not give accurate
results as some products might be consuming more resources even if they are producing
lower volumes.

Problem with Traditional Approach:

From the above image, we can ascertain that Overhead Cost is being allocated, apportioned
and reapportioned to Department A, B and C. Let’s assume all departments includes various
different types of activities. So, at the time of calculating we are considering that Overhead
Rate A as the complete overhead for all activities of Department A. But this is incorrect as
various activities would have different rates and not the same rate.

Hence, we can see that Traditional costing uses an average overhead rate for all activities
(like labor hour rate or machine hour rate) to allocate costs to cost objects i.e., products or
services. Such a costing approach that uses broad averages for charging overhead uniformly
to products or services is known as cost smoothing or peanut butter costing.

Cost smoothing leads to under costing of certain products and over costing of other
products. Where one product is under costed, it results in another product being over costed
because total amount of overhead remain unchanged. This is known as product cost cross-
subsidisation.

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 2 Modern Approach
In this computer age of advancing technologies and automation, the proportion and
importance of overhead in manufacturing operations is increasing and direct costs are being
relegated to the background.

Therefore, there is a need for a more sophisticated system of accounting for overhead so that
more accurate costs of products and services may be ascertained. Activity-based costing
(ABC) is an alternative to the traditional way of overhead accounting.

The following image will help you to understand the concept of activity-based costing.

• In this system, overheads are assigned to activities or grouped into cost pools before they
are charged to cost objects, i.e., jobs or products.
• Its main focus is on activities performed in the production of goods or services. Thus,
activities become the focal points for cost computation.
• It recognizes that jobs, products, services etc. do not directly consume resources but
consume activities, which consume resources.

In brief, in activity-based costing, overheads are first assigned to activities and then
absorbed by cost objects on the basis of activities consumed by these cost objects.

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 3 Terms Used in Activity Based Costing
• Activity: An activity may be defined as a task or unit of work with a specific purpose.
Examples of activities are – placing of a purchase order, setting up of a machine, after
sales service, etc.
• Cost object: It is an item for which cost measurement is required. For example, a product,
a service, a job or a customer etc. are cost objects.
• Resource: A resource is an economic element consumed in performing activities. For
example, salaries and consumable stores are resources used in performing
manufacturing activities.
• Cost driver: It is a factor that causes a change in the cost of an activity. Cost driver is of
two types–resource consumption cost driver and activity consumption cost driver.
o Resource consumption cost driver: It is a measure of the quantity of resource
consumed by an activity. For example, number of purchase orders placed will
determine the cost of purchasing the materials. Similarly, the number of times
machines are set up will determine the cost of setting up of machines. Resource cost
driver is used to assign the cost of a resource to an activity or cost pool.
o Activity consumption cost driver: It is a measure of the frequency and intensity of
demand placed on the activities by cost objects. It is used for assigning activity costs to
cost objects consuming the activity.

4 Steps in Activity-Based Costing

1. Identification of Main Activities: This step involves identifying the key activities involved
in the production process or service delivery that consume resources.

2. Creation of Cost Pool: A cost pool or cost bucket should be created for each activity. Cost
pool is like a cost center around which costs are accumulated. For example, the total cost
of machine set ups might constitute one cost pool for all set-up-related costs.

3. Determination of the activity cost drivers: The factors that influence the cost of an
activity is known as cost drivers. Examples of cost drivers as given above are number of
machine set ups, number of purchase orders, number of customer orders placed, etc.

4. Calculation of the activity cost driver rate: Just as an overhead absorption rate is
calculated in traditional costing system, in ABC a cost driver rate is calculated as follows:
Activity cost driver rate = Total cost of activity /Cost drivers

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 5. Charging the costs of activities to products: The costs of activities are traced to products
based on demand by-products. The cost drivers are used to measure product demand of
activities.

5 Advantages of Activity-Based Costing

• Accurate and Reliable: ABC provides a more accurate and reliable way of allocating costs
to products, services, or customers. Unlike traditional costing methods that simply
allocate costs based on the volume of output, ABC takes into account the specific
activities that consume resources and assigns costs based on the drivers of those
activities. By doing so, ABC can identify the true costs of producing a product or providing
a service, which can lead to more informed decision-making.

• Better Pricing Considerations: One of the major benefits of ABC is that it can help
companies overcome the problem of under costing and over costing.

Traditional costing methods may assign costs in a way that underestimates the true cost
of producing a product or providing a service, leading to underpricing and potentially
lower profits. Conversely, some products or services may be overpriced due to an over-
allocation of costs. ABC helps to avoid these issues by providing a more accurate reflection
of the costs associated with specific activities, making it easier to set prices that reflect
the true cost of production.

Overall, ABC can provide a more accurate and reliable way of allocating costs and can help
companies make better pricing decisions by identifying the true costs associated with specific
products, services, or customers. This can ultimately lead to increased profitability and better
decision-making for the organization.

6 Disadvantages of Activity Based Costing

• All costs cannot be related to an activity: One of the disadvantages of ABC is that it may
not be possible to relate all costs to an activity that is consuming resources.
Certain costs may be general or overhead expenses, such as the factory manager's salary,
property taxes for the factory building, insurance, and other costs that are not directly
associated with a particular activity.

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 These costs cannot be assigned to a specific product, service, or customer using ABC, and
instead, must be allocated based on traditional costing methods. This can limit the
accuracy of the ABC system.
• Costly and Complex: Another disadvantage of ABC is that it can be costly and complex to
implement. Implementing ABC requires a significant investment in terms of time, money,
and resources.
It involves identifying and tracking activities, determining the cost drivers, and setting up
a system for allocating costs. This can be a complex and time-consuming process that may
require specialized software, training, and expertise. As a result, ABC may not be suitable
for smaller organizations or those with limited resources.

Overall, ABC has some disadvantages related to cost allocation and its complexity. While ABC
can provide a more accurate reflection of costs, it can be costly and difficult to implement.
Therefore, organizations need to weigh the potential benefits against the costs and resources
required to implement ABC effectively.

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 Previous Year Questions (PYQs)
on
Activity Based Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic.

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic.

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 Summary Sheet
-
Output or Unit Costing

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 1 Introduction
Unit Costing method is a method of costing applied to ascertain the cost per unit or
production where standard and identical products are manufactured.

In this method we do not need to apportion overhead costs on different basis because the
products are identical and of same nature, this means that such distribution can be done on
equal basis.

We should keep these two major points in our minds for this chapter:-

(i) Production consists of a single product or a few varieties of the same product with
variations in size, shape, quality, etc., and

(ii) Production is uniform and it is going on continuous basis.

So to sum up, when production is uniform and consists of a single or two or three varieties of
the same product or where the product is produced in different grades, costs are ascertained
grade-wise, unit costing method is used.

As the units of output are identical, the cost per unit is found by dividing the total cost by the
number of units produced. Example: mines, quarries, brick kilns, steel production, flour
mills, etc.

As we have now understood the basic concept of unit or output costing, so let us move
further and know about this concept in greater detail. It is time to look at the set of
procedure an organization must follow to carry out output costing.

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 2 Costing procedure under output costing
Where the production is of such a nature that the products manufactured are uniform or
homogeneous in nature and the cost units are identical, in that case the cost per unit of
product is simply the average cost. This average cost may be ascertained by dividing the total
cost by the number of units produced during the manufacturing process.

A cost unit is the term used for specifying a certain quantifiable unit which will be used to
indicate quantity of the output. A cost per unit, for example, may be 1000 bricks, a barrel of
beer, a gallon of milk, etc.

After finding out the cost per unit, a cost sheet is prepared to show in detail and in an
organized manner, the total cost of the output as well as the cost per unit of the output.

2.1 Cost sheet

It helps us to calculate the cost per unit, which helps us to show the detailed calculations
that how the cost per unit has been calculated.

Firstly, we have direct materials, direct labor and direct expenses and the sum of this is
called Prime cost. Then, we add works overhead or factory overhead, so a Prime cost plus
works overhead gives us works cost. After which, we add the office and administrative
overheads works cost plus administrative overheads gives us cost of production. And then
finally we had the selling and distribution overhead to cost of production which gives us the
total cost of sales.

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 Cost at a basic level is structured like this because there are various sub-elements under this
that you’ll get to know as we proceed in this chapter.

In formal language, Cost sheet is a periodical statement of cost, designed to show in detail
the various elements of cost of goods produced, like prime cost, factory cost, and cost of
production and total cost.

Cost sheet serves the following purposes:

1. It reveals the total cost and cost per unit of goods produced.

2. It discloses the break-up of total cost into different elements of cost.

3. It provides a comparative study of the cost of current period with that of the
corresponding previous period.

4. It acts as a guide to management in fixation of selling prices and quotation of tenders.

What we have just discussed was a very basic cost sheet. Now, to understand a further
complicated cost sheet, it's very important that we basically understand that how different
types of stocks are stated in cost sheet.

2.1.1 Treatment of stocks in cost sheet

There are basically three kinds of stocks that we need to know that how they are treated in
Cost sheet.

1. The first type of stock is stock of raw material which is the raw material that has not
been taken to the production facility, i.e. the raw material on which production work
is not started
2. Second is stock of work in progress, this is that raw material on which the production
work is already started but it is not completed
3. Third are stock of finished products, which are the units that are completely
manufactured but still they have not been sold.

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 So, we have to understand these three types of stocks- stock of raw material, stock a work in
progress and stock of finished product and how these three types of stocks are going to be
treated in the cost sheet.

Stock of raw material

Materials In order to calculate the value of raw materials consumed during the period,
opening stock of raw materials is added to the raw materials purchased and closing stock is
subtracted.

Stock of work in progress

This is the stock of semi-finished goods. In cost sheet, opening stock of work-in-progress is
added in works cost or factory cost and closing stock of work-in-progress in subtracted
therefrom. Thus opening and closing stocks of work-in-progress are adjusted in works or
factory cost.

Stock of finished goods

In cost sheet, finished goods are adjusted after calculating cost of production. Opening stock
of finished goods is added to cost of production and closing stock of finished goods is
subtracted there from. The resultant figure is called cost of goods sold. Cost of goods sold is
calculated because cost of production is the total cost of the whole produce, but it may
happen that all of this produce has not been sold and therefore we need to find the cost of
goods sold. Let us understand the calculation through an example-

Since, we have now covered various aspects related to stock under a cost sheet, we should
now look at a comprehensive view of cost sheet that will make things clear to us about
where the various items are placed to derive the total cost of sales as well as per unit cost
too.

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 2.1.2 Cost Sheet – Comprehensive View

The following items are of financial nature and are thus not included in cost sheet:

Cash discount Provision for bad debts

Interest paid Dividend paid
Preliminary expenses written off Damages payable at law, etc.
Goodwill written off Discount on issue of shares
Transfer to reserves Income tax paid
Provision for taxation Pension and gratuity
Donations Profit/loss on sale of fixed assets

2.1.3 Treatment of scrap

Scrap may be defined as an unavoidable residue material arising in certain types of
manufacturing processes. Examples of scrap are trimmings, turnings or boring from metals
or timber, on which operations are performed.

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 Scrap usually has a small realizable value. Such realizable value of scrap is deducted from
either factory overheads or factory cost while preparing a cost sheet.

With this concept of treatment of scrap, we have now reached to the final end of the various
possible items that form part of a cost sheet. Now, we must look at a more detailed version
of cost sheet as compared to the one discussed on the previous page.

You should thoroughly examine and understand this cost sheet in a logical manner because
it forms the basis of the various cost accounting procedures that we need to study for the
examination purpose.

2.1.4 Cost Sheet (Detailed View)

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Email – hello@edutap.co.in, M – 8146207241 8|P a g e http://www.edutap.co.in
 Let us now understand the application of this cost sheet with the help of a numerical
example, to gain the basic clarity for the preparation of cost sheet.

Numerical example: -

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 Solution:-

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 After solving the above-mentioned numerical example, we can understand how there are
various expenditures that any organization incurs on a day-to-day basis, that can be
categorized into various heads on the basis of the purpose they serve in the organization’s
functioning.

Such a division of cost is necessary to know because it can help find the various costs in a
systemized manner. Often, we will need to organize the information given to us which will
be in no particular order and thus, we need to know about the various types of overheads
and for what purposes they are incurred by the organization, so that we will have certain
legitimate basis to assign such overheads into various categories like- factory, administrative
or selling overheads.

Price Quotations and Estimated Cost Sheet

Quite often the management must quote prices of its products in advance or must submit
tenders for goods to be supplied.

For this purpose, Estimated Cost sheet is prepared.

In this cost sheet, cost of direct materials, direct wages and various types of overheads are
predetermined based on past costs after taking into account the present conditions and
the anticipated changes in the future price level.

Calculation of profit: After the total cost has been estimated, a desired percentage of profit
is added to arrive at the price to be quoted. Such profit may be given as a percentage of cost
or percentage of selling price.

Calculation of profit depends upon various factors that how much profit you want to make
but those are analytical factors, apart from that, mathematically how would you calculate
profit. So, suppose I want 20% profit on my cost. So if a cost is 100 then 20% of that is your
profit, i.e. 20. So, your selling price would become 100 plus 20 that is 120. Similarly, we can
say that instead of using a percentage of profit on cost price you might want this much
percentage of profit on selling price.

For example :- Where profit is given on cost basis

• Total cost = `50,000

• Profit = 20% of cost
• When cost is `50,000: Profit = 50,000 × 20 /100 = `10,000
• Selling Price = 50000+10000 = 60000

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 Let us understand this further with the above example, but here profit is taken on the basis
of selling price.

• Total cost = `50,000

• Profit = 20% of selling price
• Cost = Selling price – Profit
• 50000 = SP - 0.2 SP
• 50000 = 0.8 SP
• SP = 50000 / (0.8) = 62500

After knowing about the various complications that may arise while preparing a cost sheet,
it is now time for us to put our knowledge to test by solving some practical questions based
on preparation of cost sheet.

Please remember that by solving such cost sheet our aim is to provide you with conceptual
clarity so that these concepts get engrained in your minds through practical application of
such concepts.

Try to solve these on your own first without straight away taking help from the solutions
provided, this will force your mind to apply the knowledge that has been gathered so far in
the most innovative way, and if you commit some mistake while doing so, you are more likely
to catch yourself the next time you are faced with the same confusion or doubt.

3 Problems for practice

Numerical 1:-

Mr. Gopal furnishes the following data relating to the manufacture of a standard product
during the month of April 2012: You are required to prepare a cost sheet from the above,
showing:

(a) the cost per unit,

(b) cost per unit sold and profit for the period.

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 Solution:-

Notes:-

1) For production overheads we have considered the cost that machine incurs in the
production process which is 900 machine hours @ Rs.5 per hour which comes to be 4500.

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 2) The closing stock is not given directly in this question. So, to calculate the same we have
deducted units sold from the units produced i.e. 17100-16000 which comes to be 1100 units.
For which we need to find the cost of this closing stock which we will take as the per unit cost
of production that we have calculated till now i.e. Rs.2 per unit.

Numerical 2:-

Prepare a Cost sheet for the following data. The date is from 1st Sept to 30th Sept 2010.

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 Solution:-

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 Previous Year Questions (PYQs)
on
Output Costing or Unit Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic.

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic.

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 Summary Sheet
–
Job Costing and Batch Costing

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 1 Introduction-Methods of Costing
As mentioned above, we have already discussed methods of costing previously. So, in this
chapter let us revise some concepts and then we will move forward to understand Job and
Batch Costing in detail.

Job Costing Process Costing

Contract Operation Operating

Batch Costing Unit Costing
Costing Costing Costing

1.1 Job Costing

Job costing is applied where work is undertaken to customers’ special requirements. There
is no mass production. These jobs are generally dissimilar, of a non-repetitive nature, and are
not comparable with each other. Example: Printing, Interior Decoration, Painting, etc.

In job costing, the cost unit is taken to be a job or work order, which represents a specific
project or customer order. Each job is assigned a unique job number or code, and all costs
associated with that job are separately collected and computed. Job costing is also known as
job lot costing or lot costing.

For example, a construction company that builds custom homes would use job costing to
calculate the cost of building each home. Each home would be treated as a separate job, and
all costs associated with that job, such as materials, labor, and subcontractor costs, would be
tracked and allocated to that job.

Job Costing can be further classified into two types:

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 1.1.1 Contract Costing
Contract costing is used when a project is large and takes a long time to complete. Examples
of industries that use contract costing include construction, civil engineering, and
shipbuilding.

In contract costing, the cost of each contract is tracked separately and allocated to that
contract, including the cost of materials, labor, and overhead expenses. The total cost of the
contract is then divided by the number of units produced or the length of time taken to
complete the contract to arrive at the cost per unit.

For example, if a hospital is being built, the cost of materials such as steel, cement, and
bricks, as well as the cost of labor and overhead expenses, will be tracked and allocated to
that contract. The total cost of the contract will be calculated over the duration of the project,
which may take several years. The cost of the project will be divided by the number of
hospital beds, floors, or square footage of the building to arrive at the cost per unit.

1.1.2 Batch Costing

Batch costing is used when a group of identical products is produced together as a batch,
and each batch of product is a cost unit for which costs are ascertained. Examples of
industries that use batch costing include bakeries, confectioneries, and garment
manufacturing.

In batch costing, the total cost of producing a batch of products is tracked and allocated to
the batch as a whole, including the cost of materials, labor, and overhead expenses. The total
cost of the batch is then divided by the number of units produced in the batch to arrive at
the cost per unit.

For example, a tyre manufacturer produces a batch of 5,000 identical tires of a specific size
and model. The cost of producing the batch, including the cost of raw materials, labour, and
overhead expenses, is Rs. 2,50,000. To determine the cost per tire, the total cost of the batch
is divided by the number of tires produced: Rs. 2,50,000/5,000 = Rs. 50. Therefore, the cost
per tire is Rs. 50.

In the next batch, if the size or model of the tyre changes, then a separate batch cost will be
computed for that specific batch, as the costs associated with raw materials, labour, and
overhead expenses may differ from the previous batch. This is the characteristic feature of
batch costing, where costs are tracked and allocated to a specific batch or group of identical
products.

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 Till now, we have understood, Job Costing and its variations, contract costing and batch
costing. Now, we will discuss Process Costing and types of process costing.

1.2 Process Costing

Process Costing is a costing method used in mass production industries that manufacture
standardized products in continuous processes of manufacturing.

In process costing, costs are accumulated for each process or department involved in the
production of the product. This involves tracking the costs associated with each stage of the
production process, including the cost of materials, labor, and overhead expenses.

The raw material used in the production process passes through a number of processes in a
particular sequence until it reaches the completion stage. Each process or department in the
production process is treated as a cost center, and the costs incurred in each process are
allocated to the products passing through that process.

This can be understood from the following image:

However, to arrive at the cost per unit, the total cost of a process is divided by the number
of units produced in that process. This allows for the calculation of the average cost per unit,
which is used for pricing and profitability analysis.

For example, a company that produces canned goods would use process costing to calculate
the cost of producing each can of food. The costs incurred in each process, such as cleaning,
cooking, canning, and labeling, would be tracked and allocated to the products passing
through that process. The total cost of each process would then be divided by the number of
cans produced in that process to arrive at the cost per unit.

Process Costing can be categorized into three types:

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 Note: We will not be discussing types of process costing in detail. As, these are covered in
detail in different chapter.

1.2.1 Operations Costing

This is a refinement and a more detailed application of process costing. A process may consist
of several operations and operation costing involves cost ascertainment for each operation
instead of a process. This method provides minute analysis of costs and ensures greater
accuracy and better control.

1.2.2 Single, Unit or Output Costing

When production is uniform and consists of a single or two or three varieties of the same
product or where the product is produced in different grades, costs are ascertained grade-
wise. As the units of output are identical, the cost per unit is found by dividing the total cost
by the number of units produced. Example: mines, quarries, brick kilns, steel production,
flour mills, etc.

1.2.3 Operating or Service Costing

This method should not be confused with operation costing. It is used in undertakings which
provide services instead of manufacturing products. For example, transport undertakings
(road transport, railways, airlines, shipping companies), electricity companies, hotels,
hospitals.

Till now we have understood that Job Costing is categorized into Batch Costing and Contract
Costing and Process Costing is categorized as Unit Costing, Operation Costing and Operating
Costing. Now let’s start our discussion on the topic of job costing.

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 2 Job Costing
Theoretically, the scope of Job Costing and Batch Costing is very limited. Moreover, the
implementation remains the same as we discussed in previous chapters. So, here before we
learn more about job costing, first let’s do a recap, and if you recall this, this chapter will seem
very simple. If you face any difficulty in the recap, then go through the previous chapter in
which you are facing difficulty.

2.1 Recap
Now, before going further, we would like you to know that whatever you are going to study
in this chapter, theoretically it is less and implication wise it remains the same as what we
have discussed in the earlier chapters. So please go through the following image:

Earlier we have discussed that basically, we need to distribute overheads. So, the distribution
of overheads starts with in primary distribution in which we basically allocate and apportion
the overheads into production and service departments as per their usage.

So, we allocate and apportion the overheads to production department and service
department under primary distribution and then secondary distribution in which the
overheads allocated or apportioned to service department are again reallocated to the
production department. Because our main objective is to find the cost per unit and therefore
all these overheads need to be allocated to the production department.

So, once the allocation, apportionment and reapportionment is done, we generally absorb
the overheads using a certain overhead absorption rate. The formula is given in the image
above.

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 If you have understood this then job costing will become very easy for you to understand.
But in case you are not able to understand we would suggest you to please go through
previous chapters as it will not only help you in this chapter but the upcoming chapters as
well.

3 Cost Sheet and Overhead Absorption

Like what we have discussed in earlier chapters, in Job Costing we shall prepare a Cost sheet
for a Job. So, in job costing we try to find the cost of each job. Each job order is asymmetrical
to other due to specific and customized 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.

Overheads assigned to departments shall be absorbed by the Job based on certain

overhead absorption rate using some base and usage of that base by that Job.

Let’s discuss this with an example. Suppose there are two jobs Job 1 and Job 2. These jobs
are processed from various departments 1,2 and 3:

So, Total Overheads for Department 1 is 100 Rs. and overhead absorption rate is based on
machine hours. Department 1 has 100 machine hours and Job 1 has 30 machine hours, then
Overhead absorption rate = 100/100 = 1 Rs/machine hour. For Job 1 it shall be 30* 1 = 30
rupees.

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 4 Job Order Costing
The category of basic costing methods which is applicable where the work consists of
separate Jobs each of which is authorized by specific customer requirement. Job order
costing is a costing method which is used to determine the cost of manufacturing each
product. This costing method is usually adopted when the manufacturer produces a variety
of products which are different from one another and needs to calculate the cost for doing
an individual job.

Other Names of this method:

1. Specific order costing

2. Production order costing
3. Job lot costing
4. Lot costing
Every order in job costing is separate and it is not essential that the same manufacturing
operations be carried out or the same materials be utilized in respect of each. In the job
costing system, the cost unit is the Job itself.

Example: Job costing is applicable to engineering concerns, specific order furniture making,
machine manufacturing industries, repair shops, automobile garages, interior decoration,
machine tools and several such other industries where jobs or orders can be kept separate.

Job order costing is commonly used by jobbing concerns, small firms, and large enterprises
that manufacture a variety of products. Let us understand how job order costing is used in
each of these scenarios:

Jobbing Concerns:

• Jobbing concerns manufacture a variety of products according to customer’s

specifications and do not generally confine their activities to producing uniformly any
specific product for sale in the market.

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 • The jobs, products or services are dissimilar or unique and non-repetitive having
different specifications and methods of manufacture, and each one requires different
types, sizes and quantities of materials and equipment's and utilizes different labor hours

• Job order costing is ideal for jobbing concerns because it allows them to track the costs
of materials and labor for each unique job. By doing so, they can accurately calculate the
cost of each job and adjust pricing accordingly. Hence Jobbing Concerns need to use Job
Order Costing

• Examples include printing shops, machine shops, and custom furniture makers.

Small Firms:

• Though small firms produces some products which are used on relatively mass scale but
no product can have a run long enough to be established as a standard process.

• On account of the frequent changes from one product to another, job costing would be
suitable for determining the cost of each lot of products.

• For example, a small bakery that produces custom cakes and pastries can use job order
costing to track the cost of materials and labor for each order. This can help the bakery
determine the profitability of each order and make pricing decisions accordingly.

Large Enterprises manufacturing variety of products:

• A single department would be manufacturing several products, perhaps all at a time, so

that none of the departments is specialized for continuous runs of product lines. As
definite process departments cannot be established, job costing is more suitable in such
cases
• For example, an automobile manufacturer that produces multiple models of cars can use
job order costing to track the cost of materials and labor for each car model. This can help
the manufacturer determine the profitability of each model and make decisions about
production and pricing.

Note- Jobbing Concern is an ideal Case of Job Order Costing. Small Firms and Large
Enterprises manufacturing a variety of Products may use Job Order Costing as per the
suitability of this method.

5 Procedure/ Steps for Job Costing

Now we will discuss the steps for job costing:

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 1. Job Number: When an order has been accepted, an individual job number must be
assigned to each job so that separate jobs are identifiable at all stages of production.
Assignment of job numbers also facilitates reference for costing purposes in the ledger and
is conveniently short for use on various forms and documents.

2. Production Order: The production control department then makes out a Production Order,
thereby authorizing to start work on the job. The copies of production order are sent to:

i. All departmental foremen concerned with the job

ii. Storekeeper for issuance of materials and Cost Department for accounting of the Job
iii. Tool room for an advance notification of tools required

Format of Production Order:

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 3. Job Cost Sheet: The unique accounting document under job costing for each job is the job
cost sheet. Cost accountant prepares a job cost sheet on which he records the cost of
materials used and the labor and machine time taken.

Job cost sheets are not prepared for specified periods but they are made out for each job
regardless of the time taken for its completion. However, material, labor and overhead costs
are posted periodically to the relevant cost sheet.

Format of Job Cost Sheet:

6 Advantages of Job Costing

• In job costing, the cost of each job or order is ascertained separately, which means
that the costs incurred in producing a specific job or order are tracked and recorded
separately. This helps in determining the profitability of each job, as the revenue
generated from the job can be compared with the cost incurred to produce it. This

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 information can be used to make decisions about pricing and resource allocation in
the future.
• Another advantage of job costing is that it helps in identifying the source of spoilage
and defective work. As each job is tracked and recorded separately, any issues with
the production process can be easily identified and traced back to a specific job or
product. This helps in taking corrective action and reducing waste and rework.
• Job costing is particularly suitable for cost-plus contracts where the selling price is
determined directly on the basis of costs. In such contracts, the customer agrees to
pay a certain percentage above the actual cost of the job, and job costing helps in
accurately determining the cost of the job. This ensures that the price charged to the
customer covers all costs incurred in producing the job and results in a fair profit for
the company.

7 Limitations of Job Costing

• Job costing is comparatively more expensive as more clerical work is involved in
identifying each element of cost with a specific job: Job costing involves tracking the
cost of materials, labor, and overheads for each individual job or project.
• With the increase in the clerical processes, chances of errors are enhanced: The
accuracy of job costing depends on the accuracy of the information recorded for each
job. As the number of clerical processes involved in job costing increases, so does the
chance of errors.

8 Practice Problems
Please note that the main idea of providing practice problems is to make you understand the
practicality of the concepts.

Question 1- A factory uses job costing. The following data are obtained from its books for the
year ended 31 December 2011.

(a) Prepare a Job Cost Sheet indicating the Prime cost, Works cost, Production cost, Cost of
sales and the Sales value.

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 (b) In 2012, the factory received an order for several jobs. It is estimated that direct materials
required will be `1,20,000 and direct labor will cost `75,000. What should be the price for
these jobs if factory intends to earn the same rate of profit on sales. The factory recovers
factory overheads as a percentage of direct wages and administration and (selling and
distribution overheads + 15% Increase) as a percentage of works cost, based on cost rates
prevailing in the previous year.

Solution-

So, let’s start with the first part of the question:

Initially, we will create the format and then we just have to put the values in the format. In
this question, we have been provided direct information for Direct Material and Direct
Wages. Adding these we will get our Prime Cost. Now, we will add Factory Overheads as
mentioned in the question to ascertain the works cost. Similarly, we will add administration
overheads to ascertain the cost of production. And then we will add selling and distribution
overheads to ascertain the cost of sales.

As, we have calculated the cost of sales. We can add profit as mentioned in the question to
get the sales value as 3,65,000. Please refer to the following statement:

So, the above statement can be made easily, you just need to put the values as per the
format. Now, moving on to the second part of the question. But before going further we must
need to calculate rates:

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 Notes:

1. % of factory overheads to direct wages means that it is a ratio that measures the amount
of factory overhead costs incurred relative to the direct wages paid to employees.

The formula for calculating this ratio is:

Factory Overheads to Direct Wages Ratio = (Factory Overheads / Direct Wages) x 100%

2. Similarly, the formula to calculate % of administration overheads to works cost is:

Administration Overheads to Works Cost Ratio = (Administration Overheads / Works Cost)

x 100%

3. Also, we have to calculate the selling and distribution overheads + 15% Increase as a
percentage of works cost. So, to calculate this we have to increase selling and distribution
overhead by 15%. And then we have to calculate the % of selling and administration
overheads to works cost by using the formula:

Selling and Administration Overheads to Works Cost Ratio = (Selling and Administration
Overheads (incl. of 15% increase)/ Works Cost) x 100%

4. We also have to calculate the % of profit to sales can be easily calculated by the following
formula:

% of Profit to Sales = (Net Profit / Sales) x 100%

Also, CP (Cost Price) = Sales - Profit

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 Now, as we have calculated the rates. So, now we can create the Job Cost Sheet with the
estimated cost and price:

(Direct Materials and Direct wages are already provided in the second part of the question.
And then with the help of calculated rates we have ascertained Factory Overheads,
Administration Overheads and Selling and Distribution Overheads and Profit.)

9 Batch Order Costing

This is a variation of job costing. While job costing is concerned with costing of jobs that are
made to a customer’s requirements, batch costing is used when production consists of
limited repetitive work and a definite number of articles are manufactured in each batch
to be held in stock for sale to customers generally.

Batch order costing is particularly useful for companies that produce products in batches
with similar characteristics, such as size, shape, or color. It allows for the efficient allocation
of costs to each batch of products and enables managers to track the profitability of each
batch.

Basic Features of Batch Costing

(a) Each batch is treated as a cost unit.

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 (b) All costs are accumulated and ascertained for each batch.

(c) A separate Batch Cost Sheet is used for each batch and is assigned a certain number by
which the batch is identified.

(d) The cost per unit is ascertained by dividing the total cost of a batch by the number of
items produced in that batch.

Application of Batch Costing:

Batch Costing is applied in those industries where the similar articles are produced in definite
batches for internal consumption in the production of finished products or for sale to
customers generally. It is generally applied in

1. Read made Garments Manufacturing Industries

2. Pharmaceutical/ Drug Industries
3. Spare parts and Components Manufacturing Industries
4. Toys Manufacturing Industries
5. Tyre and Tubes Manufacturing Industries
6. Shoes Manufacturing

10 Procedure for Batch Costing

The procedure for batch costing involves several steps, including assigning a unique batch
number, creating a production order, and preparing a batch cost card.

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 1. Batch Number- Each batch of products must be assigned a unique identification number
or code that distinguishes it from other batches. This helps to ensure accurate tracking of
costs and enables managers to monitor the performance of each batch.

2. Production Order- The production order is released signaling the start of production and
related allocation of resources such as material, tools, labor etc.

3. Batch Cost Card/ Sheet- The Batch cost card is maintained for each batch to records all the
costs related to production in that batch. When a batch is completed, the total cost of the
batch is divided by the quantity produced in the batch to arrive at the cost per unit.

Now let us discuss some practice problems related to Batch Costing:

Question 4- Component 89-X is made entirely in cost centre

Material cost is 6 paise per component and each component takes 10 minutes to produce.
The machine operator is paid 72 paise per hour, and the machine hour rate is ` 1.50.

The setting up of the machine to produce component 89-X takes 2 hours 20 minutes. On the
basis of this information, prepare a comparative cost sheet showing the production and
setting up cost, both in total and per component assuming a batch of (a) 10 components, (b)
100 components and (c) 1,000 components, is produced.

Solution-

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 Note- The questions are based on the format and then only calculation. So, the explanation
provided in the solution is sufficient. However, if you have any doubt, please post it in the
discussion forum, we will be happy to help you.

11 Economic Batch Quantity (EBQ)

In the previous question, it is seen that when batch size increases, the total cost per
component decreases. It is due to the fixed nature of setting up cost which remains
unchanged with the increase or decrease in the batch size.

So should the cost per component keeps on decreasing with increase in batch size. The
answer is no as there are two types of costs:

1. Set Up Cost: This is the cost of setting the machine and the tools for production of a batch.
This is of a fixed nature. Therefore, when the size of the batch is large, setting-up cost per
article in the batch is lower.

2. Carrying Cost: The cost to store raw material and finished goods, interest on capital
invested etc. Larger size of a batch leads to higher carrying costs.

So, there must be a level of quantity at which the sum of these costs is minimum. Such a level
is called Economic Batch Quantity (EBQ) and this level both the cost are equal.

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 Alternatively, it can be written as:

Let’s discuss an example:

Question- Calculate EBQ from the following information:

U = Production per year = 12,000 units

S = Set-up costs per batch = `150

C = Carrying cost per unit per year = `0.20

Solution-

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 Previous Year Questions (PYQs)
on
Job Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 – Industries that manufacture products or render services against specific orders as distinct from
continuous production for stock or sales use the ________ method of costing. PFRDA Grade A – Phase 2 - 2021

A. Job Costing
B. Process Costing
C. Unit Costing
D. Both A and B
E. None of the above

Section B

Answer Key

PFRDA Grade A questions

Question Number Answer

Question 1 Option A

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 Section C

Explanation
PFRDA Grade A questions

Question 1 – Industries that manufacture products or render services against specific orders as distinct from
continuous production for stock or sales use the ________ method of costing. PFRDA Grade A – Phase 2 - 2021

A. Job Costing
B. Process Costing
C. Unit Costing
D. Both A and B
E. None of the above

Answer – Option A

Explanation –
• Industries that manufacture products or render services against specific orders as distinct from
continuous production for stock or sales use the Job Costing method. Hence, Option A is the correct
answer.
• Job costing is a precise method of tracking all the costs and revenue associated with a particular project.
• Projects might include one-off customer undertakings, manufacturing new products or delivering
multiple products that will be developed at the same time.

All other options are incorrect.

Additional Information:

• Process Costing: Process costing is an accounting method typically used by companies that mass produce
very similar or identical products or units of output. Hence, Option B is incorrect.
o It’s common in manufacturing industries where the costs of producing each unit of output are
very similar, and it doesn’t make sense to try to track costs for each individual unit throughout
the production process.
o For example, process costing is used by oil companies that produce millions of gallons of fuel and
by processed food companies that make millions of identical packages of snacks.

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 • Unit Costing: Unit costing is a method of costing where identical / same / homogenous products are
made on a large scale through continuous manufacturing. Hence, Option C is incorrect.
o Unit cost is the total expenditure incurred by the company to produce, store & sell one unit of a
company’s product.
o Unit costing is synonymously known as Single / Output costing and this costing is followed by
industries which produce Single output or few variants of a single output.

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 Summary Sheet
-
Contract Costing

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 1 Introduction
Contract costing (also known as terminal costing) is a form of specific order costing where
job undertaken is relatively large and normally takes period longer than a year to
complete. And that is the reason why it can be called as a variant of job costing.

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. A contract
takes longer period to complete, and the result of the contract can be known only after
the completion of the contract.

Some distinctive features of contract costing: -

1. Cost Unit in Contract Costing is the Contract itself.

2. Cost Accountant opens an account called Contract Account for each contract in the
books of the contractor to ascertain profit/loss thereon for the contract. In this account,
all the expenses incurred by the contractor are debited and the income is credited; the
difference represents profit or loss.

3. It is applied in situations where Job is for larger duration such as building of dams,
roads, ships and Bridges.

4. As the number of such contracts handled at a time by a business may not be usually
large, Contract Costing is comparatively simpler in operation than job costing system as
the data needed to process in contract costing is relatively of small size when compared
to the data of different jobs in job costing. We will discuss this point in more detail as we
move forward in this chapter.

Now, let us learn basics about the major parties involved in a particular contract.

The person who takes contract for a price is called the Contractor. Example: if Ram is an
architect and he takes a contract to design Sham’s house then Ram is the Contractor.

The person from whom the contract is taken is called the Contractee. Example: if Ram is an
architect and he takes a contract to design Sham’s house then Sham is the Contractee.

The Contractor might further contract some specialized part of work to third party called
Sub-Contractor. Example: if Ram is an architect and he takes a contract to design Sham’s
house then Ram further gives contract for AC fitting in the house to Mohan then Mohan is

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 sub-Contractor.

1.1 Features of Contract Costing

1. Contracts are generally of large size and, therefore, a contractor usually carries out a
small number of contracts in the course of one year.
2. A contract generally takes more than one year to complete.
3. Work on contracts is carried out at the site of contracts and not in factory premises.
Because of fewer contracts in a year and contract being executed at the site, most of
resources for a particular contract are dedicated to that Contract and hence most of the
costs are direct. In other words, overheads are very less.

In other types of costing such as Job costing though the jobs are specific for customer
needs but still at a time many jobs are being executed and since work is carried in factory
premises, therefore many resources across departments are being shared across jobs and
therefore overheads can be more.

For example, let us suppose a supervisor is hired under a particular job and supervisor may
be undertaking a number of tasks in this duration of job and thus the apportionment of cost
for such a supervisor becomes difficult to assign to a particular task. Whereas, if a
supervisor was hired for a particular contract, his working hours can be directly assigned to
the contract and therefore such cost becomes direct and will not be considered as a
overhead.
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 4. Most of the materials are specially purchased for each contract. These will, therefore,
be charged direct from the supplier’s invoices. Any materials drawn from the store is
charged to contract on the basis of material requisition notes.

5. Nearly all labor expenses are direct.

6. Most expenses (e.g., electricity, telephone, insurance, etc.) are also direct.

7. Plant and equipment may be purchased for the contract or may be hired for the
duration of the contract. Most of the times this is also direct cost.

8. Payments by the customer (Contractee) are made at various stages of completion of

the contract based on architect’s certificate for the completed stage. An amount,
known as retention money, is withheld by the Contractee as per agreed terms. We
will discuss more about this concept later in the document.

9. Penalties may be incurred by the contractor for failing to complete the work within the
agreed period.

1.2 Difference between Job Costing and Contract Costing

1. While the number of jobs in hand at any time in a concern may be large, only a few
contracts may be undertaken at a time.

2. The accumulation, analysis, apportionment, allocation and control of costs is simplified

in Contract Costing. The same is more complicated in the case of job costing because
there are number of tasks that are being carried out for a particular job.

3. Most of the expenses are chargeable direct to the Contract Account, which means
there are less overheads that need to be apportioned to different tasks. Direct
allocation to such an extent is not possible in job costing and therefore there are
indirect costs that arise, which needs to be allocated on some logical basis to the
concerned tasks.

4. As contracts may run for long periods, there arises the problem of assessment and
crediting of profits on incomplete contracts at the end of the accounting period,
because when the contract is not complete fully one can only estimate such profit and
not know the exact amount of profit that the contract may yield at the completion
whereas no such problem is there in Job costing.

As we have now discussed the theoretical portion of what a contract means and how to
distinguish it from a job, we shall proceed to the various implications that arise while

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 preparing a contract account to determine the profits that we have earned from a
particular contract.

Please read the following points of consideration with great attentiveness as it will lay the
base for the whole chapter and the various procedures, which we will follow to
determine the contract profits through different methods.

2 Contract Costing Procedure

In this section, we will learn the various accounting measures that we need to take while
maintaining accounts for a particular contract and thereby keep track of the progress of
such contracts.

1. Contract Account- Each contract is allotted a distinct number and a separate account is
opened for each contract. In this account all the payments done by the contractor comes on
the debit side and all the remuneration received by the contractor comes on the credit side,
remember this as a rule of thumb while preparing this account.

2. Direct Costs- Most of the costs of a contract can be allocated direct by to the contract. All
such direct costs are debited to the contract account. Direct costs for contracts include: (i)
Materials; (ii) Labour (iii) Direct expenses; (iv) Depreciation of plant and machinery; (v) Sub-
contract costs, etc.

3. Indirect Costs- Contract account is also debited with overheads which tend to be small
in relation to direct costs. Such costs are often absorbed on some arbitrary basis as a
percentage on prime cost, or materials, or wages, etc. Overheads are normally restricted to
head office and storage costs.

4. Transfer of materials- When materials other items which are left are transferred from
one contract to possibly another contract where it can be utilized, the contract account is
credited by that amount.

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 5. Contract price- The contract account is also credited with the contract price. However,
when a contract is not complete at the end of the financial year, the contract account is
credited with the value of work-in-progress as on that date, this is the amount of contract
that has been partially completed till the end of the particular financial year.

6. Profit and Loss of Contract- The balance of contract account represents profit or loss
which is transferred to Profit and Loss Account.

However when contract is not completed within the financial year, the profit calculated is
called notional profit (because it is not actual) and only a part of it is considered and the
remaining profit is kept as reserve to meet any contingent loss on the incomplete portion
of the contract. This is discussed in detail later in this chapter.

Now, let us solve a basic example in which we will take into account all these items and
get more clarity on how they are presented in the contract account.

Example: Suppose this is the information given for the contract

• Materials used – 2,40,000

• Wages – 3,00,000
• Sub-Contract Cost - 28000
• Plant – 40,000
• Overheads – 18,200
• Work in Progress – 608000

The value of material in hand was 12000 and plant had undergone 20% depreciation.

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 Notes:-

1) Some part of notional profit is transferred to P& L account whereas rest of the money is
kept as reserve. In this example out of 25800, 15000 is assumed as profit where as other is
kept as reserve.

2) We have assumed the whole of the overheads given are to be considered to be incurred
for this particular contract.

2.1 Some Special Points in Contract Costing in detail

There are various key points that you need to keep in mind for each of the above-
mentioned items that are present in the contract account. These are very crucial to
understand as they will be utilized in each of the numerical that you will be aiming to
solve for the purpose of this chapter.

In order to solve numerical questions successfully we need to understand the implications

of various items thoroughly and thus, these points are discussed in great detail in the
following sections.

2.1.1 Cost of Material

Material cost is the cost of materials used to manufacture a product or provide a service.
Materials include:

1. Materials specifically purchased for the contract.

2. Materials issued from store against material requisition notes.

The cost of both these types of materials is debited to the contract account.

Materials Returned to Store: Whenever materials are issued in excess, for instance,
cement, sand, pipes these are later returned to the store accompanied by a Material Return
Note which gives the details of the materials returned. Such returned materials are
credited to contract account.

In the example discussed earlier, the highlighted part in red below shows how the
Material used needs to be debited and how the Material Returned to store are to be
credited.

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 In case the return of surplus materials appears uneconomical on account of high cost of
transportation, the same is sold and the concerned contract account is credited with the
price realized. Any loss or profit arising therefrom is transferred to the Costing Profit and
Loss Account.

Any loss of materials due to theft or destructions etc. is transferred to the Costing Profit
and Loss Account.

Now Suppose instead of returning 12000 worth of material, they were sold at price of
10,000 then basically there is additional loss of 2000, but this loss is transferred to Costing
Profit and Loss Account and it does not impact the Notional Profit of this contract.

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 2.1.2 Cost of Labor
All wages of workers engaged on a particular contract are charged direct to the contract,
irrespective of the type of work they perform.

When several contracts are running at different locations, payroll is normally sectionalized
to have separate payroll for each contract. Difficulties in costing may be encountered
when some workers may have to move from one site to another if a number of small
contracts are undertaken. In such situations, it becomes necessary to provide time sheets
from which allocations can be made.

Indirect expenses (such as expenses of engineers, surveyors, supervisors, corporate office

etc.) may be distributed over several contracts on certain reasonable basis (such as
Percentage (%) of prime cost or wages or materials) as overheads and are charged as
Overheads in the contract Account.

In the example discussed earlier, the highlighted part in red below shows how the Wages
and Overheads needs to be debited.

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 2.1.3 Plant
There are two different methods of dealing with depreciation of plant in contract account:

Method 1: Contract account is debited with the cost of the plant installed. When the
contract is completed or the plant is no longer required, the plant is revalued, and contract
account is credited with this revalued or depreciated figure.

The net effect of the above debit and credit will be that the contract account will stand
debited with the amount of depreciation. The method is generally used on long contracts
which extend over more than one year

Example: Suppose this is the information given for the contract

• Materials used – 2,40,000, Wages – 3,00,000

• Sub-Contract Cost – 28000, Plant – 40,000
• Overheads – 17,200, Work in Progress – 608000

The value of material in hand was 12000 and plant had undergone 20% depreciation

Method 2: Contract account is simply debited with the amount of depreciation. It is usual
to use this method when plant is sent to contract only for a short period. For example,
mobile crane or bulldozer used in a contract may be charged on this basis.

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 2.1.4 Sub Contractor
Any specialized work given by contractor to third party is called sub-contractor. The
payments made to sub-contractors are charged in totals to the concerned Contract Account
as direct expense and no detailed records or break-up of the sub-contract amount is
necessary for cost purposes.

In our earlier example we have already shown how to handle the Subcontractor
expenses.

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 2.1.5 Defective Work
Defective work will not evidently be paid for by the Contractee, but the cost of such
defective work should be charged(debited) to the Contract Account. Sometimes,
rectification of the defective work is required to be made at the contractor’s cost; the cost
of such rectification should also be charged(debited) to the Contract Account but shown
separately.

Suppose in our earlier example, there is defective work of 25000 then it shall be debited
from the contract account as shown below. Please note that value of work in progress will
remain the same and it need not be reduced, but the value of notional profit will
decrease, because the total of debit side has now increased.

Earlier we were having notional profit of 25,000 but to the defective work cost, our
notional profit will now reduce to 800 only.

Refer to the following image for better clarity.

2.1.6 Escalation Clause and Descalation Clause in Long Contracts

Escalation clauses are often provided in contracts as safeguards against any likely changes
in price or utilization of material and labour. Such a clause in a contract would provide that
in the event of a specified contingency happening, the contract price would be suitably
enhanced.

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 This clause is particularly necessary where the price of certain raw materials are likely to
rise, where labour rates are anticipated to increase, or where the quantity of material or
labour time cannot be properly assessed or estimated unless the work has sufficiently
advanced.

There may also be ‘De-escalation or Reserve Clause’ to provide for any future decrease in
price etc. so that the benefit may be passed on to the Contractee.

2.1.7 Work in Progress

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

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

For example- contract to build the house, at the end of certain financial year they are ready
with certain doors and windows, but certain doors and windows are not completed. So,
these doors and windows which are completed and are certified by the architect, that is
called work certified.

Work Uncertified: This is that part of the work-in-progress which is not approved by the
architect or engineer. This is valued at cost and thus does not include an element of profit.

Both work certified and uncertified appear on the credit side of the contract account.

Example:

Suppose the contract is given to builder to make 2 doors and 1 window. The pricing is such
that for each door Rs. 1000 is to be given and for window 500 is to be given. The costing for
one door and window for the contractor are 800 and 300 respectively Now suppose at the
end of financial year

1) One door and One Window is ready and the same is certified by the architect
2) The other door is half ready but is not certified by the architect
What shall be the work Certified and Work Uncertified?

Ans: Work certified (at selling price) = 1* 1000 + 1* 500 = 1500 and Work Uncertified (at
cost price) = ½*800 = 400

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 Now, let us look at another practical example in which we will gain more clarity on
presentation of work certified and uncertified in the contract account.

Example:

Materials used – 2,40,000, Wages – 3,00,000

Sub-Contract Cost – 28000, Plant – 40,000

Overheads – 17,200, Work certified – 600000

Work Uncertified = 8000

The value of material in hand was 12000 and plant had undergone 20% depreciation

2.1.8 Retention Money and Cash Ratio

Retention Money: Sometimes some part of money that is due to contractor is held back
as a safeguard available to the Contractee in case the contractor is not able to fulfill one or
more of the conditions laid down in the contract or to compensate for the defective work.
Such a held back money is called Retention Money.

For example, work certified by an architect is 10000 but out of this the payment for 3000 is
held back, this 3000 will be the retention money, because it is owed by the Contractee but
not paid as of yet to safeguard for future contingencies.
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 Cash Ratio: The Contractee may pay a fixed percentage, say 80% or 90% of the work
certified, depending upon the terms of the contract. This is known as Cash Ratio. The
balance amount not paid is known as Retention Money. For example, if cash ratio is 75%,
the retention money in % terms will be the remaining 25%.

Example:

Suppose the contract is given to builder to make 2 doors and 1 window. The pricing is such
that for each door Rs. 1000 is to be given and for window 500 is to be given. The costing for
one door and window for the contractor are 800 and 300 respectively Now suppose at the
end of financial year

1) One door and One Window is ready and the same is certified by the architect
2) The other door is half ready but is not certified by the architect
What shall be the work Certified and Work Uncertified?

Answer :- Work certified (at selling price) = 1* 1000 + 1* 500 = 1500 and Work Uncertified
(at cost price) = ½*800 = 400

Now the contractor need to paid for work certified but suppose the contractor is given
only 1000 instead of 1500, then cash ratio is 1000/1500 = 66.66% and Retention Money
Ratio will be (1- Cash Ratio) = 33.33% or Retention Money = 500

2.1.9 Extra Work

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

Let us solve some concept checks to further understand these concept of retention
money as well as notional profit.

2.1.10 Profit on Uncompleted Contracts

Contracts which are started and finished during the same financial year create no accounting
problems. But in case of those contracts which take more than one year to complete, a problem arises
whether profit on such contracts should be worked out only on the completion of the contract or at
the end of each financial year on the partly completed work.

1. If profit is computed only on the completion of the contract, profit will be high in the
year of completion of the contract, whereas in other years of working on contract, profit
will be nil. This would result not only in distorted profit pattern but also higher tax
liability because income tax at higher rates may have to be paid.
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 2. Therefore, when contracts extend beyond a year, it becomes necessary to take into
account the profit earned (or loss incurred) on the work performed during each year.

There are two aspects of profit computation:

(a) Computation of notional profit or estimated profit.

(b) Computation of the portion of such profit that is to be transferred to Profit and Loss
Account.

The portion of the notional or estimated profit to be transferred to P&L Account depends
upon the stage of completion of the contract, i.e., ratio of work-in-progress certified to
total contract work. For this purpose work-in-progress uncertified is not considered.

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 Prudence requires that the total notional profit should not be transferred to P&L Account
but a portion of it should be withheld as a reserve to meet any unforeseen future
expenses or contingencies.

Rules for Transfer of Notional Profit to P&L Account: For the purpose of finding out the
portion of the profit out of notional profit to be transferred to Profit and Loss Account, the
contracts are divided in the following manner and for each type of contract specific rules
are defined.

This categorization is not a hard and fast rule for organizations, the main objective must
be to be consistent in following such rules.

1) Contracts which have just commenced- When work certified is less than 1/4 of the
contract price, then no profit is transferred to Profit and Loss Account.

2) Contracts which have reasonably advanced- When work in progress certified is (>= 1/4
and < 1/2) of contract price, then 1/3 of the notional profit shall be transferred to Profit and
Loss Account and the remaining amount would be kept as reserve.

Or, When work in progress certified is (>=1/2 and < 9/10) of contract price, then 2/3rd of
the notional profit shall be transferred to Profit and Loss Account and the remaining
amount would be kept as reserve.

As we can see that in above cases we are only taking a portion of notional profit and not
whole of it because out of this notional profit much of the work might be uncertified and
thus we cannot take the risk of transferring whole of the notional profit to Profit & Loss
account as of yet.
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 3) Contracts which are almost complete- When contract is near completion, then the
estimated profit should be calculated on the whole contract. The proportion of estimated
profit to be transferred to Profit and Loss Account is computed by any one of the following
formulas:

Please note that we have applied the cash ratio in two of the above formulas (cash ratio=
cash received/work certified), because it may so happen that the whole of the cash has not
been received for the work that has been completed and duly certified by the architect.

2.1.11 Loss on Uncompleted Contracts

In the event of a loss on uncompleted contracts, this should be transferred in full to the
Profit and Loss Account, whatever be the stage of completion of the contract.

It was stated earlier also that these are not hard and fast rules. The practice may vary from
firm-to-firm depending upon the nature of work involved, degree of risk in the business,
extent of work completed, etc. But whatever method is adopted, it should be applied
consistently from year-to-year so as not to disturb the trend of profits.

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 Previous Year Questions (PYQs)
on
Contract Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic.

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 - Contract costing is a specialized type of costing used in which of the following business domain ?
PFRDA grade A – Phase 1 – 2022

A. Textile industry
B. Agriculture
C. Real Estate
D. Marketing
E. None of the above

Section B

Answer Key

PFRDA Grade A questions

Question Number Answer

Question 1 Option C

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 Section C

Explanation
PFRDA Grade A questions

Question 1 - Contract costing is a specialized type of costing used in which of the following business domain ?
PFRDA grade A – Phase 1 – 2022

A. Textile industry
B. Agriculture
C. Real Estate
D. Marketing
E. None of the above

Answer – Option C

Explanation

Contract costing is a form of specific order costing which applies where work is undertaken to customer's special
requirements and each order is of a long duration.

Following are the features of contract costing

1. Cost Unit in Contract Costing is the Contract itself

2. Cost Accountant opens an account called Contract Account for each contract in the books of the contractor
to ascertain profit/loss thereon for the contract.
3. In this account, all the expenses incurred by the contractor are debited and the income is credited; the
difference represents profit or loss
4. It is applied in situations where Job is for larger duration such as building of dams, roads, ships and Bridges
5. As the number of such contracts handled at a time by a business may not be usually large, Contract Costing
is comparatively simpler in operation than job costing system.

Hence the correct answer will be option C

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 Summary Sheet
–
Process or Operations Costing

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 1 Introduction
Process costing is a widely used method of cost ascertainment in mass production
industries where goods are produced in large quantities and are identical in nature. This
method is commonly used in industries such as steel, sugar, chemicals, and other
manufacturing sectors where standardized products are produced.
In process costing, the production process is divided into several processes or
departments, and costs are accumulated separately for each process or department. The
costs incurred in each process or department are compiled in a separate account known as
the process or departmental account.

Goods produced are identical and all factory processes are standardized.

Raw materials are introduced at the beginning of the production process and move through
the different processes or departments in a predetermined sequence. Costs such as direct
materials, direct labor, and factory overhead are incurred at each process or department,
and these costs are recorded in the respective process accounts. This can be understood
from the following image:

Also, the output of one process becomes the input of the next process in a sequential
manner. This means that the partially completed units or goods produced in one process

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 are transferred to the next process as the input, and the production process continues until
the final product is completed. This can be understood from the following image:

At the end of each accounting period, the costs incurred in each process or department are
summarized, and the total cost is apportioned to the units produced during that period.
This allocation of costs is usually based on the equivalent units of production, which takes
into account the work done on partially completed units.
Example of Process Costing: • Soap making
•Textiles mills, weaving • Sugar works
• Chemical works • Confectionaries (Biscuits)
• Oil refining •Box Making
• Cement manufacture • Canning Industry
• Paper manufacture • Coke Works
• Food processing • Meat Products
• Steel mills • Milk Dairy
• Paint manufacture • Plastic manufacture, etc.

2 Essential Characteristics of Process Costing

The following characteristics are commonly observed in industries where process costing is
used. Let's briefly review them:

1. Continuous production and sequential processes: Process costing is used in industries

where production is continuous and the final product is the result of a sequence of

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 processes. Each process adds value to the product, and the output of one process
becomes the input for the next process in a predetermined sequence.

2. Costs accumulated process-wise: Costs incurred in each process are accumulated

separately in the respective process accounts. This allows for tracking and recording of
costs at each process or department level, enabling better cost control.

3. Standardized and homogeneous products: The products produced in each process are
standardized and homogeneous, meaning they are similar in nature and characteristics.
This allows for the application of average costing methods in determining the cost per
unit produced.

4. Average cost per unit: The cost per unit produced is calculated as the average cost,
which is obtained by dividing the total process cost by the number of units produced
during a specific period. This helps in determining the cost of production for each unit of
output.

5. Sequential flow of materials: The output of each but the last process becomes the raw
material for the next process in sequence, and the output of the last process is
transferred to finished goods stock. This sequential flow of materials ensures a smooth
and organized production process.

6. Specific and predetermined sequence of processes: The sequence of operations or

processes is specific and predetermined in process costing. Each process has a
predefined role and follows a predetermined order to add value to the product.

7. Unavoidable loss of materials: Some loss of materials during the production process,
such as due to chemical action, evaporation, etc., is unavoidable. Process costing takes
into account such losses and includes them in the overall cost of production.

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

These characteristics collectively define the nature of process costing and are important
factors to consider when implementing process costing in industries where production is
continuous and sequential.

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 3 Difference between Job Costing and Process Costing
This is very important to understand as these two are the very important methods of
costing. Please refer to the following table:

4 Procedure of Process Costing

Following is the procedure of process costing:
1. The factory is divided into several processes and an account is maintained for each
process.
2. Each process account is debited with material cost, labor cost, direct expenses and
overheads allocated or apportioned to the process.
3. The output of a process is transferred to the next process in the sequence. In other
words, finished output of one process becomes input of the next process. So output is
credited to the process and is debited to the process to which it is transferred
4. The finished output of the last process (i.e., the final product) is transferred to the
Finished Goods Account.

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 Another thing that you must know is that in Process Costing the overheads are allocated
and apportioned to different processes based on some criteria.
Suppose total overheads must be given as Rs 100. But in the question, you may find some
criteria to allocate the overheads to their specific process. The company may use a criterion
such as machine hours, labor hours, or material costs to allocate the overhead costs to the
process.
Let's take a general example to illustrate the procedure of process costing:
Let's say a company manufactures bicycles and has three processes in its production line:
Frame Manufacturing, Wheel Assembly, and Painting. Each process is considered as a
separate department or stage in the production process, and an account is maintained for
each process.
1. Division of factory into processes: The company divides its factory into three processes:
Frame Manufacturing, Wheel Assembly, and Painting. Each process has its own
designated area where specific tasks related to that process are carried out.
2. Debiting of process accounts: For each process, the company debits the respective
process account with costs incurred during that process. For example, in the Frame
Manufacturing process, costs such as material cost for frame components (e.g. metal
tubes, welding rods), labor cost (e.g. wages of frame manufacturing workers), direct
expenses (e.g. welding gas), and allocated or apportioned overheads (e.g. depreciation
of welding machines) are debited to the Frame Manufacturing process account.
3. Transfer of output to next process: Once the Frame Manufacturing process is
completed, the finished frames are transferred to the Wheel Assembly process as input.
The output of one process becomes the input of the next process in the sequence. The
finished frames are credited to the Frame Manufacturing process account and debited
to the Wheel Assembly process account, reflecting the transfer of goods from one
process to another.
4. Transfer of final product to Finished Goods Account: Once the Wheel Assembly process
is completed, the finished bicycles are transferred to the Painting process for painting
and finishing. Finally, after the Painting process is completed, the finished bicycles,
representing the final product, are transferred to the Finished Goods Account, indicating
that they are ready for sale or distribution.
By following this procedure, the company can accumulate and allocate costs at each
process, and determine the average cost per unit for the entire production process. This

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 helps in understanding the cost of production at each process and ultimately in determining
the cost of the final product.
Note- Some of you may find this easy but some of you may find it difficult. It’s just a bit
complicated. So, the following example will help you understand the procedure.

5 Example
Question- A product passes through three distinct processes to completion. These
processes are numbered respectively, 1, 2 and 3. During the week ended 31 January, 1,000
units are produced. The following information is obtained:

The indirect expenses for the period were Rs 2,800, apportioned to the processes on the
basis of labor cost.
Prepare process accounts showing total cost and cost per unit.
Solution-
As discussed previously, in this question they have specified that indirect expenses is to be
apportioned on the basis of labour cost. So, it has been calculated under process 1 as 20%
of labour cost.
We also know that 1000 units are produced. This will help us to understand the Per unit
cost.
So, in case of Process 1 account, we will debit the materials, labour, direct expenses and
indirect expenses and the balance amount will be termed as output (credit side) that will
further be transferred to Process 2. And same treatment will be made in process 2 and
process 3. And by the end we will get the finished stock.

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 In the above example, we can see that the cost per unit gets on increasing as the product
passes through the processes. So, we can say that Process accounts are created in process
costing to track and accumulate costs related to each individual process or stage of
production.

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 6 Accounting Adjustments in Process Costing
There are 3 types of accounting adjustments which are peculiar to process costing
(i) Process losses and wastages
(ii) Valuation of work-in-progress—Equivalent Production
(iii) Inter-process profits
We shall discuss them one by one.

6.1 Process Losses and Wastages

• Losses occur at various stages of production: In many industries that use process
costing, losses can occur during the production process due to various reasons such as
evaporation, chemical reactions, inefficiencies, or other factors.
For example, in the food processing industry, evaporation may occur during the cooking
process, leading to a loss in weight and volume of the product. In a chemical manufacturing
industry, some of the raw materials may react with each other and result in a loss of
quantity or quality. These losses can impact the overall cost of production and need to be
accounted for accurately.
• The later the loss occurs, the greater the financial loss: In process costing, products
move through multiple stages of production before reaching completion. The later the
stage at which a loss occurs, the more costs have been incurred in the preceding
stages, which can result in a higher financial impact.
For example, if a loss occurs during the final packaging stage of a product, it may result in a
higher financial loss compared to a loss that occurred during an earlier stage of production,
such as the initial mixing or blending stage.
• Accurate record keeping of input and output is necessary: To properly account for
losses in process costing, it is essential to maintain accurate records of both input and
output quantities at each stage of production. This includes tracking the quantity and
cost of raw materials used, the quantity and value of work-in-progress at different
stages of production, and the quantity and cost of finished goods produced. Accurate
record keeping allows a company to identify and quantify losses at different stages of
production, which helps in calculating the cost of production accurately and
determining the cost per unit of output.
For example, let's consider a beverage manufacturing company that produces fruit juices.
During the processing stages, some juice is lost due to evaporation and spillage. If the losses
occur during the initial juicing process, the financial impact may be relatively low, as the lost

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 quantity is still a small portion of the total input. However, if the losses occur during the
final packaging stage, when the product is almost complete, the financial impact may be
much higher, as more costs have been incurred in the preceding stages. Accurate record
keeping of the input (e.g., quantity and cost of fruits) and output (e.g., quantity and value of
finished goods) at each stage of production would enable the company to calculate the
actual cost of production, taking into account the losses incurred, and make informed
decisions about pricing, inventory management, and profitability analysis.
There are two types of Losses:

Now, let us discuss these in detail:

1. Normal Process Loss: Normal process loss refers to the amount of loss that is expected
and unavoidable due to the nature of the material or process involved in production. It
is quite common and accepted as a normal part of the production process. Normal
process loss is caused by factors such as chemical changes, evaporation, withdrawals
for tests or sampling, and unavoidable spoiled quantities. This type of loss is
considered as a standard loss that occurs under normal operating conditions.
Example: Let's consider a bakery that produces bread. During the baking process, some
amount of bread dough may get dried up or burned, resulting in a loss of weight and
volume. This loss is expected and considered as a normal process loss due to evaporation
during the baking process. The bakery may anticipate a certain percentage of normal
process loss, say 2% of the total dough used, which is considered as a standard loss and
accounted for in the cost of production.
2. Abnormal Process Loss: Abnormal process loss refers to the loss that occurs due to
abnormal or unforeseen factors that are not considered as a regular part of the
production process. It arises due to abnormal circumstances such as carelessness,
machine breakdown, accidents, use of defective materials, etc., which are not expected
or planned. Abnormal process loss is considered as a loss that is over and above the
normal process loss and is treated separately in accounting.

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 Example: Let's consider a manufacturing company that produces electronic components.
During the production process, a machine breaks down unexpectedly, leading to a loss of
production due to the downtime for repairs. This loss of production is not a regular part of
the production process and is considered as an abnormal process loss. The cost of repairs
and the loss of production due to machine breakdown would be treated as abnormal
process loss and accounted for separately from the normal process loss.
Note- Accounting procedure for normal and abnormal loss differs.
Let’s consider one more example with numerical terms to understand normal and abnormal
loss:
Example- Company takes 100 units as input and 5% is normal loss. If total units in output is
93 then compute normal loss and abnormal loss.
Sol:
From the question, we can easily identify normal loss as:
Normal Loss = 5% of 100 = 5
But, in the question, we can see that total output was 93 and not 95. So, the remaining loss
must be abnormal loss:
Total Loss = 100 – 93 = 7
Abnormal Loss = 7 – 5 = 2
Till now, we have understood that the normal process loss represents the loss that would
be expected under normal conditions. It is an estimated figure. The actual loss may be
greater or less than the normal loss. If the actual loss is greater than normal loss, it is
known as abnormal loss. But what if actual loss is less than normal loss? So, here arises the
concept of Abnormal Gain.
Type of Gain: Abnormal Gain
Abnormal gain, also known as abnormal efficiency or abnormal advantage, refers to a
situation where the actual loss in a production process is less than the normal loss that
was estimated or expected under normal conditions.
When the actual loss is less than the normal loss, it means that the production process has
been more efficient or effective than anticipated, resulting in a lower loss of materials or
resources. This could be due to factors such as better process management, improved
quality control, reduced wastage, or other favourable circumstances.

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 Example: Let's consider a chemical manufacturing company that produces a certain
chemical compound. Based on historical data and industry standards, the normal process
loss for the production process is estimated to be 5% of the total input material. However,
during a particular production run, the actual loss of material is only 3% due to improved
process control, better equipment maintenance, and reduced evaporation. In this case, the
company has achieved an abnormal gain of 2% (5% - 3%) as the actual loss is less than the
normal loss.
Let’s consider one more example with numerical terms to understand abnormal gain:
Example: Company takes 100 units as input and 5% is normal loss. If total units in output is
97 then compute normal loss and abnormal loss/gain.
Sol:
From the question, we can easily identify normal loss as:
Normal Loss or expected loss = 5% of 100 = 5
Total Loss = 100 – 97 = 3
But we can see that actual loss was less.
Abnormal Gain (Since actual loss is less than normal loss) = 5 -3 = 2
So, we have covered the theoretical concept of normal loss, abnormal loss and abnormal
gain. Now we shall study accounting treatment for Normal loss, Abnormal loss and
abnormal gain.

6.1.1 Accounting Treatment for Normal Loss

• According to the fundamental costing principle, the cost of normal losses should be
included as part of the cost of production. This means that the cost of these losses
should be borne by the goods that are successfully produced.
• Normal loss is usually calculated as a percentage of the input used in the production
process. For example, if 5% of the input is expected to be lost as normal loss, then the
cost of that 5% loss should be included in the cost of the goods that are produced.
• In some cases, normal loss may not be physically present, such as when it is lost due to
evaporation or chemical reactions. Since this type of loss does not have any physical
existence, it is not considered to have any value and is not included as part of the cost
of production.
• However, if the normal loss is in the form of scrap, meaning it is physically present but
cannot be used for its original purpose, it may have some value and can be sold. In such
cases, the value of the scrapped material is credited to the Process Account.

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 Let’s understand the above accounting treatment with the following example:
Question- The following information is given in respect of Process A

Solution-
Firstly, we will discuss a part and then we will move to b part. So, that you may see the
difference in both the parts.
So, in the first part we can see that the normal loss is absorbed by good production and as
a result the cost per unit of good production inflates.

When there is no loss, the cost per unit produced is Rs 13 (i.e., 13,000 ÷ 1,000 units). But
when there is a normal loss, the cost per unit is higher at Rs 14.44.

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 b) Whenever any value is realized from the sale of normal wastage, it reduces the cost to
that extent.

So, here the cost has reduced from 14.44 per unit to Rs 14.33 per unit.
Now, we will see the accounting treatment in case of Abnormal Loss.

6.1.2 Accounting Treatment for Abnormal Loss

• Abnormal process loss refers to losses that occur due to unforeseen or abnormal
circumstances such as accidents, carelessness, or machine breakdowns during the
production process. Unlike normal loss, which is considered a part of the normal
production process and is absorbed by good production, abnormal loss is not
considered a normal part of the production and is treated differently in the accounting
records.
• Abnormal loss is not absorbed by good production because it is not considered a
regular occurrence in the production process, and including it in the cost of good
production would distort the true cost of production and mislead financial reporting.
Instead, abnormal loss is separately accounted for and transferred to the Costing Profit
and Loss Account.
• The Costing Profit and Loss Account is a separate account used to record items that do
not form a part of the regular production cost, such as abnormal losses, abnormal
gains, or other non-recurring items. By transferring abnormal loss to the Costing Profit
and Loss Account, it is isolated from the cost of good production and reported
separately to provide a clearer picture of the company's financial performance.
Let’s understand the above accounting treatment with the following example:
Question- Fifty units are introduced into a process at a cost of rupee one each. The total
additional expenditure incurred by the Process is 30. Of the units introduced, 10% are

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 normally spoiled during manufacture, these possess a scrap value of `0.25 each. Owing to
an accident, only 40 units are produced. You are required to prepare
(i) Process Account, and
(ii) Abnormal Loss Account.
Solution-
i) Firstly, we will create a process account and then we will write the given data in the
format. So, we will write Materials as 50 Units and the price as Rs 50 on the debit side. And
then we will add expenses worth Rs 30 on the debit side.
10% is the normal loss. So, we will mention 5 units as normal loss worth Rs 1.25 (5*0.25).
The calculation of abnormal loss is given in the following image:

The answer is we have credited the abnormal loss account because we have transferred it
to Abnormal loss account and from there it shall be transferred to Profit and Loss Account.
When we transfer it, it does not increase the cost per unit of this process i.e. we do not
absorb abnormal loss in this process.
ii) Let’s create an abnormal loss account:

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 This figure transferred on credit side to Profit and Loss Account shall be deducted from
Overall Profit of the company while preparing Income statement. This can be understood
from the following example:
Suppose the Profit of the company before adjusting the amount in Profit and Loss A/c is
coming out to be 100, then what shall be the Profit after adjusting this amount
Profit After Adjustment = Profit – Amount to adjusted in Profit and Loss A/C
= 100 – 7.50 = 92.50
So, from the previous example we can say steps in Accounting Treatment for Abnormal
Loss are:

6.1.3 Accounting Treatment for Abnormal Gain

• The accounting treatment for abnormal gain is similar to that of abnormal loss.
• The abnormal gain is recorded on the debit side of the Process Account, which is the
account used to track the production costs and progress of a specific process. This is
because the abnormal gain increases the total output or units produced, and hence, is
recorded as a debit in the Process Account.
• Simultaneously, the abnormal gain is also recorded on the credit side of the Abnormal
Gain Account. This is a separate account used to specifically track abnormal gains. The
abnormal gain is recorded as a credit in the Abnormal Gain Account, indicating that it is
a gain or income for the business.

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 • It is shown on the debit side of the Process Account and credit side of the Abnormal
Gain Account. Like abnormal loss, it is ultimately transferred to Costing Profit and Loss
Account.
Let’s understand the above accounting treatment with the following example:
Question- Fifty units are introduced into a process at a cost of rupee one each. The total
additional expenditure incurred by the Process is 30. Of the units introduced, 10% are
normally spoiled during manufacture, these possess a scrap value of 0.25 each. You are
required to prepare
(i) Process Account, and
(ii) Abnormal Gain Account.
When the results are analyzed, It is seen that normal loss is only 6% instead of 10%
Solution-
In the above question we can see that actual loss was around less than the expected normal
loss. So, from this information we can see that there must be abnormal gain.
So, we will write Materials and Expenses as Rs 50 and Rs 20 respectively on the debit side of
the process account:

But, as we already know that there is an abnormal gain, it will come on the debit side as:
Total Units = 50,
Expected Loss Units = 50*10/100= 5 units,
Actual Loss Units = 50*6/100= 3 units.
So, Abnormal Gain = 5-3 = 2 Units. The value of abnormal gain is calculated as follows:

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 Earlier we accounted normal loss for 5 units. But, please note here that we need to adjust
the money from scrap because now there shall be 3 and not 5 scrap units. So, this has been
adjusted on the debit side of the abnormal gain account.
The amount transferred on debit side to Profit and Loss A/C will be added in Profit and Loss
of Company.

6.2 Valuation of work-in-progress—Equivalent Production

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-
progress, closing work-in-progress and completed units.
Thus to ascertain the cost of each completed unit it is necessary to ascertain the cost of
work-in-progress in the beginning and at the end of the process. The valuation of work-in-
progress 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. The valuation of such work-in-progress is done in terms of equivalent or
effective production.
For Example: In the following image, we can see that a chair is a finished product. But,
there is work in progress that seems to be half complete. So, we will say that the work is
done by 1.5 units.

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 So, we can see that production in terms of finished products is one. But when we consider
the equivalent production then the production will be 1.5. This is the concept of equivalent
production.

Equivalent production represents the production of a process in terms of completed units.

Work-in-progress at the end of an accounting period are converted into equivalent
completed units. This is done by the following formula:

So, in simple words we can say that Equivalent production means converting the
incomplete production units into their equivalent completed units.
For example, if there are 50 units in work-in-progress as closing stock and these are
estimated to be 60% complete, then their equivalent production is 50 units × 60% = 30
units.
Now you may be thinking, what is the degree of completion?
Degree of completion can be given in two ways:
1. Overall degree of Completion
2. Different Degree of completion in terms of Material, Labor and Overheads
We will discuss both ways in the following examples:

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 Example – Overall Degree of Completion
Question- In process A, on 1 March, there was no work-in-progress. During the month of
March, 2,000 units of material were issued. On 31 March, 1,500 units were completed and
transferred to the next process. On the remaining 500 units, which were incomplete, the
degree of completion was 50%. Find the statement of Equivalent Production.
Solution- From the question, we can interpret that in Process A there was no work in
progress. But in March 2,000 units were issued out of which 1500 units were completed.
But the remaining 500 units were 50% completed. So, we can calculate that:
Equivalent Production = 1500 + 500* .50 = 1750.
Example – Different Degree of completion in terms of Material, Labor and Overheads
Question- In process A, on 1 March, there was no work-in-progress. During the month of
March, 2,000 units of material were issued. On 31 March, 1,500 units were completed and
transferred to the next process. On the remaining 500 units, which were incomplete, the
degree of completion was as follows.

Find the statement of Equivalent Production.

Solution-
In this question, the Equivalent Units are found separately in terms of Material, Labor and
Overhead. Given the information provided, we can calculate the equivalent units of
production for March as follows:
Units completed and transferred: 1,500 units
Units in process (500 units):
• Material: 500 units x 100% completion = 500 equivalent units
• Labour: 500 units x 60% completion = 300 equivalent units
• Overheads: 500 units x 30% completion = 150 equivalent units
The above details can be written in the following format as:

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 So, now we have understood the both ways of Degree of completion. We can interpret that
whenever overall degree is given, it is very easy. But in case of Different Degree of
completion in terms of Material, Labor and Overheads, the calculation is a bit complicated.
However, the basic idea remains the same.
Now, we will discuss accounting adjustments. We will be discussing the points with the help
of examples. So, for better understanding you must have understood the concepts
discussed till now.
Now, let us discuss the two cases of accounting adjustments:
Case 1: When there is no opening stock, i.e., when there is only closing stock of work-in-
progress. In such a case 2 situations can be there

1. No Process Loss
2. There is some process Loss
Case 2: When there is opening as well as closing stock. In this 2 situations can be there

1. No Process Loss
2. There is some Process Loss
Now, let us discuss Case 1 point 1 i.e there is no opening stock and there is no process loss

Example: Work in Progress (Equivalent Production): When there is no opening stock and
no process loss
Question 1- In process A, on 1 March, there was no work-in-progress. During the month of
March, 2,000 units of material were issued at a cost of `18,000. Labor and overheads
totalled `9,000 and `6,600, respectively. On 31 March, 1,500 units were completed and
transferred to the next process. On the remaining 500 units, which were incomplete,
degree of completion was as follows:

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 Prepare:
a. Statement of Equivalent Production
b. Statement of Cost
c. Statement of Evaluation
d. Process Account
Solution-

From this example, we can learn about steps to follow:

Note: For better understanding first go through the solution and then refer to the steps and
then again go through the solution.
(i) Find the Statement of Equivalent Production. We have already discussed this
before.
(ii) Find out the total cost (net) for each element of cost, i.e., material, labor and
overheads. Scrap value of normal loss is deducted from the material cost (In our
example it was already given that material were issued at 18,000, Labour at 9000
and Overhead at 6600)
(iii) Statement of Cost: Ascertain the cost per unit of equivalent production separately
for each element of cost. This is done by dividing the total cost of each element by
the respective number of equivalent units.
(iv) Statement of Evaluation: At this rate of cost per unit, ascertain the value of finished
production and work-in-progress.
(v) Process Account can be created.

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 So, we can see that we have to create Statement of Evaluation, as it provides details
regarding the Finished Goods and Value of work in progress, which is used to create the
Process Account.
Work in Progress (Equivalent Production): When there is no opening stock and but there
is process loss
In process costing, when there is no opening stock but there is process loss, we need to
account for normal loss, abnormal loss, and abnormal gain. Here's how each of these
concepts is treated:
1. Normal Loss: Normal loss refers to the expected loss or waste that occurs during the
production process, which is considered as a normal part of the production process. This

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 normal loss is not added to the equivalent production, as it is not considered as a
completed unit. However, the realizable value of the normal scrap is deducted from
the cost of material in order to calculate the net material cost. This net material cost is
then used as the basis for calculating the material cost per unit in the statement of cost.
This ensures that the cost of normal loss is absorbed in the production process.
2. Abnormal Loss: Abnormal loss refers to the loss or waste that occurs during the
production process, which is not expected or planned. Abnormal loss is added to the
equivalent production, taking into consideration its degree of completion. This means
that the incomplete units that are lost abnormally are included in the equivalent
production, and their degree of completion is accounted for in the calculation.
3. Abnormal Gain: Abnormal gain refers to the unexpected or unplanned gain or recovery
that occurs during the production process. Abnormal gain is deducted from the
equivalent production in order to calculate the net equivalent production. This means
that the units that are gained abnormally are not considered as completed units, and
Example:
Question- Refer to the following image:

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 Please note that this question is pretty tough. The basic idea of providing this example is to
make you understand the practicality of the concept.
Solution-
In this question, we have to prepare a Statement of Equivalent Production, Cost of
Abnormal loss, finished goods and closing stock and Process I account and abnormal loss
account.
The basic idea of the question is the same as discussed before. So, in this question, we will
only explain the treatment of normal loss and abnormal loss.
As, normal loss was estimated at 5% on input. It means that normal loss will be 2000*5%=
100 units. Also, total loss – normal loss = abnormal loss. So, abnormal loss is 40 units. We
already know that finished production was for 1400 units and 460 units were in work in
progress.
So, with the help of above data we can create the statement of equivalent production.
After creating the statement of equivalent production. We will create the Statement of Cost
and then the statement of Evaluation.

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 Now, we will create the Process I account and the abnormal loss account as follows:

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 So, from the above example we can interpret that in case when there is no opening stock
and process loss Overall Input cost – Realizable value of Normal loss = Value of Finished
Goods + Work in Progress + Abnormal Loss.
Till now we have discussed case 1. Now we will discuss case 2 which is When there is
opening as well as closing stock. Under case 2 we also have 2 points that is when there is no
process loss and second when there is some process loss.
Work in Progress (Equivalent Production): When there is opening and closing stock and
but there is no process loss
In such a case there are two methods of calculating equivalent production:
(i) FIFO Method: In FIFO method the units on which work in progress was there at the
opening is supposed to be completed first and then other units are started to be worked up
on. Let us discuss FIFO method using some examples:
Question 1-

Solution-
We can solve it like this
So, 20,000 units were added to 2000 (opening stock) = 22,000. Also, 18,000 +4,000 (closing
stock) =22,000. So, input = output. This means there is no loss.
Now, if we assume the FIFO method, It means out of 18000, 2000 units that were
completed were the one’s which were from opening stock because we are following FIFO
method. So, 70% remaining work on this 2000 was completed i.e., 1400 units.
Rest 18000-2000 = 16000 units completed were the one’s which were introduced this
month. So, 100% work on these 16000 units was done i.e. 16000 units
Work done on closing units = 40% of 4000 = 1600
So total work done during the period= 1400+16000+1600= 19000
(ii) Average Cost Method.
Note- We will not be discussing Average cost method as it is very complex.

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 Now we are left with the case 2 Point 2 i.e. when there is opening stock and closing stock
and there is process loss. We shall not be discussing this as it becomes very complex and
moreover the logic remains the same as we discussed in case of Case 1: Point 2. We shall do
some simple examples.
Example: Work in Progress (Equivalent Production): When there is opening and closing
stock and there is process loss.
Question 1- Refer to the following image:

Solution-
In this question, the calculation of normal loss would be as follows:
Normal Loss when there is both opening stock is calculated as-
Normal loss = Normal Loss % of (Opening Stock + Units Introduced – Closing Stock)
Normal Loss = 10% of (1600+10200-1800)
= 10% of 10000 = 1000 units
But, as per the question, the actual loss is 800 units. This means that there is an abnormal
gain for 200 units. Please remember that abnormal gain is deducted to obtain equivalent
production.

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 6.3 Inter-process profits
In some businesses, it is a practice to charge the output of each process to the next process
not at cost but at a price showing profit to the transferor process. The transfer price may be
either the current market price or cost plus a fixed percentage.
Let's discuss Inter-Process Profits with the help of an example:

In the above example, we can see that after process 1 we add profit to the transfer price
and similarly we add profit after process 2.
Let us consider one more example, consider a company that manufactures automobiles.
The company has different departments or processes, such as engine assembly, body
fabrication, painting, and final assembly. The engine assembly department produces
engines that are then transferred to the body fabrication department. The engine assembly
department may include a markup or profit margin in the transfer price of the engines,
which is charged to the body fabrication department. This inter-process profit allows the
engine assembly department to generate profits and cover its costs, while also providing an
incentive for efficient operations.
The objectives of Internal Process Profit are:
1. To show whether the cost in each process competes with the market prices.

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 2. To make each process stand on its own efficiency and economy.
But this is a very complicated procedure in terms of accounting. Internal process profits
have the disadvantage of complicating the costing records. The complications brought into
the accounts arise from the fact that inter-process profit, so introduced, remains included in
the price of process stocks, finished stocks and working-progress. For balance sheet
purposes, such stocks have to be reduced to actual cost because a firm cannot make profits
by trading with itself.

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 Previous Year Questions (PYQs)
on
Process or Operations Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – 8000 units were introduced in the process. 5% is the normal loss. 6800 units were transferred to
next process. WIP is 1000 units which is 60% complete. Find the Equivalent Units. SEBI Grade A – Phase 2 -
2020

A. 6200 units
B. 7600 units
C. 7200 units
D. 7400 units
E. 6300 units

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic

Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option D

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 Section C

Explanation
SEBI Grade A questions

Question 1 – 8000 units were introduced in the process. 5% is the normal loss. 6800 units were transferred to
next process. WIP is 1000 units which is 60% complete. Find the Equivalent Units. SEBI Grade A – Phase 2 -
2020

A. 6200 units
B. 7600 units
C. 7200 units
D. 7400 units
E. 6300 units

Answer – Option D

Explanation –

Input – 8000 units

Normal Loss – 5% * 8000 units = 400 units

Balance Units = 7600 units

Transferred units = 6800 units

WIP = 1000 units

Completed WIP units = 60% * 1000 = 600 units

Equivalent units = 6800 units + 600 units = 7400 units

Hence, Option D is the correct answer. All other options are incorrect.

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 Summary Sheet
-
Joint and By-products Costing

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 1 Introduction
Sometimes we get two or more products as an
output from a process or set of processes, those
products are either Joint Products or By-Products.
For Example: In refining of crude oil we get so many
products such as Petrol, diesel, Kerosene etc.

Joint and by-product costing are two methods used

by companies to allocate the costs associated with
the production of multiple products. Both joint and
by-product costing are important for companies to
determine the profitability of their products and to
make informed decisions regarding production,
pricing, and inventory management.

1.1 Difference between Joint Products and By-products

Join Products: Two or more products of almost equal economic value or equal economic
significance such that no one product can be called main Product. In such case all the
products will be called Joint By-Products

A classic example of joint products, as given above, is found in oil refining, where items like
petrol, diesel, naphtha and kerosene are produced from the crude oil.

By Products: By-products are products of relatively small value which are incidentally and
unavoidably produced while manufacturing the main product. By-products are often a
source of additional revenue for companies and can help offset the costs of producing the
main product.

For example, in sugar mills, the main product is sugar. But molasses of comparatively
smaller value are incidentally produced and thus are by-products.

We can better understand this difference from the below example too.

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 Let’s say there are three products that are being produced while carrying out a particular
process, as shown in the image above. In this particular case we would consider product 1
and 2 as the joint product because they have almost equal economic value. Whereas,
product 3 is the by-product as its value is relatively very low as compared to the joint
product.

Though we have classified Joint Products and By-Products based on their economic value
but that is not always right. Sometimes irrespective of the value, the objective of
manufacturing decides what main product is and what is by product.

Suppose we are producing oxygen and another chemical in a process; the other chemical
might be costly but main objective might be to produce oxygen then oxygen would be the
main product though it is less in terms of value.

There are many such instances when a by-product attains so much importance in terms of
the company objective, then it is regarded as a main product.

Now let us try to understand the meaning of joint product in further detail, so that we could
be able to distinguish it from other kind of products such as by-products or co-products.

2 Characteristics of Joint Products

1. Joint products are produced from the same raw material in natural proportions,
such proportions cannot be altered.

2. They are produced simultaneously by a common process

3. They are comparatively of almost equal value or equal significance

4. Joint products may be saleable after separation or may be further processed by

incurring additional costs to make them saleable or an improved product (See
diagram below)

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 Some examples of joint products can be:-

Flour Mill: Joint products are white flour, brown flour, and animal feeding stuff, etc.

Meat canning: Joint products are hides, canned meat, fertilizers, etc.

Dairy: Skimmed milk, butter

Mining: Mining several metals from the same ore, e.g., copper, silver, zinc, etc.

The term joint product is also used to describe various qualities (or different grades) of
the same product, for example, many grades of coal which may be produced in coal mining.

Joint products should be distinguished from co-products.

Co-products refer to more than one product being manufactured by a company but need
not necessarily arise from the same raw material and manufacturing process. The quantity
of each co-product can be changed by the management.

For example- If a company is producing biscuits, cakes, bread in a bakery then these are co-
products and not joint products.

2.1 Joint Costs and Subsequent Costs

Joint costs are those costs which are incurred before that stage in manufacture at which
the products get separated. It comprises raw material, labor and overheads. It is a complex
task to divide such costs amongst the various products being produced, which means that
they are not easily identifiable with each of these products.

Subsequent (or attributable) costs, on the other hand, are those costs which are incurred
after the separation or split-off point. These are separately incurred for individual joint or
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 by-products and thus are identifiable with each product. Subsequent costs are also known
as ‘after separation costs’ or ‘after split-off costs.

The distinction between joint costs and subsequent costs is important because when
accounting for products, the joint costs are the main problem. This is because joint costs
cannot be traced to individual products and the cost accountant is faced with the problem
of apportioning the joint costs incurred to various joint products produced.

Subsequent costs, on the other hand, pose no accounting problem because such costs
relate to individual products. These are, therefore, charged to the appropriate product and
not regarded as joint. It should be noted and remembered that selling and distribution
costs are virtually always subsequent costs.

Now, as we have studied about the costs related to joint products, we must now proceed
to accounting procedure to determine the cost of such joint products. This is where we
understand the practicality of the concepts mentioned above.

2.2 Accounting for Joint Products

Accounting for joint products means the apportionment of joint cost to each of the joint
product. This is important because we need to find the cost price for each of the product
separately so that we could determine their selling price and respective profit percent
separately too. Such apportionment serves the following objectives:

(a) To determine the cost per unit of products

(b) To determine the profit or loss on each line of Product
(c) To determine the price of each product

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 2.3 Various Methods of Apportionment of joint costs

Let us discuss these methods one by one.

2.3.1 Sales Value Methods

There are two sub-methods under Sales Value Methods-

1. Based on Unit Prices

2. Based on Sales Value
Let's discuss these sub-methods one by one.

Sales Value Methods – On the basis of Unit Price

In this method, the selling price per unit of various joint products is taken as the basis for
apportionment of joint costs.

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 The drawback in this method is that we do not consider number of units. Suppose A,B and
C are produced in Quantities of 200, 600 and 700 respectively. There sale values are 2400,
4800 and 2800 respectively. Would it be right if we apportion based on selling price? The
answer shall be no.

Sales Value Methods – On the basis of Sales Value

In this method, the apportionment is done on the basis of weighted sales value, i.e.,
number of units produced and sold × selling price per unit.

2.3.2 Reverse Cost Method or Net Realizable Value

In this method basically we do reverse calculations because, here we know the sales value
and the profit/loss margin and therefore we need to go backwards to find the cost.

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 Example- The sale value is 42000 and Profit is 50%. The subsequent Costs are 7000. Find the
Cost apportioned to it from the Joint Costs.

Solution- Sale Value = Cost + Profit

42000 = Cost + 21000

Cost = 21000

So we can say Subsequent Costs + Apportioned Joint Costs = 21000

Apportioned Joint Costs = 21000 – 7000 = 14000

Now, let us try to solve a practical question through this method for better clarity. This
question is quite straight forward, so try to do it yourself first without looking at the
question, keeping in mind the concepts just studied in the above example.

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 Note:- You can verify your answer by summing up the joint cost apportioned to each of the
product; they must always come equal to the joint cost mentioned in the question.

2.3.3 Physical Units Method

Under this method, the joint cost is apportioned on the basis of relative weight, volume or
quantity, etc., of each product, obtained at the point where the split-off occurs.

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 Note:-

1) Firstly, we need to find the per cent of yield of each product on the basis of total lbs
produced i.e. 2000lbs.

2) Alternatively: a shorter method for directly deriving the cost of each product what we
can do is instead of apportioning each type of cost separately, we can also follow the steps
below which is simply the unitary method-

Since, for 2000 lbs. cost is 180, therefore for 1420 lbs. of coke the cost shall be (180/2000)*
1420 = 127.8

2.3.4 Average Cost Method

In this method, the joint cost is apportioned by using the average unit cost which is
obtained by dividing the total joint cost by the total number of units produced of all the
products. The average cost per unit of each product is the same.

This is quite similar to the sales value- unit price method, because the parameter here is
the number of units rather than the weight or volume which was done in physical units’
method.

Let us solve a numerical example for the same to get the clarity over this method-

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 3 By-products

By-products may be:

(a) Those sold in their original form without further processing

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

3.1 Difference between By-products and Scrap & Waste

Sometimes people get confused between By-Products and Scrap or Waste thinking they are
same, but they are different

1. Waste is used to describe a material which has no value or even negative value, if
it must be disposed of at some cost. Examples of waste are gases, smoke and other
unsalable residues from the manufacturing process.
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 2. Scrap is also different from by-products in the sense that it is the leftover part of the
raw materials whereas by-products are different from the material which went into
the production process. For example, small pieces of wood left in furniture
manufacture or metal sheet pieces left in utensil manufacture are examples of scrap
whereas minor chemicals, having some value, emerging from a chemical process are
classified as by-products.

3. Sale value of scrap is relatively less than that of by-products.

3.2 Accounting Treatment for By-Products

There are 4 major methods through which accounting treatment of by-product is done:-

3.2.1 Where By-Product is of small Value

Suppose in a process we consume 10,000 rupees (5000 rupees for material and 5000 for
wages). Two products A (Main Product) and B (By product) are produced. Value of A in is
9980 and value of B is 20.

In this case B is By Product and it has small value. Should we take the pain to apportion
10,000 between A and B? The answer is no.

If we do not apportion it, we have 2 ways to handle it-

1. It may be credited to the process account in which the by-product has arisen (Shown
in Table below)

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 2. It may be treated as ‘miscellaneous income’ and credited to the Costing Profit and
Loss Account.

Here, separate account for by-product is not being maintained as the amount of such
valuation is very low and holds less significance value in order for us to make a separate
account for such income.

3.2.2 Where By-Product is of reasonable value

Here the By Product has reasonable value, so we will be required to apportion the cost
between Main Product and By-Product. That can be done using any of the methods we
discussed previously-

1. Sales Value Method

2. Physical Units Method

3. Average Cost Method

In this method, separate Account is maintained for Main Product and By-Product because
by product holds some significance level.

For example:-

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 3.2.3 Where By-Product requires Further Processing
Here as in case of Joint Products, we can use the Reverse Cost method to apportion the
joint cost at split off point between Main Product and the By-Product.

The cost at split off point needs to be handled further-

1. In case the cost of the by-products at the split-off point is small or negligible, it may
be treated as per the Method 1 we just discussed.

2. On the contrary, if it is of considerable amount, it is treated as per Method 2 we just

discussed.

Let us solve a numerical example to understand this method a little better.

It must be noted that in the above example we will maintain separate accounts for by-
product A and B as they have significant value in the production process.

Firstly, we need to find the cost of each of the by-product, which we will find out by
deducting profit, after separation cost and selling expenses from the sales value of each of
the by-product. Then, we will deduct joint cost of these by products so calculated from the
joint cost of manufacture to reach to the cost of main product Z.

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 3.2.4 Where By-product is utilized in the undertaking itself
In those cases where byproducts are used by the company itself as a raw material for some
other process, such by-products are credited to the Process at the market price i.e. the
price at which it is available in the market

So we will not be required to apportion the cost between Main product and By-Product as
we did in Method 1.

For example, suppose in manufacturing sugar we produce bagasse which is used in paper
plant by the same company. In the market bagasse is available at 100 per unit. The cost of
the process is 5000 each for Material and Labor. In this 100 per unit would be credited to
the process manufacturing sugar.’

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 3.3 Decision regarding Further Processing of Joint and By-products
Whether we shall do further processing of the product or not depends on-

• If incremental value after split off > Subsequent Costs or the incremental costs after
split off then, we should do further processing.
• If incremental value after split off < Subsequent Costs or the incremental costs after
split off then, we should not do further Processing)

Let us take an example to understand this concept in a better way.

For example, if a company produces two joint products P and Q, their cost up to separation
point being `47,000. These products can be sold at the split-off point at `150 and `350 per
unit, respectively. Alternatively, the two products can be further processed at a cost of
`15,000 and `12,000, respectively. After further processing these can be sold at `320 and `
500 per unit, respectively. The output of P is 150 units and of Q is 60 units.

Solution: -

Conclusion: - Product P should be processed further because it gives an incremental profit

of `10,500 whereas product Q should be sold at split-off point because it results in
incremental loss of `3,000.

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 Previous Year Questions (PYQs)
on
Joint and By-Product Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic.

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic.

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 Summary Sheet
–
Service Costing or Operating Costing

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 1 What is Service Costing?
Operating costing or Service Costing is a method of cost ascertainment used in those
undertakings which are engaged in providing services, such as transport, electricity, etc.
These undertakings do not manufacture tangible products.

The main objective of operating costing is to determine the cost per unit of service provided.
This method considers all the costs incurred in providing the service, including direct costs
such as labor, materials, and supplies, as well as indirect costs such as rent, depreciation, and
overheads.

The operating cost is calculated by dividing the total cost incurred in providing the service
by the total number of units of service provided. This helps the management of service-
oriented businesses to determine the profitability of each service provided and make
informed decisions about pricing, resource allocation, and cost control.

Service costing can be done by organizations engaged in providing services to other

companies, as well as organizations where one department provides services to other
departments within the same company.

1. In the case of organizations providing services to other companies, service costing is

important to determine the cost of providing the service and to ensure that the service is
priced appropriately to cover the costs and generate a profit.

For example, a consulting firm that provides services to other companies may use service
costing to determine the cost of providing consulting services and set a price that covers the
costs and generates a profit.

2. In the case of organizations where one department provides services to other

departments within the same company, service costing is important to ensure that the cost
of the service is accurately allocated to the departments that use the service. This helps to
ensure that the departments are charged the appropriate cost for the service they receive,
and that the department providing the service is able to cover its costs and generate a profit
if applicable.

For Example, IT departments within a company provide services such as network support,
software development, and help desk support to other departments within the same
company. They use service costing to ensure that the cost of providing these services is
accurately allocated to the departments that use the service.

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 2 Examples of Service Costing
Following are some examples of service costing:

1. Road transport companies 8. Hospitals and nursing homes

2. Railways 9. Cinemas

3. Airways 10. Canteens and hotels

4. Shipping companies 11. Computer centres

5. Electricity companies 12. Schools and colleges

6. Water supply companies 13. Local authority

7. Gas supply companies 14. Powerhouse in a factory

3 Characteristics of Service Costing

There are three characteristics of Service Costing:

1. Services rendered to customers are of unique and standardized type: This means that
the service being provided is unique and customized to the customer's specific needs, but
it is also standardized in terms of the way it is provided.

2. A large proportion of the total capital is invested in fixed assets and comparatively less
working capital is required: This characteristic refers to the fact that organizations
providing services may require large investments in fixed assets such as equipment,
buildings, and vehicles, but may require relatively less working capital such as cash and
inventory. This is because the focus is on providing a service rather than manufacturing a
product.

3. The costs are designated as fixed costs and variable costs: This characteristic refers to
the fact that Service Costing distinguishes between fixed costs and variable costs. Fixed
costs are costs that remain constant regardless of the level of output or service provided,
such as rent or insurance. Variable costs are costs that vary with the level of output or
service provided, such as labor or materials. Service Costing takes into account both fixed
and variable costs to accurately determine the cost of providing services.

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 4 Cost Units in Service Costing
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. Let’s first understand this with example:

Suppose, if Motu and Patlu wants to travel from Ahmedabad to Bhopal by a bus. Then how
much will be the fare charged? Will Motu be charged more as compared to Patlu? No.

Bus companies charge the same fare for each passenger traveling on their bus, regardless of
their individual characteristics such as height, weight, or gender. So, Motu and Patlu should
be charged the same fare for their journey from Ahmedabad to Bhopal.

Now, let us consider one more example.

Suppose, now if in a case of Courier company. If there are two products one with a bigger
box and other with smaller box. These boxes are sent from Ahmedabad to Bhopal. Now what
will be the fare charged? Same for both size of boxes? No.

In this case, there are two packages with different sizes being sent from Ahmedabad to
Bhopal, it's likely that the fare charged will not be the same for both boxes. Usually, courier
companies charge based on the weight and dimensions of the package, and the larger box
will likely be charged more because it will take up more space in the delivery vehicle and
require more handling.

Cost units are categorized as:

• Simple Cost Unit:

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 A simple cost unit is a single, homogeneous unit of product or service that is used as the
basis for cost calculation.

• Composite Cost Unit:

A composite cost unit is a unit of product or service that is made up of a combination of

different simple cost units. The cost of producing a composite cost unit is calculated by
adding the costs of the individual simple cost units that make up the composite unit. In
service undertakings, generally, a composite cost unit is used. In this type, two units are rolled
into one.

5 Transport Costing
Transport organizations can be divided into two categories viz. Passenger transport and
Commercial transport.

The cost unit for Goods (commercial) transport organization is Tonen– Kilometer – that
means cost of carrying one Tonne of goods over a distance of one kilometer.

Cost unit for Passenger transport organization is Passenger– Kilometer – which means cost
of carrying one Passenger over a distance of one kilometer.

Now, we will understand the determination of number of Cost Units for Passenger
Transport with the help of following example:

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 Question- A Delhi-Jaipur Transport Co. runs four buses between two towns which are 50 kms
apart. The seating capacity of each bus is 50 passengers and actual passengers carried are
80% of the seating capacity. All the 4 buses run on 25 days in a month and each bus makes
one round trip per day. Calculate passenger-kms.

You can see that this is a very easy question. It is a simple reasoning question. In this chapter,
you will see questions are way too easy as they are based on basic idea.

Now, we will understand the determination of number of Cost Units for Commercial
Transport.

In Commercial Transport, composite cost units may be computed in two ways—

(a) Absolute tonne-km - In absolute tonne-km, cost units between each two stations is
calculated separately in tonne-kms and then totaled up

(b) Commercial tonne-km. But in commercial tonne-km, the trip is considered as a whole
and it is arrived at by multiplying the total distance in kms by average load quantity.

Let’s discuss an example for better understanding:

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

Solution-

The following diagram will help us to understand the question:

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 Now, we calculate the absolute tonne-km and the commercial tonne-km in the following
manner:

We can see that in case of absolute tonne-km we have considered cost units between each
two stations separately and then we have added all. But in case of commercial tonne-km we
have considered the trip is considered as a whole and then calculated the average load and
then have multiplied with the total kilometers.

Log Sheet in Transport Sector

A log sheet in the transport sector is a valuable source of information for costing purposes,
as it provides a detailed record of the vehicle's movements, including the distance traveled,
time spent on the road, and any stops made along the way. This information is essential for
calculating the cost of transporting goods or passengers, as it allows companies to accurately
determine the cost per trip or per unit of distance traveled.

Overall, log sheets are an important tool for transport companies to manage their costs and
improve their operational efficiency. By keeping accurate and detailed records of their
vehicles' movements, companies can make informed decisions about how to allocate
resources and optimize their operations for maximum efficiency and profitability.

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 Costing Procedure in Transport Sector

Standing or fixed charges

• These are constant costs and are incurred irrespective of the mileage run. Such costs,
therefore, should not be allocated to specific journeys on the basis of mileage. For
example – Insurance Cost, Road Tax of Vehicle

• Some of these are direct or traceable fixed costs and can be allocated to specific
vehicles, other such costs are suitably apportioned to each vehicle. For example – The
road tax for each vehicle is separate and can be traced and allocated to a specific vehicle
whereas Administration Cost for the vehicles cannot be traced back to the specific vehicle
and the same needs to be apportioned

• Opinions differ as to whether depreciation is to be regarded as a fixed cost or a variable

cost. It is thus sometimes regarded as a variable cost and sometimes as a fixed cost.
Interest on capital may also be included in fixed charges.

Running or variable charges

• These costs are those which vary in direct proportion to mileage run and so variable cost
per unit may be computed straightaway. For example – Petrol, Diesel, Repair, etc.

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 Now you must be thinking why opinions differ in case of depreciation and in case of some
wages as well. So, please remember that:

1. Depreciation is sometimes regarded as fixed cost and sometimes as variable cost

depending on the industry and the specific circumstances. In services like hotels,
depreciation is typically considered a fixed cost because it occurs even if the hotel is not
fully occupied. This is because the hotel property is being depreciated over time and not
necessarily based on the number of guests staying at the hotel.

On the other hand, in the transport industry, depreciation is sometimes considered a

variable cost because it occurs in proportion to how much the vehicle has been driven.
The more the vehicle is used, the faster it depreciates, and the higher the depreciation
cost will be.

2. The wages of drivers, cleaners, and other support staff are typically considered fixed
costs because they are generally paid a fixed salary or wage per month regardless of how
much work they actually perform. However, if the payment is made according to the
distance traveled or trips made, then the wages may be considered variable costs.

5.1 Cost Sheet for Transport Sector:

Now let us discuss an example and then some Practice Problems.

Question- Refer to the following image:

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 Solution-

Working Notes:

Calculation of Interest:

Vehicle A: 25,000*5/100 = 1250 Vehicle B: 15,000*5/100 = 750

Fixed Cost per annum can be ascertained easily. After calculating fixed cost per annum we
can calculate fixed cost per mile by dividing 4,500 by 15,000 for A i.e Rs 0.30 and 3,600 by
6,000 for B i.e Rs 0.60.

Now for the calculation of Variable Cost per mile:

Driver’s wages:
A: 3/20= Rs 0.15 B: 3/20= Rs 0.15
Fuel Cost per mile:
A: 3/20= Rs 0.15 B: 3/15= Rs 0.20
Depreciation:
A: 25,000/1,00,000 = Rs 0.25 B: 15,000/75,000= Rs 0.20
So, after putting all the values, we will get Variable cost per mile as Rs 3.00 for A and Rs 3.15
for B. Now, after adding the variable cost per unit and the fixed cost per unit, we can calculate
Total Cost per running mile.

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 6 Powerhouse Costing
Powerhouse costing is a method used to determine the cost of generating electricity by a
power plant or a power house. It is a type of service costing that takes into account the cost
of all the resources that are used in generating electricity, including the cost of fuel, labor,
maintenance, and overheads.

The objectives of Power House Costing are as follows:

1. To ascertain the operating cost of generating electricity: Power House Costing aims to
determine the cost of generating electricity by taking into account all the resources used
in the process, including fixed and variable costs. By doing so, managers can get a clear
understanding of the operating cost involved in generating electricity.

2. To fix the rates of electricity to be charged to various departments using electricity:

Once the cost of generating electricity has been determined, power plant managers can

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 use the information to set rates for various departments that use electricity. The rates
charged should be sufficient to cover the operating cost of generating electricity while
also allowing for a reasonable profit margin.

3. To compare the cost of generating electricity with that of using an alternative mode of
generating electricity: Power House Costing can also help managers compare the cost of
generating electricity using different methods. For example, they can compare the cost
of generating electricity using fossil fuels with the cost of generating electricity using
renewable energy sources. This comparison can help managers make informed decisions
about the most cost-effective method of generating electricity.

6.1 Costing Sheet for Powerhouse Costing

Let’s discuss an example:

Question- Refer to the following image:

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 Solution-

Now we will discuss Canteen Costing.

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 7 Canteen Costing
Canteen costing is a method of ascertaining the cost of providing meals or dishes of
different types in a canteen or cafeteria. It is a type of service costing that takes into account
the cost of all the resources that are used in preparing and serving food, including the cost of
raw materials, labor, overheads, and any other costs associated with the canteen.

Cost unit shall be Cost per meal.

The objectives of Canteen Costing are as follows:

1. To ascertain the cost of producing meals or dishes: Canteen costing aims to determine
the cost of producing meals or dishes by taking into account all the resources used in the
process, including direct and indirect costs. By doing so, managers can get a clear
understanding of the cost involved in producing each meal or dish.

2. To fix the rates of meals/dishes to be charged: Once the cost of producing each meal or
dish has been determined, canteen managers can use the information to set rates for
each food item served in the canteen. The rates charged should be sufficient to cover the
cost of production while also allowing for a reasonable profit margin.

7.1 Cost Sheet for Canteen Costing

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 Please note that the above format is not mandatory. We can even make a cost sheet
having Fixed and Variable expenses.

1. Provisions, Wages, Consumables and services shall be variable expenses and

2. Miscellaneous shall be fixed expenses

Or We can just find the total expense without segregation into Fixed of Variable Cost.

Also, note that if in exam they have asked you to calculate Total Cost. You can directly
calculate it. You may not need to calculate as per the standard format. This applies to every
type of service costing.

We have already said that the Cost sheet that we are showing for service is kind of standard
format but not mandatory and only format. You can tweak it the way you want as per the
question or the way it seems easy to you.

Also, for solving the questions the basic idea remains the same.

Let us discuss one example, for better understanding:

Question- Refer to the following image:

Solution-

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 We just need to put the values in the format. So, we are not providing analysis of each
transaction as the solution is self-explanatory:

Now, we will discuss Hotel Costing.

8 Hotel Costing
Hotel costing is a method of ascertaining the cost of providing services by a hotel. It is a type
of service costing that takes into account the cost of all the resources used in providing
services.

Cost Unit- Per room per day or Per bed per day.The objectives of Hotel Costing are as
follows:

1. To ascertain the operating cost of running a hotel: Hotel costing aims to determine the
cost of all the resources used in providing services by a hotel, including direct and indirect
costs. By doing so, hotel managers can get a clear understanding of the cost involved in
running the hotel.

2. To fix the room rent per day on the basis of operating costs: Once the cost of operating
the hotel has been determined, hotel managers can use the information to set the room

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 rent per day. The room rent charged should be sufficient to cover the cost of operation
while also allowing for a reasonable profit margin.

3. To fix the hire charges of the banquet hall: Hotels often have banquet halls that can be
rented out for events such as weddings, conferences, and meetings. Hotel costing can
help managers determine the cost of providing these services and use the information to
set the hire charges for the banquet hall.

8.1 Cost Sheet for Hotel Costing

Refer to following image:

Let’s discuss some examples,

Question- Refer to the following image:

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 9 Hospital Costing
Hospital costing is a method of ascertaining the cost of providing services by a hospital. It is
a type of service costing that takes into account the cost of all the resources used in providing
healthcare services.

Cost Unit- Per Patient per Day, Per Bed Per Day

The objectives of Hospital Costing are as follows:

1. To ascertain the operating cost of running a hospital: Hospital costing is used to

determine the cost of all the resources used in providing healthcare services, including
direct and indirect costs.

2. To fix the room rent per day/bed on the basis of operating costs: Hospital costing is used
to determine the cost of providing each type of healthcare service, including inpatient
care.

9.1 Cost Sheet for Hospital Costing:

Refer to the following image:

Now, we will solve an example for better understanding.

Question- Zenith Hospital runs a CCU consisting of 35 beds and 5 more beds can be added, if
required.

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 Rent per month: `75,000 Nurses - 4 persons @ `20,000 per month
Supervisors - 2 persons @ ` 25,000 per each
month each Ward Boys - 4 persons @ `5,000 per month
each
Doctors were paid `250,000 per month based on number of patients attended and the time
spent by them.
Other expenses for the year are as follows:
Repairs (fixed) – `87,000 Medicines (variable) – `7,50,000
Food to patients (variable) – `8, 80,000 Other fixed expenses – `10, 80,000
Other services to patients (variable) – Administration expenses allocated –
`3,00,000 `10,00,000
Laundry charges (variable) – `6,00,000

It was estimated that for 150 days in a year 35 beds are occupied, and 25 beds are occupied
for 80 days only.
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 -

(a) Calculate profit, If the hospital recovers on an average `2,000 per day from each patient

Solution-

In this question, we will firstly, calculate the number of patient days:

Now, we will calculate the profit. For calculation of profit we will deduct total cost (variable
and fixed) from the total revenue/income:

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 Previous Year Questions (PYQs)
on
Service Costing or Operating Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

No questions were asked in the SEBI Grade A exam from this topic.

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

No questions were asked in the PFRDA Grade A exam from this topic.

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 Summary Sheet
-
Marginal Costing

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 First let’s start with the revision of the concept of various kinds of costs and what they
mean in order to better understand the main topic of marginal costing.

1 Components of Cost

1.1 Fixed and Variable Costs

Fixed Costs: These remain constant and do not increase of decrease when volume of
production changes.

Example: Rent of Building , Salaries of Managers etc.

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 Note: Fixed Cost per Unit decreases as volume of Production increases and vice-versa.

Variable Costs: In other words, when volume of output increases, total variable cost also
increases, and vice versa, when volume of output decreases, total variable cost also
decreases, but the variable cost per unit remains fixed.

Example: Cost of cloth required to produce a shirt, Direct Material, Direct Wages,
Commissions.

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 Is Variable Cost same as Direct Cost – Answer is NO
Direct costs can also be fixed costs, such as rent payments that are directly tied to a
production facility. Also, salaries of mangers or supervisors might also be included in direct
costs, particularly if they're tied to a specific project

Also, variable costs do not need to be directly related to the product. In other words,
a variable cost can be an indirect cost. For example, a company produces mobile phones
and has several production machines to produce their devices. The factory
machinery needs electricity to function. The cost of electricity is an indirect cost since it
can't be tied back to the product or the specific machine. However, the cost of electricity is
a variable cost since electricity usage increases with the number of products that are
produced or manufactured.

When we say variable costs can be indirect costs, it means indirect costs (Overheads) can
be variable or fixed. So-

Production Overhead = Variable Prod. Overhead + Fixed Prod. Overhead

Administrative Overhead = Variable Adm. Overhead + Fixed Adm. Overhead

Selling Overhead = Variable Selling Overhead + Fixed Selling Overhead

1.2 Product Costs and Period Costs

Product costs- These are those costs which are necessary for production and which will not
be incurred if there is no production.

Example: These consist of direct materials, direct labour and some of the factory
overheads. This is also called inventoried Costs.

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 Period costs- These are those costs which are not necessary for production and are incurred
even if there is no production. These are written off as expenses in the period in which
these are incurred.

Example: Showroom rent, salary, municipal taxes.

As we have now revised the various components of costs, we can now proceed to our
main topic of understand marginal costing and various aspect related to the same. It must
be noted that this revision was necessary to understand the concept of marginal costing as
they will be mentioned repeatedly in this chapter.

2 Introduction to Marginal Cost

Marginal Cost is an increase in total cost that results from a one unit increase in output. It is
basically the extra cost that is incurred to produce one additional unit.

For example, the total cost of producing one pen is $6 and the total cost of producing two
pens is $10, then the marginal cost of producing second unit is $4 only (10 - 6 = 4).

As we can see in the above example if we find the difference of total variable cost incurred
to produce one and two pen which is 8-4=4 this 4 is also the variable cost per unit.
Therefore, when fixed cost remains constant, the marginal cost remains the same as the
variable cost.

Marginal costing system is not a method of costing like job or batch costing or process
costing or contract costing or operating costing which are used for the purpose of
calculating the cost of products or services.

Marginal costing is a technique/system of presentation of sales and cost data with a view
to guide the managers for taking short term decisions like sales mix selection, acceptance of
special order, etc. It is also used by the managers for cost control, budgeting and profit
planning purposes.

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 What is Marginal Cost?
Marginal Costing is a costing technique wherein the marginal cost, i.e. variable cost is
charged to units of cost, while the fixed cost for the period is completely written off against
the contribution.

Let us suppose-
Sales 100
Variable Cost 50
Contribution (Sales-Variable Cost) 50
Fixed Cost 30
Profit (Contribution – Fixed Cost) 20
This example shows that contribution should be high enough to cover the fixed cost so that
as the company sells more and more number of units of a particular product there could be
a simultaneous increase in the profit so derived. And that is the reason why management
pays great focus on the amount that it incurs as variable cost, because if this cost is
maintained in a manner that contribution increases with the sale of each additional unit
then ultimately the fixed costs can be covered in a manner that would yield to desirable
amount of profit.

Variable Cost shall include all variable costs –

1. Direct Material Cost (Assuming all direct material cost are Variable)
2. Direct labor Cost (Assuming all direct material cost are Variable)
3. Variable Production Overhead
4. Variable Administration Overhead
5. Variable Selling Overhead

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 Why do we need Marginal Costing?

As shown above, the Traditional Cost sheet is organized in terms of 'functional' showing
the functions of production, administration, selling and distribution. No attempt is made to
distinguish between fixed cost and variable cost.

Whereas in present situation, the manager needs cost data organized into fixed and
variable costs that will facilitate planning, control and decision making. Therefore, the
Marginal costing format (as shown in the previous page) separates costs into fixed and
variable categories, which makes it easier for the management to derive quick and efficient
decisions regarding the manufacturing process as the variable cost is clearly visible in this
case as compared to the cost sheet which does not represent elements of variable and fixed
cost in an explicit manner.

Definition as per CIMA

The official terminology of CIMA, UK, has defined marginal costing as- "A principle
whereby marginal costs of cost units are ascertained. Only variable costs are charged to
cost units, the fixed costs attributable to a relevant period being written off in full against
the contribution for that period."

What is CIMA?

CIMA (Chartered institute of Management Accountants) established in the year 1919, is a

globally recognized qualification for careers in Business & Finance. CIMA qualified
professionals work in the field of Corporate Finance, Financial Reporting, Financial Analysis,
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 Business Analysis, Project Finance, Treasury Management, Risk Management, Cost
Accounting etc.

2.1 Features of Marginal Costing

(1) In marginal costing system, only variable costs are taken into consideration for
calculating unit cost.
(2) Fixed costs are treated as period cost and written off during the period in full.
(3) It is used extensively for short term (less than one year) decision making .
(4) The difference between sales revenue and cost of sales is called contribution. Fixed
costs are adjusted against contribution.

2.2 What is Contribution?

Contribution is the difference between the sales revenue and variable cost of such sales.
It is a surplus after all variable costs (manufacturing as well as non-manufacturing) have
been covered.

Contribution = Sales – Variable Cost

Contribution is used first to cover fixed costs and then whatever remains goes towards
profit.

If the contribution is not sufficient to cover fixed cost, then a loss occurs for the period.

2.2.1 Difference between Contribution Per Unit and Total Contribution

Total Contribution or Simply Contribution- 60000

Contribution per Unit- 6

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 Total Contribution or Simply Contribution is total contribution made by all the units,
whereas ‘contribution per unit’ is contribution made by one unit.

In the example, we find that product having more contribution is more profitable, this is
because in the above case there is no limiting factor.

However, when there is a limitation on any input factor, the profitability of the product
cannot simply be determined by finding out the contribution of the unit, but it can be found
out by ascertaining the contribution per unit of that factor of production which is limited
in the given situation.

Such factor of production which is limited in the question is called key factor or limiting
factor or constraining factor.

So when, the three products take same raw material. A takes 1 kg, B requires 2 kgs, C
requires 5 kgs and the raw material is not abundant.

2.2.2 Profit Volume Ratio (P/V Ratio) or Contribution – Sales Ratio (C/S Ratio)
The profit-volume ratio is the contribution divided by sales. It is also known as
contribution-sales ratio.

This ratio is normally expressed as a percentage and is abbreviated as P/V ratio or C/S ratio.
It indicates the rate at which each rupee sales available to cover fixed costs and provide for
profit.

Let’s understand this better with the help of a practical example.

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 From the above calculation it can be inferred that, for every Rs 100 sales, contribution is
Rs 37.50.

One more Inference:

Since P/V ratio is expressed is in percentage, we can calculate it either of the below
method, the result will be the same in both the following cases-

1. Contribution/Sales or

2. Contribution per unit/Sales per Unit

It is to be noted that when selling price and variable cost are constant, P/V Ratio will also
be constant. We can even use the below formulae.

Let us understand this by taking an example where the quantity purchased of a product
differs.

CASE 1:-
Product A (100 units)

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 Sales (5/unit) 500
Variable Cost (2/unit) 200
Contribution 300
Fixed Cost 100
Net Profit 200
Therefore, Change in Profit = 500 – 200 = 300
Change in Sales = 1000 – 500 = 500
P/V Ratio in above example would be = 300/500 = 60%

CASE 2:-
Product A (200 units)
Sales (5/unit) 1000
Variable Cost (2/unit) 400
Contribution 600
Fixed Cost 100
Net Profit 500
Change in Contribution = 600 – 300 = 300
Change in Sales = 1000 – 500 = 500
P/V Ratio in above example would be = 300/500 = 60%
Now if an estimate of total sales revenue is give, it is possible to use P/V ratio to estimate
total contribution. The formula for calculating total contribution by using P/V ratio is as
follows:

Example: if P/V ration is 37.5 % and Total Sales is estimated to be 1,60,000 then what shall
be the total contribution?

Solution: Total Contribution = 1,60,000 * .375 = 60,000

Application of P/V Ratio

The P/V ratio (C/S ratio) is particularly valuable in those situations where company has
multiple products and sales value can be increased to a certain extent. In such situations,
the product having higher P/V ratio is to be preferred more than the product having less
P/V ratio.

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 For example: There are two products, X and Y. The P/V ratio of X – 40% and that of Y – 30%.
The company can increase sales by Rs. 10,00,000 of either products. Which product sales it
will increase?

Answer: The Company will prefer to push sales of X than that of Y as X's P/V ratio is more
than that of Y.

Improvement of P/V or C/S Ratio

It is always desirable to improve the P/V ratio. Higher the P/V ratio -> more the
contribution per one rupee of sale -> More profit

P/V ratio can be improved in the following manner:

1. Reducing Labor Cost: By increasing the efficiency of the workers through proper
training, good working environment, use of more sophisticated equipment's.

2. Reducing Material Cost: By using alternative materials which are cost effective.

3. More Sales by using current Resources: By changing the sales mix, it will be possible if
production can be switched to product with higher P/V ratio.

4. More Sales by increasing the selling price without affecting sales quantity.

5. By reducing variable overhead per unit.

All these measures will increase the contribution that will ultimately lead to efficient
coverage of fixed cost which will yield to improved profits.

3 Cost Volume Profit Analysis

CVP analysis provides valuable insights to businesses, enabling them to make informed
decisions about pricing strategies, cost control measures, production levels, and overall
financial planning. It helps managers assess the financial feasibility of different scenarios
and identify the most profitable course of action.

Analysis of CVP helps us in answering following Questions

1. Finding the Break-Even Point

2. Sales required to achieve a certain amount of Profit
3. Profit at Different Sales Value
4. Margin of Safety

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 Assumptions - Cost Volume Profit Analysis
1. Fixed cost, variable Cost per unit and selling price per unit will remain same at all
level of activity (in short-run)
2. There is no change in technology, production process and efficiency.
3. All costs can be segregated into fixed and variable elements (although, in practice, it
might be difficult to implement.
4. Total variable cost will change in linear fashion with the change in activity.
5. The analysis is applicable only to a short-term period.

3.1 Break Even Point

The break-even point is the volume of activity where organization's total revenue is equal
to total cost. At this level, there is no profit, no loss, it breaks even.

There can be two types of break-even Points-

1. In terms of number of units at which there is no profit or loss
2. In terms of value of sales at which there is no profit or loss

Let us understand each of these methods in greater detail and the implications arising out
of them.

3.1.1 Contribution Method

Let us understand it by taking the following example-

(Per Unit Data)

Sales 100
Variable Cost 50
Contribution (Sales-Variable Cost) 50

If fixed cost is 1000, then how many units needs to be sold to make it break even.
Solution:-
Since, each unit is contributing of 50 to cover the fixed cost.

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 Therefore, to cover the fixed cost of 1000, number of units required would be = 1000/50 =
20
Let us verify answer by solving it for 20 units
Sales 2000
Variable Cost 1000
Contribution (Sales-Variable Cost) 1000
Fixed Cost 1000
Profit 0
Break even point in number of units = 20
Break even point in sales value = 20* 100 = 2000
Therefore, we can conclude that-

Since P/V ratio = Contribution per unit/Sales per Unit, equation given above can be written
as below-

3.1.2 Equation Method

Under equation method we use the following formula-

The following symbols can be used to represent the various items in the above equation:

NP=Profit

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 x= Units sold

P=Selling price per unit

a= Fixed cost

b= Unit variable cost

The equation can be expressed in mathematical terms as:

NP=Px-(a + bx)

At the break-even point, profit is zero. Therefore, break-even point can be computed by
finding that point where sales just equal to total of the variable cost plus fixed cost.

Let us understand this better with the help of an example where we will solve the
problem with both the methods.

Example-

(i) Sales (10,000 units) --1,60,000;

(ii) Variable cost - 96,000; and
(iii) Fixed Cost - 48,000
From the following information you are required to calculate:
(a) Sales to break-even in unit
(b) Sales to break-even in sales revenue
Solution:-

By Contribution Method-

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 By Equation method-

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.

3.2 Estimating the Sales Volume Necessary to Earn a Target Profit

CVP analysis is used frequently by the management to estimate sales required to earn a
target profit. In this case, contribution should be sufficient to cover fixed cost plus target
profit.

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 There can be two type of Sales Volume for a Target profit-
1. In terms of number of units
2. In terms of value of sales

3.2.1 Contribution method

Let us understand it by taking the following example-
(Per Unit Data)
Sales 100
Variable Cost 50
Contribution (Sales-Variable Cost) 50
If fixed cost is 1000, then how many units needs to be sold to make Profit of 1000
Solution:-

Since, each unit is contributing of 50 to cover the fixed cost and giving profit.
Therefore, to cover the fixed cost of 1000 and profit of 1000, number of units required
would be = 2000/50 = 40
Let us verify the same by calculating the same for 40 units-
Sales 4000
Variable Cost 2000
Contribution (Sales-Variable Cost) 2000
Fixed Cost 1000
Profit 1000
Number of Units which shall give profit of 1000 = 40
Sales value which shall give profit of 1000 = 40* 100 = 4000
Therefore, we can conclude that-

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 Alternatively,

3.2.2 Equation method

Let us understand this better with the help of an example.

(i) Sales (10,000 units) --1,60,000;
(ii) Variable cost - 96,000; and
(iii) Fixed Cost - 48,000
From the following information you are required to calculate:
(a) Sales to earn a profit of ~ 60,000.
Solution:-
By contribution method-

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 By equation method:-

3.3 Estimating Profit at Different Sales Volume

CVP analysis is used frequently by management to estimate the profit/ loss that would be
earned at different levels of sales assuming that there is no change in selling price per unit,
variable cost per unit, and total fixed cost.

3.3.1 Contribution method

Let us understand it by taking the following example-
(Per Unit Data)
Sales 100
Variable Cost 50
Contribution (Sales-Variable Cost) 50
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 If fixed cost is 1000, What would be the Profit at 40 Units and 60 Units.
Solution:-

So each unit is contributing of 50 to cover the fixed cost and giving profit.
Therefore, Contribution for 40 Units = 50*40 = 2000
Profit = 2000 – 1000 (Fixed Cost) = 1000
Let us verify the same by calculating the same for 40 units-
Sales 4000
Variable Cost 2000
Contribution (Sales-Variable Cost) 2000
Fixed Cost 1000
Profit 1000
Also, since each unit is contributing of 50 to cover the fixed cost and giving profit

Contribution for 60 Units = 50*60 = 3000

Profit = 3000 – 1000 (Fixed Cost) = 2000
Let us verify the same by calculating the same for 60 units-
Sales 6000
Variable Cost 3000
Contribution (Sales-Variable Cost) 3000
Fixed Cost 1000
Profit 2000
Therefore, we can conclude that-

Alternatively,
Equation 14 can also be written as
Expected Profit = Contribution – Fixed Cost
Since P/V Ratio = Sales/Contribution we can derive equation 15 from equation 14

3.3.2 Equation method

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 Let us understand this better with the help of an example.

Solution:-

(ii) Break Even Point = Fixed Cost / Contribution per unit

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 4000 = 50,000/Contribution per unit
Contribution per unit = 50000/4000 = 12.5
Variable Cost = 4+3+3 = 10
Contribution per unit = SP per unit – Variable Cost per unit
12.5 = SP per unit – 10
SP per unit = 22.5

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 Which method is best Contribution or Equation Method?
We have seen in our previous Illustrations that results are same under both the methods.

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 You can go by any method in which you are comfortable in, provided you can reorganize
the data accordingly and don’t miss the necessary points.

Suppose Contribution per unit is 50. Fixed cost is 500, then find the break even point.

By Contribution method- BEP = 500/50 = 10 units

By Equation method-
NP = SP*x – (FC + VC * X)
0 = SP* x – FC – VC* x
0 = (SP-VC)* x – FC
0 = Contribution per unit * x – FC
FC = Contribution per unit* x
X = 500/50 = 10
In the above case it is clearly visible that usage of contribution is much more straight
forward and has less chance of error commission, because in equation method the
contribution is signified by SP-VC, and if we would have forgotten the above fact we would
not have been able to put the given data at the right places.

3.4 Margin of Safety

The margin of safety of an enterprise is the excess of budgeted sales revenue (or actual
sales revenue) over the break-even sales revenue.

Margin of safety indicates the amount by which sales can drop before losses begin to be
incurred. So for example, if sales is 1000 and the BEP is 500 this means the margin of safety
is 1000-500 i.e. 500. This helps us to know that what should be the minimum value of
sales if the company does not want to incur losses.

Margin of safety can be expressed in terms of units as well as sales value. For example-
Margin of Safety in Sales Value- X Ltd.'s
Sales Value is = 10,00,000
Break-even sales Value is = 6,00,000.
Margin of safety in Sales Value is = 4,00,000
Margin of Safety in Sales Units- X Ltd.’s SP per unit is 1000
Sales in units is = 1000
Break-even sales in units = 600.
Margin of safety in Sales units = 400
Let us understand this concept better with an example which will help us understand the
logic behind the formula that should be used to calculate margin of safety.

(Per Unit Data)

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 Sales 100
Variable Cost 50
Contribution (Sales-Variable Cost) 50
Fixed Cost 1000
Break even in case of example on left is 20 units (1000/50)
(40 units)
Sales 4000
Variable Cost 2000
Contribution (Sales-Variable Cost) 2000
Fixed Cost 1000
Profit 1000
Margin of safety for data on left shall be = 40-20 = 20
Which is, Profit/Contribution per Unit = 1000/50 =20
So, we can conclude that Margin of safety in Units = Profit/Contribution per Unit.

4 Multi-Product CVP Analysis

In our previous discussion, we assumed that a company produces and sells only one
product. However, in practice, most companies produce and sell more than one product.

In traditional CVP analysis, a company typically focuses on a single product or service and
analyzes its cost, volume, and profit relationships. However, in a real-world business
scenario, companies often deal with multiple products or services, each having different
selling prices, variable costs, and contribution margins.

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 Multi-product CVP analysis considers the combined impact of different products or
services on a company's overall profitability. It involves analyzing the sales mix, which
refers to the proportion of each product/service sold relative to the total sales.

Following are the points that arise in such type of analysis:-

1. Assuming one product is not right. Take example of Sony, it has so many products.
2. The selling price, Variable Cost, Fixed Cost and contribution per unit of different
products are generally different.
3. Consequently, P/V ratio, Break-even point, margin of safety will depend upon the
sales mix of products.
4. Profits will be more if high margin products (e.g., Plasma TV) are sold more than low
margin products (e.g., digital camera, music system, etc.).

Calculating Break Even Point in Units

Step 1: Calculate contribution of individual product taking into consideration selling price
and variable cost of that product.

Step 2: Calculate overall weighted contribution margin considering sales mix.

Step 3: Calculate break-even point in unit as follows:

Step 4: Calculate the number of each product to break-even as follows:

Break-even in unit × Proportion in Sales Mix

Let us take an example to understand the above process better-

M Ltd. Manufactures three products, P, Q and R. The unit selling prices of these products
are 100, 80 and *50 respectively. The corresponding unit variable costs are 50, 40 and 20.
The proportions (quantity-wise) in which these products are manufactured and sold are
20%, 30% and 50% respectively. The total fixed costs are 14,80,000. Given the above
information, you are required to work out the overall break-even quantity and the product-
wise break-up of such quantity.

Solution:-

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 Calculating Break Even Point in Sales Volume
Step 1: Calculate contribution of individual product taking into consideration selling price
and variable cost of that product.

Step 2: Calculate total contribution of each product by multiplying contribution and number
of units sold/to be sold.

Step 3: Calculate overall weighted P/V ratio as follows:

Step 4: Calculate break-even point in sales revenue as follows:

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 Step 5: Calculate sales revenue of each product to break-even as follows:

Break-even in Sales Revenue × Proportion of Sales Revenue in total Sales

Let us take an example to understand the above process better-

(a) Compute Net Profit given Tax rate of 40%

(b) Compute the budgeted break-even point of the company as a whole, from the data
provided.

Solution:-

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 Let us solve one more question for better clarity of both the types of calculation
discussed, so that this concept gets better ingrained in our minds in addition to the basic
clarity we have gained so far.

Question :-

Solution:-

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 (ii)

Break Even Point in units = Fixed Cost/144.47 = 24813500/144.47 = 171745 units

5 Treatment of Specific Fixed cost and Semi-Variable Costs in Marginal

Costing
Specific Fixed Cost:
Specific fixed costs are incurred for particular product.

For example, special machinery may be taken on lease for manufacturing a particular
product.

Like, you take Crain on lease to manufacture a certain product. This is just temporary
arrangement but still it is fixed cost for you.

At the time of calculating contribution, the specific fixed cost is deducted just like variable
cost.

Semi-Variable Costs/Semi Fixed Costs

A semi-variable cost, also known as a semi-fixed cost is a cost composed of a mixture of
both fixed and variable components.

Costs are fixed for a set level of production or consumption and become variable after this
production level is exceeded.

Example: A supervisor can supervise 10 workers. Till 10 workers salary of 1 supervisor is

required but after that salary of 2 supervisors is required. So, it is fixed till 10 workers and
after that becomes variable. The salaries paid to the supervisor(s) in this case will be
treated as semi-variable cost or semi-fixed cost.
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 Another Example: In Landline telephone cost, monthly rent is fixed along with some free
calls. After free calls, calls are charged at a certain rate like 30 paisa/minute.

5.1 Splitting Semi-variable/ Semi-fixed Costs

Treatment of such costs will be as follows: -

1. Variable portion of the semi-variable/ semi-fixed cost will be deducted from the
selling price to calculate contribution.
2. However, fixed portion of the semi-variable/ semi-fixed cost will be treated as period
cost and adjusted against contribution.

5.1.1 High/ Low Point Method for calculation of Semi-variable/ Semi-fixed

Costs

Let us take an example to understand the above process better-

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 Solution:-

Variable cost = 4000*200 = 800000

Let us solve one more question for better clarity so that this concept gets better ingrained
in our minds in addition to the basic clarity we have gained so far.

Question :-

Use the high-low technique to calculate:

(a) Variable overhead cost per unit and Fixed overhead cost per annum.

(b) Contribution per unit.

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 (c) Calculate the contributions/sales ratio and the break-even point in sales revenue for
Lundegaards.

Solution:-

Sale Price Per Unit = 150000/100000 = 15

Direct material per unit = 60000/100000 = .6
Direct Labor Cost pet unit = 165000/100000 = 1.65
Variable Overhead = 3.75 per unit
Contribution per unit = 15 – 0.6 – 1.65 – 3.75 = 9 per unit

6 CVP Analysis in Graphic Form

CVP analysis can be done in graphic form also to help us analyze

1. Break Even Point

2. Sales required to achieve a certain profit
3. Profit at different sales volume
4. Margin of Safety

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 6.1 Break Even Chart
We will understand this chart with the help of an example where,

1. Fixed cost for the period ~ 2,00,000

2. Selling price per unit ~ 100
3. Variable cost per unit ~ 60
4. Sales for the period 7,000 units

Therefore, we can derive the answers of following questions from the above graph:-

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 1. Break Even Point = 5000 units or 5 lakh
2. Sales required for profit of around 80000= 7000 units
3. Profit sales volume of 6000 = Around 40000
Here's a brief explanation of a break-even chart:

• Axes: The chart typically consists of two axes. The x-axis represents the sales volume
or quantity of products or services sold, while the y-axis represents the total
revenue, total cost, and profit.
• Total revenue line: This line starts from the origin (0,0) and represents the total
revenue generated by the business at different sales volumes. As the sales volume
increases, the total revenue line rises proportionally.
• Total cost line: The total cost line shows the cumulative costs incurred by the
business at different sales volumes. It includes both fixed costs (which remain
constant regardless of sales volume) and variable costs (which change with sales
volume). The total cost line generally starts above the origin and rises as sales
volume increases.
• Break-even point: The break-even point is the point at which the total revenue line
intersects the total cost line. It represents the sales volume at which the business
covers all its costs and achieves a neutral financial position—neither profit nor loss.
• Profit and loss regions: The area above the break-even point on the chart indicates a
profit zone, where total revenue exceeds total costs, resulting in a positive profit.
Conversely, the area below the break-even point represents a loss zone, where total
costs exceed total revenue, resulting in a negative profit or loss.
• Margin of safety: The margin of safety is the difference between the actual or
projected sales volume and the break-even point. It represents the cushion or buffer
zone that businesses have above the break-even point to cover unexpected changes
or fluctuations in sales volume.

Angle of Incidence:
• Angle of Incidence is an angle formed at the intersection point of total sales line and
total cost line in a formal break even chart.
• If the angle is larger, the rate of growth of profit is higher and if the angle is lower,
the rate of growth of profit is lower.
• So, growth of profit or profitability rate is depicted by Angle of Incidence

6.2 Profit Volume Graph or Profit Graph for Individual Products

Taking the same example as above, we can also try to understand Profit Volume Graph.

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 Firstly, we will plot the point at -2 because of 2 lakh of fixed cost at even 0 amount of
output and then at 80000 which is the profit at total sales of 7000 units. And then joining
these two will give the following graph which shows the break even point of 5000 units.

6.3 Contribution Chart

Contribution chart is like a traditional break-even chart. All lines like, variable cost line, sales
revenue line, total cost line, except fixed cost line are drawn in the usual manner. In
contribution chart, the contributions made to fixed costs and profit is more clearly shown.
Taking the same example as mentioned earlier we derive the following graph:-

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 7 Effect of Changes in CVP Factors
The main aim of CVP analysis is to get the most profitable combination of selling price,
volume of sales, variable costs and fixed costs. Profits can be increased in various ways

1. By reducing fixed costs or variable costs

2. Reducing selling price and therefore increasing the sales volume
3. Increasing selling price
4. Increasing Units without change in Price

7.1 Effect of Changes in CVP Factors - Change in Selling Price

A change in selling price can have several effects on various aspects of a business's financial
performance. Let's explore how it impacts the margin of safety, contribution margin ratio
(also known as the PV ratio), break-even point, sales volume, and profit volume:

1. Margin of safety: When the selling price increases, the margin of safety typically
improves. This is because each unit sold generates more revenue, allowing the
business to cover its costs and achieve the break-even point with a smaller sales
volume.

2. PV ratio: When the selling price increases, assuming variable costs per unit remain
constant, the contribution margin ratio also increases. This means that each unit
sold contributes a higher proportion to cover fixed costs and generate profit. A
higher contribution margin ratio indicates a more favorable profit potential for the
business.

3. Break-even point: When the selling price increases, the break-even point typically
decreases. This happens because a higher selling price leads to a higher contribution
margin per unit, requiring a lower sales volume to cover fixed costs and reach the
break-even point.

4. Sales volume: An increase in selling price can have a direct impact on the required
sales volume to achieve a desired profit. When the selling price increases, the
required sales volume to achieve the same profit level decreases.

5. Profit volume: A change in selling price affects the overall profitability of a business.
When the selling price increases, assuming all other factors remain constant, the
potential for profit volume generally improves.

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 Figure shows increase in selling price-

From the chart, we observe that profit is

increased by increasing the selling price
and, if there is change in selling price,
BEP also changes.

If selling price is increased, then BEP

decreases. If selling price is decreased,
then BEP increases. Thus, we say that
there is an inverse relationship between
selling price and BEP.

7.2 Effect of Changes in CVP Factors - Change in Variable Cost

Variable cost effects the contribution inversely. Therefore if you decrease the variable cost-

• The p/v ratio will increase.

• The break even point will decrease.
• The margin of safety would increase.
• The profit volume will increase
• The sales volume will decrease.

Figure shows decrease in Variable Cost-

When variable costs are decreased, no

doubt, profit is increased. If there is
change in variable cost then BEP also
changes.

If variable cost is decreased then BEP also

decreases. If variable cost is increased then
BEP also increases. Thus there is direct
relationship between variable cost and
BEP.

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 7.3 Effect of Changes in CVP Factors - Change in Fixed Cost
It must be noted that fixed does not impact contribution and p/v ratio. But when fixed cost
is increased other factors are impacted as follows:-

• Break-even point increase

• Margin of safety will increase
• Profit volume will increase
• Sales volume will decrease

In the figure on the left decrease in Fixed

Cost is shown-

DE and DB’ line indicate decrease in fixed

cost and total cost respectively and
consequent decrease in BEP.

From the chart we find that there is

increase in profit due to decrease in fixed
cost.

If fixed cost is increased, then BEP also

increases. If fixed cost is decreased, then BEP also decreases. Thus there is a direct
relationship between fixed cost and BEP.

7.4 Effect of Changes in CVP Factors - Change in Selling Price

It must be noted that change in number of units sold does not effect break even point,
contribution or p/v ratio. But it will lead to-

• Increase in margin of safety

• Increase in overall profit

Figure shows increase in number of units- if

we clearly observe we find that there is no
change in BEP even if there is increase or
decrease in No. of units

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 Use of CVP Analysis in Decision Making
CVP analysis provides businesses with crucial financial insights for decision-making. It
supports pricing decisions, product mix optimization, cost control measures, break-even
analysis, profit planning, and various other strategic choices that contribute to achieving
financial stability and profitability.

It's important to note that CVP analysis simplifies the complex real-world dynamics of
business operations and assumes linear relationships between variables. Therefore, the
results should be interpreted with an understanding of their limitations and the specific
context of the business.

By following these steps, businesses can effectively utilize CVP analysis to gain insights into
their financial performance, assess the impact of decisions on profitability, and make
informed choices to optimize their operations and achieve their objectives.

8 Some important closure points

8.1 Selling at Marginal Cost or Below Marginal Cost
Let us suppose marginal Cost to Manufacture a Candle is 10 and Fixed cost is 20. If you sell
it at 12, then you would need 10 units to break even.

How Many Units for break-even if we sell it at 9 per unit?

Answer: You will never be able to break even because you are not even able to recover
variable cost

So, Should you sell below Marginal cost or at Marginal Cost? The answer is no. But in some
situations, we do so.
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 Situations in which we sell at Marginal cost or below Marginal Cost
1. To get entry into the market- for example, jio, when they started to provide internet
services for free because here the aim was to attract customers.
2. To eliminate a weak competitor who will not be able to survive if the price was
lowered.
3. To retain good customers and prevent loss of future orders say for example, when a
regular customer demands a discount.
4. To dispose off products with outdated technology, and get rid of obsolete machinery in
order to enhance the market standing of the company by catering to the trends.
5. To sell perishable goods or goods with lesser expiry period so that the losses arising
from such wastage could be minimized.
6. To help the sale of a high margin conjoined product. For example, a car music system
can be sold at marginal cost or below marginal cost along with the car.

8.2 Advantages of Marginal Costing

1. Useful for Internal Decision making by Managers
2. Calculation of cost is relatively easy to understand in Marginal Costing
3. Marginal costing system avoids the problem apportioning of overheads
4. It eliminates the problem of over/ under absorption of overheads.

8.3 Limitations of Marginal Costing

1. Marginal costing system is not very useful in situations where a very small proportion of
total cost is variable cost. For example, in telecommunication business, majority
portion of the total cost is depreciation and insurance of network, rates and taxes, etc.
which are fixed in nature; marginal costing system may not be very useful here.

2. In many organizations, the splitting of semi-variable costs into fixed element and
variable element may not be possible accurately. In this case, marginal costing system
may give misleading results.

3. In long-run, revenue must cover all cost, whether direct or indirect, fixed or variable.
Marginal costing may run the risk of understating unit costs by excluding fixed cost.
Pricing based on this unit costs may not be sufficient for the survival of the enterprise.

4. Cost of all the factors of production is changing continuously. In such a situation, any
decision based on marginal costing system (where it is assumed that there is no change
in material price, labor cost or selling prices may not be useful at all.

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 Previous Year Questions (PYQs)
on
Marginal Costing

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – If the Contribution is Rs 40,000; Sales is Rs 2,00,000. Calculate P/V Ratio. SEBI Grade A – Phase 1 -
2020

A. 5%
B. 20%
C. 80%
D. 500%
E. None of the above

Question 2 – The Selling price per unit is Rs 40. The P/V Ratio is 40%. The amount of fixed costs = Rs 60,000.
Find the BEP in units. SEBI Grade A – Phase 2 - 2020

A. 3750 units
B. 3250 units
C. 3500 units
D. 3675 units
E. 3720 units

Question 3 – Calculate the Breakeven point (BEP) from the following information. SEBI Grade A – Phase 2 -
2022

Sale - ₹30 per unit

Trade Discount – 10%

Direct Material - ₹12 per unit

Direct Labour - ₹6 per unit

Variable Expenses – 50% of Direct Labour

Fixed Cost - ₹60,000

A. 1000 units
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B. 10000 units
C. 100000 units
D. 6000 units
E. None of the above
Question 4 – Which of the following is incorrect with reference to Marginal Costing? SEBI Grade A – Phase 2 –
2022
A. It is a method of costing like Job Costing and Service Costing
B. Marginal Cost is the change in the total cost when the quantity produced is incremented by one.
C. It considers expenses incurred at each production stage, except for overhead pricing.
D. Contribution Margin is computed as the selling price per unit, minus the variable cost per unit.
E. None of the above

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 – The selling price of a product is ₹100. PV ratio is 40%. Fixed cost is ₹30,000. Calculate the break-
even point. PFRDA Grade A – Phase 1 – 2021
A. 120 units
B. 300 units
C. 400 units
D. 750 units
E. 1200 units
Question 2 – If Sales are ₹25,000, PV ratio is 40%, Fixed cost is ₹20,000. Calculate the profit and loss. PFRDA
Grade A – Phase 1 – 2021
A. Profit of Rs 12,500
B. Loss of Rs 10,000
C. Profit of Rs 10,000
D. Loss of Rs 12,500
E. Profit of Rs 13,125

Question 3 – Total variable cost is the sum of ___________. PFRDA Grade A – Phase 1 – 2021
A. Total fixed cost and Direct Labour
B. Direct Expenses and Direct Materials
C. Fixed Overheads and Variable Overheads
D. Prime Cost and Fixed Overheads
E. Total Direct Cost and Variable Overheads
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Question 4 - Costing is any system for assigning costs to an element of a business, in the same regard,
___________ is the change in the total cost when the quantity produced is incremented by one. PFRDA Grade
A – Phase 1 – 2022
A. Total Costing
B. Process Costing
C. Unit Costing
D. Marginal Costing
E. None of the above

Question 5 - Calculate the break-even point from the following given information PFRDA Grade A – Phase 1 –
2022
• Fixed Cost – Rs. 35,00,000
• Selling Price – Rs 37.5
• Variable Cost – Rs 17.5

A. 1,55,000
B. 1,75,000
C. 1,60,000
D. 1,45,000
E. None of the above

Question 6 - From the following information, calculate the value of projected sales. PFRDA Grade A – Phase 2
– 2022

• Sales = Rs. 3,00,000

• Fixed Cost = Rs. 90,000
• Profit for this year = Rs. 60,000
• Loss expected in the next or coming year = Rs. 30,000

A. Rs. 5,00,000
B. Rs. 1,10,000
C. Rs. 1,00,000
D. Rs. 5,60,000
E. Rs. 1,20,000

Question 7 - In an organisation, total units produced in an organisation is 16000 and 18000 units respectively,
therefore the total cost incurred increased from Rs. 22,00,000 to Rs. 24,00,000. You are required to calculate
per unit variable cost. PFRDA Grade A – Phase 2 – 2022

A. Rs. 80

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B. Rs. 95
C. Rs. 188
D. Rs. 185
E. Rs. 100

Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option B
Question 2 Option A
Question 3 Option B
Question 4 Option A

PFRDA Grade A questions

Question Number Answer

Question 1 Option D
Question 2 Option B
Question 3 Option E
Question 4 Option D
Question 5 Option B
Question 6 Option E
Question 7 Option E

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 Section C

Explanation
SEBI Grade A questions

Question 1 – If the Contribution is Rs 40,000; Sales is Rs 2,00,000. Calculate P/V Ratio. SEBI Grade A – Phase 1 -
2020

A. 5%
B. 20%
C. 80%
D. 500%
E. None of the above

Answer – Option B

Explanation –

P/V Ratio = (Contribution / Sales)*100

= (Rs 40,000 / Rs 2,00,000)*100

= 20%

Hence, Option B is the correct answer. All other options are incorrect.

Question 2 – The Selling price per unit is Rs 40. The P/V Ratio is 40%. The amount of fixed costs = Rs 60,000.
Find the BEP in units. SEBI Grade A – Phase 2 - 2020

A. 3750 units
B. 3250 units
C. 3500 units
D. 3675 units
E. 3720 units
Answer – Option A

Explanation –
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Selling price per unit = Rs 40

P/V Ratio = 40%

Therefore, Variable cost per unit = Rs 40 * 60%

= Rs 24

Contribution per unit = Rs 40 – Rs 24

= Rs 16

Fixed Costs = Rs 60,000

Therefore, BEP in units = Fixed Costs / Contribution per unit

= Rs 60,000 / Rs 16
= 3750 units
Hence, Option A is the correct answer. All other options are incorrect.

Question 3 – Calculate the Breakeven point (BEP) from the following information. SEBI Grade A – Phase 2 -
2022

Sale - ₹30 per unit

Trade Discount – 10%

Direct Material - ₹12 per unit

Direct Labour - ₹6 per unit

Variable Expenses – 50% of Direct Labour

Fixed Cost - ₹60,000

A. 1000 units
B. 10000 units
C. 100000 units
D. 6000 units
E. None of the above

Answer – Option B

Explanation –
In the Given Question
Selling Price = Rs 30

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 Trade Discount = 10 % of SP = 10% of 30 = Rs 3

Break-even point as per units:

Break-Even point (Units)= Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit).
Revenue per unit = Selling price - Discount - Material cost - Labour cost
= 30 - 3 - 12 - 6 {Discount highlighted is the trade discount that we calculated Above}
=9
Variable Cost per unit = 50 % of Direct Labour
= 50 % of 6
=3
Break-Even point (Units)= Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit)
=> BEP = 60000 / (9-3) = 10,000 units
Hence, Option B is the correct answer. All other options are incorrect.

Question 4 – Which of the following is incorrect with reference to Marginal Costing? SEBI Grade A – Phase 2 –
2022
A. It is a method of costing like Job Costing and Service Costing
B. Marginal Cost is the change in the total cost when the quantity produced is incremented by one.
C. It considers expenses incurred at each production stage, except for overhead pricing.
D. Contribution Margin is computed as the selling price per unit, minus the variable cost per unit.
E. None of the above

Answer – Option A

Explanation –
• Job costing is an accounting method designed to help you track the cost of individual projects and jobs.
• Similarly, Service costing is the accounting method of identifying all costs associated with building,
supporting, and delivering your service.
• Whereas Marginal Costing is a costing technique wherein the marginal cost, i.e., variable cost is charged
to units of cost, while the fixed cost for the period is completely written off against the contribution.
• Marginal cost is the change in the total cost when the quantity produced is incremented by one.

Hence Option A is incorrect and is the correct answer.

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 Explanation
PFRDA Grade A questions

Question 1 – The selling price of a product is ₹100. PV ratio is 40%. Fixed cost is ₹30,000. Calculate the break-
even point. PFRDA Grade A – Phase 1 – 2021
A. 120 units
B. 300 units
C. 400 units
D. 750 units
E. 1200 units

Answer – Option D

Explanation –

Break-even sales = Fixed cost / PV Ratio

= ₹30,000 / 40%

= ₹75,000

Break-even point = Break-even sales / Selling Price per unit

= ₹75,000 / ₹100
= 750 units
Hence, Option D is the correct answer. All other options are incorrect.

Question 2 – If Sales are ₹25,000, PV ratio is 40%, Fixed cost is ₹20,000. Calculate the profit and loss. PFRDA
Grade A – Phase 1 – 2021
A. Profit of Rs 12,500
B. Loss of Rs 10,000
C. Profit of Rs 10,000
D. Loss of Rs 12,500
E. Profit of Rs 13,125

Answer – Option B

Explanation –

If Sales are given as ₹25,000 and PV Ratio is 40%, then contribution is = ₹10,000
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Therefore, Contribution – Fixed Cost
₹10,000 - ₹20,000
= Loss of ₹10,000.
Hence, Option B is the correct answer. All other options are incorrect.

Question 3 – Total variable cost is the sum of ___________. PFRDA Grade A – Phase 1 – 2021
A. Total fixed cost and Direct Labour
B. Direct Expenses and Direct Materials
C. Fixed Overheads and Variable Overheads
D. Prime Cost and Fixed Overheads
E. Total Direct Cost and Variable Overheads

Answer – Option E

Explanation –

Total variable cost is the sum of Total Direct Cost and Variable Overheads. Hence, Option E is the correct
answer. All other options are incorrect.

Question 4 - Costing is any system for assigning costs to an element of a business, in the same regard,
___________ is the change in the total cost when the quantity produced is incremented by one. PFRDA Grade
A – Phase 1 – 2022
A. Total Costing
B. Process Costing
C. Unit Costing
D. Marginal Costing
E. None of the above
Answer – Option D

Explanation –

The marginal cost refers to the increase in production costs generated by the production of additional product
units. It is also known as the marginal cost of production. .

Marginal costing is a technique/system of presentation of sales and cost data with a view to guide the managers
for taking short term decisions like sales mix selection, acceptance of special order, etc.

It is also used by the managers for cost control, budgeting and profit planning purposes.

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Hence the correct answer will be option D

Question 5 - Calculate the break-even point from the following given information PFRDA Grade A – Phase 1 –
2022

• Fixed Cost – Rs. 35,00,000

• Selling Price – Rs 37.5
• Variable Cost – Rs 17.5

A. 1,55,000
B. 1,75,000
C. 1,60,000
D. 1,45,000
E. None of the above
Answer – Option B

Explanation –

This question is based on the concept of break-even point, which explains the level of production wherein the
organisation neither have any profits and neither do they suffer from any losses.

We will be using the following formula

Break-Even point (units) = Fixed Costs ÷ (Sales price per unit – Variable costs per unit)

From the question,

• Fixed cost = 35,00,000

• Selling Price – Rs 37.5
• Variable Cost – Rs 17.5

Apply these values in the formula

We will get, Break-Even point (units) = 35,00,000/37.5-17.5 = 35,00,000/20 = 1,75,000

Hence the correct answer will be option B

Question 6 - From the following information, calculate the value of projected sales. PFRDA Grade A – Phase 2
– 2022

• Sales = Rs. 3,00,000

• Fixed Cost = Rs. 90,000
• Profit for this year = Rs. 60,000
• Loss expected in the next or coming year = Rs. 30,000
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A. Rs. 5,00,000
B. Rs. 1,10,000
C. Rs. 1,00,000
D. Rs. 5,60,000
E. Rs. 1,20,000

Answer – Option E

Explanation –

This question is based on the concept of variable cost.

The given question is based on the concept of marginal costing. To begin with first we will calculate the
contribution, which we will Profit plus the fixed cost, therefore we can say, contribution will be 1,50,000 (60,000
+ 90,000).

Now, after calculating contribution, we can calculate PV ratio, which is given by Contribution divided by sales.

PV ratio = Contribution/Sales = 1,50,000/3,00,000 = 50%

Now, we have the PV ratio as 50%, however the question is demanding the value of projected sales and in the
question, its clearly given that, we are expecting the loss of Rs. 30,000

Indirectly the question is asking us to calculate the level of sales, at which the losses of the company are limited
to 30,000

Therefore, projected sales = Fixed cost – loss expected/ PV ratio = 90,000 – 30,000 / 50%

Projected Sales = 60,000/50% = 1,20,000

Hence the correct answer will be option E.

Question 7 - In an organisation, total units produced in an organisation is 16000 and 18000 units respectively,
therefore the total cost incurred increased from Rs. 22,00,000 to Rs. 24,00,000. You are required to calculate
per unit variable cost. PFRDA Grade A – Phase 2 – 2022

A. Rs. 80
B. Rs. 95
C. Rs. 188
D. Rs. 185
E. Rs. 100

Answer – Option E

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Explanation –

This question is based on the concept of variable cost.

Variable costs are expenses that vary in proportion to the volume of goods or services that a business produces.
In other words, they are costs that vary depending on the volume of activity.

The costs increase as the volume of activities increases and decrease as the volume of activities decreases.

To calculate per unit variable cost, we will be using following formula

• Per Unit Variable cost = Change in Total variable Cost/Change in the production level
• Change in total variable Cost = 24,00,000 – 22,00,000 = 2,00,000
• Change in the production level = 18000 – 16000 = 2000
• Per Unit Variable cost = 2,00,000/2,000 = 100

Hence the correct answer will be option E

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 Summary Sheet
–
Standard Costing and Variance Analysis

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 1 What is Standard Costing?
Standard costing is a cost accounting system that establishes predetermined standards for
the cost of products or services based on the company's past experience and current
market conditions. These standards include the cost of materials, labor, and overhead, and
are used to measure actual costs against expected costs during the production process.
Once the standards are established, actual costs are tracked and compared with the
standard costs periodically. The difference between the standard cost and the actual cost is
termed as variance, and variances are analyzed to identify the reasons for variation.
Adverse variances are investigated to find out the reasons for the deviation from the
standard and corrective action is taken to prevent reoccurrences.
Standards are adjusted from time to time to accommodate technological changes, design
changes, volatility in price of raw materials, or changes in labor laws. This helps the
company to maintain control over costs and to make better decisions related to pricing,
product design, and process improvement. Standard costing helps companies to make
informed decisions, identify inefficiencies, and continuously improve their processes to
increase profitability.

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 Let’s consider an example to understand standard costing:
Let's say a company produces a product, and they want to determine the standard cost for
each unit. They estimate that the following costs will be incurred for each unit:
Direct materials: Rs 5 Direct labor: Rs 3 Overhead: Rs 2 Total standard cost: Rs 10
The company then sets this Rs 10 as the standard cost per unit for the product.
As production continues, the actual costs for each unit are calculated. Let's say for a specific
period, the actual costs were:
Direct materials: Rs 6 Direct labor: Rs 4 Overhead: Rs 3 Total actual cost: Rs 13
The difference between the actual cost and the standard cost is the variance. In this case,
the variance is Rs 3 (Rs 13 actual cost – Rs 10 standard cost).
The company would investigate this variance to find out the reasons for the variation.
Perhaps there were issues with the production process that caused materials or labor to be
wasted, or overhead costs were higher than expected. The company would then take
corrective action to prevent similar variances from occurring in the future.
Overall, standard costing allows companies to establish a benchmark for costs, compare
actual costs to the benchmark, and identify areas for improvement.

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 2 Objectives of Standard Costing
Objectives of standard costing are:
1. To establish a basis for suitable cost comparisons: Standard costing helps to establish
predetermined costs for products or services, which can be used as a basis for cost
comparisons with actual costs. This enables the management to identify cost savings
opportunities and make informed decisions to improve profitability.
2. To introduce a system of management by exception: Standard costing focuses
management's attention on significant variances or exceptions, rather than on all costs.
This helps management to quickly identify areas where corrective action is necessary.
3. To provide a means of performance evaluation and rewards for employees: Standard
costing provides a basis for evaluating the performance of employees or departments,
and can be used to set performance targets and reward employees for meeting or
exceeding those targets.
4. To provide a basis for cost reduction: Standard costing helps to identify inefficiencies
and opportunities for cost reduction. By comparing actual costs with standard costs,
management can identify areas where cost reduction efforts are necessary.
5. To provide reliable, well-calculated cost data for quotation, bidding, etc.: Standard
costing provides reliable cost data that can be used for quoting prices, bidding on
contracts, and other business decisions.
6. To motivate achievers to get more bonus: Standard costing can be used to motivate
employees to achieve the standards set by management. By offering bonuses or other
incentives for meeting or exceeding standards, employees are encouraged to work
harder and more efficiently.
7. To reduce overall inefficiencies: Standard costing helps to identify inefficiencies and
areas where costs can be reduced, which can lead to overall cost savings and improved
profitability.

3 Difference between Standard and Estimate Cost

Following are the some of the differences between Standard and Estimate Cost:
1. Estimated Costs are intended to determine what the costs ‘will’ be. Standard Costs aim
at what costs ‘should’ be.
2. Estimated Costs are based on average of past actual figures whereas standard Costs are
planned costs determined on a scientific basis

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 3. In Estimated Costing Systems, stress is not so much on cost control, but costs are used
for other purposes such as fixation of prices to be quoted in advance. Standard Costs
serve as effective tools for cost control.

4 Who uses Standard Costing System?

Standard Costing System is almost used in many companies especially the manufacturing
companies and can also be useful for nonprofit organizations that need to track their costs
and demonstrate accountability to their donors and stakeholders.
• Manufacturing companies often use standard costing to determine the cost of
producing a product or service.

• Non-profit organizations may also use standard costing to manage their costs and
evaluate their performance.

5 How is Standard Cost Determined?

The inputs from purchase managers, engineers, production supervisors, production
workers, and accountants are important in determining standard costs. Each of these may
provide input on different aspects of the production process. Technical and engineering
studies may also be conducted to analyze the production process, identify potential
inefficiencies or areas for improvement, and determine the optimal cost structure for
each unit of production. Based on the inputs and studies conducted, standard costs are
determined.
Once the standard cost is determined the output looks like:

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 Cost sheet or card or computer record is prepared to show the itemized cost of each
materials and labor operation as well as production overhead cost. The cost sheet typically
includes a breakdown of the costs of direct materials, direct labor, and manufacturing
overhead for each unit of production. The direct materials are usually listed with their
item code, the direct labor is listed with the operation number, and the production
overhead is allocated to departments.
In the image we can see that, the total amount for Direct Materials can be ascertained by
multiplying standard quantity with standard price; Direct Labour can be calculated by
multiplying Standard Hours and Standard Price; Production Overhead can be calculated
by multiplying Hours and Overhead Recovery Rate.
Please note that the standards are revised at least once in a year and sometimes more
frequently where cost of inputs are likely to fluctuate widely over a shorter period. (Ex:
Price of Crude Oil).

6 Types of Standards
Basically, there are three types of standards.

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 6.1 Basic Standard
A basic standard is a standard cost that is set for a particular product or service based on
historical data and previous experience. This standard cost is generally used as a
benchmark or a reference point for evaluating the performance. A basic standard is usually
set at a level that represents a reasonable and achievable targe. It is just like a hygiene
standard.

6.2 Ideal Standard

Ideal standard can be attained only under perfect conditions. It assumes that there will be
no wastage, every worker will give his 100% efforts, there will be no machine break down,
no idle time, or no problems of any nature.”

6.3 Attainable Standard or Normal Standard

Attainable standard is most used standard. It is tight but attainable. At the time of
establishing attainable standards, normal loss of materials, normal machine break–down,
and normal idle time, all are taken into consideration. Most of the organizations use this
standard to evaluate the performance of man, machine and material. Majority of managers
feel that attainable standard motivate the worker to 'beat' the standard for earning bonus,
thus increasing the productivity of the organization.

7 Setting of Standards
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 costs are divided into three main cost components, such as
(a) Direct materials
(b) Direct labor and
(c) Manufacturing overhead
Now, we will discuss the factors that are used for setting of standards for each of the above
in detail.

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 7.1 Standards for Direct Materials
Standards for direct materials are the expected quantity and cost of materials that will be
used to produce one unit of a product. There are two types of standards for direct
materials:
1. Quantity standard: This refers to the expected amount of material that should be used
in producing one unit of the product.
2. Price standard: This refers to the expected cost of one unit of the material. The price
standard takes into account the cost of acquiring the material, as well as any additional
costs such as shipping, handling, and storage.

7.2 Direct Labor Standards

Labour Standards can be categorized as:
1. Labour Time Standard- This is based on the following factors:
(i) Number of operations to be performed
(ii) Time required in each operation per unit of product
2. Labour Rate Standard- This is based on the following factors:
(i) Skill Required to perform Different Operations
(ii) Wage structure of different workers.

7.3 Manufacturing Overhead Standards

As, already discussed in previous chapters that Overhead can be Production Overhead,
Administration Overhead or Selling and Distribution Overhead.
Please note that when we sat Manufacturing Overhead it only includes only Production
Overhead. Also, we already understood that when we say variable costs can be indirect
costs, it means indirect costs (Overheads) can be variable or Fixed. So, we can say that:
Prod Overhead = Variable Prod Overhead + Fixed Prod Overhead
Adm Overhead = Variable Adm Overhead + Fixed Adm Overhead
Selling Overhead = Variable Selling Overhead + Fixed Selling Overhead
Generally, separate standard is set for variable manufacturing overheads and fixed
manufacturing overheads.

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 8 Variance Analysis
Variance analysis is a technique used to compare actual results to planned or expected
results in order to identify and analyze the reasons for any differences or variances. It
involves comparing the actual costs, revenues, or performance levels of a business to its
budgeted or standard costs, revenues, or performance levels.
Variance Analysis is done for:
1. Direct materials
2. Direct labour
3. Manufacturing overhead

8.1 Direct Material Variance

Direct material variance or direct material cost variance is a variance that measures the
difference between the actual cost of direct materials used and the standard cost of direct
materials that should have been used during a period of production. This is also known as
Direct Material Cost Variance.

Cost Variance might exist due to:

1) Price Variance: It occurs when the actual price paid for direct materials is different
from the standard price that was expected. If the actual price paid is higher than the
standard price, it will result in an unfavorable price variance, while if the actual price
paid is lower than the standard price, it will result in a favorable price variance. Since the
purchase manager is responsible for negotiating and purchasing the materials, they
have a significant impact on the price paid for the materials. Therefore, they are held
accountable for any price variances that occur.

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 Example:

2) Usage Variance: It occurs when the actual quantity of direct materials used is different
from the standard quantity that was expected. If the actual quantity used is higher than
the standard quantity, it will result in an unfavorable usage variance, while if the actual
quantity used is lower than the standard quantity, it will result in a favorable usage
variance. The production manager is responsible for ensuring that the materials are
used efficiently and effectively in the production process, and they have control over
the quantity of materials used in production. Therefore, they are held accountable for
any usage variances that occur.
Example:

Please note that we will discuss numerical problems to help you understand the practical
application.
Formula for Direct Material Cost Variance
Theoretically, the formula can be understood as:

The formula can be simplified as:

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 It is to be noted that actual output is the basis for calculation of standard cost as well as
actual cost of material.
Formula for Direct Material Price Variance

Formula for Direct Material Usage Variance

From the formulas discussed till now, we can interpret that:

Direct Material Cost Variance= Direct Material Price Variance + Direct Material Usage
Variance
= AQ*SP – AQ* AP + SP* SQ – SP* AQ
= SP*SQ - AQ*AP

Favorable Variance: If the standard direct material cost of actual

output is > Actual cost of direct materials consumed.

Adverse Variance: If the standard direct material cost of actual

output is < Actual cost of direct materials consumed.

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 Question- Please refer to the following image:

Solution-

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 From this question we can also see the practicality that Direct Material Cost Variance will be
equal to Price + Usage Variance.
Material Cost Variance= Material Price Variance + Material Usage Variance
Rs 20,800 (Adverse)= Rs 12,800 (Adverse) + Rs 8,000 (Adverse)
So, we can see that Material Cost Variance = Material Price Variance + Material Usage
Variance.

8.2 Direct Labor Cost Variance

Amount paid to employees for their labor is generally known as employee or labor cost. In
this chapter labor cost is used to denote employees cost. Labor (employee) cost variance is
the difference between actual labor cost and standard cost. So, we can say that Direct
labor cost variance is the difference between the actual cost of direct labor used in
production and the standard cost of direct labor that should have been used. This variance
is calculated to measure the efficiency of the labor force.

Cost Variance might exist due to:

1) Labor Rate Variance: Labor rate variance is the difference between the actual wage rate
paid to workers and the standard wage rate that should have been paid.
Example: Suppose the standard wage rate per hour for a production worker is Rs 10, but
due to a shortage of workers, the company pays Rs 20 per hour to hire additional workers.
This results in an unfavorable labor rate variance of Rs 10 per hour, as the actual wage rate
paid is higher than the standard wage rate.

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 2) Labor Efficiency Variance: Labor efficiency variance is the difference between the actual
labor hours worked and the standard labor hours that should have been worked.
Example: Suppose the standard labor hours required to produce 1,000 units of a product is
25 hours, but the actual labor hours worked to produce 1,000 units is 35 hours. This results
in an unfavorable labor efficiency variance of 10 hours, as the actual labor hours worked is
more than the standard labor hours required.

Formula for Direct Labor Cost Variance

Theoretically, the formula can be understood as:

The formula can be simplified as:

Formula for Direct Labor Rate Variance

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 Formula for Direct Labor Efficiency Variance

From the formulas discussed till now we can interpret that:

Direct labor Cost Variance = Direct Labor Rate Variance + Direct Labor Efficiency Variance
Question- Refer to the following image:

Solution-

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 For verificiation we can also check the accuracy by:

Calculation of Variances when there are Two or More Materials

If there are two or more materials, the usage variance is sub–divided into Material Mix
and Material Yield Variances. So we will calculate
1) Material Cost Variance
2) Material Price Variance
3) Material Usage Variance
i) Material Mix Variance
ii) Material Yield Variance
Usage Variance = Mix Variance + Yield Variance
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.
Now, let’s go a bit deeper to understand what is being said in the above statement:

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 Material mix variance is the difference between the actual mix of materials used in the
production process and the standard mix of materials that should have been used based
on the production plan.
It can occur due to various reasons, such as changes in the availability of raw materials or
changes in the production process. When the actual mix of materials used is different from
the standard mix, it can affect the cost of production, as the prices of different materials
may vary.
For example, let's say a company produces a chemical product that requires a standard mix
of 50% of material A and 50% of material B. However, due to non-availability of material A,
the company uses a mix of 60% of material B and 40% of material C. This change in the mix
can result in a material mix variance, as the actual mix of materials used is different from
the standard mix.
If the cost of material B is higher than material C, the change in the mix may result in a
higher cost of production, as the company is using more expensive material in higher
quantities. On the other hand, if the cost of material C is higher than material B, the change
in the mix may result in a lower cost of production, as the company is using less expensive
material in higher quantities.
Material Yield 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.
Now, let’s go a bit deeper to understand what is being said in the above statement:
Material yield variance is the difference between the actual amount of materials used in the
production process and the amount of materials that should have been used based on the
standard yield or productivity rate.
Material yield variance can occur due to various reasons, such as the use of sub-standard
quality of materials, inefficiency of workers, or wrong processing. When the actual yield or
productivity of the materials is different from the standard yield or productivity, it can
affect the cost of production, as the amount of material required may vary.
For example, let's say a company produces a product that requires a standard yield of 90%
for material A. However, due to the use of sub-standard quality of material A, the actual
yield is only 80%. This difference in the yield can result in a material yield variance, as the
actual amount of material used is different from the standard amount.

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 If the cost of material A is high, the lower yield may result in a higher cost of production,
as the company is using more material to produce the same amount of product. On the
other hand, if the cost of material A is low, the lower yield may result in a lower cost of
production, as the company is using less expensive material.
Let’s take another example: Suppose 1 pineapple gives 100ml of Juice as the standard yield.
But when we mix pineapple with a certain proportion of orange then the actual output is
80ml. So, this is yield variance.
Now, we will discuss one figure that will help you understand and remember the
formulas:

Before, discussing you must know the full forms of the terms discussed in the above figure:
SQ= Standard Quantity for Actual RSQ= Revised Standard Quantity
Production or Output. SQSP= Standard Cost of Standard Material
SP= Standard Price RSQSP= Revised Standard Cost of
AQ= Actual Quantity of Materials Standard Material
Consumed AQSP= Standard Cost of Actual Material
AP= Actual Price AQAP= Actual Cost of Actual Material
Note- Try to understand the above figure thoroughly as this will help throughout the
chapter.
So, from the figure we can ascertain that (1-4), SQSP -AQAP this is cost variance. Similarly
(3-4), AQSP- AQAP is price variance. Also (1-3), SQSP- AQSP is usage variance. On the same
lines (2-3) that is RSQSP- AQSP will give us mix variance and (1-2) that is SQSP- RSQSP will
give us yield variance. This can be concluded in the below image:

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 We have got a new term RSQSP. So we’ll discuss RSQSP in detail with the help of an
example.
Question- Refer to the following image:

Solution-
For better understanding, we will be providing step by step solution to calculate the mix
and yield variance.
From the question, we can ascertain that 80kgs (Price= Rs 2 per kg) of material A and 40 kgs
(Price= Rs 6 per kg) of Material B were mixed to manufacture 100kgs of a chemical. So, this
information is of standard nature.
But in actual, 80kgs (Price= Rs 3 per kg) of material A and 70kgs (Price= Rs 5 per kg) were
used. And the actual output was 120 kgs.
Firstly, we can calculate Standard Cost per kg of output (A):

Now, we will calculate Actual cost (AQAP):

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 Now, we will calculate SQSP:

Now with the above information’s we can calculate the material cost variance as:
Material Cost Variance = SQSP – AQAP
= 480 – 590 = 110 (adverse)
Now we will calculate AQSP:

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 Now, we can calculate Materials Price Variance (AQSP - AQAP) as:

And Materials Usage Variance (SQSP - AQSP) as:

Now, let’s calculate RSQSP part:

Revised Standard Quantity is the updated or revised standard quantity of material that
should be used in the production process, taking into account any changes in production
methods, technology, or materials.
For example, in this question actual total input is 150 kg (70 kg of B and 80 kg of A). But, if
the total input remains the same but the ratio changes with respect to standard. This can be
better understood by the following table:

Now, we can calculate the yield variance and mix variance as follows:
Yield Variance (SQSP – RSQSP):

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 Mix Variance (RSQSP - AQSP):

Please note that we have discussed a detailed example. In the exam, they can ask only
specific variance.
So, we can conclude that the chart discussed is very important. If you can remember the
chart that would be very helpful for you to remember the complicated formulas.
Now, the basic or we can say the theoretical formula for material and yield variance can be:
Mix variance = (Revised Standard Quantity minus Actual Quantity) x Standard Price.
= RSQSP-AQSP
Material yield variance = (Standard Yield for Actual mix – Actual Yield ) x Standard Price
We have already discussed Direct Labour Rate Variance and Direct Labor Efficiency
Variance. Now, we will discuss Labor Mix and Yield Variances.

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 Generally, Efficiency Variance is divided into Mix and Yield Variance. But, it can also be
divided into Mix, Yield and Idle Time Variance.
So, let us discuss labor mix and yield variance theoretically:

Suppose, your company is indulged in manufacturing a certain quantity of a product which

on a standard requires 10 skilled workers, 5 semi-killed workers and 5 non-skilled workers.
But due to some reasons, this composition was changed to 8 skilled workers, 8 semi-skilled
workers and 4 non-skilled workers. So, this change would be called Labor Mix Variance.
Also, when we change the composition the efficiency might also be changed. So, the change
in efficiency will be called Yield Variance.
In addition, the final labor cost is influenced by the efficiency of the 'team' or 'gang'.
Generally, it is measured as yield variance.
So, we can conclude that Labour efficiency variance which arises due to change in the mix
or combination of different skill sets i.e. number of skilled workers, semi-skilled workers
and un-skilled workers is known as Labor Mix Variance. Also, Labour efficiency variance
which arises due to the productivity of workers is known as Labor Yield Variace.
Now, let us discuss the chart to remember the formula, this is similar as we have discussed
in the Material Mix and Yield Variances:

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 Where,
SR= Standard Rate of Labour per hour AR= Actual rate of Labour per hour
SH= Standard Hours for Actual Production SRSH= Standard Cost of Standard Labour
or Output SRRSH= Revised Standard Cost of Labour
RSH= Revised Standard Hours SRAH= Standard Cost of Actual Labour
AH= Actual Hours ARAH= Actual Cost of Labour
From the chart we can ascertain:

Also note that, Idle Time Variance is calculated for the idle hours. It is difference between
paid and worked hours. It can also be calculated as:

Now, let us discuss the basic formula for the terms discussed above, so that they can be
easily understood:
Mix or Gang or Composition Variance = (Actual Hours at Standard Rate of Standard Gang)
minus (Actual Hours at Standard Rate of Actual Gang)
Direct Labour Yield Variance= Standard Cost per unit* (Standard Output for Actual Mix-
Actual Output)
Idle Time Variance= (Standard Rate*Actual hours paid for)- (Standard Rate* Actual hours
worked) or
= Standard Rate*Idle Hours
Till now, we have discussed Direct Labour and Direct Material Variance in detail. Now we
will discuss Manufacturing Overhead Variance.

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 8.3 Manufacturing Overhead Variance
Manufacturing overhead refers to all indirect costs associated with the manufacturing
process that cannot be directly traced to specific products or processes. This includes costs
such as supervision, depreciation of plant and machinery,etc.

We have already discussed in the previous chapters that Overhead can be classified into:
Prod Overhead = Variable Prod Overhead + Fixed Prod Overhead
Adm Overhead = Variable Adm Overhead + Fixed Adm Overhead
Selling Overhead = Variable Selling Overhead + Fixed Selling Overhead
Manufacturing Overhead relates to Production Overhead only.
In modern production technologies, machines and automation have replaced manual labor
in many manufacturing processes. As a result, the cost of supervision and maintenance of
these machines has become an increasingly important component of the overall
manufacturing overhead cost.

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 As, you can see that Prod Overhead = Variable Prod Overhead + Fixed Prod Overhead. So,
variance analysis is done separately for Variable Manufacturing Overhead and Fixed
Manufacturing Overhead.
Firstly we will discuss variance for Variable Manufacturing Overhead and the we will be
understanding the variance for fixed manufacturing overhead.
Before we start in detail about Variable Manufacturing Overhead Variance. Let us discuss
some examples:
1. Cost of supervision can be variable overhead if it varies with the level of production or
activity.
2. Cost of electricity can be variable overhead if it varies with the level of production or
activity.
Analysis of Variable Manufacturing Overhead Variance
Generally, three variances are computed for variable overheads. These are:

Please note that Variable manufacturing overhead variances are computed using the
same basic formulas that are used to calculate direct materials variances and direct labor
variances.

Before, moving further let us discuss Absorption Overhead Rate:

Absorption Overhead Rate (AOR) is the rate used to allocate or absorb manufacturing
overhead costs to the cost of goods produced. Let us discuss with an example:

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 Suppose there is a supervisor cost associated with the company as Rs 1500 and this
supervisor supervises the manufacturing of Product 1 and Product 2. So, it is difficult to
know how much cost is associated with Product A and how much cost is associated with
Product B. So, to divide Rs 1500 to Product A and Product B can be anything like machine
hours, labour hours. So, in this example let us consider the basis as machine hours. Also,
let’s assume that the total machine hours are 150. So, Product 1 and Product 2 are made
using the same machines and the total machine hours are 150. Now for this Rs 1500, 150
machine hours were used. So, we can say that Overhead Absorption Rate is Rs 10/
machine.
Out of the 150 hours, let us assume that Product 1 used 100 machine hours to produce 20
units and Product 1 used 50 machine hours to produce 5 units.
Now, the question arises of how to divide Rs 1500 for Product 1 and Product 2. Since we
know the Overhead Absorption Overhead Rate. Now, in Product 1 100 machine hours were
used. So, we can allocate (100*10) = Rs 1000 as overhead absorbed. Similarly, this can be
calculated for Product 2 as Rs 500.
Also, to calculate per unit, we can divide the overhead absorbed by the no. of units
produced. So, for Product 1 we will get Rs 50 per unit and Rs 10 per unit for Product 2.
Variable Manufacturing Overhead Cost Variance
It is the difference between variable manufacturing overhead absorbed during the period
and variable overhead incurred during the period.

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 Variable manufacturing overhead costs are indirect costs that vary with the level of
production, such as electricity or supplies used in the manufacturing process. The
absorption of these costs into the cost of goods sold is typically based on a predetermined
rate that is calculated using budgeted variable overhead costs and a measure of activity,
such as direct labor hours, machine hours, or units produced.
The basis for the absorption of variable manufacturing overhead could be any of the
following:
(a) Direct labor hours;
(b) Machine hours;
(c) Output in units.
Variable Overhead Absorption Rate = Budgeted Variable Overhead/ Budgeted Direct
Labor or Machine hours
Now, let us discuss an example to understand the concept.

So, basically there are three types of overheads:

A- Budgeted Overheads.
B- Overheads to be absorbed as per standard.
C- Actual Overheads Absorbed.
Manufacturing Overhead Cost Variance is the difference between B and C. But anyways we
will understand A, B and C.
Budgeted Overheads- It refers to the estimated or projected indirect costs that a business
or organization expects to incur during a given period. These are usually prepared in

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 advance of the budgeted period, often as part of the budgeting process, and are based on
historical data, industry trends, and other relevant factors.
So, suppose the company has decided to produce 100 units of a particular product. And for
that 100 machine hours will be used, overhead cost is 100. Now, we can calculate the
standard rate to absorb overhead as Rs 1 per machine hour. So, Total Budgeted Overhead
= Rs 100.

Overheads to be absorbed as per standard-

Standard costs are predetermined costs that are set based on the expected level of activity,
and are used as a basis for calculating the expected costs of production. We have already
discussed that for calculating standard we must know the actual production. So, suppose in
this case 95 units were produced. Then 95 machine hours should have been used.
Therefore, at standard rate, absorbed overhead should have been 95.

Actual Overheads Absorbed-

In this case, 95 units were produced but 110 machine hours were used. So, the rate of 1.5
per machine hour was used and actual overhead absorbed were of Rs 165.
So, firstly, we have calculated budgeted overhead, overheads to be absorbed as per
standard and actual overheads. Now, we can calculate variances as:
B – C = Variable Overhead Cost Variance = 95 – 165 = 70 (-)
B – C (Diff in Rate at actual hours) =Variable Expenditure Variance = 55(-)
B- C (Diff in hours at standard rate) = Variable Efficiency Variance = 15 (-)
So, we have discussed the concept. Now we shall discuss the official formulas:

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 Please note, If the absorbed variable overhead as per standard is > than the variable
overhead incurred, then it is termed as 'Favourable' variance.
Similarly, if the absorbed variable overhead as per standard is < than the variable overhead
incurred, then it is termed as ‘Adverse' variance’.
You must understand the following terms as the formula remains the same.

Variable Overhead Expenditure Variance or Variable Overhead Budget Variance or

Variable Overhead Spending Variance
It is like price variance of direct materials or rate variance of direct labor.
Formula:

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 Variable Overhead Efficiency Variance
It is similar to usage variance of direct materials or efficiency variance of direct labor.

Fixed Manufacturing Overhead

Fixed manufacturing overheads are the indirect costs of production that do not vary with
changes in the level of production or sales volume. These costs remain constant regardless
of the number of units produced, and are incurred whether or not any production takes
place.
Fixed manufacturing overheads examples would be
1. Rent
2. Depreciation
It's important to note that these costs are typically indirect costs of production that are not
easily traceable to a specific product or production process. A fixed overhead absorption
rate is calculated using budgeted fixed overhead and budgeted direct labour hours or
machine hours or units.

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 Please refer to the following chart:

The Fixed Manufacturing Overhead Cost Variance is divided into Expenditure Variance and
Volume Variance. And Volume Variance is divided into Capacity Variance, Efficiency
Variance and Calendar Variance.
Please note that we shall not be discussing Overhead Calendar Variance.
So, we can say that Fixed manufacturing overhead cost variance = Expenditure Variance +
Volume Variance
Volume Variance = Capacity Variance + Efficiency Variance
Please note Volume Variance can be equal to Capacity Variance + Efficiency Variance +
Calendar Variance. As Calendar Variance is very complex that is not relevant for exams.
Now, let us discuss an example before discussing the formulas.
In case of variable manufacturing overheads, we have discussed the three types of
overheads. Similarly in this case, firstly, we will see the case for Budgeted Overheads and
then Overheads to be absorbed as per standard and then Actual Overheads Absorbed.

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 Firstly in case of Budgeted Overheads, we have assumed that 100 units is being produced
by utilizing 100 machine hours. Considering the Budget Overhead as 100 we can say that
standard rate is Rs 1 per hour.

But, if instead of 100 units, only 95 units were produced then actual 95 machine hours
would’ve been used. So, in this case the absorbed overhead should have been Rs 95 (at
standard rate).

But, if 95 units were produced and for producing 95 units 110 machine hours were used
then the actual rate will be Rs 1.5 and the Actual Overhead absorbed would be Rs 165
(110*1.5).

Now, how can we calculate the three variances?

B – C (Standard Overheads to be Absorbed - Actual Overheads) = Fixed Overhead Cost
Variance = 70(-)
A – C (Budgeted Cost – Actual Cost) = Fixed Overhead Expenditure Variance = 65 (-)
A – B (Budgeted Cost – Fixed Overhead Cost as per Standard)) = Fixed Overhead Volume
Variance = 5 (-) Opposite sign
So, we have discussed the concept. Now we shall discuss the official formulas:
Fixed Manufacturing Overhead Cost Variance

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 Please note that Fixed Manufacturing Overhead Cost Variance is the difference between
fixed manufacturing overhead absorbed during the period and fixed manufacturing
overhead incurred during the period.

Fixed Manufacturing Overhead Expenditure Variance

It is the difference between the budgeted fixed manufacturing overhead and actual fixed
manufacturing overhead cost incurred. In other words, the expenditure variance is simply
the difference between managements' estimate of fixed manufacturing overhead cost and
actual fixed manufacturing overhead cost of the period.

Fixed Manufacturing Overhead Volume Variance

It is the difference between the budgeted fixed manufacturing overhead for the period and
the fixed manufacturing overhead absorbed in the production during the period.

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 Note: Opposite sign is taken when deciding Adverse or Favorable.
If volume is less the volume variance will be adverse whereas if volume is more than
volume variance will be favorable.
Till now, we have understood the Fixed Manufacturing Expenditure Variance and Fixed
Manufacturing Overhead Volume Variance. Now, let us discuss Fixed Manufacturing
Overhead Capacity and Efficiency Variance.
Fixed Manufacturing Overhead Capacity and Efficiency Variance
Firstly, let’s go through the example then we will discuss the concept.
So, as discussed previously:

In this example we can calculate variances as:

A – C (Difference in hours at standard rate) = Fixed Overhead Capacity Variance = 10 (+)
B -C (Difference in hours at standard rate) = Fixed Overhead Efficiency Variance = 15 (-)
Fixed Overhead Capacity Variance: It is the difference between budgeted hours and actual
hours at standard rate per hour.

Note- Opposite sign is taken when deciding Adverse or Favorable.

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 Fixed Overhead Efficiency Variance: It is the difference between the actual hours and the
hours considered sufficient to produce the actual quantity of units at standard rate per
hour.

In standard costing we learn about cost variances. But as part of variance there is another
part of variance which is not related to costing variance but related to sales. Now let us
discuss about Sales Variances.

8.4 Sales Variances

Under this method all variances are calculated based on Sales Revenue. It is also known as
Turnover Method. Generally, the following sales variances are calculated under this
method:
(1) Sales value variance (4) Sales quantity variance
(2) Sales price variance (5) Sales mix variance
(3) Sales volume variance
Refer to the following chart to understand the types of sales variances:

Please note that we shall not be discussing Sales Quantity Variance and Sales Mix Variance,
but you should remember
Sales Value Variance = Sales Price Variance + Sales Volume Variance

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 Sales Volume Variance = Sales Quantity Variance + Sales Mix Variance
Now, let us discuss Sales Value Variance, Sales Price Variance, and Sales Volume Variance.
But before discussing we must know the favorable and unfavorable variance in case of sales
variance. So, let us compare variance with respect to cost and sales:

Try to remember the above as we always try to maximize sales but we try to minimize
costs. So, in case of sales if actual sales are greater then it is favourable, and vice versa.
Now let us discuss an example of Sales Variance:
Now, let us discuss the formulas.
Sales Variance – Formulas

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 Please note that in all the above cases Opposite sign is taken when deciding Adverse or
Favorable.

9 Advantages of Standard Costing

1. Standard Costing system establishes yard-sticks against which the efficiency of actual
performances is measured: Standard costing sets predefined standards for various
aspects of production, such as materials, labor, and overhead costs. These standards act
as benchmarks against which the actual performance is measured. By comparing actual
costs with the standard costs, businesses can identify areas of inefficiency and take
corrective actions.
2. The standards provide incentive and motivation to work with greater effort and
vigilance for achieving the standard: Having standard costs in place provides employees
with clear targets to strive for. It creates motivation and encourages employees to work
diligently to achieve or surpass the set standards. This can lead to improved efficiency,
productivity, and cost control.
3. Waste of time and materials is eliminated: Standard costing helps identify and
eliminate wastage of time and materials by setting specific standards for resource
usage. By closely monitoring actual consumption against these standards, businesses
can identify areas of waste and take measures to reduce or eliminate them, thus
improving overall efficiency and reducing costs.
4. Variance analysis and reporting helps in timely corrective actions: Standard costing
involves analyzing and reporting variances, which are the differences between actual
costs and standard costs. Variances can indicate areas of concern or opportunities for
improvement. By promptly identifying and investigating variances, businesses can take
corrective actions to address issues and improve performance.

10 Limitations of Standard Costing

1. Establishment of standard costs is difficult in practice: Setting accurate and reliable
standard costs can be challenging, especially in complex and dynamic business
environments. It requires detailed analysis, historical data, and a thorough
understanding of various cost elements. It may also be difficult to establish standards
for unique or customized products or services.
2. Inaccurate, unreliable and out of date standards do more harm than benefit: If the
standards used in standard costing are inaccurate, unreliable, or outdated, they can lead

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 to misleading cost information and incorrect decision-making. If the standards do not
reflect the actual costs and efficiencies achievable, it can undermine the effectiveness of
the standard costing system.
3. If the standard is set at high level, its non achievement would result in frustration and
build-up of resistance: Setting overly ambitious or unrealistic standards can create
frustration among employees. If the standards are set too high and are consistently not
achieved, it can demotivate employees and lead to a negative work environment. This
can result in resistance to the standard costing system and hinder its effectiveness.
4. Standard costing may not sometimes be suitable for some small concerns. Where
production cannot be carefully scheduled, frequent changes in production conditions
result in variances: Standard costing assumes a stable production environment with
consistent processes and predictable outputs. However, in small businesses or
industries where production processes are highly variable or subject to frequent
changes, standard costing may not be suitable. Variability in production conditions can
lead to significant variances, making it challenging to establish and maintain accurate
standards.

11 Controllable and Non-Controllable Variance

Controllable variances are those which can be controlled by the departmental heads
whereas Uncontrollable variances are those which are beyond their control.
However, controllability is a subjective matter and varies according to situations. If the
Uncontrollable variances are of significant nature and persistent, the standard may need
revision.

12 Favorable and Unfavorable Variance

Please remember the following terminology in case of Cost and Sales Variance:

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 Previous Year Questions (PYQs)
on
Standard Costing and Variance Analysis

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Sales unit is 162500. Total Actual Cost is Rs 3 lakhs. Actual Fixed Cost is Rs 87000 (in line with
budgeted cost). Total Actual Cost is Rs 18000 more than the budgeted cost. Find the Budgeted Variable Cost per
unit. SEBI Grade A – Phase 2 - 2020

A. 2.27
B. 1.74
C. 2.43
D. 1.20
E. 1.42

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 – If Material Cost Variance is given as 24,000 (F), Material usage variance is given as 30,975 (F), then
Calculate the Material Price Variance. PFRDA Grade A – Phase 1 - 2021

A. 6,975 (F)
B. 13,950 (A)
C. 6,975 (A)
D. 13,950 (F)
E. 54,975 (A)

Question 2 – Find the budgeted variable cost per unit. Given that the actual fixed cost is ₹52,000 which is same
as the budgeted fixed cost and the actual total cost is ₹1,50,000 which is ₹9000 over the budgeted total cost.
Total units manufactured is 62,500 units. PFRDA Grade A – Phase 1 - 2021

A. Rs 1.430
B. Rs 1.424
C. Rs 3.232
D. Rs 1.712
E. Rs 3.088

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 Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option D

PFRDA Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option B

Section C
Explanation
SEBI Grade A questions

Question 1 – Sales unit is 162500. Total Actual Cost is Rs 3 lakhs. Actual Fixed Cost is Rs 87000 (in line with
budgeted cost). Total Actual Cost is Rs 18000 more than the budgeted cost. Find the Budgeted Variable Cost per
unit. SEBI Grade A – Phase 2 - 2020

A. 2.27
B. 1.74
C. 2.43
D. 1.20
E. 1.42
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Answer – Option D

Explanation –
Total Actual Cost = Rs 3,00,000
Difference between Total Actual Cost and Budgeted Actual Cost = Rs 18,000
Budgeted Actual Cost = Rs 3,00,000 – Rs 18,000
= Rs 2,82,000
Less: Budgeted Fixed Cost = Rs 87,000
Budgeted Variable Cost = Rs 1,95,000
Therefore, Budgeted Variable Cost per unit = Budgeted Variable Cost / Sales units
= Rs 1,95,000 / 162500 units
= Rs 1.2 / unit
Hence, Option D is the correct answer. All other options are incorrect.

Explanation
PFRDA Grade A questions

Question 1 – If Material Cost Variance is given as 24,000 (F), Material usage variance is given as 30,975 (F), then
Calculate the Material Price Variance. PFRDA Grade A – Phase 1 - 2021

A. 6,975 (F)
B. 13,950 (A)
C. 6,975 (A)
D. 13,950 (F)
E. 54,975 (A)

Answer – Option C

Explanation –

Material Cost Variance = Material Usage Variance + Material Price Variance

Therefore, 24,000 (F) = 30,975 (F) + Material Price Variance

Hence, Material Price Variance = 6,975 (A)

Therefore, Option A is the correct answer. All other options are incorrect.

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Question 2 – Find the budgeted variable cost per unit. Given that the actual fixed cost is ₹52,000 which is same
as the budgeted fixed cost and the actual total cost is ₹1,50,000 which is ₹9000 over the budgeted total cost.
Total units manufactured is 62,500 units. PFRDA Grade A – Phase 1 - 2021

A. Rs 1.430
B. Rs 1.424
C. Rs 3.232
D. Rs 1.712
E. Rs 3.088

Answer – Option B

Explanation –

Budgeted total cost = Actual total cost – cost incurred over budgeted cost

= ₹1,50,000 – ₹9,000 = ₹1,41,000

Budgeted variable cost = Budgeted total cost – Budgeted fixed cost

= ₹1,41,000 – ₹52,000

= ₹89,000

Total units manufactured 62,500

Budgeted variable cost per unit= Budgeted variable cost / Total units manufactured

= ₹89,000/62,500
= ₹1.424/-
Hence, Option B is the correct answer. All other options are incorrect.

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 Summary Sheet
–
Budgeting

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 1 Introduction
Budgeting is a fundamental aspect of financial management that allows individuals and
organizations to effectively plan, allocate resources, and track their financial activities. By
creating a budget, individuals and organizations gain insight into their income, expenses,
and financial goals, enabling them to make informed decisions and achieve financial
stability.
To understand the concept of budgeting, let's consider a basic example involving managing
personal finances. You might have observed your mother or any other family member at
home who takes charge of managing the household finances. They are often concerned
about the total income and how much should be allocated for different expenses such as
groceries, shopping, or vacations.
In this example, creating a budget helps your family member ensure that the income
earned is properly allocated to cover necessary expenses and achieve financial objectives.
By setting aside a specific amount for groceries, they can control spending and avoid
overspending. Similarly, allocating a portion of the income towards savings for shopping or
vacation allows for planning and achieving these desired activities without jeopardizing the
overall financial well-being.
This basic example highlights the importance of budgeting in personal finance
management. It serves as a tool to prioritize and manage financial resources efficiently,
ensuring that income is utilized effectively to meet both short-term and long-term financial
goals.

1.1 What is a Budget?

In simple words, a budget is a plan of operation expressed in monetary terms, it
consequently includes a forecast of income and expenditure usually for a period of 12
months.
Now, let us see the official definition. As per CIMA, A plan quantified in monetary terms,
prepared and approved prior to a defined period, usually showing planned income to be
generated and/or expenditure to be incurred during that period and the capital to be
employed to attain a given objective is termed as a Budget.

1.2 Features of a Budget

The features of a budget are as follows:
1. Expresses quantitative or monetary values: A budget can be expressed in quantitative
form, specifying the number of units of different products, or it can be expressed in
monetary terms, using currency values for each product or expense category.

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 2. Prepared in advance: A budget should be prepared before the period for which it is
required. For example, if a budget is needed for the year 2013-14, it should be prepared in
the preceding year, such as 2012-13.
3. Covers a definite period: A budget is prepared for a specific period, typically spanning a
fiscal year or any other predetermined time frame.
4. Aligned with business policies: A budget must be prepared in accordance with the
policies and objectives of the business enterprise. It should align with the strategic direction
and goals of the organization.
5. Clearly states objectives and responsibility: The objectives of the budget and the level of
responsibility assigned to different individuals or departments should be clearly stated and
communicated. This ensures that everyone understands their roles and accountability.
6. Monitored and flexible: Budgets should be regularly monitored to track performance
and make necessary adjustments. They should also be flexible enough to allow for mid-term
revisions based on changing circumstances or new information.
7. Whole organization commitment: The budgeting process requires the commitment and
involvement of the entire organization. It is important for all stakeholders to understand
and support the budget to ensure its effective implementation.
8. Covers all material aspects: A comprehensive budget should cover all material aspects of
the organization's financial activities. It should include revenues, expenses, investments,
and other relevant financial elements to provide a holistic view of the organization's
finances.
These features contribute to the effectiveness and functionality of a budget, allowing
organizations to plan, control, and evaluate their financial performance.

1.3 Objectives of a Budget

The objectives of a budget are as follows:
1. Planning: A budget serves as a planning tool, forcing managers to think ahead and
anticipate potential problems.
2. Proper Allocation of Resources: A budget helps in allocating resources effectively and
efficiently.
3. Removing Bottlenecks: By identifying potential bottlenecks or constraints in resource
allocation, a budget enables proactive measures to overcome them.

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 4. Establishing Divisional and Departmental Responsibilities: A budget assigns
responsibilities to different divisions and departments within an organization.
5. Coordination: A budget facilitates coordination among various departments and units
within an organization.
6. Motivational Impetus: The budget can serve as a motivational tool for managers.
7. Control: Budgets enable control over financial activities by comparing actual costs or
expenditures with the budgeted amounts.
Management by exception is an approach in which managers focus their attention
primarily on significant deviations or exceptions from planned or expected outcomes.
Instead of closely monitoring every detail or aspect of operations, management by
exception allows managers to prioritize their time and efforts by focusing on areas that
require attention due to significant variations from predetermined standards or targets.
The key principle behind management by exception is that managers should only intervene
or take action when results fall outside predetermined thresholds or when there are
notable deviations from the expected norms. This approach allows managers to
concentrate on critical issues, make informed decisions, and allocate resources effectively
to address the exceptions.

1.4 Advantages of a Budget

1.5 Limitations of a Budget

The limitations of a budget are as follows:

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 1. Inaccurate Estimates: Budgets rely on estimates and assumptions about future events,
and if these estimates are not accurate, it can lead to deviations between budgeted and
actual results.
2. Rigidity: The budgeting process can create a sense of rigidity and inflexibility in
organizations.
3. Costly Process: Budgeting can be a resource-intensive process, requiring time, effort,
and financial resources.
4. Not a Substitute for Management: Budgeting is a tool for planning and control, but it is
not a substitute for effective management.
5. Continuous Monitoring: Budgets need to be continuously monitored to track actual
performance against budgeted figures. This monitoring process requires time and effort
from management to analyze variances and take corrective actions.

2 Distinction between Budgetary Control System and Standard Costing

System
Please refer to the following image:

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 3 Steps in Preparation of a Budget

Step 1: Definition of Objective

This step involves clearly stating the goals and objectives that the budget aims to achieve.
These objectives can vary depending on the organization's priorities and can include
increasing sales, controlling costs, improving profitability, expanding market share,
investing in research and development, or achieving specific financial targets.
Step 2: Location of the Key or Budget Factor
The budget factor refers to the key element or constraint that significantly influences the
budgeting process. It could be a factor that limits or shapes activities in other areas of the
organization. For example, if a company has limited plant capacity, it would need to
consider this factor when budgeting for production volumes and sales targets. Other
examples of budget factors could include the availability of raw materials, labor resources,
or sales quantity.
Example: The organization has the capacity to produce 2500 units per annum. But the
production department can produce only 1800 units due to non-availability of raw
materials. In this case, the non-availability of raw materials is the principal budget factor
(limiting factor).
If the sales manager estimates that he can sell only 1500 units due to a lack of demand.
Then lack of demand is the principal budget factor.
This concept is also known as key factor, Principal Budget Factor or governing factor. This
factor highlights the constraints with in which the organization functions.
Step 3: Fixation of Budget Period
The budget period refers to the timeframe for which the budget is prepared. It is typically
aligned with the organization's financial year, which is usually 12 months. However,
budgets can also be prepared for shorter periods, such as quarters or months, depending
on the organization's needs and preferences. In the case of capital expenditure budgets,

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 which involve long-term investments, the budget period can extend over multiple years.
Rolling budgets are another approach where the budget continually rolls forward, typically
on a monthly or quarterly basis, as the current period is completed. This allows for regular
reassessment and adjustment of budgets.
Step 4: Board of Directors appoints Budget Committee which in turn appoints Budget
Controller
The involvement of the board of directors in the budgeting process ensures top-level
oversight and approval. The board typically appoints a Budget Committee, consisting of key
stakeholders such as executives and department heads, to oversee the budgeting process.
The Budget Committee plays a crucial role in setting budget guidelines, reviewing proposed
budgets, and providing input and recommendations. The committee, in turn, appoints a
Budget Controller or Manager who is responsible for coordinating and managing the
budgeting process, ensuring compliance with guidelines, and consolidating the budget
inputs from various departments or divisions. The Budget Controller often plays a key role
in preparing the budget document and liaising with stakeholders throughout the process.

4 Budget Manual
A budget manual is a document prepared by the budget department under the supervision
of the Budget Committee. It states the specific procedures and best practices to be
followed in the development of the budget.
The budget manual typically includes the following information:
1. Statement of Objectives: This section outlines the objectives of the business or
organization for the budgeting period. It provides a clear understanding of the overall
goals and targets that the budget aims to achieve.
2. Duties and Responsibilities: This section specifies the roles and responsibilities of
different personnel involved in the budget preparation process. It outlines the tasks and
duties of individuals or departments responsible for data collection, analysis, budget
formulation, review, and approval. It helps ensure clarity and accountability throughout
the budgeting process.

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 3. Time Schedule: The budget manual includes a detailed timeline or schedule for the
budget preparation process. It specifies key milestones, deadlines, and submission dates
for different stages of the budgeting process. This helps to ensure that the budget is
prepared and reviewed within a specific timeframe, allowing for timely decision-making
and implementation.
4. Procedures for Obtaining Approval: This section outlines the procedures and steps
required to obtain approval for the budget. It specifies the individuals or committees
responsible for reviewing and approving the budget and provides guidelines on the
review process, such as the documentation required, criteria for evaluation, and any
specific considerations or restrictions.

5 Budget Document
A budget document is a comprehensive report that presents the financial plans and
projections for an organization. It provides a detailed overview of the expected revenue,
expenses, and resource allocations for a specific period, such as a fiscal year or a quarter.
The content and structure of a budget document may vary depending on the organization's
needs and requirements.

A master budget is a comprehensive financial plan that integrates all the individual budgets
and financial projections of an organization. It provides a comprehensive overview of the
organization's financial activities, performance, and goals for a specific period, typically a
fiscal year. The master budget typically consists of following key components:
1. Budgeted Profit and Loss Statement: The budgeted profit and loss statement, also
known as the budgeted income statement, presents the expected revenues, expenses,
and resulting net income for the budget period. It provides a summary of the
organization's projected financial performance.

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 2. Budgeted Balance Sheet: The budgeted balance sheet outlines the expected assets,
liabilities, and equity at the end of the budget period. It provides a snapshot of the
organization's financial position based on the projected figures.
3. Budgeted Cash Flow or Cash Budget: The budgeted cash flow or cash budget estimates
the expected cash inflows and outflows over the budget period. It helps to forecast the
organization's cash position, monitor cash flow, and identify potential cash surpluses or
shortages.
Please note that Master Budget is at higher Level. Apart from this respective Budgets are
prepared by various departments/Functions
1. Sales Budget
2. Production Cost Budget
3. Material Usage and Purchase Budget
4. Direct Labor Requirement and Cost Budget
5. Production Overhead Cost Budget
6. Selling and Distribution Overhead Cost Budget
7. Administrative Overhead Cost Budget
8. Capital Expenditure Budget

5.1 Sales Budget

Sales Budget can be understood as:
1. A sales budget is a detailed schedule that forecasts expected sales in units and their
corresponding selling prices. It typically includes breakdowns by product or service and
region or market segment. The sales budget serves as a forecast of the anticipated
sales volume and revenue for a specific period, such as a month, quarter, or year. It
takes into account factors such as market demand, historical sales data, market
research, and anticipated changes in the business environment.
2. An accurate sales budget is crucial for the overall budgeting process. It serves as the
foundation for planning other activities, such as production levels, resource allocation,
marketing strategies, and financial projections.
3. The sales budget is considered the cornerstone of budget preparation because it
provides the basis for determining other budget components. Once the expected level
of sales is determined, an organization can plan and allocate resources accordingly,
ensuring that production targets and other activities align with anticipated sales.

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 In summary, a sales budget plays a vital role in the budgeting process, providing key
information on expected sales and serving as a basis for planning and decision-making in
various areas of the organization.

Practice Problem 1
Question- Refer to the following image:

Solution-

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 5.2 Production Budget
The production budget is a financial plan that outlines the quantity of goods to be
produced during a specific period. It is an important component of the overall budgeting
process in organizations involved in manufacturing or production activities.
The production budget takes into account the sales forecast from the sales budget and
considers factors such as desired ending inventory levels, production capacity, and any
specific production requirements. It outlines the quantity of each product that needs to be
produced to meet the projected sales demand and maintain appropriate inventory levels
(level of stocks to be carried).
In a multi-product company, the production budget is prepared separately for each
product. This allows for a more detailed and accurate plan, considering the specific
production requirements and demand patterns of each product.
In the production budget, one of the key steps is to calculate the budgeted production
quantity in units. This calculation involves considering the budgeted sales in units, desired
closing stock in units, and deducting the opening stock in units.
Production Budget is mostly prepared on a monthly basis. However, it can also be made on
an annual basis.
The process of a Production Budget can be understood as follows:
1. Budgeted sales in units: The production budget starts by considering the expected sales
volume for each product or product category. This information is typically obtained from
the sales budget or sales forecast.
2. Desired closing stock in units: The production budget also takes into account the
desired level of inventory at the end of the budget period. This includes considering
factors such as customer demand patterns, lead times, and inventory carrying costs. The
company may aim to maintain a specific level of closing stock to ensure smooth
operations and meet customer needs.
3. Opening stock in units: The production budget considers the quantity of inventory
carried over from the previous period. This is known as the opening stock.
4. Total requirement: To determine the budgeted production in units, the total
requirement is calculated. This is done by adding the budgeted sales and desired closing
stock and subtracting the opening stock.

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 5. Budgeted production in units: The final step is to obtain the budgeted production
quantity by subtracting the opening stock from the total requirement. This figure
represents the number of units that need to be produced during the budget period.
The Production Budget will look like this:

Let’s discuss a practice problem. So, that the basic idea of implementation can be
understood.
Practice Problem 2
Question- Refer to the following image:

Solution-
In this we have to create the production budget for four products. It’s very easy as you just
need to put the values in the format as follows:

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 However, you don’t need to solve the questions thoroughly you can just solve these kinds
of questions in your brain to get the answer.
Till now we have discussed the sales budget and production budget in detail. Now we shall
discuss Material Usage and Purchase Budget.

5.3 Direct Materials Usage and Purchase Budget

5.3.1 Direct Material Usage Budget

The material consumption budget will require data from the production budget to
determine the quantity of each product to be produced and the materials to be consumed
per unit of production. It will also consider anticipated production loss into consideration.
So, it basically lays down what will be the material usage during a specific period. Also, it
includes the anticipated loss. For better understanding let us discuss an example:
Example- A company wants to produce 1000 units of cars and each unit of a car requires 9
Kg of material A. If the loss of 10% occurs while using material A then how much material A
would be used:
A. 9,000 Kg
B. 8,100 Kg
C. 10,000 Kg
D. 11,000 Kg
Ans: Option C
Solution-
Material required is 9 kg for a single unit. But as per the question 10% is wasted. That
means for production of a car 10 kg is required (as 10% would be lost and we need 9 kg for
the production of a single unit of a car)
So, for 1000 units, material required= 1000*10 = 10000 kg.

5.3.2 Direct Material Purchase Budget

A material purchase budget details the raw materials that must be purchased to fulfill the
production budget after keeping materials in stock as per the company's policy. The
material purchase budget will be based on the material consumption budget including cost
per unit of materials to determine the total material cost.
For better understanding let us discuss an example:

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 Example: A company wants to produce 1000 units of cars and each unit of car requires 9 Kg
of material A. The loss would be 10% in material A. How much material it would buy
considering that the raw material in inventory for material A should be 100 Kg. Assume 50
kg of Material A as opening stock.
A. 9,050 Kg
B. 10,050 Kg
C. 10,000 Kg
D. 11,000 Kg
Ans: Option B
Solution-
In the previous example, we have calculated that a car can be produced with total material
as 10 kg. So, moving further we have to use 10,000 kg (10 kg*1000 units) and then we add
100 kg as it must be kept in the inventory and as the opening stock was 50 kg. So, we will
deduct the opening stock. So, the total material that will be required= 10,000+100-50 =
10,050 kg.

5.4 Direct Labor (Requirement and Cost Budget)

The direct labor requirement and cost budget is other important component of the overall
budgeting process in manufacturing or production companies. It outlines the labor hours or
labor resources required for production, as well as the associated labor costs.
The direct labor requirement and cost budget is typically developed from the production
budget, which provides information on the planned production quantities. It considers
factors such as production processes, labor requirements per unit of production, and the
desired level of workforce utilization.
In addition to the production budget, the direct labor requirement and cost budget may
also take into account other budgets, such as:
1. Capital Expenses Budget: This budget outlines the company's planned capital
expenditures for the budget period. It may include investments in machinery,
equipment, or other assets that have an impact on the labor requirements. For
example, if the company plans to introduce new automated machinery, it may affect the
labor hours required for production.
2. Research and Development Cost Budget: If the company is engaged in research and
development activities, the associated costs may be considered in the direct labor

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 requirement and cost budget. Research and development efforts can impact labor
requirements, particularly if there are new product development or process
improvement initiatives.
Total Labour Hours Required and Total Labour Cost can be calculated as:

If you are not able to understand don’t worry as we will be discussing some practice
problems.
The most important budgets were Sales Budget, Production Cost Budget, Material Usage
and Purchase Budget, and the Direct Labour Requirement and Cost Budget which we have
discussed in detail. Now, let us discuss the other remaining budgets which are not too
important but let us discuss them in brief.

5.5 Production Overhead Budget

Production overhead outlines the costs associated with production overhead, which
includes all costs of production excluding direct materials and direct labor.
Here are some key inclusions under the production overhead budget:
1. Cost of indirect material: This includes the cost of materials that are indirectly used in
the production process, such as grease, lubricants, or other consumables. These
materials are not directly incorporated into the final product but are necessary for the
production process.
2. Cost of indirect labor: This includes the cost of labor that is indirectly involved in the
production process, such as the salaries of supervisors, quality control personnel, or
maintenance staff. They play a vital role in supporting and managing the production
activities.
3. Cost of indirect expenses: This includes various indirect expenses related to production,
such as depreciation of machinery, rent of production facilities, utilities, maintenance,
insurance, and other overhead costs. These expenses are necessary to operate the
production facilities and support the overall production process.
It's important to note that production overhead costs can be variable or fixed. Variable
costs, such as the cost of indirect materials, may vary in proportion to the production
volume or level of activity. Fixed costs, such as rent or depreciation, generally remain
constant regardless of the production volume.

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 5.6 Administrative Overhead Cost Budget
Administrative overhead cost budgets focuses on estimating and planning for the fixed
costs associated with administrative functions and activities.
Here are some key points about the administrative overhead cost budget:
1. Fixed nature of expenses: Administrative overhead costs typically consist of fixed
expenses such as staff salaries, rent for office space, utilities, insurance, office supplies,
and other ongoing administrative expenses. These costs are relatively stable and do not
vary significantly with changes in production levels or sales. It's important to note that
while administrative overhead costs are generally fixed, there may still be some
variability in certain expenses.
2. Compilation of departmental budgets: The administrative overhead cost budget is
typically a compilation of individual budgets submitted by various departments
responsible for administrative functions. These departments may include accounting,
human resources, legal, secretarial work, and other administrative activities. Each
department provides their budget estimates for the relevant expenses within their area
of responsibility.
3. Main administrative activities: The budget includes costs associated with various
administrative activities, which may vary depending on the organization's size, industry,
and specific requirements. Examples of main administrative activities covered in the
budget could include accounting, human resource, legal secretarial work and so on.

5.7 Selling and Distribution Overhead Cost Budget

This budget is based on Sales Budget. It focuses on estimating and planning for the costs
associated with selling and distributing products or services.
Selling and distribution overhead costs consists largely of salesmen's salaries, commissions
and hotel expenses, depreciation and running cost of delivery vans, sales management cost
and advertising costs. So, it can be said that any expense that is related to selling and
distribution will be treated under Selling and Distribution Overhead Cost Budget.
Practice Problem 3
Question- Refer to the following image:

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 Solution-
Firstly, we will segregate the cost into fixed and variable. Fixed overhead will remain the
same irrespective of the sales.

As, 80,000 is the total sales which include 8,000 as agent sales. So, this means sales worth
Rs 72,000 is done by the salesmen. So, the commission will be calculated on 72,000. This
concept will be applied in every case. And the Carriage outwards will be calculated on full
sales amount. Also, the agent commission will be calculated on the sales made by the

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 agent. So, after solving we can ascertain the grand total which can be understood from the
above table.

5.8 Capital Expenditure Budget

The Capital Expenditure Budget is a financial plan that outlines the intended expenditure
on fixed assets such as land, buildings, plant, and machinery during a specified budget
period. Typically, this budget is prepared for a long period, usually spanning 5 to 10 years.
To facilitate control and monitoring, the Capital Expenditure Budget is further broken down
into shorter periods, such as annual or quarterly budgets. This breakdown allows for better
management and evaluation of the capital investments made by the organization.

5.9 Cash Budget

A cash budget is a financial tool that helps organizations forecast and manage their cash
flows over a specific period, typically on a monthly or quarterly basis. It provides a detailed
projection of expected cash inflows and outflows, allowing businesses to plan and control
their cash position effectively.
A cash budget assists in determining whether a company will have sufficient cash to meet
its financial obligations and make strategic decisions accordingly. Cash Budget is necessary
to make sure that your cash flows are manageable.
Format of Cash Budget:

It consists of 4 sections
1. Receipts: This section includes all anticipated sources of cash inflows during the
budgeted period.

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 2. Disbursements: The disbursements section outlines all expected cash outflows during
the budgeted period.
3. Cash Excess or Deficiency: This section calculates the difference between the total
receipts and total disbursements for each period. If the total receipts exceed the total
disbursements, it represents a cash excess, indicating a surplus of cash during that
period. Conversely, if the total disbursements exceed the total receipts, it represents a
cash deficiency, indicating a shortage of cash during that period.
4. Financing (Borrowing/Investments): The financing section takes into account any
borrowing or investment activities that the organization plans to undertake during the
budgeted period.
Sources for Preparation of Cash Budget
The data required for the preparation of the cash budget is gathered from different
budgets. These are:
1. Sales Budget: The sales budget provides information on the expected quantity of goods
to be sold and the corresponding cash collections from customers during the budget
period. It helps estimate the cash inflows from sales revenue.
2. Purchase Budget: The purchase budget outlines the expected cash payments for
materials and supplies during the budget period. It helps estimate the cash outflows for
inventory purchases.
3. Various Expenditure Budgets: Different expenditure budgets, such as the direct labor
budget, production overhead budget, selling and distribution overhead budget, and
administrative overhead budget, provide details on the anticipated cash expenses for
labor, overhead costs, and other operating expenses during the budget period.
4. Capital Expenditure Budget: The capital expenditure budget provides information on
the cash outflows required for the purchase of long-term assets such as plant and
machinery, equipment, land, and buildings. It helps estimate the cash outflows for
capital investments.
5. Executive's Budget: The executive's budget includes items such as dividend payments,
donations, income taxes, and other financial obligations. It helps estimate the cash
outflows for these specific expenses during the budget period.
Practice Problem 4

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 Question- A company bought a machine worth Rs. 20 lakh in 2009. In 2010 the depreciation
on machine is 2 lakh. What would be cash outflow corresponding to Depreciation of
Machine?
Answer-
In the given scenario, the depreciation on the machine is Rs. 2 lakh. However, there is no
corresponding cash outflow associated with depreciation. The depreciation expense
reduces the reported value of the machine on the company's books, but it does not involve
the expenditure of cash. Therefore, the cash outflow corresponding to the depreciation of
the machine would be zero.

5.10 Budgeted Profit and Loss Account

Budgeted Profit and Loss Account is prepared from various Functional Budgets. The data
required for the preparation of cash budget is gathered from different budgets. These are:
(i) Sales Budget
(ii) Purchase Budget
(iii) Various Expenditure Budgets
(iv) Capital Expenditure Budget for calculating Depreciation
(v) Executives Budget

5.11 Budgeted Balance Sheet

The Budgeted Balance Sheet is an essential component of the master budget and is
prepared after all the functional budgets, the Cash Budget, and the Budgeted Profit and
Loss Account have been created.
The Budgeted Balance Sheet provides a snapshot of the financial position of a company at a
specific point in the future, usually at the end of the budgeted period. It outlines the
projected assets, liabilities, and owner's equity based on the information gathered from the
other budgeted statements.

6 Classification of Budgets
Budgets are broadly classified based on:
Budgets based on Time:
Budgets can be categorized based on the time period they cover:
1. Long-term budget: A long-term budget is typically prepared to cover a period of more
than a year. Long-term budgets are commonly used for strategic planning, investment

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 decision-making, and forecasting financial performance over an extended period. They
often involve projections of revenues, expenses, and capital expenditures.
2. Short-term budget: A short-term budget, on the other hand, is prepared to cover a
period of one year or less. It usually focuses on the immediate operational needs and
financial targets of a business within a shorter time horizon. Short-term budgets are
frequently used for day-to-day operational planning, resource allocation, and
monitoring of financial performance.
Budgets based on Nature of Expenditure and Receipts:
Budgets can also be categorized based on the nature of expenditure and receipts.
1. Capital Budget: A capital budget is prepared to estimate and allocate funds for capital
expenditures and receipts that are related to long-term investments and assets. It
focuses on the acquisition, enhancement, or disposal of fixed assets, such as land,
buildings, equipment, and infrastructure.
2. Revenue Budget: A revenue budget is prepared to estimate and allocate funds for
revenue receipts and expenses that are associated with the ongoing operations of a
business or organization. It focuses on day-to-day operational activities and
transactions. The revenue budget includes estimates of revenue sources, such as sales,
services, fees, and other income streams.
Budgets based on Functions:
There are various types of Budget Based on Functions. We have already discussed them
1. Sales Budget
2. Production Cost Budget
3. Material Usage and Purchase Budget
4. Direct Labor Requirement and Cost Budget
5. Production Overhead Cost Budget
6. Selling and Distribution Overhead Cost Budget
7. Administrative Overhead Cost Budget
8. Capital Expenditure Budget
The budget related to Principal Budget Factor is prepared first and then rest of the budgets
are prepared.
Budgets based on Capacity:
1. Fixed Budget- A fixed budget is one which is prepared for one level of activity for a
certain period. A fixed budget is suitable when the organization's activity can be estimated

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 accurately. However, in a dynamic condition this type of budget has limited usefulness as a
control tool.
Now, let us assume that St. Xavier's College, Kolkata uses heavy duty printers for printing
question papers and other materials. Monthly budgeted expenses are as follows:

Budgeted output 10,000 copies and budget cost per page of printing is ~ 2 (~ 20,000/
10,000).
Now if in a month the actual output was 5000 copies, then what would happen. Ideally, we
should calculate the cost for 5000 copies because some costs are fixed, and some are
variable. Cost of paper and cartridge would reduce if lesser copies are printed.
But in fixed budget we do not have provision for budget at different levels of activity. So,
here arises the need for the flexible budget.
2. Flexible Budget- A flexible budget is one which is prepared in such a way that it will be
possible to determine the budgeted cost for any level of output. It is a budget that is flexible
as per the needs of the hour. It helps in controlling cost by projecting cost at different level
of activities. It is the most useful tool for control of cost when activities cannot be predicted
accurately.
Now, if in the above scenario, flexible budget was made then we can easily ascertain the
budget for 5000 output as:

In case of Flexible Budget we prepare budget at different levels of activity. So,

1. Budgeted output 10,000 copies, then budget cost per page of printing is = 2. This have
been calculated before.

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 2. Budgeted output 5000 copies, then budget cost per page of printing is = 2.7 (13500/
50000).
In flexi budget the costs are divided into fixed and variable costs and accordingly the budget
is prepared at different levels of activity. The variable component will vary with output/
activity and fixed component will remain the same.
Difference between fixed and flexible budget
For easy understanding, you can refer to the following table and can compare the same:

Practice Problem 5
Question- Refer to the following image:

Solution-
In this question, we have been provided data for 10,000 units and we have to prepare a
flexible budget for 8,000 and 6000 units.

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 Direct Materials is 7,00,000 for 10,000 units. This means for one unit the direct materials is
70 Rs. So, for 8,000 units it will be 5,60,000 (70*8000) and 4,20,000 for 6,000 units
(70*6000). Similarly, all variable costs can be calculated.
After the calculation of Variable Costs. We have to add all the variable costs and then we
will add fixed costs. And then to get to total cost we will add the total variable costs and
total fixed costs.

So, you may see that this is very simple. You just ned to do the correct calculation. As, we
have discussed the basic idea of solving the question we will not be providing the analysis in
upcoming questions. However, if you are not able to understand or you face any kind of
difficulty you can post your query in the discussion forum. We will be happy to help you.
Also, as these questions are simple try to solve the upcoming questions by yourself without
referring to the solution.
Practice Problem 6
Question- Refer to the following image:

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 Solution-
Now, you may be having doubts regarding the Semi-Variable Expenses. Semi-variable
expenses, also known as mixed expenses or semi-fixed expenses, are costs that consist of
both fixed and variable components. These expenses have a fixed portion that remains
constant within a certain range or level of activity, and a variable portion that changes
based on the level of activity.
To illustrate this, let's consider the example of supervisor salaries. Suppose the salary of the
supervisors is fixed when they are supervising 10 workers. However, if the number of
workers increases to 20, an additional supervisor will be required. In this scenario, the
salary of the additional supervisor represents the variable portion of the expense, as it
varies with the level of activity (number of workers).
So, in the question we have been provided that semi-variable expenses remain constant
between 45% and 65% of capacity. But, the semi-variable expenses increases by 20%
between 80% and 100% capacity. As we have to calculate one for 60% capacity the semi

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 variable expenses will remain the same but in case for 90% capacity the semi variable
expenses will increase by 20%.

7 Zero Based Budgeting (ZBB)

In simple words, Zero based budgeting means that when we make our budget without
considering the last year’s figure. As you know in case of Traditional Budgeting, the last
year's figures are taken as 'Base' and a percentage is added for inflation and making
adjustment for any unusual factors or incremental changes. So, we can say that:
Zero Base Budgeting (ZBB) starts from the position of zero previous expenditure and
managers are required to justify all budgeted expenditures.
The base line is zero rather than the previous year's budget. Actual figures of the last year
are virtually ignored.
It takes the view that every item of expenditure incurred in any activity should be re-
evaluated and re-assessed and fixed.
So, we can say that by using zero-based budgeting, the company may identify
opportunities to reallocate funds from less impactful marketing activities to more

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 promising ones, leading to better utilization of resources and potentially higher returns
on investment.
Advantages of Zero-Based Budgeting
1. Allocate scarce resources of the organization in a more efficient and equitable
manner: With zero-based budgeting, resources are allocated based on a fresh
evaluation of needs and priorities. This helps ensure that limited resources are
distributed in the most efficient and fair way possible, taking into account the current
needs and goals of the organization.
2. The managers are forced to take budgeting more seriously: ZBB requires managers to
justify every expenditure from scratch, making them more accountable for their
budgeting decisions. It encourages them to thoroughly analyze and assess each
expense, promoting a more thoughtful and responsible approach to budgeting.
3. It challenges the status quo and encourages a questioning approach to activities and
expenditure: Zero-based budgeting questions the assumption that all expenses should
continue automatically. It prompts managers to critically evaluate each activity and
expenditure, identifying areas where improvements can be made or costs can be
reduced. This challenges the status quo and encourages a mindset of continuous
improvement and efficiency.

8 Responsibility Accounting
Responsibility accounting is a system of control within an organization where specific
individuals or departments are assigned responsibility for managing and controlling costs
related to their areas of authority.
The key idea behind responsibility accounting is to hold individuals accountable for their
performance by assigning them clear responsibilities and granting them the necessary
authority to carry out their tasks. They are responsible for managing the costs and
performance associated with their specific responsibilities.
If the performance of the assigned responsibility does not meet the predetermined
standards or expectations, the individuals or departments responsible will be held
personally accountable for it.

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 9 Performance Budgeting
Performance budgeting, also known as performance-based budgeting, is a budgeting
practice that involves preparing the budget based on evaluating the productivity and
performance of different operations within an organization. The objective is to allocate
budget resources to divisions or activities that contribute the most to profitability or
desired outcomes.
In performance budgeting, the allocation of the budget is determined by the effectiveness
and efficiency of each division or operation. Divisions or activities that demonstrate higher
productivity, generate greater revenue, or deliver better outcomes receive a larger share of
the budget.

10 Budgetary Control
Budgetary control is a systematic process of planning, coordinating, and controlling an
organization's activities through the use of budgets. It involves setting specific financial
targets or budgets and then monitoring and comparing actual performance against those
targets. The concept can be easily understood from the below image:

Steps in Budgetary Control-

1. Establishment of Budgets.
2. Responsibilities of Executives.
3. Comparison of Actuals with Budgets.

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 4. Analysis of Variances and Taking Corrective Action.
Advantages of Budgetary Control-
1. Maximization of Profits through Optimum Utilization of Resources.
2. Facilitates Management by Exception.
3. Budgets Act as a Motivating Force to Achieve Desired Objectives.
4. Acts as a Basis for Internal Audit.

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 Previous Year Questions (PYQs)
on
Budgeting

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – Which of the following does not appear in Cash Budget? SEBI Grade A – Phase 2 - 2020

A. Collection from Debtors

B. Depreciation
C. Cash Sales
D. Cash Disbursement
E. None of the above

Question 2 – Which of the following is not the feature of budgetary control? SEBI Grade A – Phase 1 - 2022

A. Budgeting is a plan of action based on past performance and governed by rational judgment of factors that
will influence the course of business in future.
B. For budgeting the organisational structure must be clearly defined and responsibility should be assigned to
identifiable units within the organization
C. Budgeting does not facilitate in management by exception
D. Budgeting is quantifiable in monetary or quantity or both terms
E. All are correct

Question 3 – Which of the following is a modern management accounting technique? SEBI Grade A – Phase 2
- 2022

A. Human Resource Accounting

B. Statistical Reports
C. Responsibility Accounting
D. Break Even Analysis
E. None of the above

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

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Question 1 – Budgetary control is a system for monitoring an organization's process in monetary terms. In the
same regard, which of the following statement is correct regarding budgetary control PFRDA Grade A – Phase
2 - 2022

A. Budgetary Control System over looks the manufacturing operations

B. Budgetary Control System decreases coordination between departments as the results and costs are
interrelated.
C. Budgetary Control System is not a Time-consuming and costly process
D. Budgetary Control is used to compare actual results against the budget
E. None of the above

Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option B
Question 2 Option C
Question 3 Option C

PFRDA Grade A questions

Question Number Answer

Question 1 Option D

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 Section C

Explanation
SEBI Grade A questions

Question 1 – Which of the following does not appear in Cash Budget? SEBI Grade A – Phase 2 - 2020

A. Collection from Debtors

B. Depreciation
C. Cash Sales
D. Cash Disbursement
E. None of the above

Answer – Option B

Explanation –
• A cash budget is a company's estimation of cash inflows and outflows over a specific period of time,
which can be weekly, monthly, quarterly, or annually.
• A company will use a cash budget to determine whether it has sufficient cash to continue operating
over the given time frame.
• The cash budget represents a detailed plan of future cash flows and is composed of four elements: cash
receipts, cash disbursements, net change in cash for the period, and new financing needed.
• Depreciation is not a part of Cash Budget. Hence, Option B is the correct answer.
All other options are incorrect.

Question 2 – Which of the following is not the feature of budgetary control? SEBI Grade A – Phase 1 - 2022

A. Budgeting is a plan of action based on past performance and governed by rational judgment of factors that
will influence the course of business in future.
B. For budgeting the organisational structure must be clearly defined and responsibility should be assigned to
identifiable units within the organization
C. Budgeting does not facilitate in management by exception
D. Budgeting is quantifiable in monetary or quantity or both terms
E. All are correct

Answer – Option C
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Explanation –
• 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 organization into a plan of action
based on past performance and governed by rational judgement of factors that will influence the course
of business in the future.
• The overall purpose of budgeting is to plan different phases of business operations, coordinate activities
of different departments of the firm and to ensure effective control over it.
• One of the major advantages of Budgetary control is to Economize management time by using the
management by exception principle. So, it is an advantage of Budgetary Control.
• Management by exception is the practice of examining the financial and operational results of a
business, and only bringing issues to the attention of management if results represent substantial
differences from the budgeted or expected amount. For example, the company controller may be
required to notify management of those expenses that are the greater of $10,000 or 20% higher than
expected and therefore helps in exercising budgetary control.
Hence, Option C is the correct answer. All other options are incorrect.

Question 3 – Which of the following is a modern management accounting technique? SEBI Grade A – Phase 2
- 2022

A. Human Resource Accounting

B. Statistical Reports
C. Responsibility Accounting
D. Break Even Analysis
E. None of the above

Answer – Option C

Explanation –
Some of the Techniques involved in modern management accounting are:
1. Marginal costing- this technique allows an organization to know the point at which production can be
expanded or to determine the point at which economies of scale can be achieved.
2. Capital Budgeting- it allows organizations to analyze inflows and outflows of major projects and
investments especially new projects to determine whether expected results are met and to look for
alternatives to maximize production.
3. Inventory valuation- the managers use this technique to calculate the value of unsold inventory and also
evaluate the value of goods sold and the profit generated.
4. Product costing- this technique helps managers to determine the costs incurred when creating a product,
hence making it easy to set product prices.

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5. Responsibility accounting is a kind of management accounting that is accountable for all the management,
budgeting, and internal accounting of a company. The primary objective of this accounting is to support all the
Planning, costing, and responsibility centres of a company. Hence, Option C is the correct answer.

Additional Information:

• Human Resource Accounting: It is the process of identifying and measuring data about Human
Resources and communicating this information to the interested parties. It is not included in the
techniques of modern management accounting. Hence, Option A is incorrect.
• Statistical Reports: It's the science of collecting, exploring and presenting large amounts of data to
discover underlying patterns and trends. It is not included in the techniques of modern management
accounting. Hence, Option B is incorrect.
• Break-Even Analysis: It is a financial calculation that weighs the costs of a new business, service or
product against the unit sell price to determine the point at which you will break even. In other words,
it reveals the point at which you will have sold enough units to cover all of your costs. It is not included
in the techniques of modern management accounting. Hence, Option D is incorrect.

Explanation
PFRDA Grade A questions

Question 1 – Budgetary control is a system for monitoring an organization's process in monetary terms. In the
same regard, which of the following statement is correct regarding budgetary control PFRDA Grade A – Phase
2 - 2022

A. Budgetary Control System over looks the manufacturing operations

B. Budgetary Control System decreases coordination between departments as the results and costs are
interrelated.
C. Budgetary Control System is not a Time-consuming and costly process
D. Budgetary Control is used to compare actual results against the budget
E. None of the above

Answer – Option D

Explanation

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Budgetary control is a system of procedures used to ensure that an organization's actual revenues and
expenditures adhere closely to its financial plan. The system typically involves setting personal goals for
managers that are based on the budget, along with a set of rewards that are triggered when the goals are
attained. Budgetary Control System carefully understands the manufacturing operations. Therefore statement
A is incorrect

Advantages of Budgetary Control

1. An effective tool for performance measurement of departments, individuals, and cost centers
2. Identification of areas for reduction and efficiency improvement;
3. Increased efficiency and cost reduction result in profit maximization;
4. It also helps in introducing incentive schemes based on performance.
5. Cost reduction is always the primary target.
6. Improves coordination between departments as the results and costs are interrelated. Therefore
statement B is incorrect
7. It provides insight for in-depth analysis and any corrective action.
8. Helpful in achieving an organization’s long-term goal.

Disadvantages of Budgetary Control

1. Budgeted numbers often need revision as future prediction is difficult.

2. Time-consuming and costly process, need people and resources Budgetary control processes. Therefore
statement C is incorrect
3. This process sometimes requires coordination between various departments and is a difficult task.
4. This process requires approval and support from top senior management.
5. Always comparing the actuals with a budget is detrimental to employees’ motivation.

Hence the correct answer will be option D

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 Summary Sheet
-
Lean system and Innovation

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 1 Introduction
Lean system and innovation under cost accounting are two concepts that are closely related
to the efficient management of resources in business operations.

Lean system and innovation under cost accounting can help companies create a
competitive advantage by reducing waste, improving efficiency, and developing new
products and services that meet the changing needs of consumers.

1.1 What does lean mean?

‘Lean’ is a way to do more and more with less and less - less human effort, less equipment,
less time, and less space - while coming closer and closer to providing customers exactly
what they want.

It relies on 3 very simple ideas:

1. Deliver value from your customer’s perspective
2. Eliminate waste (things that don’t bring value to the product)
3. Continuous improvement

‘Lean system’ is where the philosophy of lean is applied in various processes.

It all started with lean manufacturing, where the aim was to minimize wastage and make
the production process efficient and afterwards this concept of lean was applied to various
other fields for the purpose of optimization. Thus, the term lean system came to be used as
a generic term where the concept of lean was applied to different fields to collectively gain
optimization.

1.2 Pillars of lean system

Two main pillars of the Lean methodology are:

1. Respect for people

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 2. Continuous improvements

2 Lean Manufacturing
Lean manufacturing or lean production is basically a concept that came into existence
because of Toyota Production System (TPS) which was based on Taylor’s Views that there
should be continuous Improvement and workers should be given incentives for the same.

This concept was discovered by Ohno Taiichi. The aim of TPS was-

• Less Wastage
• Less Resources
• Higher Productivity
• Lower Cost
• Lower Cycle Time

As we can see that TPS lays down the same objectives as lean system and thus, it was later
renamed as ‘Lean Manufacturing’ by John Krafcik.

In Lean production, the concept of "less wastage" is of utmost importance, this refers to
the systematic elimination of any activity or process that does not add value to the
customer. Waste is any activity or process that consumes resources but does not create
value or meet customer needs. Therefore, the goal of Lean production is to identify and
eliminate waste, thereby reducing costs, improving quality, and increasing efficiency.

Types of Waste:-

1. Overproduction- that means the organization is producing more than what is required
in the market which will lead to additional cost of stocking and also the possibility of
selling such stock at discounts later, which will lead to reduction in profit ultimately.

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 2. Waiting (time on hand)- this can happen in case of machinery, where one machinery
takes more time to convert the product for the next step of production which will lead
to increase in costs because such stock will need to be maintained.

3. Unnecessary transport or conveyance- it arises mainly due to inefficient planning where

suppose you are to transport a product to the same place but instead of planning it well
and sending it in optimum quantity in one truck you are making use of multiple trucks
multiple times.

4. Incorrect processing- this means that proper process that should be followed while
production is not being adhered to.

5. Excess inventory- it is the cost of maintaining extra stock that is not yet sold in the
market.

6. Motion- it is the extra cost arising due to excess of motion that machinery might have to
do.

7. Defects- this is the inability to offer standardized quality of products to the customers.

8. Delegating Tasks with lack of Training- which will lead to inefficient working an
increased cost.

9. Less Participation from workers on ideas- this is the lack of feedback that the
employees might give which may have helped the organization to function better.

10. Underutilization of skills- this happens when employees are not given the work
according to their expertise and skills which they can offer.

There is another approach for looking at the types of wastage. This can be categorized as-
1. Muda
2. Mura
3. Muri
Muda means wastefulness, uselessness and futility, which is contradicting value-addition.
For example- you are manufacturing a phone but the value-addition you are doing is giving
7 years of warranty on battery but this is of no use because technological advancement is
such that customer tend to change their phone on an average every 3 years.

Types of Waste (MUDA)-

1. Overproduction
2. Waiting (time on hand)
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 3. Unnecessary transport or conveyance
4. Incorrect processing
5. Excess inventory
6. Motion
7. Defects
Mura means- unevenness, non-uniformity, and irregularity. Mura is the reason for the
existence of any of the seven wastes. In other words, Mura drives and leads to Muda. For
example, in a manufacturing line, products need to pass through several workstations
during the assembly process. When the capacity of one station is greater than the other
stations, you will see an accumulation of waste in the form of overproduction, waiting, etc.

Muri means overburden, beyond one’s power, excessiveness. An example of Muri is

putting a machine under undue strain by expecting it to produce more and faster than it is
capable of. It also applies to putting employees under pressure to work longer, harder, or
faster than they physically can.

Muda, Mura, and Muri are interrelated. Eliminating one of them will affect the other two.

For example, a firm that needs to transport 6 tons of materials to a customer has several
options which are being depicted in the following diagram-

2.1 Principles of Lean Manufacturing

(A) Identify Value:

1. A company needs to add value defined by its customers’ needs.

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 2. The value lies in the problem you are trying to solve for the customer for your
customer is actively willing to pay

3. Any other activity or process that doesn’t bring value to the end product is
considered waste.

(B) Value Stream Mapping: It must include all actions and people involved in the process of
delivering the end product to the customer. By doing so, you will be able to identify what
parts of the process bring no value.

(C) Create Flow: Developing a product/service will often include a cross-functional

teamwork. Bottlenecks and interruptions may appear at any time.

However, by breaking up work into smaller batches and visualizing the workflow, you will
able to easily detect and remove process roadblocks.

(D) Create a Pull System: In such a system the work is pulled only if there is a demand for it.
This lets you optimize resources’ capacity and deliver products/services only if there is an
actual need. This basically means that when the necessary order or demand is created then
only manufacturing should be done. Unnecessary Production when there is no demand on
the market will lead to losses.

(E) Continuous Improvement (Perfection): Problems may occur at any of the previous
steps. Therefore you need to make sure that employees on every level are involved in
continuously improving the process.

3 Tools of Lean System

In terms of Tools the main pillars are-

1. JIT - As the name implies, Just in Time (JIT) is a management philosophy that calls for
the production of what the customer wants, when they want it, in the quantities
requested, and where they want it, without being held in inventory.

Instead of stockpiling large quantities of what you believe the customer might want,
only produce what the customer requests when they request it. This allows you to
focus your resources on only completing what you will be paid for rather than
building for stock.

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 2. Jidoka- Reduces Waste though
controlling Defects. This
concept's goal is to free
equipment from the need for
constant human attention, to
separate people from
machines, and to allow
workers to staff multiple
operations.

JIDOKA allows the machine

operator to stop the flow line,
preventing defective pieces
from moving to the next
station.

And the base for these two pillars is-

Stability and standardization- Provides stability through basic hygiene standards and
continuous improvement. Visual management and the 5S system are the foundations of
stability. 5S promotes standardized work and Total Productive Maintenance (TPM), both of
which are critical to method and machine stability.

Finally, 5S promotes just-in-time (JIT) production by providing decision-making information

at the point of use.

3.1 5S in Lean Systems

5S is one of the basic building blocks of Lean Manufacturing and one of the first lean tools
that you will start your implementation with.

This originated at Toyota as part of TPM. 5S is a simple tool for organizing your workplace in
a clean, efficient and safe manner to enhance your productivity, visual management and to
ensure the introduction of standardized working.

(1) Sort (Seiri): Sort, Clearing, Classify

According to Seiri, employees should sort out and organize things well.

Label the items as “Necessary”, ”Critical”, ”Most Important”, “Not needed now”, “Useless
and so on. Throw what all is useless..

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 (2) Straighten (Seiton): Straighten, Simplify, Set in order, Configure

Now, the organization is left with essential items. Seition means to Organize.

Research says that employees waste half of their precious time searching for items and
important documents. Every item should have its own space and must be kept at its place
only.

(3) Shine (Seiso): Sweep, shine, Scrub, Clean and Check

Shine here refers to maintaining cleanliness in the workplace. It creates a positive work
environment for the employees.

(4) Standardize (Seiketsu): Standardize, stabilize, Conformity

The problem is, when 5S is new at a company, it's easy to clean and get organize and then
slowly let things slide back to the way they were. SEIKETSU refers to Standardization. Every
organization needs to have certain standard rules and set policies to ensure everything
done in first 3 steps gets converted into habits .

(5) Sustain (Shitsuke): Sustain, self discipline

It means self-discipline. Employees need to respect organization’s policies and adhere to

rules and regulations. Self discipline is essential

6th S – Safety

Some companies like to include a sixth S in their 5S program: Safety. When safety is
included, the system is often called 6S. The Safety step involves focusing on what can be
done to eliminate risks in work processes by arranging things in certain ways.

3.1.1 5S and Visual Communication

Seiton and seiso can be achieved through Visual Communication. Visual communication
tools such as labels, floor markings, cabinet and shelf markings, and shadow boards can
make navigating spaces even simple. Therefore, if any organization has clear and good
visual communication, it becomes easier to achieve 5S.

3.1.2 CANDO
This is a concept which is same as 5S. When some American companies tried to
incorporate 5S, they changed the terminologies so that they would not be accused of
imitating Japan and therefore CANDO was introduced-

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 3.2 Kaizen
What is Kaizen Costing?

Kaizen is a Japanese word which means ‘change for better’ which ultimately leads to
continuous improvement. Its main aim is to reduce costs even below standard costs and for
this small-small changes are introduced leading to innovations rather than big changes.

Its earlier application was in Manufacturing Stage, but now it is applied everywhere.

What is Kaizen?

Idea of Kaizen Originated From One of the 14 Principles of Dr. Deming. So according to the
5th Principle given by Dr. Deming Improvement must be constant and forever so that there
is improvement in quality and productivity, and thus there is gradual decrease in costs. Mr.
Deming visited Japan after the World war and from his visit Japan adopted the idea of
Kaizen.

3.2.1 Types of Kaizen

In Asset-specific kaizen all improvement activities are related to reduction of use of chosen
asset or resource. It would involve identifying areas for improvement related to these
assets and implementing changes to enhance their performance, efficiency, reliability, or
lifespan.

The goal of asset-specific kaizen would be to optimize the utilization and effectiveness of
the organization's assets, leading to improved productivity, reduced downtime, cost
savings, and better overall operational performance. Example: Reducing Electricity
Consumption in Office in all departments.

In product-specific kaizen improvement activities are related to different resources related

to one product. This involves applying Kaizen principles to improve the design, features, or

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 quality of a specific product. It could involve gathering feedback from customers,
conducting product tests, and making iterative improvements based on the insights gained.

Example: Reducing Cost of Washing Machine by reducing consumption of all resources

Types of Costs to be Reduced in Kaizen(major examples):-

• Working with suppliers to reduce costs in supply chain

• Waste in Manufacturing Process
• Recruitment and training costs (more effective methods of training)
• Disposal
• Cost of acquiring a patent, license, registration fees, hiring of chartered accountant
and all other legal formalities require kaizen costing
• Redesigning of any product
• Marketing, sales and distribution

What does Kaizen seek to achieve?

Its main objective is to reduce costs, but it achieves this objective through eliminating
problems associated with the wastes inherent within our processes.

3.2.2 Principles of Kaizen Costing

1. Lays no emphasis on the present existing situation, it starts afresh and therefore it
does not have biases from the past experiences.

2. The system does not strive for perfection, rather seeking gradual improvements in
the existing situation, at an acceptable cost as it believes in gradual changes through
stable efforts.

3. It encourages collective decision—making, i.e. the ideas of many are better than that
of one single person, and so the shared responsibility is achieved.

4. There are no limits to the level of improvements that can be implemented, but these
should be consistently followed.

5. Kaizen involves setting standards and then continually improving these standards to
achieve long-term sustainable improvements.

3.2.3 Kaizen Process

1. Involve You Employees: The participation of employees and their feedback helps in
generating ideas and information. It also eliminates the resistance to change from their
side.
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 2. Find Problems: The organization together with its employees of all the departments
(such as customer support, finance, human resource, production, design, etc.), needs
to find out the various problems in the organization with the help of techniques like
360-degree feedback.
3. Think and Find Solutions: The next step is solving the identified problems. This step
needs a lot of brainstorming and tactical approach; therefore, managers form a team
of ingenious employees to find out a practical solution to each question.
4. Implement at smaller Level: Implementing any change involves cost and risk
simultaneously. Therefore to be on a safer side, the new idea must be testified on a
small part of the organization.
5. Check: The managers need to look after the proper implementation of the kaizen
costing at smaller level. The learning’s must be noted.
6. Standardize: After being satisfied with the results, the organization needs to set this
change as a standard procedure for all the departments and across the whole
organization.
7. Repeat: A standardized procedure becomes the organizational culture when
continuously practiced over a period

3.2.4 Advantages of Kaizen Costing

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 3.2.5 Drawbacks of Kaizen

3.2.6 Tools for Kaizen

There are major 5 tools of kaizen-
1. 5S (discussed earlier in the chapter)
2. TPM (to be discussed later in the chapter)
3. Value Stream Mapping (discussed earlier in the chapter)
4. PDCA - This is the Plan, Do, Check, Act method
5. Quality Circles

3.2.7 PDCA
Plan: In this initial step, the goal is to plan and establish objectives for improvement. It
involves identifying and defining the problem or opportunity for improvement.

Do: The "Do" step involves implementing the plan and carrying out the actions defined in
the planning phase. Key activities include executing the planned actions or changes. It
emphasizes on collecting data and information during the implementation process.

Check: In this step, the focus is on evaluating the results and comparing them against the
goals and expectations. Key activities include analyzing the collected data to assess the
outcomes and performance and comparing the actual results with the expected targets.

Act: The "Act" step involves taking corrective actions and implementing necessary changes
based on the findings from the "Check" step. Key activities include deciding on the
appropriate adjustments or modifications to address any identified issues or shortcomings.

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 Once the "Act" step is completed, the PDCA cycle starts again, creating a continuous
improvement loop. The cycle encourages organizations to strive for ongoing enhancement
by applying the knowledge gained from each iteration to subsequent cycles.

The PDCA cycle is iterative, meaning that after completing one cycle, the process begins
again with planning for the next improvement.

3.2.8 Quality Circles

A quality circle is a participatory management technique that enlists the help of employees
in solving problems related to their own jobs.

For example- Let's say there is a manufacturing company that produces electronic devices.
The company establishes a quality circle comprising employees from different departments,
such as production, quality control, and design.

Circles are formed of employees who meet at intervals to discuss problems of quality and
to devise solutions for improvements. The quality circle continues to meet regularly to
identify new problems, brainstorm solutions, and drive continuous improvement efforts.
They learn from their experiences, share best practices, and strive for ongoing
enhancement of product quality and process efficiency.

Difference b/w Kaizen and Standard Costing

In summary, kaizen focuses on continuous improvement by involving employees and

making incremental changes, while standard costing is a cost accounting method that sets
predetermined standards for costs and analyzes variances. Kaizen has a broader application
and is a long-term approach, while standard costing is primarily used for cost control and
performance evaluation in the short term.

3.3 TQM – Total Quality Management

Total quality management is an organization-wide philosophy with its core values centered
on continually improving the quality of its product and services, and the quality of its
processes, to meet and exceed customer expectations

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 TQM seeks to achieve quality by establishing a quality management system, setting quality
standards, and implementing processes to meet those standards. It also involves ongoing
measurement and analysis of performance data to drive improvement.

Kaizen, on the other hand, is a specific methodology that focuses on continuous

incremental improvements in processes, products, and services.

Therefore, TQM is a broader management philosophy that encompasses various principles

and practices to achieve overall quality, while Kaizen is a specific methodology for
continuous improvement that emphasizes small, continuous changes.

3.3.1 6 Cs of TQM
Commitment: If a TQM culture is to be developed, total commitment must come from top
management.

Culture: Training lies at the center of effecting a change in culture and attitudes. Negative
perceptions must be changed to encourage individual contributions and to make ‘quality’ a
normal part of everyone’s job.

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 Continuous improvement: TQM should be recognized as a ‘continuous process’. It is not a
‘one-time programme.

Co-operation: TQM visualizes Total Employee Involvement (TEI).

Customer Focus: The needs of customers shall be the focus.

Control: Unless control procedures are in place, improvements cannot be monitored and
measured, nor deficiencies corrected.

3.4 TPM – Total Productive Maintenance

TPM aims at improving the reliability and efficiencies of our equipment and machines.

TPM (Total Productive Maintenance) is a comprehensive approach to equipment

maintenance and productivity improvement. It aims to maximize the effectiveness and
efficiency of machines by involving all employees in their care.

It seeks to improve the OEE (Overall equipment effectiveness). The overriding objective of
TPM is the elimination of LOSSES. TPM focuses on proactive maintenance, operator
involvement, and continuous improvement to minimize equipment breakdowns, improve
availability, and optimize overall equipment effectiveness (OEE). It integrates maintenance
activities with production processes to achieve higher productivity, quality, and safety.

Seiichi Nakajima is regarded as the father of TPM. Total Productive Maintenance as we

know it today was developed at a company called Nippondenso (an important supplier of
Toyota.)

6 big losses that are tracked under TPM are-

1. Breakdowns
2. Setup and Adjustment losses
3. Start-up losses
4. Idling and minor stoppages
5. Reduced Speed
6. Defects and rework
Measurement of OEE -> Availability x Performance x Quality,

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 3.4.1 8 Pillars of TPM

Pillar 1: Autonomous Maintenance: Operators monitor the condition of their own

equipment and work areas.

Pillar 2: Process & Machine Improvement: Team leaders collect information from
operators and work areas then prioritize preventative maintenance and improvements.

Pillar 3: Preventative Maintenance: Preventative maintenance tasks and schedules are

shared by operators and team leaders.

Pillar 4: Early Management of New Equipment: Based on maintenance reports, team

leaders anticipate and plan for parts of new equipment (Predictive Maintenance).

Therefore, preventive maintenance is based on predefined schedules and activities, while

predictive maintenance utilizes data analysis to predict and address maintenance needs
based on the actual condition of the equipment. Preventive maintenance aims to prevent
failures, while predictive maintenance aims to anticipate and prevent failures before they
occur, optimizing maintenance efforts and reducing costs.

Pillar 5: Process Quality Management: Shared responsibility for operation and

maintenance encourages quality improvement ideas from all work areas.

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 Pillar 6: Administrative Work: Managers prioritize data from the previous pillars and share
outcomes with team leaders and work areas.

Pillar 7: Education & Training: Continuous improvement includes operator and work area
education and training which improve morale, retention, and efficiency.

Pillar 8: Safety & Sustained Success: Facility-wide safety is prioritized which positively
impacts sustained success of the TPM program.

The Three Goals of TPM:

1. Zero unplanned failures
2. Zero product defects
3. Zero accidents

Benefits of effective TPM include the following:

1. Safer Working Environment
2. Improved Equipment Reliability - Uptime
3. Increased Capacity
4. Increased Productivity
5. Improved Quality
6. Company Financial Performance and Job Security

3.5 Just In Time (JIT)

Just in Time (JIT), as the name suggests, is a management philosophy that calls to produce
1. What the customer wants and how much quantity
2. When they want it
3. Where they want it

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 Instead of producing in mass and
thinking customer would want it, you
only make exactly what the customer
ask for, when they ask for it. This allows
you to concentrate your resources on
what is being paid for. No unnecessary
stock of inventory and finished goods.

JIT helps in reducing inventory levels by

eliminating excess stock and relying on a
pull-based system where items are
produced or ordered only when there is
actual demand. This leads to lower
holding costs, reduced storage space
requirements, and improved cash flow.

JIT can also benefit by reducing various

costs associated with inventory, storage, overproduction, defects, and inefficient processes.
By eliminating waste and improving efficiency, organizations can achieve cost savings and
improve their overall financial performance.

3.5.1 Advantages of JIT

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 3.5.2 How Can you Implement JIT
1. Reliable Equipment and Machines: You cannot afford delays with JIT because it
focuses on producing and delivering goods or services at the precise moment they
are needed, minimizing waste and maximizing efficiency.
2. Quality Improvements by workers themselves through Kaizen: An empowered
workforce that is tasked with tackling their own quality problems with all the
support that they need is another vital part of any lean and JIT implementation.
Setting up kaizen or quality improvement teams and using quality tools to identify
and solve problems is vital: You cannot afford delays with JIT
3. Well designed work cells though 5S: Poor layout, unclear flow, and a host of other
issues can all be cleared up by the implementation of 5S within your production.
Such clear-cut instructions and working processes ensure efficiency in the
production.
4. Pull Production: The inventory is pulled as per demand from the customer and not
pushed to create which is not ordered. The pull is implemented through KANBANS
which are signals (flags) to tell the previous process what needs to be made

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 For example, a production worker at the assembly line notices that there are only a few
engine components left in the inventory. The worker retrieves a Kanban card that is specific
to the engine components from a designated location, often a Kanban board or rack. The
worker fills out the necessary information on the Kanban card, such as the part number,
quantity needed, and location of the inventory.

The Kanban card acts as a visual signal to trigger the replenishment process. It indicates to
the materials or logistics department that more engine components need to be produced or
obtained from the supplier. Upon seeing the Kanban card, the materials or logistics
department retrieves the bin, acknowledges the request, and replenishes the engine
components to the specified quantity.

For some time now KABAN Cards are replaced by electronic systems due to technological
advancements that have taken place in the economy worldwide.

Toyota has formulated six rules for the application of kanban-

1. Each process issues requests (kanban) to its suppliers when it consumes its
supplies. When a Kanban card is received or encountered, it triggers the necessary
action for material replenishment, production, or movement.

2. Each process produces according to the quantity and sequence of incoming

requests. This rule ensures that production is aligned with demand and avoids
excessive stock levels.

3. No items are made or transported without a request. This helps prevent

overproduction and waste.

4. The request associated with an item is always attached to it. It ensures that
production is based on actual demand, with items produced or replenished only
when there is a Kanban signal.

5. Processes must not send out defective items, to ensure that the finished products
will be defect-free. This includes identifying and addressing bottlenecks, reducing
waste, improving quality, and striving for overall process optimization.

6. Higher number of pending requests makes the process more sensitive and reveals
inefficiencies (limited Kaban cards shall be active at one instance).

Meeting TAKT Time :

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 Takt time is the rate at which a finished product needs to be completed in order to meet
customer demand

By aligning production with takt time, organizations can achieve a steady and efficient
production flow, optimize resources, and meet customer expectations without unnecessary
waste or delays. It serves as a key performance indicator for planning production activities,
establishing work cycles, and managing capacity in a lean and demand-driven manner.

This must be met otherwise there will be delays. This is implemented using hejiunkna.

Hejiunkna: It deals in leveling the volume and type of Production

Example of leveling the volume- say a hat producer receives orders for 500 of the same hat
per week: 200 orders on Monday, 100 on Tuesday, 50 on Wednesday, 100 on Thursday, and
50 on Friday.

If he does not use Heijunkna then he will work more on Monday and less Wednesday and
so on. On Mondays, workers spend overtime to meet the spike in demand and so
businesses incur additional costs. On Wednesdays and Fridays when demand is low,
workers would have idle time.

Instead of trying to meet demand in sequence of the orders, the hat producer would
use heijunka to level demand by producing an inventory of 100 hats near shipping to fulfill
Monday’s orders. Every Monday, 100 hats will be in inventory

Now, if we want to level the type of production we use heijunkna box after some brain
storming of the requirements that the production process needs. It looks something like
this-

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 Each square on the board represents a kanban to signal production of one product at
mentioned quantity. Leveling the type and volume of production will help in meeting the
TAKT time.

Heijunkna helps us achieve:-

Predictability: Heijunka aims to balance production by smoothing out variations in demand.

This helps organizations predict and plan their production capacity more accurately, leading
to reliable delivery times and consistent customer satisfaction.

Flexibility: By implementing Heijunka, organizations can respond more effectively to

changes in customer demand or market conditions. The leveled production schedule allows
for easier adjustment and allocation of resources, making it easier to accommodate
fluctuations in product mix and volume.

Stability: Heijunka promotes stability in production processes by reducing waste and

variability. It helps eliminate overproduction, uneven workloads, and unnecessary
inventory. By maintaining a steady and balanced production flow, Heijunka minimizes
disruptions and bottlenecks, resulting in smoother operations and increased overall
stability.

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 3.5.3 Cellular Manufacturing

Cellular Manufacturing is based on principle of group technology which was invented by

Flanders in 1925.

The principle of group technology is to divide the manufacturing facility into

small groups or cells of machines. This division into small cells of machines is called Cellular
manufacturing.

In cellular manufacturing, equipment and workstations are arranged in a U-shape sequence

that supports a smooth flow of materials and components through the process, with
minimal transport or delay.

Overall, cellular manufacturing focuses on creating small, self-contained units that optimize
flow, minimize waste, and increase flexibility. In contrast, batch production revolves around
processing products in larger batches, which may result in longer lead times and less
flexibility.

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 An organization must often replace large, high volume production machines with small,
flexible, "right-sized" machines to fit well in the cell because the batch size is small.

It helps to shift to another product type within short time without wastage of time in
equipment change over or in setting up machines. Single-minute exchange of die (SMED)
enables an organization to quickly convert a machine or process to produce a different
product type.

Each worker is expected to have mastered a full range of operating skills required by his or
her/his cell. Therefore, systematic job rotation and training are necessary conditions for
effective cell development because this worker needs to train in a way that job rotation
could be possible.

4M in Cellular Manufacturing

1. Man : Operators are cross‐trained on various machines in the cell

2. Material: Material flow in the cell is streamlined to minimize travel distance
3. Machine: The layout of the cell arranges equipment to be immediately adjacent,
permitting smooth material flow
4. Method: Method associated eliminates waste. The most apparent waste
is defective parts which can be caught early

3.6 JIDOKA
Jidoka was also invented as part of TPS at Toyota. It is the process of providing machines
and operators the ability to detect when an abnormal condition has occurred and
immediately stop work.

Jidoka highlights the causes of problems because work stops immediately when a problem
first occurs. This leads to improvements in the processes that build in quality by eliminating
the root causes of defects.

Jidoka sometimes is called autonomation, meaning automation with human intelligence.

This is because it gives equipment the ability to distinguish good parts from bad
autonomously, without being monitored by an operator.

3.6.1 Principles of Jidoka

The principle of Jidoka can be broken down into a few simple steps;
1. Discover an abnormality
2. STOP
3. Fix the immediate problem
4. Investigate and correct root cause
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 3.6.2 How can you implement Jidoka
Line Stop: Every individual in a lean company such as Toyota has the authority, in fact the
requirement to stop the process should they discover an abnormality. For this purpose,
workers are empowered to find such errors or defects so that they could be paid due
attention.

Some people fear that this would lead loss of productivity but in real sense through jidoka
we don’t just stop the process, we highlight the problem, correct it and then tackle root
cause to prevent the problem ever happening again.

Poka-Yoke: A poka-yoke device is one that prevents incorrect parts from being made or
assembled, or easily identifies a flaw or error. It is also known as Mistake Proofing. For
example: if a three pin plug is being produced then a poka-yoke to test if it fits or not should
be used at the end of the produce to test if it fits well or not.

Andon: Andon is a Japanese term meaning “light” or “lamp.” In Lean manufacturing, an

andon refers to a tool that is used to inform and alarm workers of problems within their
production process

Autonomation: Automatic ability to detect defect by the machine without any human
intervention

3.7 What is Back Flush Accounting

Backflush accounting is a manufacturing accounting system where the costing of a product
and the inventory consumed is calculated at the point of completion of the manufacturing
process. Backflush accounting is a simplified cost accounting method that eliminates the
need for recording individual transactions or costs at each step of the production process.

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 Instead, it waits until the completion of a production run or the sale of finished goods to
record the associated costs.

In backflush accounting, the cost of production is "flushed" or directly allocated to the

finished goods inventory or cost of goods sold without explicitly tracking the costs of
individual components or intermediate stages of production. It relies on predetermined
standard costs or standard labor and material usage to calculate the cost of the finished
goods. This method is often used in settings with high-volume repetitive manufacturing
processes.

This approach has the advantage of avoiding all manual assignments of costs to products
during the various production stages, thereby eliminating many transactions and the
associated labor.

4 Six Sigma
Six Sigma (6σ) is a set of techniques and tools for process improvement.

Engineer Bill Smith introduced Six Sigma while working at Motorola in. Six Sigma became
well known after Jack Welch made it a focus of his business strategy at General Electric in,
and today it is widely used in many sectors of industry.

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 It is quality improvement technique whose objective to eliminate defects in any aspect
that affects customer satisfaction. The premise of Six Sigma is that by measuring defects in
a process, a company can develop ways to eliminate them and practically achieve "zero
defects".

The benchmark set by six sigma is 99.99966% of the Products are defect free or 3.4
defects per million.

4.1 Doctrine of Six Sigma

1. Continuous efforts to achieve stable and predictable results through decrease of defects
and errors in a timely manner and also learning from such errors.

2. Manufacturing and business processes have characteristics that can be defined,

measured, analyzed, improved, and controlled (DMAIC – we will study further)

3. Commitment for Top Level Management to induce conformity and adherence to the
standards set by the organization.

4. A clear focus on achieving measurable and quantifiable financial returns.

5. Decisions based on verifiable data and statistical methods, rather than assumptions and
guesswork.

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 4.2 Difference between Six Sigma and Lean Systems

Differences:-

Lean focuses on eliminating waste, improving flow, and optimizing processes to enhance
efficiency and value delivery which shortens the cycle time. Six Sigma aims to reduce
variation and defects, using statistical analysis and structured problem-solving
methodologies which improves process capability.

Lean focuses on process improvement through waste reduction, while Six Sigma focuses on
quality improvement through defect reduction.

Similarities:-

Both Lean and Six Sigma promote a culture of continuous improvement. They encourage
organizations to continually seek opportunities for process optimization, waste reduction,
and quality enhancement. Both methodologies emphasize the importance of ongoing
monitoring, measurement, and refinement of processes.

Both Lean and Six Sigma methodologies emphasize understanding customer needs and
delivering value to customers. They strive to improve customer satisfaction by eliminating
defects, reducing waste, and enhancing overall process performance.

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 4.3 Lean Six Sigma
When the concept of lean and six sigma are combined it is termed as lean six sigma.

Lean traditionally focuses on the elimination of all kinds of waste but in the lean, there is
not much focus on limiting the number of defects. And therefore, through six sigma
combined with lean one can achieve the objective of identifying and eliminating the
defects.

Lean exposes sources of process variation and Six Sigma aims to reduce that variation
resulting in perfect scenario. So, when lean and six sigma is combined we get a perfect
combination wherein not only waste is being reduced during the production process, but
also identification of defects is done in a timely manner.

4.4 Six Sigma Methodologies

There are mainly two most important methods under Six sigma in the production process
which are DMAIC and DMADV.

4.4.1 DMAIC
Define the process improvement goals that are consistent with customer demands. For
example, if a customer complaints about slow processing of his phone, this would become
as the target to reduce such delays.
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 Measure the current process and collect relevant data for future comparison. For example-
measuring how much time is taken to open a particular application in that phone which was
processing slow.

Analyze the problem which needs to be addressed. For example- finding out the cause for
the slow processing and why these certain apps are not able to be opened in a timely
manner.

Improve or optimize the process based upon the analysis using techniques like Design of
Experiments. For example, updating such apps which are causing the delay.

Control-to ensure that any variances are corrected before they result in defects. For
example, tracking such apps in future so that the same delay does not occur again.

This is used for projects aimed at improving an existing business process.

4.4.2 DMADV
Define design goals that are consistent with customer demands and the enterprise strategy.

Measure and identify CTQs (characteristics that are Critical To Quality)

Analyze to develop and design alternatives

Design an improved alternative, best suited per analysis in the previous step

Verify the design, set up pilot runs, implement the production process and hand it over to
the process owner(s).

Used for projects aimed at creating new product or process designs.

Six Sigma projects follow two project methodologies inspired by Deming’s Plan–Do–
Check–Act Cycle.

Both DMAIC and DMADV methodologies within Six Sigma emphasize data-driven
decision-making, continuous improvement, and the systematic problem-solving approach
advocated by the PDCA cycle. They provide a structured framework to guide Six Sigma
practitioners in achieving process improvements and meeting customer expectations.

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 4.5 Key Roles Required in Six Sigma

Executive Leadership includes CEO and other key top management team members. They
are responsible for setting up a vision for Six Sigma implementation. They set goals and
priorities, ensure alignment with strategic objectives, and champion continuous
improvement efforts.

Champions are responsible for the Six Sigma implementation across the organization in an
integrated manner. They identify improvement opportunities, select project leaders, and
provide necessary resources and support to project teams.

Master Black Belts, identified by champions, act as in-house expert coaches for the
organization on Six Sigma. They devote 100% of their time to Six Sigma. Master Black Belts
are highly experienced and skilled individuals responsible for overseeing multiple Six Sigma
projects.

Black Belts operate under Master Black Belts to apply Six Sigma methodology to specific
projects. They also devote 100% of their time to Six Sigma. Black Belts lead and manage
complex improvement projects, train Green Belts, and work closely with teams to achieve
project goals and deliver sustainable results.

Green Belts are the employees who take up Six Sigma implementation along with their
other job responsibilities, operating under the guidance of Black Belts. Green Belts work
under the guidance of Black Belts and may lead smaller-scale projects within their
functional areas.
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 Yellow Belts, for employees that have basic training in Six Sigma tools and generally
participate in projects. They collaborate with the project team, provide insights and data,
and help validate improvement ideas. SMEs contribute their subject matter knowledge to
ensure effective problem-solving and implementation.

4.6 Six Sigma and Standard Deviation

Now we need to understand why six sigma is known as “six” sigma. We can understand it
with the help of above diagram where each purple line from the centre to the respective
end indicated the deviations that occur, and as we can see these deviations are six in
number. Organizations operate within the Six sigma as it is considered as a standard
amount of deviation as compared to, let’s say, one or two sigma because it is very less and
is practically impossible for such organization to operate within this narrow window.

The more number of standard deviations between process average and acceptable
process limits fits, the less likely that the process performs beyond the acceptable process
limits. The industry has accepted Six sigma as a level which is attainable and beneficial.

5 Business Process Re-engineering

Its main two objectives are-
• Focuses on the analysis and design of workflows and business processes within an
organization.
• The whole process in reinvented rather than sub-process

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 This is opposite from Kaizen, because Kaizen emphasizes continuous incremental
improvements in small steps. It involves making small changes and adjustments to existing
processes, with a focus on optimizing efficiency, eliminating waste, and improving quality.
Business process re-engineering, on the other hand, involves a radical and fundamental
redesign of processes. It aims to achieve significant improvements by rethinking and
reengineering the entire process from scratch.

Aims for this concept are:

1. Improve customer service
2. Cut operational costs
3. Become world-class competitors
4. Reduce time to market
5. Increase productivity
6. Improve quality and Customer Satisfaction
The founder of the Business Process Reengineering concept is Michael Hammer. He was of
the view that “Don’t Automate, Obliterate” because according to him the major challenge
for managers is to obliterate forms of work and reinvent the various business processes in a
manner that would suit the current environment and do not add value, rather than using
technology for automating it. Therefore, he emphasized that first priority should be given
to reinvent rather than automating.

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 Six Pillars of BPR

Business Process Reengineering (BPR) is a management approach aimed at transforming

and improving processes within an organization. The six pillars of BPR provide a framework
for successful process redesign. By focusing on these six pillars, organizations can effectively
plan, execute, and sustain the transformational changes brought about by Business Process
Reengineering.

Factors Important for Success of BPR

1. Business needs analysis : Needs should be analyzed Properly in relation with what
customer wants.
2. Organization wide commitment : Commitment from all the stakeholder is necessary
3. BPR team composition: The right team composition with talented people
4. Adequate IT infrastructure: Proper IT Infra and Support to drive the change
5. Effective change management: Change is always opposed, it needs to be smoothly
integrated into the company
6. Ongoing continuous improvement

Principles of BPR
1. Organize around outcomes, not tasks because it may so happen that certain tasks
are not required for a particular outcome to take place and therefore focusing on
tasks rather than an outcome would be a mistake.
2. Information processing should be included in the work, by the entity which produces
the information.

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 3. Geographically dispersed resources should be treated, as if they are centralized to
organize them properly.
4. Parallel activities should be linked because they also have some linkages.
5. Doers should be allowed to be self-managing, there is no need to micro-manage the
people who are experts in their particular processes.
6. Information should be captured once at source because if this is not done it might
lead to unauthentic information or simply a rumor that has not been validated or
derived from the correct source.
7. Process must have clear cut ownership so that the responsibility and accountability
could be established properly.

The concept of BPR has pioneered in implementing the concept of BPR, along with various
other companies like IBM, Walmart, Sony, Citibank, etc.

Difference between BPR and Lean

Lean, which involves small, incremental steps towards gradual improvement, re-
engineering involves a giant leap

It has been described as taking a blank piece of paper and starting from scratch to redesign
a business process. Rather than searching continually for minute improvement,
reengineering involves a radical shift in thinking. Re-engineering involves high risk and big
rewards whereas lean involves less risk and less rewards in a specific period.

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 Previous Year Questions (PYQs)
on
Lean System and Innovation

Introductory Note

This document contains following 3 sections –

Section A – Under this section, you will find the exact previous year questions which were asked in SEBI
and PFRDA. This section will enable you to test your knowledge based on different concepts and for
your comfort, we have segregated the questions according to the different examinations. The questions
have been arranged in the following manner

1. SEBI Grade A - Here, you will find all the previous year questions, which were asked in the
Phase 1 and Phase 2 of SEBI Grade A exam, starting from 2020 onwards
2. PFRDA Grade A – Here, you will find all the previous year questions, which were asked in
phase 1 and Phase 2 of PFRDA Grade A exam, starting from 2021 onwards

If there is no question in this document on any exam for a particular year or years, it means no
question was asked for that exam in that year(s) or exam itself was not conducted in that year.

Section B - In this section, you will find the answer key for all the questions, and it will enable you to
check your marks and understand your performance accordingly.

Section C – This section contains a detailed explanation to every question, and herein you will be able
to understand the concept in the best holistic manner as possible.

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 Section A

Questions asked in Phase 1 and Phase 2 from SEBI Grade A exam, starting from 2020 onwards

Question 1 – JIT is used in __________. SEBI Grade A – Phase 1 - 2020

A. Scheduling
B. Marketing
C. Inventory Management
D. Overheads Treatment
E. None of the above

Question 2 – MRP II is a type of __________. SEBI Grade A – Phase 2 - 2020

A. Production Design Technique

B. Selling and Distribution Development Technique
C. Price Reduction Technique
D. Efficient Marketing Technique
E. None of the above

Question 3 – Which of the following is aimed at eliminating waste and increasing efficiency? SEBI Grade A –
Phase 2 - 2020

A. Six Sigma
B. Kaizen
C. Business Process Re-engineering
D. Both B and C
E. None of the above

Question 4 – Which of the following is not a part of the 5S? SEBI Grade A – Phase 1 - 2022

A. Seiton
B. Seiri
C. Shitsuke
D. Seiso
E. Support

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Question 5 – Change for better and continuous improvement is termed as ______________? SEBI Grade A –
Phase 1 - 2022

A. Kaizen
B. GenchiGembutsu
C. Poka Yoke
D. Muda
E. None of the above

Question 6– Which of the following is not part of Lean system? SEBI Grade A – Phase 1 - 2022

A. Continuous Improvement
B. It is based on Push System
C. Identify Value
D. Value Stream Mapping
E. None of the above

Question 7– TPM does not include which of the following component? SEBI Grade A – Phase 1 - 2022

A. Preventive Maintenance
B. Breakdown Maintenance
C. Predictive Maintenance
D. Maintenance Prevention
E. None of the above

Question 8– Which of the following statement is incorrect regarding KANBAN? SEBI Grade A – Phase 1 - 2022

A. Kanban card is a visual representation of a work item, tasks and its status
B. Kanban cards helps in tracking the progress from moment of ‘to do’ to ‘done’
C. Number of Kanban cards in progress are increased over time
D. Kanban card Reduce the need for actual meetings
E. None of the above

Question 9– Which of the following is not correct with respect to DMAIC? SEBI Grade A – Phase 1 - 2022

A. Measure
B. Analyze
C. Improve
D. Correct
E. Define

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Question 10– Which of the following is not a feature of cellular manufacturing system? SEBI Grade A – Phase 2
- 2022

A. Cellular manufacturing brings scattered processes together to form short, focused paths in concentrated
physical space.
B. Cellular manufacturing facilitates both production and quality control.
C. Cellular manufacturing increases waste
D. Cellular manufacturing involves the use of multiple "cells" in an assembly line fashion.
E. None of the above

Questions asked in Phase 1 and Phase 2 from PFRDA Grade A exam, starting from 2021 onwards

Question 1 – Which of the following is not a principle of Kaizen Costing? PFRDA Grade A – Phase 2 - 2021

A. Continuous Improvement
B. Advocates Collective Decision Making
C. All unskilled employees
D. Concentrates on waste elimination
E. None of the above

Question 2 - The 5S methodology has gained importance throughout the years and is now one of the basic
foundational elements of Lean, along with other Lean processes and practices. In the same regard, which of the
following is not the component of 5S methodology. PFRDA Grade A – Phase 1 - 2022

A. Seiri - Sort
B. Seiton – Set in Order
C. Seiso – Shine
D. Seiketsu - Standardize
E. Shitsuke – Sincerity

Question 3 - Lean manufacturing is a production method aimed primarily at reducing times within the
production system as well as response times from suppliers and to customers. In the same regard, which of the
following statement is incorrect regarding lean system? PFRDA Grade A – Phase 1 - 2022

A. Lean manufacturing is a production method aimed primarily at reducing times within the production system
as well as response times from suppliers and to customers
B. Lean manufacturing is a production process based on an ideology of maximizing productivity while
simultaneously minimizing waste within a manufacturing operation

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C. The lean principle sees waste is anything that doesn’t add value that the customers are willing to pay for.
D. Lean System follows push system mechanism
E. None of the above

Question 4 - DMADV is a Six Sigma framework that is focuses primarily on the development of a new product
and service. In the same regard, which of the following component is not the part of DMADV acronym . PFRDA
Grade A – Phase 1 - 2022

A. Measure
B. Define
C. Diagnose
D. Verify
E. Analyze

Question 5 - SIPOC is a tool that summarizes the inputs and outputs of one or more processes in table form. It
is used to define a business process from beginning to end before work begins. What does SIPOC stands for ?
PFRDA Grade A – Phase 1 - 2022

A. Supplier, Input, Product, Output and Customer

B. Services, Input, Process, Output and Customer
C. Supplier, Input, Process, Outcast and Customer
D. Supplier, Input, Process, Output and Customer
E. Supplier, Input, Process, Output and Campus

Question 6 - In the field of costing management, which of the following is a wastage controlling technique
means continuous improvement? PFRDA Grade A – Phase 1 - 2022

A. Six Sigma
B. Total Productivity Management (TPM)
C. Kaizen
D. Just-In-Time
E. None of the above

Question 7 - Total Productive Maintenance (TPM) started as a method of physical asset management focused
on maintaining and improving manufacturing machinery, in order to reduce the operating cost to an
organization. In the same regard, which of the following is the main objective of TPM? PFRDA Grade A – Phase
2 - 2022

A. Safer Working Environment

B. Zero defects, Zero Breakdowns, Zero Accidents
C. Early Management of New Equipment
D. Education & Training of employees

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E. None of the above

Section B

Answer Key

SEBI Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option A
Question 3 Option B
Question 4 Option E
Question 5 Option A
Question 6 Option B
Question 7 Option B
Question 8 Option C
Question 9 Option D
Question 10 Option C

PFRDA Grade A questions

Question Number Answer

Question 1 Option C
Question 2 Option E
Question 3 Option D
Question 4 Option C
Question 5 Option D
Question 6 Option C
Question 7 Option B

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 Section C

Explanation
SEBI Grade A questions

Question 1 – JIT is used in __________. SEBI Grade A – Phase 1 - 2020

A. Scheduling
B. Marketing
C. Inventory Management
D. Overheads Treatment
E. None of the above

Answer – Option C

Explanation –
• The just-in-time (JIT) inventory system is a management strategy that aligns raw-material orders from
suppliers directly with production schedules.
• Companies employ this inventory strategy to increase efficiency and decrease waste by receiving goods
only as they need them for the production process, which reduces inventory costs.
• This method requires producers to forecast demand accurately.
Hence, Option C is the correct answer. All other options are incorrect.

Question 2 – MRP II is a type of __________. SEBI Grade A – Phase 2 - 2020

A. Production Design Technique

B. Selling and Distribution Development Technique
C. Price Reduction Technique
D. Efficient Marketing Technique
E. None of the above

Answer – Option A

Explanation –
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 • Manufacturing Resource Planning (MRP II) is a computer-based system that can create detailed
production schedules using real-time data to coordinate the arrival of component materials with
machine and labor availability. MRP II is used widely by itself, but it's also used as a module of more
extensive enterprise resource planning (ERP) systems.
• MRP II is an extension of the original materials requirements planning (MRP I) system. Materials
requirements planning (MRP) is one of the first software-based integrated information systems designed
to improve productivity for businesses.
• A materials requirement planning information system is a sales forecast-based system used to schedule
raw material deliveries and quantities, given assumptions of machine and labor units required to fulfill
a sales forecast.
Hence, Option A is the correct answer. All other options are incorrect.

Question 3 – Which of the following is aimed at eliminating waste and increasing efficiency? SEBI Grade A –
Phase 2 - 2020

A. Six Sigma
B. Kaizen
C. Business Process Re-engineering
D. Both B and C
E. None of the above

Answer – Option B

Explanation –

• Kaizen is aimed at decreasing waste by eliminating overproduction, improving quality, being more
efficient, having less idle time, and reducing unnecessary activities. All these translate to money
savings and turn potential losses into profits. Hence, Option B is the correct answer.

All other options are incorrect.

Additional Information:

• Six Sigma: It is a set of management tools and techniques designed to improve the capability of the
business process by reducing the likelihood of error. Hence, Option A is incorrect.
• Business Proces Re-engineering: It involves the radical redesign of core business processes to achieve
dramatic improvements in productivity, cycle times and quality. Hence, Option C is incorrect.

Question 4 – Which of the following is not a part of the 5S? SEBI Grade A – Phase 1 - 2022

A. Seiton
B. Seiri

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C. Shitsuke
D. Seiso
E. Support

Answer – Option E

Explanation –

• 5S is the name of a workplace organization method that uses a list of five Japanese words: seiri, seiton,
seiso, seiketsu, and shitsuke. It explains how a workspace should be organized for efficiency and
effectiveness by identifying and storing the items used, maintaining the area and items, and sustaining
the new order.
The 5S’s are as follows:

1. Seiri: Make work easier by eliminating obstacles and evaluate necessary items with regard to cost or
other factors. Hence, Option B is a part of 5S.

2. Seiton: Arrange all necessary items into their most efficient and accessible arrangements so that they
can be easily selected for use and make workflow smooth and easy. Hence, Option A is a part of 5S.

3. Seiso: Clean your workplace, keep workplace safe, easy to work. Hence, Option D is a part of 5S.

4. Seiketsu: Standardize the best practices in the work area, every process has a standard.

5. Shitsuke: Sustain (i.e., training for continuous implementation). It makes the habit of keeping things in
an orderly and neat way. This should be done by giving proper training and with every individual’s
commitment. Hence, Option C is a part of 5S.

Support is not a part of 5S. Hence, Option E is the correct answer.

All other options are incorrect.

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Question 5 – Change for better and continuous improvement is termed as ______________? SEBI Grade A –
Phase 1 - 2022

A. Kaizen
B. GenchiGembutsu
C. Poka Yoke
D. Muda
E. None of the above

Answer – Option A

Explanation –

• Kaizen is a Japanese term meaning "change for the better" or "continuous improvement." Hence,
Option A is the correct answer.
• It is a Japanese business philosophy regarding the processes that continuously improve oper ations and
involve all employees.
• Kaizen sees improvement in productivity as a gradual and methodical process.

All other options are incorrect.

Additional Information:

• Genchi Genbutsu is the Japanese principle of going to and directly observing a location and its
conditions in order to understand and solve any problems faster and more effectively. The phrase
literally translated means “go and see for yourself” and is a part of the Toyota Way philosophy. Hence,
Option B is incorrect.
• Poka-Yoke is any mechanism in a Lean manufacturing process that helps to avoid mistakes. Its purpose
is to eliminate product defects by preventing, correcting, or drawing attention to human errors as they
occur. Hence, Option C is incorrect.
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 • Muda in lean management is any activity that doesn't add value to the business. Hence, Option D is
incorrect.

Question 6– Which of the following is not part of Lean system? SEBI Grade A – Phase 1 - 2022

A. Continuous Improvement
B. It is based on Push System
C. Identify Value
D. Value Stream Mapping
E. None of the above

Answer – Option B

Explanation –

In this question, Principles of Lean Manufacturing have been discussed.

• Identify Value:
1. A company needs to add value defined by its customers' needs.
2. The value lies in the problem you are trying to solve for the customer for your customer is actively
willing to pay
3. Any other activity or process that doesn't bring value to the end product is considered waste.
• Value Stream Mapping:
It must include all actions and people involved in the process of delivering the end product to the
customer. By doing so, you will be able to identify what parts of the process bring no value.
• Create Flow:

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 Developing a product/service will often include a cross-functional teamwork. Bottlenecks and
interruptions may appear at any time.
However, by breaking up work into smaller batches and visualizing the workflow, you will be able to
easily detect and remove process roadblocks.
• Create a Pull System:
In such a system the work is pulled only if there is a demand for it. This lets you optimize resources
capacity and deliver products/services only if there is an actual need. Unnecessary Production when
there is no demand on the market will lead to losses.
• Continuous Improvement (Perfection):
Problems may occur at any of the previous steps. Therefore, you need to make sure that employees on
every level are involved in continuously improving the process.

From the above, we can easily conclude that Lean is based on Pull System and not Push. Therefore, Answer is
Option B.
All other options are incorrect.

Question 7– TPM does not include which of the following component? SEBI Grade A – Phase 1 - 2022

A. Preventive Maintenance
B. Breakdown Maintenance
C. Predictive Maintenance
D. Maintenance Prevention
E. None of the above

Answer – Option B

Explanation –

• Breakdown maintenance is maintenance performed on equipment that has broken down and is
unusable.
• TPM is a lean manufacturing philosophy that centres on achieving near-perfect production.
• The aims of TPM are high: no breakdowns, no small stops or slow running, no defects, and no
accidents.
• It emphasizes proactive and preventative maintenance and not the Breakdown maintenance to
maximize the lifespan and productivity of equipment. Hence, Option B is the correct answer.

All other options are incorrect.

Question 8– Which of the following statement is incorrect regarding KANBAN? SEBI Grade A – Phase 1 - 2022

A. Kanban card is a visual representation of a work item, tasks and its status

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B. Kanban cards helps in tracking the progress from moment of ‘to do’ to ‘done’
C. Number of Kanban cards in progress are increased over time
D. Kanban card Reduce the need for actual meetings
E. None of the above

Answer – Option C

Explanation –

• A Kanban card is a visual representation of a work item. Translated from Japanese, it literally means a
visual (kan) card (ban).
• It is a core element of the Kanban system as it represents work that has been requested or is already in
progress.
• One of Kanban's primary functions is to ensure a manageable number of active items are in progress at
any one time.
• If there are no work-in-progress limits, you are not doing Kanban. Number of Kanban Cards in progress
is limited as Kanban cards facilitate just-in-time delivery. Hence, Option C is incorrect and is the correct
answer.

Question 9– Which of the following is not correct with respect to DMAIC? SEBI Grade A – Phase 1 - 2022

A. Measure
B. Analyze
C. Improve
D. Correct
E. Define

Answer – Option D

Explanation –
• DMAIC refers to a data -driven quality strategy for improving processes and is an integral part of the
company’s Six Sigma Quality Initiative.
• DMAIC is an acronym for five interconnected phases: Define, Measure, Analyze, Improve, and
Control.
• Hence, Option D is incorrect and is the correct answer.

Additional Information:

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Question 10– Which of the following is not a feature of cellular manufacturing system? SEBI Grade A – Phase 2
- 2022

A. Cellular manufacturing brings scattered processes together to form short, focused paths in concentrated
physical space.
B. Cellular manufacturing facilitates both production and quality control.
C. Cellular manufacturing increases waste
D. Cellular manufacturing involves the use of multiple "cells" in an assembly line fashion.
E. None of the above
Answer – Option C
Explanation –

Cellular manufacturing helps reduce waste by reducing defects that result from processing and product
changeovers. Since products or components move through a cell one piece at a time, operators can quickly
identify and address defects. Hence, Option C is the correct answer.

Explanation
PFRDA Grade A questions

Question 1 – Which of the following is not a principle of Kaizen Costing? PFRDA Grade A – Phase 2 - 2021

A. Continuous Improvement
B. Advocates Collective Decision Making
C. All unskilled employees
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D. Concentrates on waste elimination
E. None of the above

Answer – Option C
Explanation –

Kaizen Costing Principles:

i. Continuous improvements in the present situation, at an agreeable cost. Hence, Option A is correct
principle.
ii. No limits to the improvement level that has to be implemented.
iii. Advocates collective decision-making and knowledge application. Hence, Option B is correct
principle.
iv. Concentrates on waste or loss elimination, system and productivity improvement. Hence, Option D is
correct principle.
v. Establishing standards and then continually working on improving them.
vi. Participating all employees and covering every business area, i.e., all the levels, departments and units.

Option C is not a principle of Kaizen Costing. Hence, Option C is incorrect and is the correct answer.

Question 2 - The 5S methodology has gained importance throughout the years and is now one of the basic
foundational elements of Lean, along with other Lean processes and practices. In the same regard, which of the
following is not the component of 5S methodology. PFRDA Grade A – Phase 1 - 2022

A. Seiri - Sort
B. Seiton – Set in Order
C. Seiso – Shine
D. Seiketsu - Standardize
E. Shitsuke – Sincerity

Answer – Option E

Explanation –

5S is a system to reduce waste and optimize productivity through maintaining an orderly workplace and using
visual cues to achieve more consistent operational results.

The 5S pillars, Sort (Seiri), Set in Order (Seiton), Shine (Seiso), Standardize (Seiketsu), and Sustain (Shitsuke),
provide a methodology for organizing, cleaning, developing, and sustaining a productive work environment.
In the daily work of a company, routines that maintain organization and orderliness ar e essential to a smooth
and efficient flow of activities.

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This lean method encourages workers to improve their working conditions and helps them to learn to reduce
waste, unplanned downtime, and in-process inventory.

Hence the correct answer will be option E

Question 3 - Lean manufacturing is a production method aimed primarily at reducing times within the
production system as well as response times from suppliers and to customers. In the same regard, which of the
following statement is incorrect regarding lean system? PFRDA Grade A – Phase 1 - 2022

A. Lean manufacturing is a production method aimed primarily at reducing times within the production system
as well as response times from suppliers and to customers
B. Lean manufacturing is a production process based on an ideology of maximizing productivity while
simultaneously minimizing waste within a manufacturing operation
C. The lean principle sees waste is anything that doesn’t add value that the customers are willing to pay for.
D. Lean System follows push system mechanism
E. None of the above

Answer – Option D

Explanation –

Lean manufacturing is a production process based on an ideology of maximizing productivity while

simultaneously minimizing waste within a manufacturing operation. The lean principle sees waste is anything
that doesn’t add value that the customers are willing to pay for.

Lean manufacturing is a production method aimed primarily at reducing times within the production system as
well as response times from suppliers and to customers and The lean principle sees waste is anything that
doesn’t add value that the customers are willing to pay for. Hence, statement A and C are correct.

The benefits of lean manufacturing include reduced lead times and operating costs and improved product
quality.

Lean Manufacturing follows some principles which are discussed as below

1. Identify Value: A company needs to add value defined by its customers’ needs. The value lies in the problem
you are trying to solve for the customer for your customer is actively willing to pay. Lean manufacturing is a
production process based on an ideology of maximizing productivity while simultaneously minimizing waste
within a manufacturing operation. Hence, statement B is correct.

2. Value Stream Mapping: It must include all actions and people involved in the process of delivering the end
product to the customer. By doing so, you will be able to identify what parts of the process bring no value

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3. Create Flow: Developing a product/service will often include a cross-functional teamwork. Bottlenecks and
interruptions may appear at any time. However, by breaking up work into smaller batches and visualizing
the workflow, you will able to easily detect and remove process roadblocks.

4. Create a Pull System: In such a system the work is pulled only if there is a demand for it. This lets you
optimize resources’ capacity and deliver products/services only if there is an actual need. Unnecessary
Production when there is no demand on the market will lead to losses. Therefore statement D is incorrect.

5. Continuous Improvement (Perfection): Problems may occur at any of the previous steps. Therefore, you
need to make sure that employees on every level are involved in continuously improving the process.

Hence the correct answer will be option D.

Question 4 - DMADV is a Six Sigma framework that is focuses primarily on the development of a new product
and service. In the same regard, which of the following component is not the part of DMADV acronym . PFRDA
Grade A – Phase 1 - 2022

A. Measure
B. Define
C. Diagnose
D. Verify
E. Analyze

Answer – Option C

Explanation –

Six Sigma is a method that provides organizations tools to improve the capability of their business proc esses.
This increase in performance and decrease in process variation helps lead to defect reduction and
improvement in profits, employee morale, and quality of products or services.

There are various mythologies of the Six Sigma, one among them is DMADV.

DMADV is Used for projects aimed at creating new product or process designs. DMADV can be understood in
the following manner

1. Define- Design goals that are consistent with customer demands and the enterprise strategy.
2. Measure - Measure and identify CTQs (characteristics that are Critical To Quality)
3. Analyze - Analyze to develop and design alternatives
4. Design - Design an improved alternative, best suited per analysis in the previous step

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5. Verify - Verify the design, set up pilot runs, implement the production process and hand it over to the
process owner(s).

Hence the correct answer will be option C

Question 5 - SIPOC is a tool that summarizes the inputs and outputs of one or more processes in table form. It
is used to define a business process from beginning to end before work begins. What does SIPOC stands for ?
PFRDA Grade A – Phase 1 - 2022

A. Supplier, Input, Product, Output and Customer

B. Services, Input, Process, Output and Customer
C. Supplier, Input, Process, Outcast and Customer
D. Supplier, Input, Process, Output and Customer
E. Supplier, Input, Process, Output and Campus

Answer – Option D

Explanation –

SIPOC is an acronym that stands for Suppliers, Inputs, Process, Outputs and Customers. In practical terms,
SIPOC is a process mapping and improvement method that summarizes the inputs and outputs of one or more
processes.

The inputs and outputs of the process might be materials, services or information. The focus is on capturing
the set of inputs or outputs rather than the individual steps of the process.

1. Suppliers: Providers of inputs into a process.

2. Inputs: Resources, such as materials, needed to complete the process.
3. Process: Steps that convert inputs to outputs.
4. Outputs: Product or service created from the process.
5. Customers: Recipients of outputs.

Question 6 - In the field of costing management, which of the following is a wastage controlling technique
means continuous improvement? PFRDA Grade A – Phase 1 - 2022

A. Six Sigma
B. Total Productivity Management (TPM)
C. Kaizen
D. Just-In-Time
E. None of the above

Answer – Option C

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Explanation –

Kaizen is an approach to creating continuous improvement based on the idea that small, ongoing positive
changes can reap significant improvements.

Typically, it is based on cooperation and commitment and stands in contrast to approaches that use radical or
top-down changes to achieve transformation. Kaizen is core to lean manufacturing and the Toyota Way.

It was developed in the manufacturing sector to lower defects, eliminate waste, boost productivity, encourage
worker purpose and accountability and promote innovation

Question 7 - Total Productive Maintenance (TPM) started as a method of physical asset management focused
on maintaining and improving manufacturing machinery, in order to reduce the operating cost to an
organization. In the same regard, which of the following is the main objective of TPM? PFRDA Grade A – Phase
2 - 2022

A. Safer Working Environment

B. Zero defects, Zero Breakdowns, Zero Accidents
C. Early Management of New Equipment
D. Education & Training of employees
E. None of the above

Answer – Option B

Explanation –

Total Productive Maintenance (TPM) is a systematic approach to eliminate waste associated with production
equipment and machinery.

TPM focuses on involving machine operator in the routine checks and cleaning of the machine to detect
problems earlier.

Other areas of emphasis include minimizing machine "downtime" resulting from unexpected breakdowns, fully
utilizing a machine's capabilities, and tracking life cycle cost.

TPM has three main goals: zero unplanned failures, zero product defects, and zero accidents.

With the adoption of TPM, enterprise can benefit from the following aspects:

• Involve machine operators in basic daily maintenance tasks

• Earlier detection of factors critical to maintaining equipment "uptime"
• Attacks the manufacturing equipment losses of breakdowns, set-ups, adjustments, reduced speed, scrap
and rework.

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• Measure impact of defects, sub-optimal performance, and downtime using OEE (Overall Equipment
Effectiveness)
• Reduce capital expenditure through equipment refurbishment and capacity improvements

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