402 Bco 21 C&M Accounting
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bhvm215COST AND MANAGEMENT ACCOUNTING
Second Year : B.Com.
SEMESTER – IV
Lesson Writers
Dr. K. Kanaka Durga, Dr. Ch. Suravinda
M.Com., M. Phil., Ph.D. M.Com., Ph.D.
Reader in Commerce, Reader in Commerce,
H.O.D, Dept. of Commerce, Hindu College, Guntur.
Hindu College, Guntur.
Smt. Ch. Neela Krishnaveni Smt. P.Usha Rani
M.Com., M.Phil. M.Com., M.Phil.
Lecturer in Commerce Senior Lecturer in Commerce,
Hindu College, Guntur. Hindu College, Guntur.
Editor &Academic Co-ordinator
Prof. G.N. Brahmanandam,
M.Com, Ph.D,
Dept. of Commerce and Management,
Acharya Nagarjuna University.
Director
Dr. Nagaraju Battu
MBA, MHRM, LLM, M.Sc. (Psy.), MA (Soc.), M.Ed., M.Phil. , Ph.D.
Centre for Distance Education
Achaarya Nagarjuna University
Nagarjuna Nagar 522 510
Ph : 0863 - 2346208, 2346222, 2346259 ( Study Material)
Website : www.anucde.info
e-mail : anucdedirector@gmail.com
2nd Year B.Com. Semester – IV
COST AND MANAGEMENT ACCOUNTING
First Edition : 2023
No. of Copies :
© Acharya Nagarjuna University
This book is exclusively prepared for the use of students of Three – Year, UG
Programme, Centre for Distance Education, Acharya Nagarjuna University and
this book is meant for limited circulation only.
Published by :
Dr. NAGARAJU BATTU,
Director
Centre for Distance Education,
Acharya Nagarjuna University
Printed at :
FOREWORD
Since its establishment in 1976, Acharya Nagarjuna University has been forging
ahead in the path of progress and dynamism, offering a variety of courses and research
contributions. I am extremely happy that by gaining a ‘A’ Grade from the NAAC in the year
2014, the Acharya Nagarjuna University is offering educational opportunities at the UG, PG
levels apart from research degrees to students from over 285 affiliated colleges spread over the
two districts of Guntur and Prakasam.
The University has also started the Centre for Distance Education with the aim to
bring higher education within reach of all. The centre will be a great help to those who cannot
join in colleges, those who cannot afford the exorbitant fees as regular students, and even
housewives desirous of pursuing higher studies. With the goal of bringing education in the door
step of all such people. Acharya Nagarjuna University has started offering B.A, and B, Com
courses at the Degree level and M.A, M.Com., L.L.M., courses at the PG level from the
academic year 2021-22 on the basis of Semester system.
To facilitate easier understanding by students studying through the distance mode,
these self-instruction materials have been prepared by eminent and experienced teachers. The
lessons have been drafted with great care and expertise in the stipulated time by these teachers.
Constructive ideas and scholarly suggestions are welcome from students and teachers invited
respectively. Such ideas will be incorporated for the greater efficacy of this distance mode of
education. For clarification of doubts and feedback, weekly classes and contact classes will be
arranged at the UG and PG levels respectively.
It is aim that students getting higher education through the Centre for Distance
Education should improve their qualification, have better employment opportunities and in turn
facilitate the country’s progress. It is my fond desire that in the years to come, the Centre for
Distance Education will go from strength to strength in the form of new courses and by catering
to larger number of people. My congratulations to all the Directors, Coordinators, Editors and
Lesson -writers of the Centre who have helped in these endeavours.
Prof. P.Rajasekhar
Vice –Chancellor,
Acharya Nagarjuna University
402BCO21-
MODEL QUESTION PAPER (402BCO21)
B. Com.(General / Comp. Appl.s) Degree Examination
Second Year – Fourth Semester
Part – II : Commerce
Paper – IV : COST AND MANAGEMENT ACCOUNTING
Time : Three hours Maximum Marks : 70
Section – A
Answer any FIVE of the following questions. (5 × 4 = 20 Marks)
1) Elements of cost.
వ యం అం .
2) Time and rate method.
సమయం మ పద .
3) EBQ.
EBQ.
4) Trend analysis.
ం షణ.
5) Profit volume Ratio.
భం ష .
6) Job costing.
ం .
7) Cost sheet.
.
8) Inventory control.
స యం ణ.
Section – B
Answer the following questions. (5 x 10 = 50 Marks)
9) (a) Define Cost Accounting. Briefly explain the objectives and functioning of cost
accounting.
అ ం ం ర ం , అ ం ం క ల మ ల వ ంచం .
Or
(b) Distinguish between Cost Accounting and Management Accounting.
అ ం ం మ ర హణ అ ం ం మధ వ ల యం .
10) (a) From the following details write stores ledger under simple average method.
2006 Dec 1 Opening Balance 100 kg @ Rs. 5.00
4 Received 50 kg @ Rs. 5.20
8 Issued 120 kg
10 Issued 100 kg
15 Received 80 kg @ Rs. 5.00
20 Issued 50 kg
22 Received 100 kg @ Rs. 5.00
25 Issued 40 kg
30 Issued 60 kg
ం వర ం రణ సగ పద ఆవ యం .
2006 ంబ 1 రంభ ల 100 @ Rs. 5.00
4 క ంచబ న 50 @ Rs. 5.20
8 యబ న 120
10 యబ న 100
15 క ంచబ న 80 @ Rs. 5.00
20 యబ న 50
22 క ంచబ న 100 @ Rs. 5.00
25 యబ న 40
30 యబ న 60
Or
(b) Define Labour Turnover. How is it measured? Explain it.
బ ట వ ర ం ఎ వ ంచం .
11) (a) Define job cost and batch costing. Explain difference between Job costing and batch
costing.
ం మ ం ల ర ం , మధ ఉన వ ల వ ంచం .
Or
(b) Annual demand for a component is 30,000 units. Cost of set – up per batch is 600.
Inventory carrying cost per unit per annum is Rs. 1.
(i) Calculate the total cost assuming batch size of 4,000 units, 5,000 units, 6,000
units, 7,000 units, 8,000 units, 9,000 units, and 10,000 units. Also find the
economic batch quantity.
(ii) Using mathematical formula calculate economic batch quantity.
ఒక గం సం క ం 30,000 ఒ ట ఖ . 600.
సంవత ఒక ఇ ంట ం ఖ . 1.
(i) 4,000 , 5,000 , 6,000 , 7,000 , 8,000 ,
9,000 మ 4,000 . ప ఊ ం తం
ఖ ంచం . ఆ క ప క నం .
(ii) గ త ఊప ం ఆ క ప ంచం .
12) (a) Define financial statement analysis. Explain the objectives and process of financial
statement analysis.
ఆ క కటన షణ ర ంచం . ఆ క క షణ క ల మ య
వ ంచం .
Or
(b) Briefly explain comparative analysis and common size analysis.
ల తక షణ మ రణ ప ణం షణ పం వ ంచం .
13) (a) Define marginal costing. Explain the features and importance of marginal costing.
ఉ ంత వ ర ంచం . న ం క ల మ ఖత వ ంచం .
Or
(b) From the following data, you are required to calculate
(i) P/V ratio
(ii) Break – even sales with the help of P/V ratio.
(iii) Sales required to earn a profit of Rs. 4,50,000
Fixed expenses = Rs. 90,000
Variable cost per unit
Direct material = Rs. 5
Direct labour = Rs. 2
Direct overheads = 100% of direct labour
Selling price per unit = Rs. 12
ం ం ంచవ ఉం ం
(i) P/V ష
(ii) P/V ష స యం -ఈ అమ
(iii) భం ంద అమ అవసరం . 4,50,000
రఖ = . 90,000
య ధర
య = .5
త బ = .2
ఓవ = 100% బ
యం ధర = . 12
-----------------
CONTENTS
Page No.
Unit No. Lesson No. Title of the Lesson
From To
Nature and Scope of Financial Accounting and
1 1.1 – 1.9
Cost Accounting
2 Nature and Scope of Management Accounting 2.1 – 2.9
3 Cost Accounting – Advantages – Limitations 3.1 – 3.8
Unit - 1
4 Cost Concepts – Classification – Analysis 4.1 – 4.13
5 Cost Sheet 5.1 – 5.19
6 Materials – I 6.1 – 6.20
7 Materials – II 7.1 – 7.18
Unit - 2
8 Labour Cost – Control 8.1 – 8.8
Methods of Payment of Incentives
9 9.1 – 9.21
(Labour Incentive Schemes)
Unit - 3 10 Job Costing and Batch Costing 10.1 – 10.11
11 Financial Statements 11.1 – 11.11
Unit - 4
12 Financial Statements Analysis 12. 1 – 12.22
13 Marginal Costing 13. 1 – 13.13
Unit - 5 14 Marginal Costing – CVP Analysis 14. 1 – 14.36
15 Marginal Costing – Managerial Decisions 15. 1 – 15.25
Cost and Management Accounting 1.1 Natute and Scope of Financial...
LESSON - 1
NATURE AND SCOPE OF FINANCIAL
ACCOUNTING AND COST ACCOUNTING
1.0 Objective :
The objective of this lesson is to explain Definitions of Financial Accounting and Cost Account-
ing, Nature and Scope of Cost Accounting, Difference between Financial Accounting and Cost Ac-
counting.
Structure
1.1 Introduction :
1.2 Meaning and Definition of Accounting
1.3 Meaning of Financial Accounting
1.4 Limitations of Financial Accounting
1.5 Cost Accounting - Costing - Cost Accountancy
1.6 Cost
1.7 Costing
1.8 Cost Accounting
1.9 Cost Accountancy
1.10 Scope of Cost Accountancy
1.11 Objectives of Cost Accounting
1.12 Cost Accounting Vs Financial Accounting
1.13 Differences between Financial Accounting And Cost Accounting
1.14 Self Assessment Questions
1.15 Suggested Reading
1.1 INTRODUCTION :
The accounting systems which we find today have developed with the development of institutions
of trade, commerce and industry. In earlier days the business was simple and the transactions were few.
The business men used to remember the transactions by memorising them. The advent of industrial revo-
lution resulted in large scale production in widening of markets. With the increase in business activity the
businessmen were expected to keep a track of their relationship with out siders and to make a record of
their assets and liabilities. The Technological changes have also brought a change in the field of accounting.
Accounting is now considered as a managerial tool for planning and control.
1.2 MEANING AND DEFINITION OF ACCOUNTING :
Accounting involves the collection, recording, classification and presentation of financial data for
the benefit of management and outside agencies such as shareholders, creditors, bankers and government.
According to the committee on Terminology of American Institute of Certified Public Accountants, ac-
counting is “the art of recording, classifying and summarising in a significant manner and interms of money,
transactions and events, which are in part at least, of a financial character and interpreting the results there
of ”. The transactions which are measurable in monetary terms only form a part of accounting. The record-
ing of transactions is done in such away that analysis and interpretation of business activities is possible.
Centre for Distance Education 1.2 Acharya Nagarjuna University
Smith and Ashburne describe it as “Accounting is the science of recording and classifying business
transactions and events, primarily of financial character, and the art of making significant summarises,
analysis and interpretation of those transactions and events and communicating the results to persons who
must make decisions or form judgements”. This definition emphasises financial reporting and decision -
making aspect of accounting.
The word ‘ Accounting can be classified in to three categories.
a) Financial Accounting
b) Cost Accounting; and
c) Management Accounting.
1.3 MEANING OF FINANCIAL ACCOUNTING :
Financial Accounting may be defined as the science and art of recording and classifying business
transactions and preparing summaries of the same for determing year end profit or loss and the financial
position of the concern. It is the part of accounting which is employed to communicate the financial infor-
mation of a business unit.
Financial Accounting is primarily concerned with record keeping directed towards the preparation
of Profit and Loss Account and Balance Sheet. It provides information regarding the profit and loss that
the business enterprise is making and also its financial position on a particular date. The information con-
cerning the business enterprise is helpful to management to control in a general way the major functions of
a business i.e. finance, administration production and distribution but details regarding operating efficiency
of these divisions are lacking.
1.4 LIMITATIONS OF FINANCIAL ACCOUNTING :
The following limitations of financial accounting have lead to the development of cost accounting.
1. Historical Nature : Financial accounting is historical in nature in the sense that it is a record of all
those transactions which have taken place in the business during a particular period of time. The impact of
future uncertainities has no place in financial accounting. As management needs information for future
planning, financial accounting can only give information about what has happened and not about what will
happen. It does not suggest it what should be done to increase the efficiency of the concern.
2. Provides the Information About the Concern as a Whole : Financial accounting discloses
only the net result of the collective activities of a business as a whole. It does not indicate the profit or loss
of each department, job, process or contract. It does not disclose the exact cause of inefficiency.
3. Not Helpful in Price Fixation : Financial accounting is not helpful in fixing prices of products.
Price fixation requires information about variable and fixed costs, indirect costs. Indirect expenses are
estimated on the basis of past records for price determination. The concern may be required to quote price
for the supply of goods in the near future. Financial accounting can not supply all these information. So it is
not helpful in price determination.
Cost and Management Accounting 1.3 Natute and Scope of Financial...
4) Cost Control Not Possible : Cost control is not possible in financial accounting. The cost figures are
known only at the end of a financial period. When the cost has already been incurred then nothing can be
done to control it. There is no technique in financial accounting which can help to ascertain whether the
cost is more or less while the expenses are being incurred. There is no procedure to assign responsibility
for higher costs.
5) Appraisal of Policies Not Possible : It is not possible to evaluate various policies and programmes in
financial accounting. There is no technique for comparing actual performance with budgeted targets. Whether
the work is going on as per schedule or not cannot be determined. The only criterion for determing
efficiency is to see the profits at the end of financial period. The profitability is the only yardstick for
evaluating managerial performance. Profits of an enterprise are influenced by a number of outside factors
also. So it is not a reliable test for ascertaining efficiency of the management.
6) Only Actual Costs Recorded : Financial accounting records only actual cost figures. The amount
paid for purchasing of materials, property or other assets is recorded in account books. The price of
goods and assets go on varying from time to time. The present prices of assets may be absolutely different
from the recorded costs. Financial accounts do not record price level changes. The recorded costs cannot
provide correct information or exact values of assets.
7) Not Helpful in Strategic Decisions : It does not supply useful data to management for comparison
with previous period and for taking various financial decisions as introduction of new products, replace-
ment of labour by machines, price in normal or special circumstances, producing a part in the factory or
buying it from outside products, investment to be made in new products or not etc.
8) Technical Subject : Financial Accounting is a technical subject. The recording of transactions and
making their use requires knowledge of accounting principles and conventions. A person who is not con-
versant with accounting subject has little utility of financial accounts.
9) Quantitative Information : Financial accounting records only that information which can be quantita-
tively measured. Anything which cannot be quantitatively measured will not form a part of financial ac-
counting even though it is important for business.
10) Lack of Unanimity About Accounting Principles : Accountants differ on the use of accounting
principles and procedures. The use of different accounting methods reduces the usefulness and reliability
of accounts.
11) Chances of Manipulation : There are chances of using financial accounts to suit the whims of
management. The over valuation or under valuation of inventory may change the figures of profits. More
profits may be shown to get more remuneration, issue more dividend or to raise the prices of company’s
shares. Less profits may be shown to save taxes or for not paying bonus to workers etc. The possibility of
manipulating financial accounts reduces their reliability.
12) Inadequate Information for Reports : It does not provide adequate information for reports to
outside agencies such as banks, government, insurance companies and trade associations.
13) No Analysis of Lossess : It does not provide complete analysis of losses due to defective
material, idle time, idle plant and equipment. No distinction is made between avoidable and unavoidable
wastage.
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1.5 COST ACCOUNTING :
Costing is a specialised branch of accounting. It has been developed because of limitations
of financial accounts.
Concepts of Cost, Costing, Cost Accounting and Cost Accountancy.
1.6 COST :
The term ‘Cost’ has a wide variety of meanings. Different people use this term in different
senses for different purposes. For example while buying a book we generally ask “What is the cost of
book?” Here it means the price of the book. But in management terminology, the term cost refers to
expenditure and not the price. For our purposes cost is not the same as price. The costing terminology
of the Institute of cost and works Accountants, London defines cost as “ the amount of expenditure
(actual or notional) incurred on or attributable to a given thing”. Thus, cost refers to something that must
be sacrificed to obtain a particular thing.
1.7 COSTING :
Costing is the technique and process of ascertaining costs. It consists of the principles and
rules which are used for ascertaining the costs of products and services. Costing is a systematic proce-
dure of determining the unit cost of product / service.
1.8 COST ACCOUNTING :
Cost Accounting is the classifying recording and appropriate allocation of expenditure for
the determination of the costs of products or services and for the presentation of suitably arranged data
for purposes of control and guidance of management. It includes the ascertainment of the cost of every
order, job, contract process, service or unit as may be appropriate. It deals with the cost of production,
selling and distribution. It is thus the provision of such analysis and classification of expenditure as will
enable the total cost of any particular unit of production or service to be ascertained with reasonable
degree of accuracy and at the same time to disclose exactly how such total cost is constituted so as to
control and reduce its cost.
1.9 COST ACCOUNTANCY :
Cost Accountancy is the application of costing and Cost Accountancy principles, methods
and techniques to the science, art and practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived there from for purposes of managerial decision making.
Thus, Cost Accountancy is the science, art and practice of a cost accountant. It is a science because it
is a body of systematic knowledge having certain principles which a cost accountant should possess for
proper discharge of his responsibilities. It is an art as it requires the ability and skill with which a cost
accountant is able to apply the principles of cost accountancy to various managerial problems. Practice
includes the continuous efforts of a cost accountant in the field of cost accountancy. Such efforts also
includes the presentation of information for the purpose of managerial decision making and keeping
statistical records.
Cost and Management Accounting 1.5 Natute and Scope of Financial...
1.10 SCOPE OF COST ACCOUNTANCY :
The scope of Cost Accountancy is very wide and includes the following :
Cost Ascertainment : It deals with the collection and analysis of expenses, the measurement of
production of the different products at the different stages of manufacture and the linking up of produc-
tion with the expenses. The varying procedures for the collection of expenses give rise to different
systems Costing such as Historical or Actual Costs, Estimated Costs, Standard Costs etc. Again the
varying procedures for the measurement of production have resulted in different methods of costing
such as specific order costing, operation costing etc. For linking up of production with the expenses the
different techniques of costing such as Marginal Cost Technique, the Total Cost Technique, Direct Cost
Technique etc. All the three i.e. systems, methods and techniques can be used in one concern simulta-
neously.
Cost Accounting : It is the process of accounting for cost which begins with recording of expenditure
and ends with the preparation of statistical data. It is the mechanism by means of which costs of prod-
ucts or services are ascertained and controlled cost accounting is helpful to the management in decision
making.
Cost Control : Cost control is the guidance and regulation by an executive action of the costs of
operating an undertaking. The cost can be controlled by standard costing, budgetary control, proper
presentation and reporting of cost data and cost audit.
1.11 Objectives of Cost Accounting :
The Objectives of cost accounting are ascertainment of Cost, fixation of selling price, proper
recording and presentation of cost data to management for measuring efficiency and for cost control.
The following are the main objectives of cost accounting :
a) To ascertain the cost per unit of the different products manufactured by a business concern.
b) To provide correct analysis of cost both by process or operations and by different elements
of cost.
c) To disclose the sources of wastage whether of material, time or expenses or in the use of
machinery, equipment and tools and to prepare reports to control such wastage.
d) To provide requisite data and serve as a guide to price fixing of products manufactured or
services rendered.
e) To ascertain the profitability of each of the products and advise management as how these
profits can be maximised.
f) To exercise effective control of stocks of raw materials, work in progress, consumable
stores and finished goods in order to minimise the capital locked up in these stocks.
Centre for Distance Education 1.6 Acharya Nagarjuna University
g) To supply useful data to management for taking various financial decisions such as introduc-
tion of new products, replacement of labour by machine etc.
h) To present and interpret data for management planning, decision making and control.
i) To provide specialised services of cost audit to prevent the errors and frauds and to facili -
tate prompt and reliable information to management.
1.12 Cost Accounting Vs Financial Accounting :
Both financial and cost accounting are the branches of accounting whose main objective is to
provide information by recording the business transactions systematically and scientifically so that it may
serve the purpose of the management for policy formulation and controlling to provide necessary protec-
tion to outsiders. Both are based on double entry system and their role are supplementary. The ordinary
trading account provides valuable information. Financial accounting treats costs very broadly, while cost
accounting does this in much greater detail. In order to illustrate this, fact, let us examine the following two
statements under Financial Accounting
Trading and Profit and Loss Account
Dr (for the year ending 31st December..) Cr
Particulars Particulars
Rs. Rs.
To Material Consumed 20,000 By Sales 75,000
To Wages 16,000
To Direct Expenses 2,000
To Manufacturing Expenses 12,000
To Gross Profit C/d 25,000
75,000 75,000
To Office and Administration By Gross Profit B/d 25,000
Expenses 3,000
To Selling and Distribution
Expenses 7,000
To Net Profit
20% on Sales 15,000
25,000 25,000
Cost and Management Accounting 1.7 Natute and Scope of Financial...
The contents of the above accounts are reproduced by the cost accountant in the following
statement, that three products viz., A,B and C are manufactured.
Statement of Cost and Profit
Products
Particulars
Total A B C
Rs Rs Rs Rs
Direct Materials 20,000 8,000 8,000 4,000
Direct Labour 16,000 6,000 8,000 2,000
Direct Expenses 2,000 1,000 1,000 -
Prime Cost 38,000 15,000 17,000 6,000
Factory Overheads 12,000 4,000 7,000 1,000
50,000 19,000 24,000 7,000
Office & Admn Overheads 3,000 1,000 1,500 500
53,000 20,000 25,500 7,500
Selling & Distribution
Overheads 7,000 3,000 2,500 1,500
Total Cost 60,000 23,000 28,000 9,000
Sales 75,000 38,000 23,500 13,500
Profit / Loss 15,000 15,000 - 4,500 4,500
Percentage of Profit on Sales 20 % 39.47 % -19.15 % 33.33 %
Centre for Distance Education 1.8 Acharya Nagarjuna University
The profit as shown by the financial books is Rs. 15,000 being 20 % profit on sales but the
cost accountant shows how this profit has been arrived at. The product ‘A’ is giving a profit of 39.47 %
and product ‘C’ a profit of 33.33 % on sales while product B is actually giving a loss. This analysis as
shown by cost accounting is quite useful and necessary but the financial accounting does not take to this
point.
1.13 Differences between Financial Accounting & Cost Accounting :
Basis Financial Accounting Cost Accounting
Purpose It provides information business in It provides information to the manage-
general way. It tells about the profit ment for proper planning, operation,
and loss and financial position of the control and decision making.
business to owners and other out side
parties.
Form of These accounts are kept in such a way These accounts are kept voluntarily to
accounts to meet the requirements of companies meet the requirements of the manage-
Act and Income Tax Act. ment.
Recording It records the expenditure in a subjec- It records the expenditure in an
tive manner i.e. according to the nature objective manner i.e. according to the
of expenses. purpose for which it is incurred.
Control It lays emphasis on the recording It provides a detailed system of control
aspect without giving any importance for materials, labour and overheads
to control. with the help of standard costing and
budgetary control.
Period It reports operating results and finan- It gives information through cost
cial position usually at the end of the reports to management as and when
year. desired.
Analysis of Profit Financial accounts are the accounts of Cost accounts are only a part of the
the whole business. It disclose the net financial accounts and disclose the
profit or loss of the business as a profit or loss of each product, job, or
whole. service.
Reporting of The Costs are reported in aggregate in The costs are broken down on a unit
Costs financial accounts. basis in cost accounts.
Cost and Management Accounting 1.9 Natute and Scope of Financial...
Basis Financial Accounting Cost Accounting
Nature of trans- Financial accounts relate to commer- Cost accounts relate to transactions
actions cial transactions of the business and connected with the manufacture of
include all expenses i.e. manufacturing, goods and services cost accounts are
office, selling and distribution etc. concerned with internal transactions.
Financial accounts are concerned with
external transactions.
Information It deals with the monetary transactions. It deals with the monetary and non-
monetary transactions.
Figures Financial accounts deal mainly with Cost accounts deal partly with facts
actual facts and figures. and figures and partly with estimates.
Stock Valuation Stocks are valued at cost or market Stocks are valued at cost.
price whichever is less.
1.14 Self Assessment Questions
1. Give five limitations of financial accounting.
2. State the differences between financial accounting and cost accounting.
3. Define - i) Cost accounting
ii) Costing
iii) Cost accountancy.
4. State five objectives of Cost Accounting.
1.15 Suggested Reading
Cost & Management Accounting - S.P.Jain & K.L.Narang.
Advanced Management Accounting - Shashi k. Gupta, R.K.Sharma.
Cost Accounting - N.K.Prasad.
P.USHA RANI
Cost and Management Accounting 2.1 Nature and Scope of .........
LESSON - 2
NATURE AND SCOPE OF
MANAGEMENT ACCOUNTING
2.0 Objective :
The objective of this lesson is to explain the concepts of Management Accounting, characteris-
tics, Scope, objectives, Functions, Advantages, Differences and limitations of Management Accounting.
Structure
2.1 Introduction
2.2 Meaning of Management Accounting
2.3 Definitions of Management Accounting
2.4 Characteristics of Management Accounting
2.5 Scope of Management Accounting
2.6 Objectives of Management Accounting
2.7 Functions of Management Accounting
2.8 Advantages of Management Accounting
2.9 Financial Accounting Vs Management Accounting
2.10 Cost Accounting Vs Management Accounting
2.11 Limitations of Management Accounting
2.12 Self Assessment Questions
2.13 Suggested Readings / Reference books.
2.1 INTRODUCTION :
Cost accounting no doubt serves the internal management by directing their attention on ineffi-
cient operations and assisting in a day to day control of activities of the enterprise. But even costing
information fails to meet informational needs for managerial functions. In actual practice cost accountants
are doing the jobs of management accountants. Further, most of the techniques of management account-
ing are also being used by the cost accountants. That is why, management accounting is treated as
extension of cost accounting. Management accounting includes many more aspects of the study besides
the cost accounting. Management Accounting has been developed with the limitations of financial and
cost accounting.
Centre for Distance Education 2.2 Acharya Nagarjuna University
2.2 Meaning of Management Accounting :
The term Management Accounting is of a recent origin. Management Accounting is comprised
of two words ‘Management’ and ‘Accounting’. It is the study of managerial aspect of accounting. Man-
agement Accounting is the presentation of accounting information in such a way so as to assist management
in the creation of policy and day to day operation of an undertaking. That it relates to the use of accounting
data collected with the help of financial accounting and cost accounting for the purpose of policy formula-
tion, planning, control and decision making by the management.
2.3 Definitions of Management Accounting :
“Management Accounting is concerned with accounting information that is useful to manage-
ment”.
- R.N. Anthony.
“Management Accounting is the term used to describe accounting methods, systems, tech-
niques which coupled with special knowledge and ability, assists management in its task of maximising
profits or minimising losses”.
- J.Balty.
From the above it is clear that management accounting uses all techniques of financial account-
ing, cost accounting and statistics to collect and process data for making it available to management so that
it can take decisions in a scientific manner.
2.4 Nature or Characteristics of Management Accounting :
The following are the main characteristics of Management Accounting.
1) Providing Accounting Information : Management accounting involves the presentation of in-
formation in a way it suits managerial needs. Management accounting provides necessary information to
different levels of management to take various policy decisions.
2) Cause and Effect Analysis : The study of cause and Effect relationship is possible in management
accounting. If there is profit or loss, the factors directly influence the profit or loss are studied.
3) Use of Special Techniques and Concepts : Management accounting uses special techniques
and concepts to make accounting data are more useful. The techniques usually used include financial
planning and analysis, standard costing, budgetary control, marginal costing, project appraisal, control
accounting etc.
4) Taking Important Decisions : Management Accounting helps in taking various important deci-
sions. It supplies necessary information to management to take important decisions.
Cost and Management Accounting 2.3 Nature and Scope of .........
5) Achieving of Objectives : In management accounting, the accounting information is used in such a
way that it helps in achieving organisational objectives. In case there are deviations between the standards
set and actual performance of various departments corrective measures can be take at once. This is
possible with the help of budgetary control and standard costing.
6) No Fixed Norms Followed : No specific rules are followed in management accounting. Though
the tools of management accounting are the same but their use differs from concern to concern. Every
concern uses the figures in its own way. The presentation of figures will be in the way which suits the
concern most. So every concern has its own rules and by-rules for analysing the data.
7) Increase in Efficiency : The purpose of using accounting information is to increase efficiency of the
concern. The efficiency can be achieved by setting up of goals for each department. If there is any devia-
tion, an effort is made to take corrective measures so that efficiency is improved.
8) Supplies Information and not Decision : The management accountant supplies information to
the management. The decisions are taken by the Top Management. Management Accounting is only to
guide and not to supply decisions.
9) Concerned with Fore Casting : The management accounting is concerned with the future. It
helps the management in planning and forecasting.
2.5 Scope of Management Accounting :
The scope of management accounting is very wide and broad based. It includes all information
which is provided to the management for financial analysis and interpretation of the business operations.
The following field of activities are included in the scope of management Accounting :
i) Financial Accounting : Financial Accounting though provides historical data but is very useful for
future planning and forecasting. Designing of a proper financial accounting system is a must for obtaining
full control and coordination of operations of the business. So management accounting is closely related to
financial accounting.
ii) Cost Accounting :It provides various techniques of costing like marginal costing, standard costing,
differential and opportunity cost analysis etc., which play a useful role in the operation and control of the
business undertakings.
iii) Budgeting and Forecasting : Budgeting means expressing the plans, policies and goals of the
enterprise for a definite period in future. Forecasting on the otherhand is a prediction of what will happen
as a result of a given set of circumstances. Forecasting is judgement where as budgeting is an organisational
object . Both budgeting and forecasting are for management accountant in planning various activities.
iv) Cost Control Procedures : These procedures are integral part of the management accounting
process and includes inventory control, cost control, labour control, budgetary control and variance analy-
sis etc.
Centre for Distance Education 2.4 Acharya Nagarjuna University
v) Reporting :The management accountant is required to submit reports to the management on the
various aspects of the undertaking. While reporting he may use statistical tools for presentation of informa-
tion as graphs, charts, pictorial presentation, index numbers and other devices in order to make the infor-
mation more impressive and intelligent.
vi) Methods and Procedures : It includes in this study all those methods and procedures which help
the concern to use its resources in the most efficient and economical manner. It undertakes special cost
studies and estimation reports on cost volume profit relationship under changing circumstances.
vii) Tax Accounting : It is an integral part of management accounting and includes preparation of
income statement determination of taxable income and filing up the return of income etc.
viii) Internal Audit : Internal Audit helps the management in fixing responsibility of different individu-
als.
ix) Interpretation of Data : The management accountant interprets various financial statements to the
management. These statements give an idea about the financial and earning position of the concern. These
statements may be studied in comparison to statements of earlier periods or comparison with statements of
similar other concern.
x) Office Services :The management accountant may be required to maintain and control office ser-
vices in some organisation. This function includes data processing, reporting on best use of mechanical and
electronic devices, communications etc.
2.6 OBJECTIVES OF MANAGEMENT ACCOUNTING :
The Primary objective of management accounting is to enable management to maximise prof-
its or minimise losses. This is done through the presentation of statements in such a way that management
is able to take correct policy decisions. The following are the important objectives of management ac-
counting.
1) Planning and Policy Formulation :The object of management accounting is to supply neces-
sary data to management for formulating plans.
Helpful in controlling performance: management accounting devices like standard costing and budget-
ary control are helpful in controlling performance. The management is able to control performance of each
and every individual with the help of management accounting devices.
2) Helpful in Organising : Management accounting is connected with the establishment of cost
centres, preparation of budgets, preparation of cost control accounts and fixing of responsibility for differ-
ent functions. All these aspects are helpful in setting up an effective and efficient organisational frame work.
3) Helpful in Interpreting Financial Information : The main object of management accounting
is to present financial information to the management in such a way that it is easily understood.
Cost and Management Accounting 2.5 Nature and Scope of .........
4) Motivating Employees : The objective of management accounting is to help the management in
selecting best alternatives of doing the things. Targets are laid down for the employees. They feel motivated
in achieving their targets and further incentives may be given for improving their performance.
5) Helpful in Making Decisions : The information provided by the accountant helps the manage-
ment in selecting a suitable alternative and taking correct decisions.
6) Reporting to Management : One of the primary objectives of management accounting is to keep
the management fully informed about the latest position of the concern. This helps management in taking
proper and timely decisions.
7) Helpful in coordination : Management accounting provides tools which are helpful in co-ordinating
the activities of different sections or departments Management accountant act as a co-ordinator and rec-
onciles the activities of different sections.
8) Helpful in Tax Administration : Management accounting helps in assessing various tax liabilities
and depositing correct amount of taxes with the concerned authorities Tax administration is carried on with
the advice and guidance of the management accountant.
2.7 FUNCTIONS OF MANAGEMENT ACCOUNTING :
Management accounting is a part of accounting. It has developed out of the need for making
more and more use of accounting for taking managerial decisions. Some of the functions of management
accounting are given as follows :
i) Planning and Forecasting : One of the important functions of the management accounting is to help
management in planning for short-term and long term periods and also in making forecasts for the future.
ii) Modification of Data : Management accounting helps in modifying accounting data. The information
is modified in such a way that it becomes useful for the management. Management accountant classifies
and modifies information according to the requirements of the management.
iii) Financial Analysis and Interpretation : The management accountant analyses the data and presents
it before the management in Non technical language along with his comments and suggestions so that top
management can understand it and take decisions with out any difficulty.
iv) Facilitates Managerial Control : Management accounting is very useful in controlling performance.
Performance evaluation is possible through standard costing and budgetary control which are an integral
part of management accounting.
v) Communication : Management accounting establishes communication with in the organisation and
with the outside world. The management accountant prepares reports for the benefit of different levels of
management and employees. The activities of the concern, are communicated to outsiders such as bank-
ers, investors, creditors, government agencies etc.
Centre for Distance Education 2.6 Acharya Nagarjuna University
vi) Co-ordinating : Management accountant acts as a co-ordinator among different financial departments
through budgeting and financial reports.
vii) Helpful in Taking Strategic Decisions : Management accounting helps in taking strategic deci-
sions. It supplies analytical information regarding various alternatives and the choice of management is
made easy. These decisions may be regarding seasonal or temporary stoppage of production, replace-
ment decisions, expansion and diversification of works and a correct decision is taken.
2.8 ADVANTAGES OF MANAGEMENT ACCOUNTING :
The following are the advantages of Management Accounting :
1) Increase Efficiency : Management accounting increases efficiency of business operations. The targets
of different departments are fixed in advance and achievements of those goals is a tool for measuring their
efficiency.
2) Proper Planning : Management is able to plan various operations with the help of accounting informa-
tion. The activities of the concerned are planned in a systematic manner.
3) Measurement of Performance : The systems of budgetary control and standard costing enable the
measurement of performance. In standard costing, standards are determined and then actual cost is com-
pared with standard cost. It enables the management to find out deviations between standard cost and
actual cost. The performance will be good if actual cost does not exceed the standard cost. Budgetary
control system too helps in measuring efficiency of all employees.
4) Maximising Profitability : The Thrust of various management techniques is to control cost of produc-
tion and increase efficiency of each and every individual in the organisation. The profits of enterprise are
maximised with the help of management accounting system.
5) Improves Service to Customers : The cost control devices employed in management accounting
enable the reduction of prices. The quality of products becomes good because quality standards are
predetermined. The customers are supplied good quality goods at reasonable prices.
6) Effective Management Control : The tools and techniques of management accounting are helpful to
the management in planning, coordinating and controlling activities of the concern.
2.9 Financial Accounting Vs Management Accounting :
The following are the main distinctions between the financial accounting and management
accounting.
Cost and Management Accounting 2.7 Nature and Scope of .........
Basis Financial Accounting Management Accounting
1. Objects The objective of Financial accounting The objective is to help the internal
to measure the business income and management.
provide information to outsiders i.e.
creditors, bankers, investors etc.
2. Subject Matter It deals with all the activites of the It deals with vital and significant
business as a whole and reveals over activities of the business.
all performance.
3. Nature It is objective in nature lays emphasis It is subjective in nature, stresses the
on the past activities and represents future and uses historical costs and
historical records just to show the data for estimating the future.
results of the business.
4. Compulsion It is obligatory for Joint stock compa- It is optional.
nies
5. External Accounts are prepared to meet the Accountants are maintained to provide
Parties requirements of outsiders. information for internal use of manage-
ment only.
6. Methodology Financial Accounting records the Management accounting reports, costs
transactions relating to and revenue by profit centre or re-
income,expense, revenue personal sponsibility centre.
accounts and property accounts.
7. Publication and Statements are to be audited and Statements are not to be published and
audit published for the general use of public. audited as there are for internal use.
8. Description In Financial Accounting all the transac- Monetary and Non monetary transac-
tions are recorded and can be mea- tions are recorded.
sured in monetary terms.
9. Period of In Financial accounting final accounts It lays emphasis on weekly, fortnightly
reporting are prepared on year to year basis. and monthly reporting.
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2.10 Cost Accounting Vs Management Accounting :
Cost Accounting and Management Accounting both have the same objectives of helping the
management in planning, control and decision making. Both are internal to the organisation and use
common tools and techniques like standard costing, variable costing, budgetary control etc. Inspite of
these similarities there are certain differences between these two. The main distinctions between cost
accounting and management accounting are :
Basis Cost Accounting Management Accounting
1. Deals with It deals with ascertainment, allocation, It deals with the effect and impact of
apportionment and accounting aspect cost on the business.
of costs.
2. Base It provides a base for management It is derived from both cost accounting
accounting. and financial accounting.
It is helpful in collecting costing data It is greater degree of relevance and
3. Role
for management. objectivity as the management accoun-
tant has a clear idea of the types of
costs and items requiring analysis and
state the specific problems of business.
4. Scope It does not include financial account- It includes financial accounting, cost
ing, tax planning and tax accounting. accounting tax planning and tax
accounting.
5. Period of It is concerned with short term plan- It is concerned with short range and
Planning ning. long range planning.
6. Tools and It has standard costing variable cost- Along with these the management
Techniques. ing, break even analysis etc as the accounting has funds and cash flow
basic tools and techniques. statements, ratio analysis etc as his
accounting tools and techniques.
7. Assistance It merely assist the management in its It assists and evaluates the manage-
functions. ment performance.
8. Installation It can be installed with out manage- It needs financial and cost accounting
ment accounting. as its base for its installation.
Cost and Management Accounting 2.9 Nature and Scope of .........
2.11 Limitations of Management Accounting :
i) The management accountant takes into consideration the past records provided by the
financial and cost accounting while making decisions for future.
ii) Management must have the knowledge of various fields for taking sound decisions but
the person who is taxing decisions may not have comprehensive knowledge of all the
subjects.
iii) The Techniques and tools suggested by the management accountant are not alternate or
substitute of good administration.
iv) There is possibility of personal bias from the collection of data to interpretation stage in
financial accounting.
v) The installation of management accounting system is costly.
vi) Management accounting has not reached the final stage and is in the process of de-
velopment.
2.12 Self Assessment Questions :
1. Define Management Accounting.
2. What are the characteristics of Management Accounting ?
3. What is the scope of Management Accounting ?
4. State any five objectives of Management Accounting.
5. State five functions of Management Accounting.
6. What are the Advantages of Management Accounting ?
7. State any five differences between Financial Accounting and Management Accounting.
8. State the differences between Cost Accounting and Management Accounting.
9. What are the limitations of Management Accounting?
2.13 Suggested Readings :
Cost & Management Accounting - S.P.Jain & K.L.Narang.
Advanced Management Accounting - Shashi k.Gupta,
R.K.Sharma.
Cost Accounting - N.K.Prasad.
P.USHA RANI
Cost and Management Accounting 3.1 Cost Accounting - Advantages..
LESSON - 3
COST ACCOUNTING - ADVANTAGES -
LIMITATIONS
3.0 Objective:
The objective of this lesson is to explain the advantages and limitations of Cost Accounting System.
Structure
3.1 Advantages of Cost Accounting
3.2 Limitations of Cost Accounting
3.3 Objections against cost Accounting
3.4 Principles of cost Accounting
3.5 Characteristics of an Ideal Costing System
3.6 Installation of Costing System
3.7 Practical difficulties in installing a Costing System
3.8 Steps to overcome Practical Difficulties
3.9 Self Assessment Questions
3.10 Suggested Readings
3.1 Advantages of Cost Accounting:
The main advantages of cost accounting are given below :
(1) Profitable and Unprofitable activities are disclosed and steps can be taken to eliminate or
reduce those activities from which little or no benefit is obtained or change the method of
production in order to make such activities more profitable.
(2) It enables a concern to measure the efficiency and then to maintain and improve it. This is
done with the help of valuable data made available for the purpose of comparison
(3) It provides information upon which estimates and tenders are based.
(4) It guides future production policies.
(5) It helps in increasing profits by disclosing the sources of loss or waste and by controlling that
loss or wastage.
(6) It enables a periodical determination of profits or losses with out resort to stock taking.
(7) It furnishes reliable data for comparing costs in different periods.
Centre for Distance Education 3.2 Acharya Nagarjuna University
(8) The exact cause of a decrease or an increase in profit or loss can be detected.
(9) Cost Accounting discloses the relative efficiencies of different workers and there by facilitates the
introduction of suitable plans of wage to reward efficiency and to provide adequate incentive to
less efficient workers.
(10) It enables the creditors and investors to judge the financial strength and credit worthiness of the
business.
(11) It is helpful to the Government. It facilitates the assessment of Excise duty and Income Tax and
the formulation of policies regarding industry, export, import, taxation etc.
(12) It is helpful to consumers by supplying goods at lower price.
(13) Costing has a more important role to play in public enterprises than in private enterprises. In
public enterprises the primary objective is not to raise profit but it is to serve the society by
providing quality goods at cheaper rates. A good system of costing ensures efficient and effective
control through a proper analysis of their working.
3.1.1 Costing – An Aid to Management:
Cost accounting helps the management in carrying out efficiently its functions by developing
practical cost procedures that provide information useful in controlling the operations of the business
enterprise. Cost accounting does this by analysing, recording, standardizing, forecasting, comparing,
reporting and recommending. In fact, cost accounting is so closely allied to management that it is
difficult to indicate where work of cost accountant ends and managerial control begins.
A good system cost accounting serves management in the following ways.
a) Classification and sub division of cost: Costs are collected and classified by various ways in
order to provide information to the management for control purposes and to ascertain the profit-
ability of each area of activity.
b) Control of Materials, Labour and Over head Costs: An efficient check is provided on stores
and materials. Stores Ledger and Material Abstracts are maintained which provide an effective
check on the stores and material used in the business. Maximum, Minimum, Reordering levels are
maintained so that stocks can be arranged in time. An efficient check on labour and machines is
provided by giving detailed information about the availability of machine and labour capacity. The
work is so planned that no section is over worked and no section remains idle. By having proper
classification of overheads into controllable and uncontrollable or fixed and variable, it helps to
control the overhead costs.
c) Business Policies: Business policy may require the consideration of alternative methods and
procedures and this is facilitated by cost information correctly presented. It helps the management
to take vital decisions such as introduction of a new product, selection of a most profitable product
mix, utilisation of spare capacity, exploration of additional market, whether to make or buy, prob-
lem of limiting factor, replacement of existing assets, appraisal of proposed investment to meet
expansion programme etc, with the help of marginal costing techniques and differential cost analy-
sis.
Cost and Management Accounting 3.3 Cost Accounting - Advantages..
d) Budgeting: It provides the use of budgets and performance reports and enables management to
correct inefficiencies before they enter into business. Two important cost accounting tools for
helping managers are budgets and performance reports.
e) Standards for Measuring Efficiency: It provides the use of standards to assist management in
making estimates and plans for future and to provide the basis of management of efficiency. Actuals
are compared with predetermined standards to determine the operating efficiency.
f) Best use of limited Resources: Cost Accounting provides the reliable data of costs with regard
to materials, wages and other expenses. These help the management to get maximum output at the
minimum cost by indicating where economies may be affected, waste eliminated and inefficiency
increased.
g) Instrument of Management control: It provides management with valuable data for
planning, budgeting and control of costs. An efficient system of cost accounting is, thus,
regarded as an important part in the efforts of any management to secure business stability.
h) Cost Audit: The operation of a system of cost audit in the organisation will assist in prevention
of errors and frauds.
i) Price Determination: It helps the management to fix the remunerative selling prices of various
items of goods in different circumstances. If prices are fixed with out costing information, it is
possible, that prices quoted may be too high or too low. In periods of depression, it may
become necessary to reduce the prices even below total cost. It is only costing which will guide
the business man in this matter.
Expansion:
Management is able to formulate expansion policy on the basis of estimates of cost of produc-
tion at various levels provided by cost accountant.
3.2 Limitations of Cost Accounting:
The Cost system has the following limitations.
1. The system is based on estimates the results differ from activities.
2. The methods and techniques adopted with in the system are several and their applications vary-
ing on different plans makes the results unworthy of cost comparison and cost control,
e.g ;
a) Pricing of issue of materials by different methods
b) Remunerating labour on different bases
c) Apportionment and Absorption of overhead at different bases and by the application of
different methods,
d) Classification of costs in to direct and indirect.
e) Classification of overheads in to fixed and variable;
f) Determination of standard in standard costing
g) Charging of depreciation and valuation of stocks at different bases.
Centre for Distance Education 3.4 Acharya Nagarjuna University
3. For getting the benefits of cost accounting many formalities are to be observed. Due to which the
establishment and running costs are so much.
4. It has not involved so far any tool for handling inflationary situation.
3.3 Objections against Cost Accounting:
A number of objections are generally raised against the introduction of costing on various grounds.
The following are some of the important objections usually raised:
1. Cost system is unnecessary: It has been argued that costing is of recent origin and that industries
prospered in the past and are still prospering with out the aid of costing and therefore it is unnecessary
expenditure. But the modern industries are running under highly competitive conditions and every manu-
facturer should know the actual cost of production to decide how far he can reduce the selling price.
2. Inapplicability: It is argued that modern methods of costing are inapplicable to many type of industries.
But in many cases some methods of costing can always be devised to suit the requirements of the business.
3. The system has failed in many cases: It is argued that the adoption of costing system failed to
produce the desired results in many cases and therefore, the system is defective. But the failure of a system
may be due to several causes. So it is hasty to find the fault with the system.
4. Cost system is a matter of forms and rulings: It is argued that after some time, a costing system
degenerates in to a matter of forms and rulings. This is not the fault of the system. It is fault of the way in
which the system is maintained.
5. Cost system is highly expensive: It is argued that the expenditure incurred on the installation of cost
system is quite heavy and the operational part is also expensive. But the cost system is so designed to suit
the economy of the business – whether small or big.
3.4 General Principles of Cost Accounting
The following are the main principles of Cost Accounting:
1. Cause – effect relationship: Cause effect relationship should be established for each item of cost.
This cost should be shared only by those units which pass through the departments for which such cost has
been incurred.
2. Charge of cost only after its incurrance: Unit cost should include only those costs which have been
actually incurred.
3. Past cost should not form part of future cost: Past cost should not be recovered from future cost as
it will not only affect the true results of future period but will also distort other statements.
4. Exclusion of abnormal costs from cost accounts: All costs incurred because of abnormal reasons
(like theft, negligence) should not be taken in to consideration while computing the unit cost. If done, so it
will distort the cost figures and mislead the management resulting in wrong decisions.
Cost and Management Accounting 3.5 Cost Accounting - Advantages..
5. Principle of double entry should be followed preferably: To Lessen the chances of any mistake
or error, cost ledgers and cost control accounts, as far as possible should be maintained on double entry
principles.
3.5 Characteristics of an Ideal costing system:
The following are the main characteristics which an ideal system of costing system should
possess or the points which should be taken into consideration before installing a costing system.
i) Suitability to the business: A costing system must be devised according to the nature, conditions,
requirements, and size of the business.
ii) Simplicity : The system of costing should be simple and plain so that it may be easily understood
even by a person of average intelligence.
iii) Flexibility: The system of costing must be flexible so that it may be changed according to changed
conditions and circumstances.
iv) Economical: A costing system should not be expensive and must be adopted according to the
financial capacity of the business.
v) Comparability : The costing system must be such so that it may provide facts and figures necessary
to the management for evaluating the performance by comparing it with the past figures, figures of other
concerns or against the industry as a whole or other departments of the same concern.
vi) Capability of presenting information at the desired time : The system must provide accurate
and timely information so that it may be helpful to the management for taking decisions and suitable
action for the purpose of cost control.
vii) Minimum changes in the existing set up: The existing system of delegation and division of
authority and responsibility must not be disturbed with the costing system.
viii) Uniformity of forms: All forms and proformas be necessary to the system should be uniform in
size and quality of paper.
ix) Efficient system of Material control: There should be an efficient system of stores and stock
control as materials usually account for a greater portion of the total cost.
x) Adequate wage Procedure: There should be a well defined wage procedure for recording the time
spent by workers on different jobs, for preparing the wage sheet and for the payment of wages. Thus
the introduction of well defined wage system will help to control the cost of labour.
xi) Departmentalisation of expenses: A sound plan should be devised for the collection, allocation,
apportionment and absorption of overheads in order to ascertain the cost accurately
Centre for Distance Education 3.6 Acharya Nagarjuna University
xii) Reconciliation of cost and financial accounts: The costing system should be so devised that the
two sets of accounts are capable of easy reconciliation.
xiii) Duties and Responsibilities of the cost accountant: Under a good system of cost accounting
the duties and responsibilities of the cost accountant should have access to all works and departments.
3.6 Installation of Costing System
The fundamental factors that a cost accountant should consider while introducing a system of
costing are:
i) The existing organisation should be distributed as little possible.
ii) There should be a gradual and smooth introduction of the system.
iii) While over – elaboration of records should be avoided.
3.6.1 Steps for Installation:
The steps to be taken in installing a costing system are:
1. Objectives to be achieved: The costing system will be simple if the objective is only to determine
cost but it will have to be elaborate if the objective is to have information which will help the manage-
ment in exercising controlling and taking decisions.
2. Studying the Organisation: In this connection the points to be noted are – the nature of the busi-
ness and of operations, extent of responsibility and authority attached to the various functionaries, the
lay out of the factory, the methods of dealing with wastage of materials, the system of time recording
and the methods of computing and paying wages, the system of issuing orders and the amount of fixed,
semi variable and variable overheads.
3. Deciding the structure of cost accounts: What system of cost accounting is suitable and the
extent of details required can be decided after a thorough study of the manufacturing process and their
ancillary services. The designing of the system should be such that there is a gradual build up of the cost
at each significance stage of production.
4. Determining the cost rates: This entails a thorough study of factory conditions and decisions are to
be made about classification of cost in to direct and indirect, grouping of indirect cost in to production,
selling and administration etc, treatment of waste of all kinds, methods of pricing issues, methods of
recovering overheads and calculation of overhead rates.
5) Introducing the system: Before the system is put in to effect, the implications of the system should
be explained to all indicating to them the benefits that will accrue to each and to the business as a whole.
6) Organising the Cost Office: It is always better that the cost office is situated adjacent to the
factory so that delay in routing out documents or in clearing up discrepancies and doubts is avoided.
The costing staff must be allowed to have access to the works if they are to perform their duties prop-
erly.
Cost and Management Accounting 3.7 Cost Accounting - Advantages..
7) Relationship of cost office to other departments: The cost department should function indepen-
dently, the cost accountant being made directly responsible to the General Manager, of Managing Director.
The costing system should be designed to serve management at all levels.
3.7 Practical difficulties in installing a costing system:
Practical difficulties apart from technical costing problems which a cost accountant has to face in
installing a costing system are:
1) Lack of support from Top Management: In most of the cases the cost accounting system is intro-
duced without the support of the top management in all the functional areas.
2) Resistance from the existing accounting staff: When ever a new system is introduced resistence is
natural, as the existing staff may feel that they would lose their importance and may be unsure of their
position in the organisation.
3) Non cooperation at other levels of organisation: The foremen, supervisors and other staff may not
cooperate with other departments in providing information which is absolutely necessary for the smooth
and efficient working of any accounting system.
4) Shortage of trained staff: The work of costing department cannot be handled with out the availability
of trained staff.
5) Heavy cost of operating system: The cost of operating system may be heavy unless the costing
system is properly designed according to the requirements of each case.
3.8 Steps to overcome Practical Difficulties:
To over come the above difficulties the following steps are suggested.
1. Support from top management: Before the installation or operation of a costing system there must be
firm commitment to the system on the part of the top management.
2. Utility of system to the existing staff: The existing accounting staff should be impressed about the
need to supplement the existing financial accounting system.
3. Workers confidence for cooperation: The various employees must be properly educated regarding
the benefits which can be obtained from such a system.
4. Training of existing accounting staff: The existing staff working in the accounts department must be
properly trained in costing methods and techniques with the help of the Institute of cost and works Accoun-
tants of India, Calcutta.
5. Proper supervision: There should be proper supervision after installation and continuous efforts on the
part of the cost accountant to make the system successful and to achieve the desired goal of cost ascertain-
ment, cost presentation and cost control.
Centre for Distance Education 3.8 Acharya Nagarjuna University
3.9 Self Assessment Questions:
1. State two advantages of cost accounting to:
i) Management
ii) Workers
iii) Creditors
iv) Government
v) General Public
2. What are the limitations of Cost Accounting
3. What are the objections against cost Accounting
4. Give five characteristics of an Ideal costing system
5. State the factors which a cost accountant should consider introducing a costing system
6. What are the practical difficulties in installing a costing system.
3.10 Suggested Readings
Cost & Management Accounting - S.P. Jain & K.L. Narang
Cost Accounting - N.K. Prasad.
P. USHA RANI
Cost and Management Accounting 4.1 Cost Concepts - Classification ..
LESSON - 4
COST CONCEPTS - CLASSIFICATION -
ANALYSIS
4.0 Objective :
The objective of this lesson is to explain the concepts of Cost, classification of Cost,
elements of Cost and preparation of Cost Sheet.
Structure
4.1 Cost Concepts
4.2 Classification of Cost
4.3 Elements of Cost
4.4 Cost Sheet / Statement of Cost
4.5 Proforma of Cost Sheet
4.6 Self Assessment Questions
4.7 Suggested Readings
4.1 COST CONCEPTS :
Some Cost Concepts which are used in cost accounting are discussed below :
a) COST :It is the amount of resources given up in exchange for some goods and services. The re-
sources given up are expressed in monetary terms. Cost is defined as “the amount of expenditure
(actual or notional) incurred on or attributable to a given thing or to ascertain the cost of given thing”
(ICMA).
In the ICMA definition cost is the amount of
a) actual expenditure incurred on a given thing and
b) notional expenditure attributable to a given thing.
Regarding notional expenditure is one which is conceptual and which is deemed to have been
incurred or attributed for instance i) rent of owned factory where rent is charged as cost for purpose of
comparison with the cost of undertaking running factory in rented factories although this rent is not
actually paid. ii) Interest on owned capital where interest is charged in cost a matter of policy although it
is not paid.
The objective for which costs are computed is also important. For example, if the purpose is to
fix selling price, the total cost is considered. For valuation of stock cost means cost of production only.
If the objective is to measure efficiency, Cost will have to be compiled differently than if the purpose is
to quote or value the stock. So the term cost has different interpretations.
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A cost must always be studied with reference to its purpose and conditions. For the valuation
of work in progress, factory cost is used but for valuation of finished goods cost of production is used. If
the purpose of the study of cost is the same, different conditions may lead in variation in cost. The cost per
unit of product changes with increase or decrease in volume of output as the amount of fixed expenses to
be borne by each unit of output decreases or increases with increase or decrease in units of production.
Cost is also different from value as cost is measured in terms of money where as value is measured interms
of usefulness or utility of an article.
b) EXPENSE : Expenses are costs which have been applied against revenue of particular accounting
period in accordance with the principle of matching cost to revenue e.g., cost of goods sold, office salaries
of the period in which they are incurred.
c) COST CENTRE : A cost centre is the smallest segment of activity or area or responsibility for which
costs are accumulated. Typically cost centres are departments but in some instances, a department may
contain several cost centres. These cost centres are the departments or sub departments of an organisation
with reference to which cost is collected for cost ascertainment and cost control. A cost centre can be a
location i.e an area such as department store yard or sales area or an item of equipment, e.g., lathe
machine, delivery vehicle or a person, e.g., sales man, foreman.
The determination of a suitable cost centre is very important for ascertainment and control of cost.
The manager incharge of a cost centre is held responsible for control of cost of his cost centre. It enables
the accumulation of all such costs at one place for which a common base of recovery may be used.
d) PROFIT CENTRE : A profit centre is the segment of activity of a business which is responsible for
both revenue and expenses and discloses the profit of a particular segment of activity. Profit centres are
created to delegate responsibility to individuals and measure their performance.
The selection of suitable cost centres or cost units for which costs are to be ascertained in an
undertaking depends upon the organisation of the factory; condition of incidence of cost; requirements of
costing i.e suitability of the unit or cost centre for cost purpose; availability of information; management
policy regarding making a particular choice from several alternatives.
4.2 COST CLASSIFICATIONS :
Cost classification is the process of grouping costs according to their common characteristics. It is
the placement of like items together according to their common characteristics. A suitable classification of
costs is of vital importance in order to identify the cost with cost centres or cost units. The cost may be
classified according to their nature i.e material, labour and expenses and a number of other characteristics.
The same cost figures are classified according to different ways of costing depending upon the purpose to
be achieved and requirements of a particular concern. The important ways of classification are :
1) By Nature or Elements, 2) By Functions, 3) By Direct and Indirect, 4) By Change in activity or
volume, 5) By Controllability, 6) By Normality, 7) By Capital and Revenue, 8) By Time,
9) According to planning and control, 10) By Association with product and 11) For Managerial deci-
sions.
Cost and Management Accounting 4.3 Cost Concepts - Classification ..
1) By Nature or Elements or Analytical Classification : According to this classification, the costs are
divided into three categories i.e Material, Labour and Expenses. There can be further sub-classification of
each element; for example material into raw material components, spare parts, consumable stores, pack-
ing material etc. This classification is important as it helps to find out the total cost, now such total cost is
constituted and valuation of work in progress.
2) By Functions (i.e. Functional Classification) : According to this classification costs are divided in
the light of the different aspects of basic managerial activities involved in the operation of a business
undertaking. It leads to grouping of costs according to the broad division or functions in a business under-
taking i.e. production, administration, selling and distribution.
3) By Direct and Indirect : According to this classification, total cost is divided in to Direct costs and
Indirect costs.
Direct Costs : Direct costs are those which are incurred for and may be conviniently identi-
fied with a particular cost centre or cost unit. Materials used and labour employed in manufacturing an
article or in a particular process of production are common examples of direct costs.
Indirect Costs : Indirect costs are those costs which are incurred for the benefit of a number
of cost centres or cost units and cannot be conveniently identified with a particular cost centre or cost unit.
Examples of indirect costs include rent of building, management salaries, machinery depreciation etc. The
nature of the business and the cost unit chosen will determine which costs are direct and which are indirect.
The importance of the distinction of costs into direct and indirect lies in the fact that direct costs of a
product or activity can be accurately determined while indirect costs have to be apportioned on certain
assumptions as regards their incidence.
4) By Changes in Activity or Volume : According to this classification, costs are classified according to
their behaviour in relation to changes in the level of activity or volume of production. On this basis, costs
are classified in to three groups i.e fixed, variable and semi variable.
i) Fixed Costs : Fixed costs are commonly described as those which remain fixed in total
amount with increase or decrease in the volume of output or productive activity for a given period of time.
Fixed cost per unit decreases as production increases and increases as production declines. Examples of
fixed costs are rent, insurance of factory building, factory manager’s salary etc. These fixed cost are
constant in total amount but fluctuate per unit as production changes. These costs are known as period
costs because these are dependent on time rather than on output.
ii) Variable Costs : Variable costs are those which vary in total indirect proportion to the
volume of output. These costs per unit remain relatively constant with changes in production. Thus, vari-
able costs fluctuate in total amount but tend to remain constant per unit as production activity changes.
Examples are direct material costs, direct labour costs, power, repairs etc. Such costs are known as
product costs because they depend on the quantum of output rather than on time.
iii) Semi Variable Costs : Semi variable costs are those which are partly fixed and partly
variable. For example telephone expenses include a fixed portion of monthly charge plus variable accord-
ing to calls; thus total telephone expenses are semi variable. Other examples of such costs are deprecia-
tion, repairs and maintenance of building and plant etc.
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5) By Controllability :Under this, costs are classified according to whether or not they are influenced by
the action of a given member of the undertaking. On this basis costs are classified in to two categories;
i) Controllable Costs: Controllable Costs are those which can be influenced by the action of a speci-
fied member of an undertaking, this to say costs which are at least partly with in the control of management.
An organisation is divided in to a number of responsibility centres and controllable costs incurred in a
particular cost centre can be influenced by the action of the manager responsible for the centre. Generally
speaking all direct costs including direct materials, direct labour and some of the overhead expenses are
controllable by lower level of management.
ii) Un controllable costs: Uncontrollable costs are those which can not be influenced by the action of
a specified member of an undertaking, that is to say, which are not with in the control of management.
Most of the fixed costs are uncontrollable. For example rent of the building is not controllable and so is
managerial salaries. Overhead cost, which is incurred by one service action and is apportioned to another
which receives the service is also not controllable by latter.
6. By Normality : Under this costs are classified according to whether these are costs which are normally
incurred at a given level of output in the conditions in which that level of activity is normally attained. On this
basis, it is classified into two categories:
a) Normal Cost: It is the cost which is normally incurred at a given level of output in the conditions in
which that level of output is normally attained. It is a part of cost of production.
b) Abnormal Cost: It is the cost which is not normally incurred at a given level of output in the
conditions in which that level of output is normally attained. It is not a part of cost of production and
charged to costing Profit and Loss Account.
7. By capital and Revenue : The cost which is incurred in purchasing an assets either to earn income or
increasing the earning capacity of the business is called capital cost. For example, the cost of machine.
Such cost is incurred at one point of time but the benefits accruing from it are spread over a number of
accounting years. If any expenditure is incurred in order to maintain the earning capacity of the concern
such as cost of maintaining an asset or running a business it is revenue expenditure e.g., cost of materials
used in production, labour charges paid to convert the materials in to production, salaries, depreciation,
repairs and maintenance charges, selling and distribution charges. The distinction between capital and
revenue items is important in costing as all items of revenue expenditure are taken in to consideration while
calculating cost where as capital items are completely ignored.
8. By Time: Cost can be classified in to
i) Historical cost and ii) predetermined cost
i) Historical Costs: The costs which are ascertained after being incurred are called historical
costs. Such costs are available only when the production of a particular
thing has already been done.
Basic Characteristics of such Costs are:
a) They are based on recorded facts
Cost and Management Accounting 4.5 Cost Concepts - Classification ..
b) They can be verified because they are always supported by the evidence of their
occurance.
c) They are mostly objective because they relate to happenings which have already taken
place.
ii) predetermined Costs: Such costs are estimated costs i.e., computed in advance of production
taking in to consideration the previous period’s costs and the factors affecting such costs. Predetermined
cost determined on scientific basis becomes standard cost. Such cost which compared with actual costs
will give the reasons of variance and will help the management to fix the responsibility and to take remedial
action to avoid recurrence in future.
9. According to planning and control: Planning and control are two functions of management.
According to this, costs can be classified as budgeted costs and standard costs.
Budgeted Costs: Budgeted costs represent an estimate of expenditure for different phases of
business operations such as manufacturing, administration, Sales, research and development etc. Continu-
ous comparison of actual performance (i.e actual cost) with that of budgeted cost is made so as to report
the variations from the budgeted cost to the management for corrective action.
Standard Costs: Budgeted Costs are translated in to actual operation through the instrument of standard
costs. The Charted Institute of Management Accountants, London defines Standard Costs as “the prede-
termined cost based on technical estimate for materials labour and overhead for a selected period of time
for a prescribed set of working conditions”. Thus standard cost is determination, in advance of production,
of what should be the cost.
10. By Association with the Product : Under this classification costs can be product costs and period
costs.
Product Costs : Product costs are those cost which are traceable to the product and are included in
inventory valuation. They comprise direct materials, direct labour and manufacturing overheads in case of
manufacturing concerns. These are used for valuation of inventory and are shown in Balance sheet till they
are sold because such costs provide income or benefit only after sale.
Period Costs:Period costs are incurred on the basis of time such as rent, salaries etc. These may relate to
administration and selling costs essential to keep the business running. Though these are not associated
with production and are necessary to generate revenue but cannot be assigned to a product. These are
charged to the period in which these are incurred and treated as expense.
II For Managerial Decisions: On this basis, costs may be classified in to the following costs.
i) Marginal Cost: Marginal cost is the total of variable cost i.e. prime cost plus variable overheads.
It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable
costs are taken in to consideration for determining the cost of products and value of work in progress and
finished goods.
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ii) Out of Pocket Costs: This is the portion of costs which involves payment to outsiders i.e gives rise to
cash expenditure as opposed to such costs as depreciation which do not involve any cash expenditure.
Such costs are relevant for price fixation during recession or when make or buy decision is to be made.
iii) Differential Costs : The change in costs due to change in the level of activity or pattern or method of
production is known as differential cost. If the change increases the cost it will be called incremental cost.
If there is decrease in cost resulting from decrease in output, the difference is known as decremental cost.
iv) Sunk Cost : A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant.
It is written down value of abandoned plant less its salvage value. Such costs are not relevant for decision
making and are not affected by increase or decrease in volume. Thus, which has taken place and is
irrecoverable in a situation is treated as sunk cost.
v) Imputed or Notional Costs : These costs are notional in nature and do not involve any cash outlay.
The charted Institute notional cost as “the value of a benefit where no actual cost is incurred”. Even though
such costs do not involve any cash outlay but are taken into consideration while making managerial deci-
sions. Examples of such costs are: Notional rent charged on business premises owned by the proprietor
interest on capital for which no interest has been paid.
vi) Opportunity Cost : It is the maximum possible alternative earning that might have been earned if the
productive capacity or services had been put to some alternative use. For example, if an owned building is
proposed to be used for a project the likely rent of the building is the opportunity cost which should be
taken into consideration while evaluating the profitability of the project.
vii) Replacement Cost : It is the cost at which there could be purchase of an asset, or material identical
to that which is being replaced or revalued. It is the cost of replacement at current market price.
viii) Avoidable and Unavoidable Cost : Avoidable costs are those which can be eliminated if a particu-
lar product or department with which they are directly related in discontinued. For example, salary of the
clerks employed in a particular department can be eliminated if the department is discontinued. Unavoid-
able cost is that cost which will not be eliminated with the discontinuation of a product or department. For
example salary of factory manager or factory rent can not be eliminated even if product is eliminated.
4.3 ELEMENTS OF COST :
Mere knowledge of total cost cannot satisfy the needs of management. For proper control
and managerial decisions, management is to be provided with necessary data to analyse and classify the
costs. For this purpose the total cost analysed by elements of cost i.e by the nature of expenses. The
elements of costs are three i.e materials, labour and other expenses. The elements of cost further analysed
in to different elements as follows :
Cost and Management Accounting 4.7 Cost Concepts - Classification ..
Elements of Cost
Material Labour Other Expenses
Direct Indirect Direct Indirect Direct Indirect
Overheads
Production Administration Selling Distribution
or overheads overheads overheads
works
overheads
1. Direct Materials : Direct materials are those materials which can be identified in the product and can
be conveniently measured and directly charged to the product. Thus, these materials directly enter the
production and form a part of the finished product. For example, timber in furniture making cloth in dress
making and bricks in building a house. The following are the Direct Materials.
i) All raw materials like jute in the manufacture of gunny bags, pig iron in foundry and fruits in
canning industry.
ii) Material specifically purchased for a specific job, process or order like glue for book,
binding, startch powder for dressing yarn.
iii) Parts or components purchased or produced like batteries for transistor radios and tyres
for cycles.
iv) Primary packing materials like cartons, wrappings, card board boxes etc used to protect
finished product from climatic conditions or for easy handling inside the factory.
2. Indirect Materials : Indirect materials are those materials which can not be identified in the product
and cannot be conveniently measured and not directly charged to the product. Example of indirect mate-
rials are : Consumable like cotton waste, lubricants, cleaning materials, materials for repairs and mainte-
nance of fixed assets, diesel used in power generators etc.
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Classification of materials into direct and indirect facilitates material control. Direct materials
are usually high value items as compared to indirect material and need strict control and critical analysis for
reducing their cost.
However in some cases, though the materials is a part of the finished product yet it is not
treated as direct material; for example sewing thread in dress making and nails in furniture making.
3. Direct Labour : Direct labour is that labour which can be conveniently identified or attributed wholly to
a particular job, product or process or expanded in converting raw materials in to finished goods. Wages
of such labour are known as direct wages.
The wages paid to supervisors, inspectors etc though not direct labour can be treated as direct
labour if they are directly engaged specific product or process and the hours they spend on it can be
directly measured with out much of an effort. Similarly where the cost is not significant like the wages of
trainees or apprentices, their labour though directly spent on product is not treated as direct labour.
4. Indirect Labour : Indirect labour is the labour which are not directly engaged in the production of
goods and services but which indirectly helps the direct labour engaged in production. The example of
indirect labour are supervisors, sweapers, foremen, watchmen, time keeper, cleaners, repairers etc. The
cost of indirect labour cannot be conveniently allocated to a particular job, order, process or article.
5. Direct Expenses : Direct expenses are those expenses which are directly incurred in process of
production other than direct material and direct labour. For example excise duty, Royalty on production,
Architect fees, travelling expenses to site, expenditure on pilot projects, experimental expenditure, plan-
ning expenditure.
6. Overheads : Overheads may be defined as the aggregate of the cost of indirect materials, indirect
labour and such other expenses including services as cannot conveniently be charged direct to specific
cost units. Thus overheads are all expenses other than direct expenses. In general terms, overheads com-
prise all expenses incurred for or in connection with the general organisation of the whole or part of the
undertaking i.e the cost of operating supplies and services used by the undertaking and including the
maintenance of capital assets. The main groups in to which overheads may be sub-divided are i) Manufac-
turing overhead ii) Administration overhead iii) Selling overheads iv) Distribution overheads
v) Research and Development overheads.
Expenses Excluded from Costs :
The total cost of a product should include only those items of expenses which are a charge
against profit. Items of expenses which are relating to capital assets, capital losses, payments by way of
distribution of profits and matters of pure finance should not form a part of the costs
Examples of such expenses are - income tax, dividends, abnormal wastage of material, abnor-
mal idle time, interest on capital given or received, expenses of raising capital, discount on shares and
debentures, profit or loss from the sale of asset or investments, excessive depreciation, appropriation of
profits, writing off goodwill, preliminary expenses and underwriting commission, cash discount, deben-
tures interest, incomes which are connected with business i.e transfer fees, rent, interest, dividend received
and capital expenditure.
Cost and Management Accounting 4.9 Cost Concepts - Classification ..
4.4 Cost Sheet or Statement of Cost :
Cost sheet is a statement designed to show the output of a particular accounting period along
with break-up of costs. There is no fixed form for preparation of a cost sheet but in order to make the cost
sheet more useful it is generally presented in columnar form. The main advantages of cost sheet are :
1. It discloses the total cost and the cost per unit of the units produced during the given
period.
2. It enables a manufacturer to keep a close watch and control over the cost of produc-
tion.
3. By providing a comparative study of the various elements of current cost with the past
results and standard costs, it is possible to find out the causes of variations in costs and
to eliminate the adverse factors and conditions which go to increase the total cost.
4. It acts as a guide to the manufacturer and helps him in formulating a definite useful
production policy.
5. It helps in fixing up the selling price more accurately
6. It helps the business man to minimise the cost of production when there is a cut throat
competition.
7. It helps the business man to submit quotations with reasonable degree of accuracy
against tenders for the supply of goods.
4.5 Proforma of Cost Sheet :
Cost Sheet
Particulars Total Cost Cost Per Unit
Rs.
Rs. Rs.
Opening stock of Raw xx x x
Materials
Add : Purchases xx x x
-
Add : Carriage on Purchases xx x x
xx x x
Less : Closing stock of Raw
Materials xx x x
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Cost Sheet
Particulars Total Cost Cost Per Unit
Rs.
Rs. Rs.
Cost of Raw Materials Used xx x x xx x x
Direct Wages xx x x xx x x
Direct Expenses xx x x xx x x
Prime Cost xx x x xx x x
Add : Factory / Works
Overheads xx x
Factory Rent Rates & Taxes xx x
Fuel & Water xx x
xx x
Indirect materials
xx x
Indirect wages
xx x
Works manager salary
xx x
Drawing office salaries
xx x
Works expenses
Depreciation on Plant &
Machinery xx x
Repairs of plant & machinery xx x
Insurance on plant &
machinery xx x
Depreciation on land &
Buildings xx x
xx x x
Less : Scrap value xx x
xx x x
Add : Opening work in xx x
progress
xx x x
Less : Closing work in xx x
progress
Cost and Management Accounting 4.11 Cost Concepts - Classification ..
Cost Sheet
Total Cost Cost Per Unit
Particulars Rs.
Rs. Rs.
Factory Cost / Works Cost /
Cost of Out put xx x x x xx x
Add : Administrative or office
overheads : x x x
Counting office salaries x x x
Office manager salary x x x
x x x
Staff salaries
Office rent, taxes, insurance x x x
Office lighting & cleaning x x x
Directors fees x x x
x x x
Managing Director Salary
Printing & Stationary x x x
x x x
Postage
x x x
Telephone expenses
x x x
Audit Fees
Depreciation on office furni- x x x
ture and buildings
Other expenses x x x
Office cost or x x x x
Cost of Production
Add : Opening stock of x x x x x x x x x x x
finished goods
x x x x
Less : Closing stock of
finished goods x x x
Cost of goods sold : x x x x x xxx
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Cost Sheet
Total Cost Cost Per Unit
Particulars Rs.
Rs. Rs.
Add : Selling and Distribution
overheads
Sales men salaries &
commission x x x
Sales manager Salary xx x
Advertisement Expenses x x x
Show room expenses x x x
Samples & free gifts x x x
Market research expenses xx x
Bad debts x x x
Ware house rent & insurance x x x
Travelling expenses xx x
Carriage outwards x x x
Packing expenses x x x
Delivery van expenses x x x
Depreciation on delivery van xx x
Cost of Sales / Total Cost x x x x x x x x
Profit / Loss x x x xx x x
Sales / Selling Price. x x x x xxx x
Cost and Management Accounting 4.13 Cost Concepts - Classification ..
4.6 Self Assessment Questions :
1. Prepare a chart showing the different elements of cost.
2. Define i) Cost ii) Cost centre.
3. Define cost classification.
4. Distinguish between Direct and Indirect Cost.
5. Define : i) fixed cost ii) variable cost iii) Semi variable cost.
6. Distinguish between product cost and period cost.
7. Explain the controllable and uncontrollable costs.
8. How the cost is classified for Management decision.
4.7 Suggested Readings
Cost & Management Accounting - S.P.Jain & K.L.Narang.
Cost Accounting - N.K.Prasad.
P. USHA RANI
Lesson - 5
COST SHEET
5.0 OBJECTIVES:
After studying this lesson you should be able to Prepare cost sheet
STRUCTURE:
5.1 Introduction
5.2 Features of incentive schemes
5.3 Method of payment of incentives
5.4 Solved Problems
5.5 Self Assessment Questions
5.6 Books Recommended
5.1 INTRODUCTION:
Cost sheet is also known as statement of cost. It is designed to show the out put of a
particular accounting period along with breakup of costs. The data incorporated in cost sheet are
coollected from various statements of accounts. The main advantages of a cost sheet are:
1. It discloses the total cost and the cost per unit of the units produced during the given
period.
2. It enables a manufacturer to keep a close watch and control over the cost of production.
3. Cost sheet provides a comparative study of the various elements, current costs with
the past results to find out the causes of variations in costs.
4. It helps the manufacturer in formulating a definite useful production policy.
5. It helps in fixing up the selling price more accurately.
6. It helps the businessmen to minimise the cost of production.
There is no fixed form for preparation of a cost sheet but in order to make the cost sheet
more useful it is generally presented in columnar form as given in the following format.
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5.2. SPECIMEN OF COST SHEET :
Specimen of cost sheet or statement of cost units ......
Particulars Inner coloumn Total cost Unit cost
Rs. Rs. Rs.
Opening stock of Raw material xxx
Add Purchases xxx
Add carriage inwards xxx
xxxx
Less : Closing stock
......m
Materials consumed
xxxx
Add: Direct wages
xxx
Direct Expenses
......m
Prime cost
~
Add: Factory or works over heads xxx
Factory Rent & Taxes
Power, fuel, water xxx
Indirect material xxx
Indirect wages xxx
Works manager slaries xxx
Drawing office salaries xxx
Factory expenses xxx
Depreciation of plant and Machinery xxx
Repairs of plant and Machinery xxx
Insurance on plant and Machinery xxx
-(COST & MANAGMENTACCOUNTINGH 5.3 I ( COST SHEET )-
Depreciation on buildings and land
of factory xxx
xxxx
Less : Scrap value xxx
xxxx
Add : Opening balance of
work in progress xxx
xxxx xxx
Factory cost or works cost xxxx xxx
Add : Office or Administration over heads
Office salaries xxx
Office manager salary xxx
Office Rent, Insurance and Taxes xxx
Directors fees xxx
Managering director salary xxx
Statinery and printing xxx
Postage xxx
Telephone & Audit fess xxx
Depreciation on office furniture and
buildings xxx
other office expenses xxx
Cost of production xxxx xxxx
Add : opening balance of finished goods xxx __m
xxxx xxxx
Less: Colsing balance of finished goods xxx ~
xxxx xxxx
Add : Selling & Distribution expenses
solaries and commission of salesmen xxx
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Salary of sales manager
Publicity and Advertisment
Showroom expenses
Samples, gifts
Market research expenses
Bad debts
godown rent, insurance
sales transportation
packing expenses
Delivery van expenses
Depreciation of delivery van
Total cost / cost of sales xxxx xxx
Profit / loss
Sales
5.3. EXPENSES EXCLUDED FROM COSTS :
Items of expenses which are relating to capital assets, capital losses, payments by way of
distibution of profits and matters of pure finance should not form a part of the costs. Examples of
such expenses are -
1. Income Tax
2. dividends
3. Goodwill
4. Reserves
5. Interest on Debentures
6. Donations
7. Preliminary expenses
8. abnormal wastage of material
9. Wages paid for abnormal idle time
10. Interest on capital
11. Expenses of raising capital
-{COST & MANAGMENTACCOUNTING)--1U.5.Q_5_j-I--~C..__--=C~O~S..:..T-=S~H=EE=-T=---_}-
12. Discount on shares and debentures
13. Profit or loss from the sale of asset
14. excessive deprecintion
15. Underwriting commission
16. Preliminary expenses
17. Cash discounts and
18. incomes which are not connected with business etc.
5.4 SOLVED PROBLEMS :
1. Following information is collected from the books of left centre corporation. prepare
a) Materials consumed
b) Prime cost
c) factory cost
d) cost of sales
e) Net profit
June 2006 June 2007
Rs. Rs.
Raw Material 30,000 25,000
Work in progress 12,000 15,000
finished goods 60,000 55,000
purchase of raw material 4,50,000
Wages 2,30,000
Factory over heads 92,000
Office over heads 30,000
Selling and distribution overheads 20,000
Sales " 9,00,000
..
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solution:
COST SHEET
Particulars June 2006 June 2007
Rs. Rs.
Opening balance of Raw material 30,000
Add : Purchases 4,50,000
4,80,000
Less : Closing balance of Raw material 25,000
Materials consumed 4,55,000
Add: wages 2,30,000
Prime cost 6,85,000
Add : factory over heads 92,000
7,77,000
Add: opening balance of work in process 12,000
7,89,000
Less : Closing balance of work in process 15,000
Factory cost 7,74,000
Add : office expenses 30,000
Total cost of production 8,04,000
Add : opening balance of finished goods 60,000
8,64,000
Less: closing balance of finished goods 55,000
Cost of goods sold 8,09,000
Add: selling & distribution expenses 20,000
Total cost 8,29,000
Net profit 71,000
Sales 9,00,000
-{COST & MANAGMENT ACCOUNTINGHL~5.L7 j-I-----<C__ __;;;...CO.;;;...S;;;..;T'--'S;;..;..H.;.;;;;E=
2. From the following data of Sai Enterprises find out:
a) Materials consumed
b) Prime cost
c) factory cost
d) Total cost
in total and per unit.
Rs.
Balance of Raw Material on 1st jan 2007 35,000
Purchases 85,000
Direct wages 1,20,000
Factory expenses 90,000
Office expenses 1,24,000
company produced 10,000 units. Closing balance of Raw material Rs. 20,000 on 31.12.2007
Solution:
COST SHEET
Particulars Per unit Per 10,000 units
Rs. Rs. Rs.
Opening balance of Raw material 35,000
Add Purchase 85,000
1,20,000
Less closing balance of Raw material 20,000
Materials consumed 10.00 1,00,000
Add : Direct wages 12.00 1,20,000
Prime cost 22.00 2,20,000
Add : work expenses 9.00 90,000
work cost 31.00 3,10,000
Add : Office expenses 12.40 1,24,000
Total cost 43.40 4,34,000
-(Centre for Distance Education )r--LI --""1C Acharya Nagaduna University}-
..s5~.8u-1
3. Following is the information of a standard production company for the month April 200B
Rs.
Raw Material BO,OOO
Direct wages 4B,OOO
Machine hours (working) B,OOO
Machine hour rate 400
Administration overheads on factory cost - 10%
Selling and distribution expenses perunit Rs 1-50.
Units produced 4,000
Units sold 3,600 at Rs 50.
From the above information find out the following:
a) Unit cost
b) Profit per month
Statement of Cost and Profit
Particulars Total cost Cost per unit
(4,000 Units)
Rs. Rs. Rs.
Raw material BO,OOO 20.00
Add : Purchase 4B1000 12.00
prime cost 1,2B,OOO 32.00
Add : factory expenses
Machine hours x machine hour rate B,OOOx4 321000 B.OO
Works Cost 1,60,000 40.00
Add: office over heads 10% of
1,60,000
Works cost 100 x10 161000 4.00
Cost of production 1,761000 44.00
-(COST & MANAGMENTACCOUNTINGH 5.9 I ( COST SHEET }-
Cost of goods sold 3,600x44 1,58,400
Add: Selling and distribution
expenses 3,600x1.50 5.400
Cost of sales 1,63,800
Profit 16.200
Sales 3,600x50 1.80.000
4. Calculate prime cost, factory cost, cost of production, cost of sales and profit from the following
particulars :
Rs. Rs.
Direct wages 30,000 Depreciation :
Direct Materials 1,00,000 Factory 500
Wages of foreman 2,500 Office 1250
Electric power 500 Consunable stores 2,500
Lighting : Factory 1,500 Manager's salary 5,000
Office 500 Director's fees 1,250
Store keeper's wages 1,000 Office stationary 500
Oil and water 500 Telephone charges 125
Rent: Factory 5,000 Postage and Telegrams 250
Office 2,500 Salesmen's Salaries 1,250
Repairs: Factory 3,500 Travelling expenses 500
Office 500 Advertising 1,250
Transfer to reserves 1,000 warehouse charges 500
Discount on shares 500 Sales 1,89,500
Dividend 2,000 carriare outand 375
Income tax 10,000
-{Centre /pr Distance Education ))--___'ILJ5~.1~OU'I----1C
Acharya Nagaduna University)-
solution:
STATMENTOF COST AND PROFIT
Particulars Rs. Rs.
Direct Material 1,00,000
Direct wages 30,000
Prime cost 1,30,000
.Add: Factory over heads:
Wages of foreman 2,500
Electric power 500
Store keeper's wages 1,000
Oil and water 500
factory rent 5,000
factory repairs 3,500
factory lighting 1,500
factory depreciation 500
consumable stores 2,500
factory cost 17,500
1,47,500
Add: Administration expenses:
Office rent 2500
office repairs 500
office lighting 500
office depreciation 1,250
manager's salareis 5,000
Director's fees 1,250
office stationary 500
Telephone charges 125
postage and telegrams 250 11,875
-(COST & MANAGMENTACCOUNTINGH 5.11 I ( COST SHEET )-
Cost of production 1,59,375
Add: Selling & Distribution overheads:
Carriage outward 375
Salesmen's salaries 1,250
Travelling expenses 500
Advertising 1,250
warehouse charges 500 3.875
Cost of sales 1,63,250
profit 26.250
sales 1.89.500
5. From the following particulars of Rum & Co. Ltd. for three months ending 31st March 2007
Prepare
a) Cost sheet for the period giving various costs and
b) profit and loss account for the quarter showing profit per barrel.
Wages Rs. 12,000 coal and oil 11,200, cooperage, corks and shives Rs. 4,000, Malt
Rs.40,000, Hops Rs. 10,800, Beer duty Rs. 2,80,000, water Rs. 1,000, Rent & Taxes
Rs. 6,000, By product Rs. 3,600, Sugar Rs. 14,000, Preservatives Rs. 1,600, Other
Materials Rs. 1,200, Repairs Rs. 1,800, Depreciation Rs. 1,200, Administration ex-
penses Rs. 24,000 , Selling and distribution expenses Rs. 30,000.
Opening stock of beer Rs. 40,500 ( 300 barrels) closing stock of beer Rs. 67,500 ( 500
barrels) Beer sales Rs. 4,98,000 (2,800 barrels), Beer brewed during the period 3,000
barrels.
solution:
COST SHEET FOR THE QUARTER ENDING 31st MARCH, 2007
(Output: Beer Brewed 3,000 Barrels)
Particulars Total Cost Cost per unit
Rs. Rs.
Material Consumed:
Malts 40,000 13.33
Hops 10,800 3.60
Sugar 14,000 4.67
-{Centre fPr Distance Education )1-----115.121 ( Acha~a NagadunaUnivers~)-
Preservatives 1,600 0.53
Other Materials 1,200 0.40
Water 11000 0.33
68,600 22.86
Beer duty 21801000 93.33
Less : proceeds from 3,48,600 116.19
Sale of by product 31600 1.19
3,45,000 115.00
wages 121000 4.00
Prime cost 3,57,000 119.00
Add: Factory over heads:
Coal and oil 11,200 3.73
Co operane, corks and shives 4,000 1.33
Rent and Taxes 6,000 2.00
Repairs 1,800 0.60
Depreciation 11200 0.40
Factory cost 3,81,200 122.06
Add: Administration expenses. 241000 8.00
.Cost of production 4105.200 135.06
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-(Centre for Distance Education )r---LI ~5.:.!14~1
---1( Acharya Nagarjuna University)-
6. A company makes two distinct types of vehicles A and B. The total expenses during a period as
shown by the books of assembly of 600 of A and 800 of B are as under:
Rs.
Material 1,98,000
Direct wages 12,000
Stores overhead 19,800
Running expenses of Machine 4,400
Depreciation 2,200
Labour amenities 1,500
Works general 30,000
Administration & selling expenses 26,790
Additional information
A:B
Material cost ratio per unit 1: 2
Direct labour ratio per unit 2: 3
Machine utilisation ratio per unit 1: 2
Calculate the cost of each vehicle per unit giving reason for the basis of apportionment
adopted by you
Solution:
Statement of Cost
Particulars Vehicle A Vehicle B Total
Rs. Rs. Rs.
Material ( 3:8) 54,000 1,44,000 1,98,000
Direct wages (1:2) 4,000 8,000 12,000
Prime cost 58,000 1,52,000 2,10,000
Storage over heads
(10% of material cost) 5,400 14,400 19,800
Running expenses of machines (3:8) 1,200 3,200 4,400
Depreciation (3:8) 600 1600 2200
-(COST & MANAGMENTACCOUNTINGH 5.151 ( COST SHEET )-
Labour amenities (2:3) 600 900 1500
works general (2:3) 10,000 20,000 30,000
Works cost 75,800 1,92,100 2,67,900
Administration and Selling
(10% of works cost ) 7,580 19,210 26,790
Total cost 83,380 21111310 21941690
Cost per unit of each vehicle 138.97, 264.14
Notes:
1. Material cost has been apportioned on the basis of cost ratio per unit multiplied by the
units produced
i.e A:B = 1x 600 ; 2 x 800 = 600; 1,600 = 3:8
2. Direct wages have similarly been apportioned
i.e A:B = 2 x 600 ; 3 x 800 = 1200; 2400 = 1:2
3. Stores overheads have been apportioned as a percentage of material cost
19800
i.e 1,98000 x100 = 10%
4. Running expenses of machines have been apportioned on the basis of machine utiliza-
tion ration per unit multiplied by the units produced
i.e A:B = 1x 600 ; 2 x 800 = 600 ; 1,600 = 3:8
5. Depreciation charges have been apportioned on the same basis as running expenses
of machines.
6. Labour amenities are apportioned on the basis of direct labour ratio Le. A: B = 2:3
7. Works general expenses have been apportioned on the basis of direct labour ratio
i.e A: B = 2 : 3
8. Administration and selling overheads have been apportioned on the basis of works cost
i.e ; 758: 1,921.
-{Centre Jor Distance Education )1-----l1 1
5.16 ....---f( Acharya Nagaduna University}-
7. From the following particulars prepare a cost sheet showing the total cost per tonne for the
period ended 31st December 2007
Rs. Rs.
Raw material 66,000 estimations 1600
Productive wages 70,000 factory stationery 1500
Direct expenses 6,000 office stationery 1800
Un productive wages 21,000 Loose tools written off 1200
Factory rent 15,000 Rent & Taxes (office) 1000
Factory lighting 4,400 Water supply 2400
Factory heating 3,000 Factory insurance 2200
Motive power 8,800 Office insurance 1000
Haulare 6,000 legal expenses 800
Directors fees (works) 2,000 Depreciation of:
Directors fees (office) 4,000 Plant & Machinery 4000
Factory cleaning 1,000 office building 2000
sundry office expenses 400 Delivery Van 400
Sales department salaries 3000 Bad debts 200
Up keep of delivery Vans 1400 Advertising 600
Bank Charges 100
Commission on sales 1,500
The total output for the period has been 29,550 tonnes.
solution:
STATMENT OF COST AND PROFIT
Particulars Rs. Rs.
Raw Material 66,000
Productive wages 70,000
Direct wages 6.000
Prime cost 1,42,000
Add: Works expenses:
-{COST & MANAGMENTACCOUNTINGH 5.171 ( COST SHEET r-
Un productive wages 21,000
factory rent 15,000
factory lighting 4,400
factory heating 3,000
Motive power 8,800
hacelege 6,000
Director's fees ( factory) 2,000
Factory cleaning 1,000
Estimation expenses 1,600
loose tools 1,200
Factory estimtion 1,500
water supply 2,400
factory insurance 2,200
Depreciation 4.000 74,100
Factory Cost 2,16,100
Add : Office expenses:
Directors fees ( office) 4,000
Sundry office expenses 400
Office stationary 1,800
Office rent 1,000
Office Insurance 1,000
legal expenses 800
Depreciation 2,000
Bank changes 100 11,100
Cost of production 2,27,200
Add : Selling & Distribution expenses :
Rent of ware house 600
Depreciation 400
Bad debts 200
-{Centr~ for Distance Education ))--~~I5~.~18UI---1(
Acharya Nagartuna University}- .
Advertising 600
Sales Dept, salaries 3,000
Commission on sales 3,000
Up keep of delivery vans 1,400 9.200
Total Cost 2.36.400
2,36,400
Cost per tonne = Rs. 29,550 =8
8. From the following particulars of a manufacturing firm, prepare a statement showing
a) Cost of materials used.
b) works cost
c) Cost of production
d) Percentage of works overhead to productive wages
e) Percentage of general overheads to works cost.
Rs. Rs.
Stock of material on 1-1-2007 40,000 Finished goods sold 24,00,000
Purchase of raw material in Works over head charges 1,50,000
January, 2007 11,00,000 Office and general expenses 1,00,000
Stock of finished goods Stock of materials
on 1st January 2007 50,000 on 31st Jan 2007 1,40,000
Wages 5,00,000 stock of finished goods
on 31st Jan 2007 60,000
solution:
STATMENT OF COST AND PROFIT
Particulars Rs. Rs.
Stock of Raw material 1.1.2007 40,000
Add purchases 11.00.000
11,40,000
-(COST & MANAGMENT ACCOUNTINGH 5.1911-----(c.......
_ ___;;;;C....;:;.O....;:;.ST..:......;:;.S;...;;HE=E;;...;T
Less stock of Raw material 31.1.2007 1,40,000
Cost of material consumed 10,00,000
Add wages 5,00,000
Prime cost 15,00,000
Add works over heads 1,50,000
Works cost 16,50,000
Add office expenses 1,00,000
Cost of production 17,50,000
Add: Stock of finished goods (opening) 50,000
18,00,000
Less: Stock of finished goods ( closing ) 60,000
Cost of goods sold 17,40,000
profit 6,60,000
sales 24,00,000
Percentage of works overheads charges to production
Wages 1,50,000 x 100 = 30 %
5,00,000
Percentage of general over headss to works cost
1,00,000
Wages 16,50,000 x 100 = 6,06 %
9. The following extract of costing information relates to commodity 'A' for the half year ending 31st
December 2007
Rs.
Purchase of Raw materials 1,20,000
Works overheads 48,000
Direct wages 1,00,000
-(Centre fPr Distance Education )r---IL5~.~20~1 ---((AA~ch~aU:;ryV;;ai1'N~ainga;rl]iii'
uiri:na;jUiiinriliiv;n;e;;;;rs~ityv)-
carriage on purchases 1,440
stock (1st July, 2003)
Raw material 20,000
Finished product ( 1,000 tons) 16,000
Stock ( 31 st Dec, 2007)
Raw material 22,240
Finished product ( 2,000 tons) 32,000
Work in progress 1st july 2007 4,800
Work in progress 1st Dec 2007 16,000
Sales finished products 3,00,000
Selling and distribution overheads are Re.1 per ton sold. 16000 tons of commodity
were produced during the period.
You are to ascertain.
a) Cost of raw material used
b) Cost of output for the period
c) Cost of sales
d) Net profit for the period
e) Net profit per ton of the commodity.
Solution:
STATMENT OF COST AND PROFIT
(For the half year ending 31st december 2007)
Particulars Units Amount
(Tonner) Rs.
Opening Stock of Raw material 20,000
Add: purchases of Raw material 1,20,000
Add: carriage on purchases 1440
1,41,440
Less: closing stock of Raw material 22.240
-{COST & MANAGMENTACCOUNTINGH 5.21 1-1 -----4 ( COST SHEET )-
Value of Raw materials used 1,19,200
Add Direct wages 1.00.000
Prime cost 2,19,200
Add: Works over heads 48.000
2,67,200
Add: opening stock of work in progress 4.800
2,72,000
Less: closing stock of work in progress 16jOOO
Cost of output for the period 16,000 2,56,000
Add: opening stock of finished goods 1.000 16.000
17,000 2,72,000
Less: closing stock of finished goods 2.000 32.000
Cost of goods sold 15,000 2,40,000
Add: Selling & distribution over heads
on 15,000 tons at Re 1 per ton 15,000
Cost of sales 2,55,000
Net profit of the period 45,000
Sales 3,00,000
45,000
Net profit per ton = 15,000 =3
Note:
Rate percentage on sale x Total cost
Profit -- 100 - Rate percentage on sales
-(Centre jfor Distance Education )f----[I S[.:g22&1
---(C:JA~c~h~ary~a~N~ag~a~rtlYuEjna~UQjn!l!iv~e~rs§
10. Following information has been obtained from the cost records of aditya chemicals Ltd. for
2007
Rs.
Finished good on 1.1.2007 50,000
Raw materials on 1.1.2007 10,000
work in progrees 1.1.2007 14,000
Direct labour 1,60,000
Purchase of Raw Material 98,000
Indirect labour 40,000
Heat, light 20,000
Factory insurance 5,000
Repairs to plants 3,000
Factory supplies 5,000
Depreciation - factory building 6,000
Depreciation - plant 10,000
Other information
Factory cost of goods produced in 2007 Rs. 2,80,000
Raw Material consumed in 2007 Rs. 95,000
Cost of goods sold in 2007 Rs. 1,60,000
prepare a statement of cost.
Solution:
STATMENT OF COST AND PROFIT
Particulars Rs. Rs.
Opening Stock of Raw material 10,000
Add purchases 98.000
1,08,000
Less closing stock (1,08,000 - 95,000) 13.000
-(COST & MANAGMENTACCOUNTINGH 5.231 ( COST SHEET }-
Cost of Raw material consumed 95,000
Add direct labour 11601000
prime cost 2,55,000
Add: factory overheads:
Indirect labour 40,000
Heat, light 20,000
Insurance 5,000
Repairs 3,000
Factory supplies 5,000
Depreciation plant 10,000
Building 6,000 891000
3,44,000
Add opening balance of work in progress 141000
3,58,000
Less closing balance of work in progress
( 3,58,000 - 2,80,000) 781000
Factory cost (given) 2,80,000
Add opening stock of finished goods 501000
3,30,000
Less closing stock ( 3,30,000 - 1,60,000) 11701000
Cost of goods sold 11601000
11. Prepare cost sheet from the following information -
No.1 No.2
Material ( Rs) 60,000 1,00,000
Labour (Rs) 1,20,000 1,40,000
Sales ( units) 360 400
Selling price (Rs) per unit 2,400 3,000
Work on cost is charged at 40% on works cost and
Office on cost is charged at 20% on total cost.
-{Centre for Distance Education )~--[I[5.~24i1-1
---1C:JA~c~h~a~ry~a~N~ag~a~I)~'uD!na~Ug:n~ivy!e~
Solution:
COST SHEET
Particulars No.1 No.2
Out put and sales: No. 1 = 360
No.2 = 400
Materials 60,000 1,00,000
Labour 1.20.000 1.40.000
Prime cost 1,80,000 2,40,000
Works on cost (40% on works cost
40
equivalent to 60 of prime cost) 1.20.000 1.60.000
works cost 3,00,000 4,00,000
Office on cost 20% on total cost or
20
80 of works cost ) 75.000 1.00.000
Total cost 3,75,000 5,00,000
Profit 4,89,000 7,00,000
Sales ( units sold x selling price)
(360 x2400 ) ( 400 x 3000) 8.64.000 12.00.000
12. A computer manufacturing company producing two types of computers A and B from the
following information prepare cost sheet
A B
Material 90,000 1,50,000
.Wages 2,15,000 4,75,000
Computers sold (units) 500 750
Works over heads 80% on wages, Administration expenses 10% on factory cost, seil-
ing price of computer A at Rs 1,200 and computer B at Rs. 1500
-{COST & MANAGMENTACCOUNTINGHLJ5~.2~5u-1--~c __ --=-CO.=..;S~T~S::;.:.,H~E=ET..:..
Solution:
Cost Sheet
Particulars Computer Computer
A (SOO) B (750)
Total cost Per unit Total cost Per unit
Rs. Rs. Rs. Rs.
Materials 90,000 180.00 1,50,000 200.00
wages 21151000 430.00 41751000 633.33
Prime cost 3.05.000 610.00 61251000 833.33
Add factory expenses
( 80% on labour) 11721000 344.00 31801000 506.67
Works cost 4}7IOOO 954.00 101501000 1340.00
Add Administration expenses
( 10% of works cost ) 471700 95.40 11001500 134.00
Total cost 5,24,700 1049.40 11,05,500 1474.00
Profit 751300 150.60 191500 26.00
Sales 61001000 1200.00 111251000 1500.00
13. From the following information prepare a monthly cost sheet of sand lime brick works, show
ing cost and profit per 1,000 bricks-
Material used Labour
Lime 895 tons of Rs 50 per ton
Sand Rs 2 per 1,000 bricks mad Sand digging and
Coal 820 tons at Rs 40 per ton Running Rs 10,000
Stores Rs 1250 Bricking Rs. 40,000
Factory on cost is 25% of direct charges. office on cost is 10% of factory cost. Bricks
sold 35lakhs, @ Rs. 70 per thousand. Stock of bricks at the end of month was 61akh bricks in the
beginning the stock was 1 lakh bricks.
-{Centr~ for Distance Education )>-----ILI ---(C
Q;5.~26!tl-1 Acharya Nagaduna University}-
Solution:
COST SHEET
Particulars Total Cost Cost per 1000 units
Rs. Rs.
Materials:
Lime 895 tons of Rs 50 per ton 44,750
Coal 820 tons at Rs 40 per ton 32,800
Sand Rs 2 per 1,000 (40 lakhs) 8,000
Stores 1,250
86,800 21.70
Labour
Sand digging & running 10,000
12.50
Brick making 40,000
Prime cost 1,36,800 34.20
Factory over heads at 25% of prime cost 34,200 8.55
Work cost 1,71,000 42.75
. Office on cost at 10 % of works cost 17,100 4.28
Cost of production (40 lakhs) 1,88,100 47.03
Add opening stock 1 lakh bricks 4,702.50
1,92,802.50
Less closing stock 6 lakh bricks 28,215.00
Cost of bricks sold (35 lakhs) 1,64,587.50 47.03
Profit 80,412.50 22.97
Sales 2.45,000.00 70.00
Cost per thousand Rs 47.03.
Note : Caculations are made approximately.
-{COST & MANAGMENT
ACCOUNTINGHLJ5~.2~7UI----1c..__--=C~O.:::.ST~S:....:;HE==E:..:T_~)-
5.6. SELF ASSESSMENT QUESTIONS
Five Marks Questions :
1. What is cost sheet, What are its advantages?
2. List out expenses which are not included in cost sheet
Ten Marks Questions :
3. In a factory 20,000 units of product A were manufactured in the month of July, 2007.
Form the following information prepare cost sheet showing cost per unit.
Rs.
Opening stock of Raw materials 10,000
Purchases 1,10,000
Closing stock 20,000
Direct wages 50,000
Factory over heads 80,000
Office and administration over head 40,000
Ans·1 ,35,000 - 6.75
4.From the following particulars of ABC ltd. prepare cost sheet
Rs.
Opening stock of Raw materials 20,000
Purchases 1,50,000
Closing stock 10,000
Direct wages 60,000
Factory over heads 22,500
Office and administration over head 27,500
Opening stock of finished goods 500 units at Rs. 11.20 per unit
Closing stock of finished goods 1,500 units worth Rs. 16,200
Profit on sales 20%
Selling and distribution expenses Rs. 20,000 units produced 25,000.
Ans • Units -24,000; Total cost - 3,49,250 Cost per unit - 14.55
-(Centre for Distance Education) 15.281 (Acharva Nagaduna University :r
5. The accounts of Sai international enterprise for the year ended 31st December 2007
shows the following prepare cost sheet.
Rs. Rs.
Factory office salary 13,000 Travelling expenses 4,200
General office salary 25,200 Travelling salaries 15,400
Carriage outward 9,200 Productive wages 2,52,000
Carriage on purchases 14,300 Depreciation - plant 13,000
Bad debts written off 13,000 furniture 600
Plant repairs 8,900 Directors fees 12,000
Insurance - factory office 17,000 Gas and water factory 2400
office 4,000 office 800
Sales 9,22,200 Managers salary
Stock of material- (3/4 factory 1/4 office 20,000
31st Dec 2006 1,25,600 General expenses 6,800
31st Dec 2007 96,000 Income Tax 1,000
Materials purchased 3,70,000 Dividend 2,000
Ans - Total cost - 8,30,800
6. In a factory two types of T.V sets are manufactured Viz optonica, Thomson model. From
the following particulars prepare a statment showing cost and profit per T.V. sold. There
is no opening or closing stock.
Optonlca Thomson
Material 27,300 1,08,680
Labour 15,600 62,920
works overheads are charged at 80% on labour and office overhead is taken at 15% on
works cost. the selling price of both T.V sets is Rs. 1,00078 optonica and 286 thomson
T.V.s were sold.
Ans· Cost per unit: Optonica - 816.50
Thomson - 892.40
-{COST & MANAGMENTACCOUNTINGHu5~.2~9~1------1C __ --=.CO=-S=-T:....:S~H..:..:E==E..:..T
__ )-
7. From the following information prepare cost sheet-
Rs. Rs.
Opening Materials 25,000 Advertisement 2000
Purchases 85,000 Depreciation on Machinery 1500
Closing Materials 40,000 Dep. on furniture 100
Carriage inwards 5,000 Office staff salaries 2500
Direct wages 75,000 factory expenses 5700
Indirect wages 10,000 other office expenses 900
Direct expenses 15,000 Managerial director salary 12000
Rent and Rates - Factory 5000 selling expenses 1000
Office 500
indirect material 500
Travelling allowance of salesmen 1100
Carriage outward 1000
sales 2,50,000
Income Tax 1500
Ans • Total cost - 2,08,800
Profit - 41,200
8. From the following information calculate the following -
a) prime cost
b) factory cost
c) production cost
d) cost of sales
Rs.
Direct materials 40,000
Direct wages 10,000
Direct expenses 2,000
Scrap 100
-{Centre fEr Distance Education) 15.301 ( Acharya Nagaduna University}-
foreman salary 1000 .
store keeper salary 500
electric power 200
Lighting - factory- 500
office - 200 700
Rent - factory- 2000
office - 1000 3000
Repair - factory plant - 500
Machinery - 1000
Office buildings - 200 1700
Depreciation - Office - SOO
factory - 200 700
Consumable store 1000
Manager salary 2000
Director's fees 500
Stationary 200
Telephone expenses 50
Postage expenses 100
salesmen commission 500
Travelling expenses 200
Advertisement expenses 500
Godown expenses 200
carriage outwards 150
Ana • Total cost - 65,300
-{COST & MANAGMENT ACCOUNTINGHL5~.~31LJI---~c..__---=C:..=O:..=S...:...T-=S.:..:.H=EE:...;T:.__
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9. From the following trading Account, prepare cost sheet showing
a) Materials consumed
b) Cost of production
c) percentage of profit on sales
Trading Account
Rs. Rs.
To Balances
Finished goods 80,000 By sales 8,40,000
Raw material 24,000 By balances finished goods 70,000
To purchase 2,40,000 By Raw materials 28,000
Towages 4,00,000
To Transportation 20,000
To Gross profit 1,74,000
9,38,000 9,38,000
Ans· Cost of production· 6,66,000
Percentage of profit - 20.7
10. XYZ ltd. is producing Refregerators. From the following expenses of production prepare
cost sheet showing cost of production for the month of april 2007.
Rs. Rs.
work in progress on 1.4.2007
At prime cost 51,000
Productive expenses 15,000
66,000
work in progress on 30.4.2007
At prime cost 45,000
Productive expenses 9,000
54,000
-----i( AcharyaNagarjunaUniversity)-
-{Centre for Distance Education )~-_'ILJ5~.3~2~1
Raw material on 1.4.2007 2,25,000
Purchases 4,77,000
Direct wages 1,71,000
Productive expenses 84,000
Raw material on 30.4.2007 2,04,000
Ans· Cost of production - 7,65,000
5.6. BOOKS RECOMMENDED :
1. Practical costing - Khanna; Pandey; Ahuja.
2. Cost & Management Accounting - S.P. Jain & K.L. Narang
3. Cost Accounting - S.P. Jain & K.L. Narang
4. Practical problems in Cost Accounting - S.P. Jain & K.L. Narang
Dr. K. Kanaka Durga
Lesson·6
MATERIALS-I
6.0 OBJECTIVES:
After studying this lesson you should be able to understand the following
~ What is material control
~ How to control material
~ Procedure for purchasing of material
~ Role of different levels of stock in controlling material ( or stores)
STRUCTURE:
6.1 Introduction
6.2 Types of material
6.3 Material Control
6.3.1 Objectives of material control
6.3.2 Essentials of material control
6.3.3. Advantages of material control
6.4 Purchasing and its organisation
6.4.1 Objectives of purchasing department
6.4.2. Centralised purchasing
6.4.3. Decentralised purchasing
6.5 Layout of stores
6.5.1 Centralised stores
6.5.2 Decentralised stores
6.5.3 Sub· stores
6.6 The store keeper
6.7 Levels of materials
6.8 Illustrations
6.9 Conclusion
6.10 Self Assessment Questions
6.11 Books Recommended
-(Centre for Distance Education )r--LI ---« Acharya Nagaduna UniversitY)-
~6~.2u-1
6.1 INTRODUCTION:
Material is a very important factor of production. It includes physical commodities used to
manufacture the final end product. Material is that it can be purchased in varying quantities according
to the requirements of the firm where as other elements of cost like labour and other services
cannot be easily varied once they are established. From this it can be concluded that material is
most flexible and controllable input. It is the first and most significant element of cost. Purchase of
material will include both direct and indirect materials. Material control is necessary from the time
orders for purchase of materials are placed with suppliers until they have been consumed. The
object of material control is to reduce material cost on all fronts so that cost of material may be
reduced.
6.2. TYPES OF MATERIAL :
Purchase of material will include both direct and indirect materials. Direct and indirect
material are treated as stores items Whereas stock of finished goods is not treated as a stores
item. Finished goods are treated as stock.
a. Direct material:
Direct material is a stores item. It can be conveniently and accurately allocated to a particu-
lar unit of cost. For example, leather used in the making of a pair of shoes is direct material.
b. Indirect material:
Indirect material is also a stores Item. It can be conveniently and accurately allocated to a
particular unit of product. For example nails and gum used in the makeing of shoes.
6.3. MATERIAL CONTROL :
Material control can be defined as a comprehensive framework for the accounting and
control of material cost designed with the object of maintaining material supplies at a level so as to
ensure uninterrupted. Production but at the same time minimising investment of funds. In other
words material control is a systematic control over the purchasing storing and using of materials
so as to have the minimum possible cost of materials. Material control involves recording on
printed forms all steps and movements which occur in the acquisition and utilisation of materials.
Effective control also requires the systematic preparation of periodic summaries and reports.
6.3.1. Objectives or need of material control:
The following are the various objectives of material control.
1. Availability of material: There should be a continuous availability of all types of mate-
rials in the factory so that the production may not be held up for want of any material.
2. Investment in material : There should be no excessive investment in stock. Over
stocking should be avoided keeping in view the disadvantages it carries. For this maxi-
mum quantity should be assigned.
3. Reasonable price : While purchasing materials, it is seen that it is purchased good
quality material at reasonably low price.
-(COST & MANAGMENTACCOUNTINGH 6.3 I (MATERIALS -I )-
4. Minimum wastage : Wastage should not exeed the normal level of wastage. Store
keeper and worker should be trained to handle the material in a scientific way to avoid
the wastage.
5. Risks of spoilage and obsolescence: Risk of spoilage and obsolescence must be
avoided. For this purpose, a maximum quantity of each material is determined and
proper method of issue of material is followed.
6. Information about availability of materials: Information should be made continu-
ously available to the management so that planning of production may be done.
7. Misappropriation by employees : Material can be easily misappropriated byemploy-
ees, this requires an internal check on materials which is a part of material control.
6.3.2. Essentials of material control:
The important requirements of material control are -
i. Proper co - ordination among the departments involved in the buying, receiving, inspec-
tion, storage and accouting.
ii. Centralisation of purchasing under the control of competent buyer.
iii. Proper scheduling of material requirements.
iv. Proper classification of materials.
v. The operation of a system of internal check to ensure that all tranction involving materi-
als and equipment are checked by properly authorised and independent persons.
vi. The storage of materials is well - planned and kept in properly designated location.
vii. The operation of a perpetual inventory system.
viii. Fixing maximum, minimum and reordering levels of stock.
ix. Adequate records to control materials.
x. Regular reports to management about material control.
6.3.3. Advantages of material control:
A good system of material control enjoys the following advantages.
a. eliminates waste in the use of material.
b. reduces the risk of loss of material from fraud and theft.
c. helps in keeping perpectual inventory and other records to facilitate the preparation of
accurated reports to management.
d. reduces the capital tied up in inventories.
e. reduces the cost of storage.
-(Centre for Distance Education) I 6.4 I (Acharya NagadunaUniversity)-
f. furnishes quickly and accurately the value of materials used in various departments.
g. Prevents production delays due to lack of materials by supplying adequate quantity at
right time.
6.4. PURCHASING AND ITS ORGANISATION :
Purchasing is a specialised activity carried on by purchasing department under the control
of a purchasing manager. Purchasing is a significant activity because it influences many factors
such as quantity, quality, cost, efficiency, economy, prompt delivery, volume of production etc, In
manufacturing organisation, purchasing includes the procuring of materials, supplies, machines
tools and services required for the equipment, maintenance and operation of the business. The
purchasing department obtains the required materials, supplies, machines, tools and serivces at
the most favourable terms, consistent with maintaining the desired standard of quality and continuity
of service. Following are the basic objectives behind establishing a separate purchasing department.
6.4.1. objectives of purchasing department:
1. To make continuous availability of materials.
2. To make purchase at the most economical prices.
3. To make purchase in reasonable quantilies.
4. To purchase proper quality of material.
5. To develop alternate sources of supply so that materials may be supplied without break.
Purchase department may be centralised or decentralised.
6.4.2. Centralised purchasing:
Centralised purchase department means that all the purchase functions are routed through
one department. All purchases should be made by the purchase department to avoid duplicaiton,
overlapping and the non - uniform procurements. All the other departments which require materials,
suppliers, services, machines and tools should send indents or purchase requisitions to the
centralised purchase department to make timely and suitable purchases.
Advantages:
Following are the advantages of centralised purchasing:
1. Favourable terms: When materials are purchased more trade discount or econo-
mies in transport can be obtained because the quantity involved will be large.
2. Specialised Knowledge: The purchasing department can be staffed with highly paid
officials who are experts in the art of purchasing the materials.
3. Better control : Better control on purchasing is possible. There are chances of reck-
less buying when several persons are authorised to make purchases for their require-
ments.
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4. Compilation & consultation of records : All records with regard to purchases are
kept at one place under the supervision of the purchase officer. This results in economy,
both in compilation and consultation of records.
5. Product standards: It avoids duplications of efforts and is helpful in achieving product
standards.
6. Economy: Centralised purchasing results in economy to a vendor because there is
only one purchase officer to be dealt with instead of many persons under decentralised
purchasing.
Disadvantages :
1. Centralised purchasing will cause delay because branches at different places will send
their requirements to the purchasing department and the purchasing department will
then look into their requirements
, and place the order for the purchase of materials.
2. There are chances of misunderstanding between the branch which requires the mate-
rials and the purchasing department with the result that wrong purchases of materials
can be made.
3. It will lead to high initial cost because a separate purchasing department for the pur-
chase of materials is to be set up.
It is advantangeous to have centralised purchasing if the branches or factories situated
at different places need the same types of materials.
6.4.3. Decentralised purchasing:
Decentralised purchasing means purchasing function is decentralised. Heads of different
departments purchase their requirments. Branches also purchase separately their requirements.
Advantages:
1. Delay in purchases can be reduced.
2. There are no chances of misunderstanding among the branches.
Disadvantages :
1. When purchases are decentralised, trade discounts or economies in transport cannot
be obtained because the quantity involved will be less.
2. Better control on purchasing is not possible. There are chances of reckless buying
when several persons are authorised to make purchases for their requirements.
6.5. LAYOUT OF STORES :
The stores department should be properly organised and equipped for handling of material
coming in and going out. The stores department should be housed in a position which is readily
accessible from any part of the factory and also as near to the road, railway siding or wharf as is
possible in order that the minimum expenditure is incurred in unloading the materials purchased.
A good location of layout of stores may bring down cost of production.
-{Centre fOr Distance Education ))---1.1 J;6~.6LtI ---1( Acharya Nagaduna UniversitY}-
Types of stores layouts:
1. centralised stores.
2. decentralised stores
3. sub- stores.
6.5.1. Centralised stores :
Under this system all materials are held in bulk in a place which is centrally located. Other
decentralised stores draw their supplies from the central stores. Centralised store is always
advisable from the point of view of control and economy.
Merits:
The advantages of purely centralised stores are -
1. Better supervision, better layout of stores and better control over stores.
2. Fewer obsolete articles.
3. Minimum investment in stock
4. Possibility of bulk buying at lower cost.
5. Inventory checks and inventory control facilitated.
Demerits:
1. Increased transportation costs
2. Inconvenience and delay in delivering goods to departments from central stores.
3. Production stoppages in departments due to breakdowns in transport or hold- ups in
central store.
6.5.2. Decentralised stores:
Under the system stores are organised individually by different branches. These stores
draw their supplies from centralised stores.
6.5.3. Sub· stores:
Sub - stores permit stocking of specialised materials for particular departments, closer
liaison between storekeeper and the department he serves, easier detection of discrepancies in
stores records and physical stocks and avoid delay in drawing stores. Each sub store is given as
a commencing stock sufficient supplies for a little more than the re - stocking period. At the end of
each week or other suitable period the sub- store keeper passes all its requisitions to the central
store which reimburses it for these issues and there by restores the stock of each material to its
imprest or original level. The control over such sub- stores is very good as over issues will not be
reimursed. This system thus. combines the advantages of centralised buying and storage with
the benefits of having stock conveniently available at several issuing points. But in this type of
organisation centralised control may be lost, more space may be required and the storage cost
may increase due to increased staff in stores and increased handling equipments.
-{COST & MANAGMENTACCOUNTINGH 6.7 1-1 --~C"_ _ ___:.:.M.::....:AT:..:....:E=..:.R=IA..:;:L=
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6.6. THE STORE KEEPER :
All manufacturing concerns appoint a person known as the store keeper, chief store keeper
or the stores superintendent who is in charge of the stores department and is responsible for
stores control. The storekeeper should have technical knowledge and wide experience in stores
routine and ability of organising the operations of the stores. He should be a man of undoubted
integrity. His duties and responsibilities include the following.
1. Receiving the stores correctly and comparing by an indent, a purchase order, an in-
spection note and a goods received note.
2. Entering all receipts regularly in the Bin cards.
3. Keeping every item of stores in its allotted bin. The principle of good store keeping is a
place for everything and every thing in its place.
4. Maintaining the stores in an orderly and tidy manner.
5. Ensuring that materials are issued only to these who present a duly signed requistion
note.
6. Requisitioning from the purchasing department when the stock of a material reaches
the re-order level.
7. Ensuring that the stocks do not exceed the maximum level nor go below the minimum
level at any time.
8. Checking the Bin card balances with the physical quantities in the bins.
9. Maintaining and supervising the duties of the different members of staff under this
charge.
10. Preventing unauthorised persons from entering into the stores.
6.7. LEVELS OF MATERIALS OR REQUISITIONING FOR STORES :
One of the duties of the store keeper is to send requistions for materials for replenishment
in time so that the production may not hamper for want to materials. In this respect, he is guided by
the re - order level, economic ordering quantity and maximum and minimum quantity which he is
authorised to store in respect of each kind of material.
a. Re - ordering level :
Re - ordering level is the point at which if stock of a particular material in store approaches,
the store keeper should initiate the purchase requisition for fresh supplies of that material. This
level is fixed supplies of that material. This level is fixed somewhere between the maximum and
minimum levels.
Re ordering level = Minimum level + consumption during the time required to get the fresh
delivery.
(or)
Re - ordering level = Maximum consumption X Maximum re - order period.
-{Centre ,or Distance Education ))....--lr661i.a:1-1 -----Ie Acharya Nagaduna University}-
Illustration:
Calculation the ordering level of material' A ' Form the following particulars.
i) Minimum limit 1,000 units
ii) Maximum limit 2,500 units
iii) Daily requirement of material 200 units
iv) Time required for fresh delivery 20 days.
Solution:
Ordering level = Minimum limit + ( consumption during the time required for fresh delivery)
= 1000 units + ( 200 units x 20)
= 1000 + 4000 = 5,000 units
order for the purchase of material should be placed when the material in stock reaches
5,000 units.
Factors governing re - order quantity are-
1. cost of placing orders
2. average consumption
3. cost of storage
4. Interest on captial
b. Maximum level:
The maximum stock level is that quantity above which the stock of any item should not be
allowed to exceed. A maximum stock is generally fixed by taking into consideration the following
factors namely -
1. Average rate of consumption
2. Re- order level and delivery time to obtain supplies
3. Amount of captial necessitated and available.
4. Keeping quality of material
5. Storage space and cost of storage.
6. Price fluctuations.
7. Risk of natural waste.
8. Economic ordering quantity
9. Incidence of Insurance.
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Formula:
Maximum Level = Re - order level- Expected minimum consumption in units during minimum
weeks required to obtain delivery + Re ordering quantity in use.
C. Minimum level:
The minimum stock level is that level below which the stock of any item should not be
allowed to fall. A minimum stock level is fixed by taking into consideration the following factors.
1. Re-order level
2. Average rate of consumption of material
3. Average time required to obtain delivery of fresh supplies.
Formula:
Minimum Level = Re - order level - [ normal or average usage per period x no. of periods
required to obtain delivery (average)]
d. Danger level :
Danger level is a level at which normal issues of the material are stopped and issues are
made only under specific instructions.
Dangel level = Average consumption x Max. re - order period for emergency purchases.
Average stock level
The average stock level is calculated by the following formula:
Average stock level = Minimum stock level + 1/2 of Re - order quantily
1/2 ( minimum stock level + 1/2 of re- order quantity).
Illustration:
Two components X and Yare used as follows:
Normal usage 50 units per week each
Maximum usage 75 units per week each
Minimum usage 25 units per week each
Reorder quantity X = 400 units Y = 600 units
Reorder period X = 4 to 6 weeks Y = 2 to 4 weeks.
-{Centre for Distance Education )>-----11 6.101-1--C Acharya Nagaduna University}-
Calculate for each component -
a. Re-order level
b. Minimum level
c. Maximum level
d. average stock level
Solution:
a) Re-order level-
Re-order level =Maximum Reorder period x Maximum usage
X =6x75 =450 units
Y = 4x 75 = 300 units
-b) Minimum level -
Minimum level = Re - order level - Normal usage per week X Average delivery time.
X = 450 - ( 50x 5) = 200 units
y = 300 - ( 50 x 3) = 150 units
c) Maximum level
Reorder level- Minimum consumption during minimum weeks + Re ordering quantity.
X = 450 - ( 25x4) + 400
Y = 300 - ( 25x2) + 600
Maximum Level + Minimum Level
Average stock level = 2
750+200
X = 2 = 475 units
850 + 150
Y = 2 = 500 units
Average delivery time =
4+6
X=-=5
2
2+4
Y=-=3
2
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e. Economic ordering qunatity :
The quantity of material to be ordered at one time is known as economic ordering quantity.
This quantity is fixed in such a manner as to minimise the cost of ordering and carrying the stock.
Out of the total costs the only costs to be taken care of are ordering costs and carrying costs.
Carrying Cost: It is the cost of holding the materials in the store and includes.
1. Cost of the storage space
2. Cost of bins and racks.
3. Cost of maintaining the materials to avoid deterioration.
4. Amount of interest payable on the money locked up in the materials.
5. Cost of spoilage in stores
6. Transportation cost of material
7. Cost of obsolescence
8. Insurance costs
9. clerical costs.
Ordering costs: It is the cost of placing orders for the purchase of materials and includes.
1. Cost of staff posted in the purchasing, inspection and payment departments.
2. Cost of stationery, postage and telephone charges.
The quantity to be ordered should be such which minimises the carrying and ordering
costs. The order to be purchased should be large enough to earn more trade discount and to take
advantage of bulk transport, but it should not be to large to incur heavy payment on account of
interest, storage and insurance costs. If the price to be paid is stable, the quantity to be ordered
each time can be ascertained by the following formula.
Q =J2~O
Q = Quantity to be ordered
C = Consumption of the material concerned in units during a year.
o = Cost of placing one order.
I = interest payment including variable cost of storing per unit per year i.e holding costs of
inventory.
-(Centre Jor Distance Education ),....---11..J6L.1~2~1---i( Acharya Nagaduna University)-
lIIustraction :
Find out the economic ordering quantity from the following particulars.
Annual usage = 6,000 units
Cost of material per unit = Rs 20
Cost of placing and receiving one order = Rs 60
Annual carrying cost of one unit = 10 % of inventory value.
Solution:
{2CO
E.O.Q. = ~I
C = 6,000 units
0= Rs 60
20x10
1= 100 =Rs2
2 x 6000 x 60 ~
E.O.Q. = 2 =3,60,000 = 600 units
E.O.Q. = 600 units
6.8 ILLUSTRATION
illustration • 1
Find out the ordering level from the following information
a. Minimum stock 1000 units
b. Maximum stock 2000 units
c. Time required for receiving the material 15 days.
d. Daily consumption of material 50 units
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Solution:
Ordering level = Minimum stock + ( consumption during the time required for fresh delivery)
= 1000 units + 50 x 15 = 1750
Ordering level = 1750 units
Illustration -2
A manufacturer buys certain equipment from outside suppliers at Rs 30 per unit. Total
annual needs are 800 units. The following further data are available
Annual return on investment 10%
Rent, Insurance, taxes per units per day Re 1
Cost of placing an order Rs 100
Determine the EOa
Solution:
E.O.a. = J2 ~O
Where C = Annual requirment of material 800 units
o = ordering cost Rs 100
I = Carrying cost per unit = 1 + 10% of Rs 30.
2 x800 x 100
E.O.Q. = = 200 units
4
E.O.a. = 200 units
Illustration -3
The components A and B are used as follows:
Normal usage 50 units per week each
Maximum usage 25 units per week each
Minimum usage 75 units per week each
Re order quantity A = 300 units
B= 500 units
-{Centre for Distance Education )I---LI !2:6.l:14~·j-1 ---« Acharya Nagaduna University)-
Re-order period A = 4 to 6 weeks
B = 2 to 4 weeks.
Calculate for each component -
a. Re-order level
b. Minimum level
c. Maximum level
d. average level
Solution:
a) Re order level-
Re order level = Maximum usage x Maximum Reorder period
Re order level of Material A = 75 x6 = 450 units
Re order level of Material B = 75 x4 = 300 units
b) Minimum level-
Minimum level = Re - order level- (Normal consumption X Normal Re- order period).
Minimum level for material X = 450 - ( 50x 5) = 200 units
Minimum level for material y = 300 - ( 50 x 3) = 150 units
Minimum Period + Maximum Period
Normal Re-order period = ------2------
4+6
Normal Re-order period for material = A = -2- = 5 weeks
2+4
Normal Re-order period for material = B= -- = 3 weeks
2
c) Maximum level
Re-ordering level + Re-ordering quantity-
( Minimum consumption x Minimum Re-order level)
Material A = 450 - ( 25x4) = 650 units
Material B = 300 - ( 25x2) = 750 units
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d) Average stock level = Minimum level + Half Re order quantity
Material A = 200 + 1/2 ( 300) =350 units
Material B = 150+ 1/2 (500) = 400 units
Illustration -4
From the following data calculate maximum stock level, minimum stock level, Re ordering
level Average stock level.
a. Normal consumption 300 units per day
b. Maximum consumption 420 units per day
c. Minimum consumption 240 units per day
d. Re order quantity 3600 units per day
e. Re order time 10 to 15 days
f. Normal Re order time 12 days.
Solution:
Ordering level = Maximum consumption x Maximum delivery time
= 420 x 15 = 3,600 units
Minimum level = ordering level - ( General consumption x general re - order level)
= 6,300 - (300 x 12) = 2,700 units
Maximum level = Ordering level + Re - order quantity - Minimum consumption x
Minimum delivery period.
= 6,300 + 3,600 - (240 x 10) = 7,500 units
Maximum Level + Minimum Level
Average stock level = ------2-----
2,700 + 7,500
= 2 = 5,100 units
lIustraction -5
Calculate EOQ
Annual consumption = 4,000 kgs
Cost per order = Rs 5
pirce per k.g = Rs 5
-{Centre for Distance Education )I-----LI 2.:6.~16Q_J-1 ---(( Acharya Nagarjuna University)-
Carrying cost = 8 % on average inventory
Solution:
E.o.a. = J2 ~O
C = 4,000 units
0= Rs 5
5xB
I = 8% = 100 = 0.40
2 x 4000 x5
E.o.a. = 0.40 = 316.23Kgs
E.o.a. = 316.23 Kgs
6.9 CONCLUSION :
Thus the stores department should be properly organised and equipped for handling of
material, coming in and going out. In determining the location and layout of stores several important
considerations should be kept in view. The stores department should be located in a position
which is readily accessible from any part of the factory and also as near to the road, railway siding
or wharf as is possible in order to reduce the expenditure.
6.10. SELF ASSESSMENT QUESTIONS
Five Marks Questions :
1. Give the meaning of material control
2. Give a list of the functions of the purchasing department
3. What is E.o.a.
4. What are the advatages of ABC analysis.
Ten Marks Questions :
1. How is centralised purchasing superior to decentralised purchasing.
2. Discuss the functions and advantages of a centralised purchasing department of a
company.
3. Eplain different levels of stock
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4. Enumerate the advantages and disadvantages of a centralised stores system
Twenty Marks Questions :
1. From the following figures compute the maximum level and minimum level.
Normal weekly requirement 1000 pieces
Maximum weekly requirement 1300 pieces
Minimum weekly requirement 800 pieces
Time required to obtain supplies 6 to 8 weeks. Re order quantity 10,000 pieces.
Ans· Min. level = 3,400 pieces
Max. level = 15,600 pieces
2. Calculate Minimum and maximum stock levels from the following:
Normal consumption 200 units per day
Maximum consumption 300 units per day
Minimum consumption 240 units per day
Re order period 10 to 15 days
Re order quantity 1500 units
Normal Re order period 12 days.
Ans· Min. level = 1620 units
Max. level = 4000 units
3. Calculate Maximum, Minimum and Average stock levels from the following:
Minimum consumption 1000 units per day
Maximum consumption 1500 units per day
Normal consumption 1200 units per day
Re-order period 10 to 15 days
Re-order quantity 15,000 units
Normal Re order period 12 days.
Ans· Min. level = 8,100
Max. level = 27,500
Ave. Stock level = 15,600
-{Centre for Distance Education) I 6.181 (Acharya Nagaduna University}-
4. Two component A and B are used as follows:
Normal usage 100 units per week each
Minimum usage 50 units per week each
Maximum usage 150 units per week each
Re-order quantity A = 600 units
B= 1000 units
Re-order period A = 8 to 12 weeks
B = 4 to 8 weeks.
5. Calculate for each component
a. Re-order level
b. Minimum level
c. Maximum level and
d. Average stock level
6. Two component X and Yare used as follows:
Minimum usage 50 units per week each
Maximum usage 150 units per week each
Normal usage 100 units per week each
Re order quantity X = 600 units
Y= 1000 units
Re order period X = 4 to 6 weeks
Y = 2 to 4 weeks.
Calculate for each material Minimum level, Maximum level and ordering level
x units y units
Ans - Min. level = 400 300
Max. level = 1300 1500
ordering level = 900 600
--{COST & MANAGMENT ACCOUNTINGH 6.19 1-1 --~C,-_~M.::....:A:..:....:JE=.:.R..:.:.:IA...::L=S;,_-..:.....I
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7. Calculate E.o.a. form the following information
Annual usage 8000 units, cost per unit Rs. 0.30 , Buying cost Rs. 7 per order. Storage
and carrying cost as percentage of average inventory holding 15 %
Ans • 1578 units
Calculate E.o.a. from the following
A factory requires 2000 units of a material for a year cost of carrying one unit is Rs1p.a.
Expenses of placing an order amount to Rs. 10.
Ans ·200 units
8. Form the following find out
a) How much should be ordered each time.
b) When should the order be placed
Annual consumption 12,000 units ( 360 days)
Cost per unit Rs 1, ordering cost Rs. 12 per
Order inventory carrying cost 24 % normal lead time 15 days and safety stock
30 days consumption
Ans· a - 1095 units
b - Safety stock + lead time
consumption i.e 1000 + 500 = 1500 units
9. From the following calculate reorder level, re- order quantity, Minimum level, Maximum
level, Average stock level and Danger level:
1. Ordering cost per order Rs. 20
2. Annual consumption of material 5,000 units
3. Purchase price per unit Rs. 50
4. Annual cost of storage Rs. 5 per unit
5. Lead time: Average 10 days, Maximum 15days Minimum 6 days and Maximum
for emergency purchases 4 days
6. Rate of consumption
Average·15 units per day
Maximum 20 units per day
Ans· ROL - 300 units; ROa = 200 units
Min. level 150 units; Max level = 440 units
Av. level 250 units; Danger level = 60 units
-(Centre for Distance Education) 1 6.20 -----i( Acharya Nagarjuna University}-
1-1
6.11 BOOKS RECOMMENDED
1. Cost Accounting - Rudra Saibaba.
2. Cost & Management Accounting - S.P. Jain & K.L. Narang
3. Cost Accounting - B.K. Bhar.
4. Cost Accounting - S.P. Jain & K.L. Narang
Dr. K. Kanaka Durga
Lesson - 7
MATERIALS-II
7.0 OBJECTIVES:
After studying this lesson you should be able to understand-
~ How to control cost through stores records
~ What are the different methods of valuing material issues
~ What is inventory Control
STRUCTURE:
7.1 Introduction
7.2 Stores Records
7.2.1 Bin Card
7.2.2 Proforma of Bin Card
7.2.3 Stores Ledger
7.2.4 Proforma of Stores Ledger
7.2.5 Differences between Bin Card & Stores Ledger
7.2.6 Stores Requistion
7.3 Methods of Valuing Material Issues
7.3.1 Cost Price Methods
7.4 Inventory Control
7.5 Conclusion
7.6 Self Assessment Questions
7.7 Books Recommended
7.1 INTRODUCTION:
Material is very significant fctor of production. It occupies more then 60% of cost of production.
Material which form prt of a finished product is known as direct material. Hence proper control of
material cost is necessary. Material control is acccomplished through functional organisation,
assignment of responsibility, and documentary evidence obtained in various stages of operation
-(Centre for Distance Education ))---U7~.2u-1--..,C Acharya Nagaduna University)-
Effective control also requires the systematic preparation of periodic summaries and reports. The
bin cards and the stores ledger are the two important stores records that are generally kept for
making a record of the various items of stores.
7.2.STORES RECORDS OR MATERIAL RECORDS
For recording the purchges , issues and balance of stock availble, in the stores, the3
company prepares two stores records vize stores ledger and bin card , preparation and
maintenance of stores ledger and bin card is the duty of store keeper.
7.2.1. Bin Card:
The stock record maintained by stores department is known as Bin Card. Bin refers to as
shelf or rack . It makes a record of the receipt and issue of material and is kept for each item of
stores received is entered in the receipt column and the quantity of stores issued is recorded in the
issue column of the bin card and a balance of the quantity stores is taken after every receipt or
issue, so that the balance at any time can be readily seen. These cards are maintained by the
storekeeper. These cards also assist the store keeper to control the stock. For each item of stores
minimum quantity, maximum quantity and ordering quantity are stated on the card.
Double Bin System: Some concerns divide the bin, rack or shelf in two parts, namely the
smaller part to store the quantity equal to the minimum quantity and the other part to store the
remaining quantity and the other part to store the remaining quantily. The quantity in the smaller
part is not issued so long as the quantity is available in the other part. This system helps in exercis-
ing stores control in an effective way as it facilitates physical verification and services as a signal
when it becomes necessary to use the quantity kept in the smaller part.
Merits of bin card :
1. By seeing the bin card, the store keeper can send the material requisition for the pur-
chase of material in time.
2. The store keeper should have a stock record under him.
3. Maintenance of bin cards is desired to have up to date balance of stock.
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7. 2.5. Differences between Bin Card and Stores Ledger:
Bin Card Stores Ledger
1. Bin card is a record of only 1. Stores ledger is a record of both
quantities quantities and values
2. ft is maintained by the store 2. ft is maintained by the costing
keeper department
3. Transactions are posted 3. Transactions are posted after the
normally just before the transaction takes place.
transaction takes place.
4. Each transaction is 4. Transactions may be summarised
individually posted. and posted periodically
5. Bin is usually kept inside 5. Stores ledger is kept outside the
the stores stores.
7. 2.6. Stores Requisition:
Materials are held in stores for utilisation but the storekeeper must not issue materials
unless a properly authorised material requisition is presented to him. The store keeper is always to
issue the material on proper authority. This authority is usually given by the foreman of the produc-
tion department on a form known as material requisition. The proforma is given below:
-{Centre for Distance Education )>-----ILI .!..7~.6_j1---1(Acharya Nagarjuna University)-
7.2.4 Proforma of Stores Ledger :
I X Company limited
I
Stores Requisition
Department . No .
JobNo . Date .
To
The store keeper
please issue the materials stated here in
For Bin Stores
Code Office
Description Quantity cost Card Ledger Remarks
No. Amount
Rate No. folio
7.3 METHODS OF VALUING MATERIAL ISSUES:
Materials issued form the stores are debited to the jobs or work orders which received
them and credited to the materials account. These jobs are debited with the value of materials
issued to them. There are many methods of pricing material issues. A very careful choice has to
be made of the methods of valuing the material issues bacause it influences the cost of the job
and the value of the closing balances of material in the stores. The various methods of pricing
material issues given above are the cost assignment methods and do not necessarily relate to the
physical flow of materials on and off the shelves. A good method of valuing materials, issues
should satrisfy the following conditions.
-{COST & MANAGMENT
ACCOUNTING)-1 7.7 I (MATERIALS -II )-
1. The issue price should recoverthe cost price of the materials
2. The issue price must be near the market price
3. The issue price shouldnot leadto anyvariationin cost of similarjobs from periodto
period.
4. The issue price should not necessitateadjustmentsin valuesof stock of materials.
5. The price shouldconsidermanagementpolicyrelatingto valuationof closingstock.
6. A methodof valuationof materialissuesshouldtake intoconsiderationthe natureof
materials used. There are many methods of pricing material issues, the most
importantare -
A Cost price methods -
i. First in first out
ii. Last in First out
iii. Averagecost
iv. Inflatedprice
v. Specific price
vi. Base stock
vii. Highestin First out.
B. Marketprice Methods-
i. Replacementprice
ii. Realisablevalue
C. Standardprice methods
i. Currentstandard price
ii. Basic standard price
-{Centre for Distance Education ))-----11 7.8 1-1----4( Acharya Nagarjuna University}-
Methods of Valuing Material Issues
A Market Standard Price
Cost Price Methods price Methods
Methods
Current Basic
Replacement Realisable standard standard
Price Value
price price
LIFO Average Inflated Specific Base HIFO
FIFO
cost Price Price stock
7. 3.1. Cost price Methods :
A. First in First Out Method [ FIFO]
Under this method materials received first are issued first. The units in the opening stock
of materials are treated as if they are issued first, the units from the first purchase issued next, and
so on until the units left in the closing stock of materials are valued at the latest cost of purchases.
It follows that unit costs are apportioned to cost of production according to their chronological
order of receipts in the store.
This method is suitable in times of falling prices. It is not suitable in case of rising prices.
Merits :
1. The FIFO method is simple to understand and easy to operate.
2. Mdierials are issued in order of purchases, so materials received first are utilised
first.
-{COST & MANAGMENTACCOUNTING}-iL..1.7.J;j.9UIr----1(..._ _ ____;,,;,;MA::....;J.;..:E::.;_R=IA..:::;:L;
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3. This method recovers the cost price of the materials because materials are issued
at the purchase price.
4. In case of falling prices this method is useful.
5. This method is useful when transactions are not too many.
Demerits:
1. There is scope for clerical errors, if consignments are received frequently at fluctuating
prices.
2. In case of fluctuations in prices of materials comparison between one job and the
other job becomes difficult.
3. In case of rising prices this method is not useful.
Illustration :
From the following information write at the stores ledger account in respect of the materials
for the month of january. Issues are to be priced on the principle of first in first out.
Jan 1 opening balance: 500 units at Rs 4.00.
Jan 5 received from vendor 200 unit .. at Rs. 4.25.
Jan 12 received from vendor 150 units at Rs. 4.10.
Jan 20 received from vendor 300 units at Rs. 4.50.
Jan 25 received from vendor 400 units at Rs. 4.00.
Issues of material were as follows:
Jan 4 - 200 units
Jan 10 - 400 units
Jan 15 - 100 units
Jan 19 - 100 units
Jan 26 - 200 units
Jan 30 - 250 units
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lIustration : 2
From the following particulars, prepare stores ledger account, showing the princing of
materials issues, by adopting FIFO method.
1- 12 - 2007 Opening stock 500 unit at Rs 2 each
3- 12 - 2007 Purchased 400 unit at Rs 2 -10 each
5- 12 - 2007 Issued 600 unit to job K
7- 12 - 2007 Purchased 800 unit at Rs 2.40 each
9- 12 - 2007 Issued 500 unit to job p
12- 12 - 2007 returned from job k 200 units
17-12 - 2007 purchased 400 unit at Rs 2.50 each
25- 12 - 2007 Issued 600 unit to job y.
solution:
Note; 1. It has been presumed that the return of material too is in accordance with the
method i.e. FIFO followed,
2. Receipts of goods returned has been considered as a fresh receipt.
-{Centre for Distance Education )>---ll L7 .112£j-1 --"""1( Acharya Nagaduna University}-
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B. Last in First Out [LIFO] :
Under this method the issues are priced in the reverse order of purchase i.e the price of
the latest available consignment is taken. This method is sometimes called replacement cost
method. This method is suitable in times of rising prices because material will be issued from the
latest consignment at a price which is closely related to the current price levels.
This method is suitable in times of falling prices. It is not suitable in case of rising prices.
Merits:
1. This method is simple to operate and is useful when transactions are not too many
and the prices are fairly steady.
2. FIFO method recovers cost from production because actual cost of material is charged
to production.
3. In times of rising prices, LIFO method is suitable.
Demerits:
1. This method may lead to clerical errors as every time an issue is made.
2. Comparison between two jobs will become difficult.
3. For pricing a single requisition, more than one price has often to be adopted.
Illustration 3 :
From the following information prepare stores ledger accounts under LIFO method.
2- 1 - 2008 Purchased 4000 unit at Rs 4.00 per unit
20- 1 - 2008 Purchased 500 unit at Rs 5.00 per unit
5- 2 - 2008 Issued 2000 units
10- 2 - 2008 Purchased 6000 units at Rs. 6.00 per unit
12- 2 - 2008 Issued 4,000 units
2- 3 - 2008 Issued 1000 units
5- 3 - 2008 Issued 2000 units
15- 3 - 2008 Purchased 4500 units at Rs 5.50 per unit
20- 3 - 2008 Issued 3000 units
-{Centre for Distance Education ))---ll .!...7.11i4tl
----1( Acharya Nagaduna University}-
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lIustration : 1
From the following date prepare stores ledger account by LIFO method.
1- 1 - 2008 Opening balance 200 unit at Rs 3
3- 1 - 2008 Purchased 300 units at Rs 4.
4- 1 - 2008 Issued 250 units
7- 1 - 2008 Purchased 100 units at Rs. 2.
9- 1 - 2008 Issued 50 units
10- 1 - 2008 purchased 300 units at Rs. 3.
11- 1 - 2008 Issued 200 units
On 8th January 2008 stock is verified and 10 units of shortage is identified.
solution:
Note; The identified shortage of stock is treated as issue.
STORES LEDGER
LIFO Method
RECEIPTS ISSUES BALANCE
DATE Price Amount Price Amount
Quantity Quantity
Price Amount
Rs Quantity
Rs. Rs Rs. Rs Rs.
1-1 -2008 - - - - - - 200 3 600
3-1 -2008 300 4 1200 - - - 200 3 600
300 4 1200
4-1 -2008 - - - 200 3 600
50 4 200 250 4 10000
7-1 -2008 100 2 200 - - - 250 4 10000
100 2 200
8-1 -2008 - - - 10 4 40 240 4 960
shortage 100 2 200
9-1 -2008 - - - 50 4 200 190 4 760
100 2 200
10-1 -2008 300 3 900 - - - 190 4 760
100 2 200
300 3 900
11-1 -2008 - - - 190 4 760 90 2 180
10 2 20 300 3 900
-(Centrelfor DistanceEducation)r---LI L7.116~1 ---1(Acharya NagarjunaUniversity)-
C. Average cost Method :
Under this method all of the materials in store are so mixed up that an issue cannot be
made from any particular lot of purchases and therfore it is proper if the materials are issued at the
average cost of materials in store. Average may be of two types.
l, Simple Arithmetic Average
ii. Weighted Arithmetic Average
i. Simple Arithmetic Average:
Simple average price is calculated by dividing the total of unit purchase prices of different
lots in stock on the date of issue by the number of prices used in the calculation and quantity of
different lots is ignored.
. Total of unit purchase prices
Average Price = N fP.
0.0 rices
ii. Weighted Arithmetic Average:
The weighted average price takes into account the price and quantity of the materials in
store. Weighted Average price is a price which is calculated by dividing the total cost of materials
could be drawn by the total quantity of materials in that stock.
Value of Stock
Weighted Average price = Quantity of Stock
Merits:
1,. This method is rational, systamatic and not subject to manipulation.
2. Average price method is considered to be the best method when prices fluctnate
considerably.
3. Issue prices changes only when new lot of materials is received.
4. This method recovers the cost of materials from production.
5. Average cost method is mostly used by different organisations because it satisfies
most of the conditions of a good method of valuing material issues.
Demerits:
1. This method involves tedious calculation.
2. There are chances of clerical errors.
3. At the time of rising prices, it over-states profit.
4. Closing stock is not valued at current cost.
-{COST & MANAGMENT ACCOUNTINGHL7L..L17ul---~C...__-=M::....:AT..:....:E::.:...R=IA...;;:L=S_;-I;.:...1
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Illustration 5 :
The following transactions took place in respect of an item of material.
Date Receipts Quantity Rate Rs. Issue Quantity
2-3-2007 200 2.00
10-4-2007 300 2.40
10-4-2007 250
28-5-2007 250 2.60
6-6-2007 200
Record the above transactions in the stores ledger, pricing the issues at :
a) Simple Average rate
b) Weighted Average rate.
STORES LEDGER
Average price method
PURCHASE ISSUES BALANCE
DATE Price Amount Price Amount Price Amount
Quantity Quantity Quantity
Rs Rs. Rs Rs. Rs Rs.
2-3-2007 200 2.00 400 - - - 200 - 400
10-4-2007 300 2.40 720 - - - 200 - 400
500 1120
300 720
20-4-2007 - - - 250 2.20 550 250 - 570
28-5-2007 250 2.60 650 - - - 250 - 570
500 1220
250 650
6-6-2007 - - - 250 2.50 500 300 - 720
Simple Average prices
RS 2 + Rs 2.40)_
1. ( 2 - 2.20
RS 2.40 + Rs 2.60)_
2. ( 2 -2.50
-{Centre~for Distance Education) I 7.18 I ( Acharya Nagaduna University)-
STORES LEDGER ACCOUNT
Weighted Average price
RECEIPTS ISSUES BALANCE
DATE Price Amount Price Amount Price Amount
Quantity Quantity Quantity
Rs Rs. Rs Rs. Rs Rs.
2-3-2007 200 2.00 400 - - - 200 - 400
10-4-2007' 300 2.40 720 - - - 500 - 1120
20-4-2007 - - - 250 2.24 560 250 - 560
28-5-2007 250 2.60 650 - - - 500 - 1210
EH5-2007 - - - 200 2.42 484 300 - 720
400+ 720)
1. ( 200 +300 = 2.24
(560+650)
2. l250 +250 = 2.42
D.lnflated price method:
There are some materials which are subjected to natural wastage. In such cases, the
materials are issued at an inflated price ( a price higher than the actual cost) So as to recover the
cost of natural wastage of materials from the production. For Ex. materials lost due to loading and
unloading.
E. Specific price method:
Under this method materials issued to production are priced at their purchase prices. The
basic assumption in following this method is that materials in the stores are capable of being
identified as belonging the specific lots. Identification can be made by placing some distingushing
mark usually price tag on every lot. When materials are issued price tags are removed and forwarded
to the costing department for assertaining the material cost of production.
Merits:
1. This method is simple in its mechanism and operation.
2. This method does not create accounting complications.
-{COST & MANAGMENT ACCOUNTINGHL7L:..Jj19;u1---"""""IC..__~M:;....:AT.:..;:E;:;...R=IA-=L=S__;-I;.;_1
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3. This method is useful where job costing is in operation.
4. It is suited to the needs of a small business enterprises.
F. Base stock Method :
Each concern always maintains a minimum quantity of material in stock. This minimum
quantity is known as safety or base stock and this should be used only when an emergency
arises. The base stock is created out of the first lot of the material purchased and therefore, it is
always valued at the cost price of the first lot and is carried forward as a fixed asset.
This method is generally used with FIFO or LIFO method. Any quantity over and above the
base stock is issued in accordance with the other method which is used in conjunction with this
method. The objective of this method is to issue the method according to the current prices.
Merits:
1. It is easy to estimate value of closing stock.
2. This method is easy to understand and simple to operate.
Demerits:
1. Value of closing stock should not reflect market price.
2. Inventory at low cost is showed in balance sheet.
Illustration 6 :
From the following information prepare stores ledger accounts following FIFO and LIFO
methods keeping 1,000 units as base stock.
1- 4 - 2008 stock of material 4000 units at Rs 5 each
2- 4 - 2008 Purchased units 1000 at Rs. 5.50 each
6- 4 - 2008 Issued 4000 units
10- 4 - 2008 Purchased 6000 units at Rs. 6.00 each
15- 4 - 2008 Issued 5000 units
20- 4 - 2008 purchased 5000 units at Rs. 6.50 each
25- 4 - 2008 Issued 6000 units
27- 4 - 2008 purchased 8000 units at Rs. 7.00 each
30- 4 - 2008 Issued 5000 units
-(Centre for Distance Education )r--LI L7"~20~1
--~( Acharya Nagaduna University}-
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-(Centre for Distance Education ))-----11 7.221-1---4C....-:A{i";c::j;h;;a~ry~a·'NNj;a;;;ga;;f)i;';·u;;na;;nU;Jni~ve;;rs~ityh7')
G. Highest in first out method:
This method is based on the assumption that the closing stock of materials should always
remain at the minimum value, so the issues are priced at the highest value of the available
consignments in the store. This method is not popular as it always under values the stock which
amounts to creating a secret reserve.
H. Market Price method:
.Market price can either be the replacement price or the realisable price. The replacement
price is used in case of the items which are held in stock for use in production while realisable
price is used in respect of the items which are kept in stock for sale. Under this method, materials
are issued at a price at which they can be replaced. Therefore cost of the materials issued is not
considered but materials are issued at the market price prevailing on the date of issue.
Merits:
1. This method is considered to be the best method where quotations have to be sent
because quotations sent would reflect the latest competitive conditions.
2. This method discloses whether the buying is efficient or in efficient.
Demerits:
1. This method does not recover cost price of the material from production because
materials are issued at the market price which may be more or less than the cost
price.
2. It makes stores ledger complicated by introducing the element of profit or loss.
I. Standard price method:
Standard price is the predetermined price and both the receipts and issues will be valued
at this price. This method is used by concerns which follow standard costing.
Merits:
1. This method is easy to operate.
2. Material price variance can be used as a management tool for control of material
cost.
Demerits:
1. The standard price does not recover the costs of material.
2. It creates problems of material price variance and stock adjustment.
Pricing of returns :
1. The returned material is valued at the original price at which it was issued
OR
2. The returned material is priced at the rate at which any materials requistion placed on
that date would have been priced.
-{COST & MANAGMENTACCOUNTING)--Iw7~.2~3~1--~c,- _ _..:..:.M:..;AT~E::..R.:.:.:.IA-=L==S_;-
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7.4 INVENTORY CONTROL :
Inventory control is the system devised and adopted for controlling investment in inventory.
It includes control over raw materials stores, supplies, spare parts, tools, components, work in
process and finished goods. Inventory control is a system which ensures the provision of the
required quantity of inventories of the required quality at the required time with the minimum amount
of capital. The function of inventory control is to obtain the maximum inventory turnover with sufficient
stock to meet all requirements. The main objectives of inventory controll are as follows.
Objectives of inventory control :
1. Maintaining adequate inventory so as to avoid production heldup leading to customer
dissatisfaction, loss of revenue etc.
2. Avoiding excessive investment in inventory.
3. Relieving management in taking inventory decisions for each and every item of
inventory.
4. Supervising the stores inventory subsidiary ledgers.
5. Maintaining up - to - date price record of all items.
6. Preparing material abstract.
Methods of Inventory control :
The common methods adopted for inventory control are -
i. Periodical inventory control method.
ii. Perpetual inventory control method.
iii ABC analysis.
i. Periodical inventory control method:
In this method the stock is verified at the end of the stipulated period by stock taking
committee constituted by the top management it consists the members drawn from different
departments of the company and its term is temporary. Committee physically counts, weights,
measures the stock in stores and gives the report to the management.
ii. Perpetual inventory control method :
The perpetual inventory system is a method of recording stores balances after each receipt
and issue, to facilitate regular checking and to obviate closing down of work for stock taking. In
order to ensure accuracy of perpetual inventory records, physical stocks should be checked.
Thus an essential feature of the perpetual inventory system is the continuous checking of stock.
The use of Tag system is a common arrangement for recording units counted.
Actual stock of material may differ from card or stores ledger balances on account of
avoidable causes and unavoidable causes.
-{Centre fOr Distance Education ))----11 7.24 1-1
----(( Acharya Nagaduna University}-
A. Avoidable causes :
i. Errors in posting or calculation of receipts, issues or balances on bin cards or on
stores Ledger accounts.
ii. Pilferages and breakages.
iii. Entering transations in the wrong bin card or in the wrong stores ledger account.
iv. Goods received and deposited in wrong bins, wrong issues, over - issues or under
issues.
B. Un Avoidable causes :
i. Shrinkage and evaporation.
ii. Losses arising out of breaking up bulk material for issue as in sawing wood, loss in
pouring liquid etc.
iii. Climatic conditions causing deterioration eg., absorption, crumbling.
iv. Small defective units e.g. bolts and screws.
v. Metarials purchased by weight but issued in quantities.
The maintenance of a satisfactory perpetual inventory records has the following advantages-
i. It obviates the need for the physical checking of all stocks at the year end.
ii. A detailed reliable check on the stores is obtained.
iii. It avoids the dislocation of production which arises when the stocks are checked at
onetime.
iv. Errors, Irregularities and loss of stock are readily discovered. It helps in preventing a
recurrence in future.
v. As the work is carried out systematically and without undue haste, the figures are
generally reliable.
vi. The disadvantages of excess stocks are avoided and capital tied up in stores materials
cannot exceed the target.
iii ABC analysis:
ABC analysis intends to concentrate on these items which are considered precious and
require effective control on selective items only. Usually the materials used in an organisation are
grouped into three categories A, Band C items under A category would be of high value, those
under B would be of medium value and under C category would be of low value.
ABC analysis measures the cost significance of each item of material. It concentrates on
important items. So it is also known as control by importance and exception ( C.I.E. ) The
significance of this analysis is that a very close control is exercised over the items of A group
-{COST & MANAGMENT ACCOUNTINGH 7.251-1
------4C"- _ ____:.;,;MA::..,;J.:..:E::.:..R.::,:.IA..;:::L=S__;-I:.:_1
__ }-
which account for a high percentage of costs while less stringent control is adequate for category
B and very little control would suffice for category C items.
Advantages :
1. A strict control is exercised on the items which represent a high percentage of the
material costs.
2. Investment in inventory is reduced to the minimum possible level because a reasonable
quantity of A items representing a Significant portion of the material costs is purchased.
3. Storage cost is reduced as a reasonable quantity of materials, which account for
high percentage of value of consumption will be maintained in the stores.
7.5. CONCLUSION
Thus the fixation of the price at which issues of materials are to be charged to production
is an important one from the point of view of cost accounting. There are numerous factors to be
taken into account in pricing the materials issued to production. Where purchase prices remain
constant for a long period, there is little difficulty in correct accouting for materials in practice we
find that prices of materials fluctuate on account of changes in the value of money, changes in
world commodity prices, buying from different sources and differences in quantity discounts. Under
these circumstances it may be observed that there may be a number of identical articles bought at
different prices. While issuing these articles it is essential to consider the price at which it should
be charged to production. There are various methods in use with attendent advantages and
disadantages from the point of view of both convenience and accounting aspects.
7.6. SELF ASSESSMENT QUESTIONS
Five Marks Questions :
1. What is bin card? What are its uses?
2. Explain stores ledger
3. Differentiate bincard from stores ledger
4. What is base stock method.
Ten Marks Questions :
1. Explain FIFO and LIFO methods of material issues.
2. How to fix prices to issue of material under average cost method?
3. What are merits and demerits of market price method.
4. Explain ABC analysis.
-{Centre for Distance Education )1:-: -___'1_;7~.2~6UI---1(Acharya NagarjunaUniversity}-
Twenty Marks Questions:
1. Explain briefly various methods of valuation of material issues.
2. What are the methods of inventory control.
3. Show the stores ledger entries as they would appear when using FIFO and LIFO methods
of pricing the issues.
1- 4 - 2008 Balance 300 units value Rs. 600
2- 4 - 2008 Purchased 200 units, value Rs. 440
4- 4 - 2008 Issued 150 units
6- 4 - 2008 Purchased 200 units, value Rs. 460
17-4 - 2008 Issued 150 units
19- 4 - 2008 Issued 200 units
22- 4 - 2008 Purchased 200 units, value Rs. 480
29- 4- 2008 Issued 250 units
Ans • [ Stock Value - FIFO 360; LIFO 300 ]
4. Prepare a stores ledger account showing the receipts and issues under FIFO and LIFO
methods.
Date Quantity Rate per unit Purchasel Issue
1-5-2008 200 20.00 Purchase
4-5-2008 100 Issued
10-5-2008 50 Issued
18-5-2008 309 18.00 Purchase
20-5-2008 250 Issued
30-5-2008 100 16.00 Purchase
31-5-2008 100 Issued
5. Prepare stores ledger accounts by using FIFO and LIFO methods.
4· 1 - 2008 500 metres of type M at Rs 20 per metre
7- 1 - 2008 800 metres of type N at Rs 30 per metre
9- 1 - 2008 1150 metres of type M at Rs 24 per metre
17- 1 - 2008 1500 metres of type N at Rs 32 per metre
26- 1 - 2008 400 metres of type M at Rs 19 per metre
-{COST & MANAGMENTACCOUNTINGH....J7[j.2~7.t1-----1C'-_ _.:.:.;M:..,:.AT.:....:E::.:...R::.:.:,.IA..:=L
__ }-
Issues were as follows :
8- 1 - 2008 350 metres of M
12- 1 - 2008 600 metres of N
28- 1 - 2008 710 metres of M
29- 1 - 2008 1430 metres of N
31- 1 - 2008 790 metres of M
Ans - FIFO - M - 3,800 N- 8640
LIFO - M - 4,200 N- 8240
6. From the following prepare stores ledger Ale by LIFO method.
Jan 2 Purchased 4000 units at Rs. 4 per unit
Jan 20 Issued 500 units at Rs. 5 per unit.
Feb 5 Issued 2000 units
Feb 10 Purchased 6000 units at Rs. 6.00 per unit
Feb 12 Issued 4000 units
March 2 Issued 1000 units
March 5 Issued 2000 units
March 15 Purchased 4500 units at Rs. 5.50 per unit
March 20 Issued 3000 units
Ans ·14,250
7. Prepare stores ledger AlC by base stock method when it operates in conjunction with
FIFO and LIFO methods. Base stock is 200 units.
2007 Dec,1 Purchased 500 tonnes at Rs. 2.00 per ton
2007 Dec,1 0 Purchased 300 units at Rs. 2.10 per ton
2007 Dec, 15 Issued 600 tonnes
2007 Dec, 20 Purchased 400 units at Rs. 2.20 per ton
2007 Dec, 25 Issued 300 tonnes
2007 Dec, 27 Purchased 500 units at Rs. 2.10 per ton
2007 Dec, 31 Issued 200 tonnes
-(Centre for Distance Education) 1 7.281 ( Acharya Nagaduna University}-
B. Following transactions took place in the month of March:
Date Receipts kgs Rate Rs. Issue Kgs.
2007 Dec, 2 200 2.00
2007 Dec,10 300 2.40
2007 Dec,15 250
2007 Dec,1B 250 2.60
2007 Dec, 20 200
Stock verifier reported a loss of 50 kg on 15th March. Prepare stores ledger Ale by
simple average and weighted average methods.
Ans - SAM - 250 Kgs - Rs 600
WAM - 250 Kgs - Rs 614
9. Prepare stores ledger by adopting simple average method and weighted average method.
200B Jan 1 Balance 500 units at Rs. 25 per unit
200B Jan 3 Issues 250 units
200B Jan 10 Purchases 200 units at Rs. 26 per unit
200B Jan 12 Returns from a work order 15 units at Rs. 24 per unit
200B Jan 15 Issues 1BOunits
200B Jan 16 stock verification reveals a loss of 5 units.
200B Jan 20 Purchases 320 units at Rs. 30 per unit
200B Jan 2B stock verification reveals a loss of B units.
200B Jan 30 Issues 112 units
Ans - SAM - 430 units, Value Rs 13,635
WAM - 430 units, Value Rs 12,623
--(COST & MANAGMENTACCOUNTINGH 7.291 ( MATERIALS -II )-
10. XYZ Ltd. has purchased and issued the material'Q' in the following order.
2007 Units Unit cost
Dec, 1 Purchase 300 3
Dec, 4 Purchase 600 4
Dec, 6 Issue 400
Dec, 10 Purchase 600 4
Dec, 15 Issue 1000
Dec, 20 Purchase 400 5
Dec, 23 Issue 200
Which of the methods of pricing issue of materials would you recommend in the above
case? Ascertain the quantity of closing stock as on 31st December and state what will
be its value in each case if issues are made under the
1. Method recommended by you
2. Weighted average cost.
7.7 BOOKS RECOMMENDED
1. Cost & Management Accounting - S.P. Jain & K.L. Narang
2. Practivcal costing - Khanna; Pandey; Ahuja.
3. Cost Accounting - S.P. Jain & K.L. Narang
4. Cost Accounting - Rudra Saibaba.
Dr. K. Kanaka Durga
· Lesson - 8
LABOURCOST-CONTROL
8.0 OBJECTIVES:
After studying this lesson you should be able to understand -
)0> What is labour
)0> What are the types of labour
)0> How to control the labour cost
)0> Role of different departments in control of labour cost.
)0> Wage payment methods.
STRUCTURE:
8.1 Introduction
8.2 Types of material
8.3 Material Control
8.4 Control over labour costs
8.4.1 Personnel Department
8.4.2 Engineering Department
8.4.3 Time and Motion study Department
8.4.4 Time Keeping
8.4.5 Time booking
8.5 Idle time
8.6 Over time
8.7 Wage payment methods
8.7.1 Essentials of a good wage payment methods
8.7.2 Time wage method
8.7.3 Piece wage method
8.8 Conclusion
8.9 Self Assessment Questions
8.10 Books Recommended
-{Centre for Distance Education )~--L_J:8~.2~1
--"'1( Acharya Nagarjuna UniversitY}-
8.1 INTRODUCTION:
Labour cost is a second majour element of cost. Remuneration paid to labour is called
labour cost or wages. Proper control and accounting for labour cost is one of the most important
problems of a business enterprise. Labour can be devided into direct labour and indirect labour.
Direct labour is that labour which is directly engaged in the production of goods and services.
Payment of direct labour is a part of prime cost whereas payment of indirect labour is an item of
indirect expenses. Since labour cost constitute a significant portion of the total cost of a product,
economic utilisation of labour is a need of the present day industry to reduce the cost of production.
Control of labour cost depends upon the co-operation of every member of the supervisory force
from the top executive to foremen. A high labour turnover increases cost of production. With the
help of some techniques such as motion study, time study, job analysis, time keeping, time booking
cost of production can be reduced. Idletime should be reduced to control cost. Overtime work
should be avoided because job done in overtime cost more as compared to the job done during
normal time.
6.2. TYPES OF LABOUR:
Labour refers to the part of human effort by which raw materials are shaped into finished
goods. Labour cost is classified as direct labour cost and indirect labour cost.
a. Direct Labour:
Direct labour cost is that cost which can be conveniently allocated to a particular job, prod-
uct or process for example labour engaged in making the bricks in a kiln is direct labour because
labour charges paid for making 10,000 bricks can be conveniently allocated to the cost of 10,000
bricks. Payment of direct labour is a direct expenditure and is a part of prime cost.
b. Indirect Labour:
Indirect Labour is that labour which is not directly engaged in the production of goods and
services but which indirectly helps the direct labour engaged in production. The cost of indirect
labour can not be conveniently allocated to a particular job, order, process or article. Payment of
indirect labour is an item of indirect expenditure and is shown as works, office selling & distribution
expenditure according to the nature of the time spent by the indirect worker. The indirect workers
are mechanics, supervisor, chowkidars, sweepers, foremen, watchmen, time keeper, cleaners,
repairers etc,.
8.3. LABOUR COSTS:
Labour costs include various items of expenditure incurred on workers towards monetary
benefits and frings benefits.
A Moneteny Benefits: Examples - Basic pay, Dearness pay, Employer's contribution to
provident fund and state insurance scheme, production bonus, profit Bonus pension
a~grn~~ .
B. Frings Benefits: Examples - Subsidised food, subsidised housing, subsidised edu-
cation to the children of the workers, medical facilities, recreation facilities etc,.
-{COaT & MANAGMENTACCOUNTINGHL~8:d.3UI---~( LABOUR COST - CONTROL)-
8.4. CONTROL OVER LABOUR COSTS:
Labour costs constitute a significant portion of the total cost of a product. Labour cost may
increase due to inefficiency of labour, more wastage of materials by labour due to lack of proper
supervision, high labour turnover, idle time and unusual overtime work etc,. Therefore, economic
utilisation of labour is a need of the industry to reduce cost of production management is interuted
in labour costs on account of the following causes -
i. to use direct labour cost as a basis for increasing the efficiency of workers.
ii. to identify direct labour cost with product for ascertaining the cost of every product.
iii. to use direct labour cost as a basis for absorption of overhead.
iv. to determine indirect labour cost to be treated as overhead.
Hence control of labour costs is an important objective of management. To reach the ob-
ject management seeks the cooperation of every member of the organisaiton. Following six de-
partments contribute much to control labour cost.
1. Personal Department
2. Engineering Department
3. Time and Motion study Department
4. Time keeping Department
5. Cost Accounting Department
6. Pay - roll Department
8.4.1. Personal Department:
Personal department is responsible for the implementation of managerial decisions re-
garding recruitment training and placement of employees. Proper planning of this process helps
the managment to take steps to improve the working conditions so that there may not be frequent
changes in the labour force. Mechanisation of operations should be considered if it is helpful in
reducing labour costs. One of the important functions of the personal department is handling labour
turnover.
8.4.1. 1. Labour Turn over:
Labour turnover denotes the percentage change in the labour force of an organisation.
High percentage of labour turnover denotes that labour is not stable and there are frequent changes
in the labour force because of new workers engaged and workers who have left the organisation.
A high labour turnover is not desirable. Labour turnover is assessed according to replacement
method with the help of following principle.
Number of workers replaced during a period
Labour Turnover = Average
. ..
number of workers dunng the period
x 100
-{Centre for Distance Education )~---I 8.4 1-1 -----i( Acharya Nagaduna University}-
8.4.1. 2. Causes of labour turnover :
Causes of labour turnover can be divided into three heads they are
a) Personal causes
b) Un avoidable causes
c) Avoidable causes.
a. Personal Causes : Workers may leave the organisation on personal grounds such
as-
1. Retirement
2. Domestic problems
3. Accident making workers permanently incapable of doing work.
4. Women workers may leave after marriage
5. Dislike for the job
6. Death.
7. Finding better jobs at some other places
In all these cases turnover is unavoidable.
b. Unavoidable causes: In some cirumstances it becomes necessary for the manage-
ment to ask some of the workers to leave the organisation for instance.
1. Workers may be discharged due to Insuburdination or inefficiency
2. Workers may be discharged due to continued or long absence.
3. Workers may retrenched due to shortage of work
C. Avoidable causes: Low wages and allowances may induce workers to leave the fac-
tory and join other factories where higher wages and allowances are paid. Other causes
are -
1. Unsatisfactory working conditions
2. Job dissatisfaction on account of wrong placement of workers.
3. Lack of fringe benefits
4. Long hours of work
5. Lack of promotion opportunities
6. Unsympathetic attitude of the management.
-{COST & MANAGMENTACCOUNTING)---1L~8J;!.5~1----1( LABOUR COST - CONTROL}-
The personnel department should prepare periodical reports on the labour turnover
listing out the various reasons due to which workers have left the organisation. The
report should be sent to the management with the necessary recommendations so that
corrective measures may be taken to reduce labour turnover.
8.4.2. Engineering Department :
This department is required to maintain control over working conditions and production
methods for each job by preparing specifications for each job, inspecting and maintaining safety
working conditions.
8.4.3. Time and Motion study department:
This department performs following functions to reduce cost of labour.
1. Motion study
2. Time study
3. Job analysis.
1. Motion study: The determination of the best way of performing an operation is made
possible by motion study. It is a study of the movements of a worker or a machine in
performing an operation for the purpose of eliminating useless movements in order to
improve productivity.
Advantages:
1. the efficiency of workers is increased
2. It helps in simplifying the existing operations
3. It leads to economy in labour cost.
2. Time study: Time study may be defined as the art of observing and recording the time
required to do each detailed element of an industrial operation. The main object of this
study is to determine the proper time required to complete the job. Such study is con-
ducted after the motion study because time is to be noted down for the necessary
movement, which are decided by motion study.
Advantages:
1. the efficiency of workers is increased
2. the labour requirements are correctly assessed because standard time for various
jobs are known.
3. The study facilitate budgeting of labour costs.
4. Time study helps in reduction of cost through proper production control.
-{Centre for Distance Education) 8.6 I (Acharya NagarjunaUniversity)-
3. Job analysis : Job analysis is the ranking, grading and weighing of all work character-
istics i.e skill, effort, responsibility etc, of all jobs and is concerned with putting money
values on them. Thus job analysis is the complete study of the job:
8.4.4. Time keeping :
Time keeping is concerned with the recording of time of workers for the purpose of attendence
and wage calculations. It serve the following purposes -
1. preparation of pay rolls in case of time paid worker.
2. meeting the statutory requirements.
3. ensuring discipline in attendance
4. recording of each workers time
5. time keeping is useful for overhead distribution.
8.4.4.1. Methods of Time· keeping:
The methods of time - keeping may be either manual or mechanical. The selection of a
particular method depends upon the requirements and policy of a firm.
Methods of Time· Keeping
Mannual Mechanical
Methods Methods
I I
Attendance Metal disc
Register Methods Time Recording Dial time
Methods clocks Records
I. Manual Methods : The manual methods of time keeping are as following -
a. Attendance Register Method : It is the oldest method of recording time. Under this
method, an attendance register or Muster Roll is kept in the time office adjacent to the
factory gate or in each department. The attendance register contains such columns as
the name of the worker, number of the worker, the name of the department, the rate
wage, the time of arrival and departure, normal time, over time. The time of arrival and
departure, may be noted down by an employee known as time keeper
-(COST & MANAGMENTACCOUNTINGHL~8;_:f...7_j1---"""1( LABOUR COST - CONTROL)-
Merits:
1. This method is simple and inexpensive
2. It is useful in small firms where number of workers is not large.
3. This method is suitable for the recording time of the worker who work at customer's
premises which are situated at a distance from the factory.
Demerits:
1. This method may lead to dishonest practice of recording wrong time because there
is possibility of collusion between some of the workers and the time keeper.
2. It is not suitable to industries where number of workers is large.
b. Metal Disc Method: Under this method, each worker is allotted a metal disc or a token
with a hole bearing his identification number. A board is kept at the gate with pegs on it
and all tokens are hung on this board. As the workers enter the factory gate, they re-
move theire respective discs or tokens and place them in a box or tray kept near the
board. After scheduled time the box is removed and the late comers will have to give
their tokens to the time - keeper personally so that the exact time of their arrival could be
recorded. The discs left on the board represent the absentee workers.
Merits:
1. This method is simple
2. Illiterate workers also easily understand the procedure
3. This method is useful when the number of employees is not large.
Demerits:
1. Thes are chances that a worker may try to remove his companion's token from the
board in order to get his presence marked when he is absent.
2. There are chances of disputes regarding the exact time of arrival of a worker.
3. There is no authentic proof of the presence or absence of the workers.
4. There are chances of inclusion of dummy workers.
II. Mechanical Methods : The Mechanical methods of time keeping are time recording clocks
and dial time records.
a. Time Recording Clocks : The time recording clock is a mechancial device which
automatically records the time of the workers. Under this method each worker is given
a time card usually of one week duration. Time cards are serially arranged in a tray near
the factory gate and as the worker enters the gate. He picks up his card from the tray,
puts it in the time recording clock which prints the exact time of arrival in the proper
-(Centre for Distance Education )----08[.8[}1---«1.A~cfiha~ry:ia~N~agrua~d~unna~U!]ni[Y!ve~rs:§]i~ty)
space against the particular day. The process is repeated for recording time of depar-
ture for lunch, return from lunch and time of leaving the factory in the evening. Late
arrivals, early leavings and overtime are printed in red to attract the attention of the
management
Merits:
1. This method is useful when the number of workers is large.
2. There are no chances of disputes arising in connection with recording of time of
worker because time is recorded by the time recording clock.
3. There is no scope for partically or carelessness of the time keeper as in case of
manual methods.
Demerits:
1. There are chances that a worker may try to get his friends time card in order to get
him marked present, when his friend is late or absent.
2. Some times, the time recording clock goes out of order and the work of recording of
time is dislocated.
b. Dial Time Records : The dial time recorder is machine which has a dial around the
clock. This dial has a number of holes and each hole bears a number corresponding to
the identification number of the worker concerned. There is one radial arm at the centre
of the dial. As a worker enters the factory gate, he is to press the radial arm after placing
it at the hole of his number and his time will automatically be recorded on roll of a paper
inside the dial time recorder against the number. The sheet on which the time is re-
corded provides a running account of the workers time.
Merits:
1. This machine allows greater accuracy and can itself transcribe the number of hours
to the wage sheets.
2. This machine can also calculate the wages of the workers and thus avoids much
loss of time.
Demerits:
1. It requires high installation cost.
2. It is useful only when number of workers is limited.
8.4.5. Time Booking :
Time booking is the recording of time spent by the worker on different jobs or work orders
carried out by him during his period of attendence in the factory. Following are the objects of time
booking.
-{COST,& MANAGMENTACCOUNTINGH B.9 I ( LABOUR COST - CONTROL}-
1. To ascertain the labour cost.
2. To calculate idle time
3. To assess bonus payment
4. To provide base for the apportionment of over head expenses.
5. To know the efficiency of workers.
8.4.5.1. Methods of Tlme- booking:
Following documents are generally used for time booking -
a ) Daily time sheets
b) Weekly time sheets
c) Job tickets or job cards.
a. Dial Time sheets: This sheet is a daily record of the work done by a worker on differ-
ent jobs. The worker completes the sheet every day and gives it to the foreman for
signature to ensure the correctness of the sheet.
Demerits:
1. Use of daily time sheets are suitable only to small organisations.
2. Use of new time sheets daily, incurs large amount of expenditure.
b. Weekly time sheet: This sheet is a weekly record of the workdone by a worker on
different jobs. This sheet is an improvement over the daily time sheet.
Demerits:
1. There are chances of these sheets being lost or mutilated because they are continu
ously left in the hands of the workers for a long period of one week.
c. Job tickets or Job cards : Ajob card is used to keep a close watch on the time spent
by a worker on each job so that the labour cost of a job may be conveniently assertained.
Four types of job cards, are generally used namely.
i. Combined time and job cards.
ii. Job card for each worker
iii. Job card for each job
iv. Piece work card.
Merits:
1. A reconciliation is possible between the time showed and time booked against job.
2. Labour cost can be easily assessed.
-(Centre for Distance Education )>---{I ]8J.1[QO~I----(Cl.A~c:fiha~ry~a~N~agllia~dfYurunaillUrunilYive~r
Demerits:
1. This method is not suitable when the number of workers is large.
2. It is not possible to assess idle time.
8.5. IDEAL TIME :
The difference between the time booked to different jobs or work orders and gate time is
known as idle time. Idle time is that time for which the employer pays, but from which he obtains no
production. Idle time is of two types -
1. Normal idle time
2. Abnormal idle time.
1. Normal idle time : Normal idle time represents the wastage of time which cannot be
avoided. therefore, the employer must bear the labour cost of this time. Following are
some of the examples of normal idle time.
1. The time taken in going from the factory gate to the work place and coming from the
work place to factory gate.
2. The time taken in picking up the work for the day.
3. The time taken between two jobs.
4. The time taken for personal needs and tea breaks.
Treatment of cost of Normal idle time : Since it is unavoidable cost and as such
should be included in cost of production. It is treated as an item of factory expenses and
recovered as an indirect charge, or it may charged direct to production at a grossed -
up rate to include normal idel time.
2. Abnormal idle time : It is that time the wastage of which can be avoided if proper
precautions are taken. Following are examples of abnormal idle time.
1. The time wasted due to breakdown of machinery on account of the inefficiency of the
works engineers.
2. The time wasted on account of the failure of the power supply.
3. The time wasted due to shortage of material
4. The time wasted due to strikes or lock - outs in the factory.
Treatment of cost of Abnormal idle time : The wages paid for abnormal idle time
should be debited to costing profit and loss account.
-(COST & MANAGMENT
ACCOUNTINGHL8~.l11ul---~( LABOURCOST- CONTROLr
8.6. OVER TIME :
Usually the workers are supposed to work for a given time per day or per week. It is called
the normal work period whereas overtime is the work done beyond the normal work period. In
India, according to the factories Act overtime wages should be paid at double the usual rate of
wages. If a worker works for more than 9 hours on any day or for more than 48 hours in a week,
he is treated to be engaged on overtime and is given wages at double the basic hourly rate for the
overtime put in by him. Double rate for overtime is paid to give incentive for late hours. The additional
amount paid on account of overtime is known as overtime premium.
Overtime work should be avoided because jobs done in overtime cost more as compared
to the jobs done during normal hours.
Treatment of overtime premium:
Normal wages are grossed up to allow for overtime premium and, therefore, each job,
whether done in normal time or overtime is charged at the same rate of wages. This method of
treatment of overtime is suitable when the sequence of jobs is a matter almost of chance, but if
overtime is needed in case of a rush job at customers' request so as to complete it within a
particular time, it is proper to charge the overtime premium to the cost of the rush job.
Where however overtime arises due to any abnormal reason such as break down of
machinary or failure of power, overtime premium is excluded from the cost of production and is
debited to the costing profit and loss account.
8.7 WAGE PAYMENT METHODS:
The amount of wages payable to the workers determines their attitude towards their work
and the employer. On the other hand, the employers try to keep down the labour cost and try to pay
less. To solve this problem the method of wage payment adopted should be such which reduces
labour cost per unit and at the same time workers are paid reasonably for their work.
8.7.1 Essentials of a good wage system:
A wage system will be treated as fair if it has the following features -
a. The system should be fair both to the employer and the' employee.
b. The worker should be assured of a guaranteed minimum wage at satisfactory level.
c. Workers should be paid according to their skills.
d. The system should ensure equal pay for equal work.
e. The system should be flexible.
f. The system should be simple and capable of being understood by the workers.
g. The system should ultimately result into higher production.
-{Centre for Distance Education )~--[I
~8·I12g}-l
---1CGA~c~h~anry~a~N~ag;ga~n~'u[inaiQUDlnilYive~rs§!itvi
There are two principal wage systems such as -
1. Payment on the basis of time spend in the factory - Time wage system
2. Payment on the basis of work done - Piece rate system
8.7.2. Time wage system:
Under this method of wage payment, the worker is paid at an hourly daily, weekly or monthly
rate. Payment is made according to the time worked irrespective of the quantity of work done. This
method of wage payment is most suitable for the highly skilled and the unskilled workers including
apprentices. The principle to calculated wage under this method is -
Wage = Time x Rate per hour.
This method is also suitable for the following types of work:
1. Where goods are in artistic nature
2. When the production is automatic
3. Where output cannot be measured Ex: repair work
4. Where close supervision is possible.
Merits:
1. Time wage method is easy and simple to follow
2. Under this method worker is assured payment of wage for the time spent by the
worker.
3. Under this method material wastage can be reduced.
Demerits:
1. Workers are not paid according to skills.
2. Efficient workers will become infefficient workers because they notice that inefficient
workers also get the same wages.
3. Management is forced to pay for idle time also.
4. It will encourage a tendency among workers to go slow so as to earn overtime wages.
Example: From the following information calculate wages of a worker under time wage system.
Rate per hour - Rs 50
Time required to complete a job - 10 hours
Ans-
Rate per hour - Rs 50
Time required to complete a job - 10 hours
Wage =TxR = 10x50=Rs.500.
-{COST & MANAGMENTACCOUNTINGHl..;8~ ..li13~1---~(
LABOUR COST - CONTROL)-
8.7.3. Piece wage system:
According to piece wage system wage is paid on the basis of work completed. A fixed rate
is paid for each unit produced, job completed or an operation performed. An equitable piece work
rate should be fixed to give an inducement to the workers to produce more. Rate can be fixed with
the help of time and motion study and job analysis. Different piece rates should be determined for
different types of jobs. Principle to calculate piece wage is -
Wage = Work done x Rate per piece
or
Wage = Time taken x Rate per hour.
This method is suitable in the following conditins :
1. When the close supervision is not possible
2. When the production is on large scale.
3. Where out put can be measured.
4. Where the work is repetitive nature.
Merits:
1. Workers are paid according to skills
2. An inducement is given to the workers to increase their production.
3. The employer is able to know his exact labour cost per unit.
4. Idle time is not paid.
Demerits:
1. Low piece rate will frustrate the workers.
2. The quality of output will suffer because workers will try to produce more to earn
more wages.
3. There may not be an effective use of material, due to the efforts of workers to
increase the production.
4. Cost of production may increase due to more wastage of material.
5. Workers have the fear of losing wages because of no guaranteed wage.
6. The system will cause discontentment among the slower workers because they
are not able to earn more wages.
-{Centre for Distance Education )}----II 8.1'411- -----j( Acharya Nagaduna University)-
Example:
Rate per hour - Rs 3.
Time alloted to produce a product = 15 minutes
In an 8 hours day 'P' produced 36 products, Q produced 30 products. Calculate their
wages under piece wage method.
Ans - Wage per hour = Rs. 3.
Time to produce one product = 15 minutes.
Production per hour = 15 - 1
60 -1
60x1
=-- =4
15
Wage per product = 4-3
1 -?
3.00
= 4=0.75
'P' Production = 36 units
wage = 36 x 0.75
= Rs. 27
Q production = 30 units
= 30 xO.75
= Rs. 22.50
8.8 CONCLUSION :
Thus the labour cost, its control and computation are very significant in the cost of production
of a product. Labour cost may be more due to inefficiency of labour, wastage of material by labour,
high labour turnover, idletime and unsual overtime work, inclusion of bogus workers in the wage
sheet etc,. Hence control of labour cost is an important objective of management. With the co-
ordination of various departments labour cost can be controlled to a large extent. If labour cost is
controlled it leads reduction in cost of production which ultimately leads reduction of price in the
market and increase the demand.
-{COST & MANAGMENTACCOUNTINGHL8~ ..JJ152..J1-----1C LABOUR COST - CONTROL}-
8.9. SELF ASSESSMENT QUESTIONS
Five Marks Questions :
1. What is labour, what are the types of labour
2. Explain Time study
3. Describe Motion study
4. What is job analysis
5. What is meant by over time.
Ten Marks Questions :
1. Explain labour turnover
2. What is meant by idle time
3. What is Time booking
4. What are essentials of good wage system.
Twenty Marks Questions:
1. Explain briefly how to control labour costs.
2. What are the merits and demerits of Time keeping.
3. Explain wage payment methods.
8.10 BOOKS RECOMMENDED
1. Cost & Management Accountinq - S.P. Jain & K.L. Narang
2. Cost Accounting - S.P. Jain & K.L. Narang
3. Cost Accounting - S.P Gupta
4. Cost Accounting - N.K. Prasad
Dr. K. Kanaka Durga
Lesson - 9
METHODS OF PAYMENT OF INCENTIVES
(Labour Incentive Sc~emes)
9.0 OBJECTIVES:
After studying this lesson you should be able to understand the following
~ Features of incentive schemes
~ Methods of payment of incentives
STRUCTURE:
9.1 Introduction
9.2 Features of incentive schemes
9.3 Method of payment of incentives
9.4 Solved Problems
9.5 Self Assessment Questions
9.6 Books Recommended
9.1 INTRODUCTION:
Incentive or Bonus means money or an equivalent given in addition to an employees usually
compensation. The objective of an incentive plan is to increase the production by giving an
inducement to the workers in the form of higher wages for less time worked. This system of wage
payment is in between the time wage system and piece wage system. In time wage system
worker does not get any reward for the time saved and in piece work system, the worker gets full
payment for the time saved, whereas in a premium plan, both the worker and the employer share
the labour cost of the time saved. The employer is able to save wages for a proportion of the time
saved and on the other hand the worker is able to get extra wages for a fraction of the time saved.
The incentive scheme is also known as bonus scheme because a worker has the incentive to
earn more wages by completing the work in less time.
The procedure of payment of incentive is standard time is fixed for the completion of a
specified job or operation and the worker is paid for the time taken by him to complete the job or
operation at an hourly rate plus wages for a certain fraction of the time saved on the standard by
way of a bonus.
-{Centre for Distance Education) I 9.2 I (Acharya NagadunaUniversity}-
9.2. FEATURES OF INCENTIVE SCHEMES :
A satisfactory premium plan should take into consideration the following factors _
i. The plan should be simple
ii. The plan should be easily understood by all workers
iii. The plan should appear reasonable both to the employer and the employee.
iv. Standard time should be determined on the basis of time and motion study.
v. An average worker should be able to complete the work within the standard time.
vi. Standards once fixed should not be altered unless there is a permanent change in the
method of work.
vii. The system should result in increased production and lower cost of production.
viii. incentive plans should be framed according to the provisions of labour Acts.
9.3. METHODS OF PAYMENT OF INCENTIVES :
Incentive schemes can be classified into four categories such as -
1. Premium Bonus plans - Halsey plan
- Rowan plan
2. Differential piece rate plans - Taylor plan
- Merrick plan
3. Bonus plans of combination of time and piece rates -
a. Gantt task bonus scheme
b. Emerson efficiency scheme
c. Bedaux plan.
4. Group bonus schemes - Co partnership
- profit sharing schemes
-(COST & MANAGMENT ACCOUNTINGH~9.~3...t1--~( METHODS OF PAYMENT ... )-
Incentive schemes
Premium Differencial Combination of
Group Schemes
Bonus plan piece rate Time & piece
plans rates
Halsey Taylor Gantt task bonus
scheme Co- Partnership
Emerson efficiency
Rowan Merrick scheme Profit sharing schemes
Bedaux plan
9.3.1. Premium Bonus Plans:
A Halsey premium plan : Under this method standard time for doing each job or opera-
tion is fixed and the worker is given wages for the actual time he takes to complete the
job or operation at the agreed rate per hour plus a bonus equal to one - half of the wages
of the time saved. In practice the bonus may vary from 33 1/3 % to 66 2/3% of the
wages of the time saved. Under Halsey plan the total earnings of a worker will be calcu-
lated with the help of the following principle.
Total earnings = T x R + 50 % ( S - T) R
T = Time taken
S = Standard time
R = Rate per hour
% = The percentage of the wages of time saved to be given as bounds.
Illustration -1
Standard time = 48 hours
Time taken = 44 hours
Rate per hour = Rs. 2.
From the above information calculate total earnings of a worker under Halsey scheme.
-{Centre fpr Distance Education )r-----I~9.!4JI---1(Acharya Nagarjuna Universityr
Total earnings = T x R + 50 % ( S - T ) R
S = 48 hours
T = 44 hours
R = Rs 2.
50
Total earnings = 44x 2 + 100 (48- 44) x 2
50
= 88 + 100 (4) x2
= 88 + (2 x 2)
= Rs 92.
Halsey - weir plan: Under the Halsey - weir premium plan the premium is set at 30%
of the time saved.
Advantages of Halsey premium plan:
i. It is simple to understand and easy to operate
ii. It guarentees time wages.
iii. The wages of time saved are shared by both employers and workers.
iv. Since this scheme provides incentive to efficient worker it makes distinction
between efficient workers and inefficient workers.
Disadvantages of Halsey premium plan:
i. Quality of work suffers because workers are in a hurry to save more and more
time to get more bonus.
ii. Workers criticise this method on the ground that the employer gets a share of
wages of the time saved.
B. Rowan plan : Under this method, the worker is again guaranteed wages at the ordi-
nary rate for the time taken by him to complete the job or operation. Bonus is calculated
as the proportion of the wages of the time taken which the time saved bears to the
standard time allowed. The principle to calculate the total earnings of the worker is -
S-T
Total earnings =TxR+ S xTx R
T = Time taken
R = Rate per hour
S = Standard time
-{COST & MANAGMENT
ACCOUNTINGHLJl9~.5~1----4( METHODSOF PAYMENT
...)-
lIIustration·2
Standard time = 10 hours
Hourly rate = Re 1
Time taken = 6 hours
S-T
Total earnings = T x R + S xTxR
T = 6hours
R = Rate per hour i.e Re 1
S = 10 hours
10-6
Total earnings = 6 x 1 + ---:j'Q x 6 x 1
= 6 + 2.40
= 8.40
Advantages of the Rowan premium plan:
i. It guarantees time wages to workers.
ii. labour cost per unti is reduced because wage of the time saved are shared by
the employer and the worker.
iii. Fixed overhead cost per unit is reduced with increase in production.
Disadvantages of the Rowan premium plan :
i. Under this system the workers do not get the full benefit of the time saved by
them as they are paid bonus for a portion of the time saved.
ii. The Rowan plan suffers from another draw back that two workers one very
efficient and the other not so efficient may get the same bonus.
9.3.2. Comparision between the Halsey plan and the Rowan plan :
Both the plans are criticised by workers on the groung that they do not get the full benefit of
time saved by them as they are paid bonus for a proportion of the time saved. The Rowan plan has
another drawback that two workers, one very efficient and the other not so efficient, may get the
same bonus.
A worker gets more premium under Rowan premium plan compare to Halsey premium
plan when time saved is less than half of the standard time.
f
-{Centre for Distance Education )~--09~.6O-I
---(C~A~c~hlia!iryiaEN[iag~ainiM·u~naiJJUnrui~ve~rs§!ity~
A worker gets more premium under Halsey premium plan compare to Rowan plan when
time saved is more than half of the standard time. For instance the following problems depects it.
Illustration
Standard time = 40 hours
Time taken = 16 hours
Rate per hour = Rs. 2.
Calculate wage under both Halsey and Rowan plans.
Solution:
According to Halsey plan the wage is-
Total earnings = T x R + 50 % of Time saved X Rate per hour
50
= 16x 2 + -100 x 24 x 2
= 32+(12x2)
= 32 + 24
= 56
Wage under Halsey plan = Rs 56.
According to Rowan plan the wage is-
S-T
Total earnings =TxR+ S xTxR
40-16
= 16 x 2 + 40 x 16 x 2
24
= 32 + 40 x 16 x 2
= 32+19.2
= 51.2
Wage under Rowan plan = Rs. 51.2
In this Illustration time saved by worker is more than half of the standard time so worker
gets more wage in Halsey plan compare to Rowan plan i.e
Wage under Halsey plan = Rs 56.
Wage under Rowan plan = Rs. 51.2
-{COST & MANAGMENTACCOUNTING)--1u9:.1.7_j1----1( METHODS OF PAYMENT...}-
9.3.3. Differential piece rate plans:
Under differential piece rate plans workers are paid according to their merits because
distinction is made between efficient and inefficient workers. An efficient worker can earn more
wages because wages are linked to output. Following are the important differential piece rate
plans.
A Taylor's Differential piece rate system: This system was introduced by F.W. Taylor,
the father of scientific management. This system penalise a slow worker by paying him
a low piece rate for low production and reward an efficient worker by giving him a higher
piece rate for a higher production. Taylor proceeded on the assumption that through
time and motion study it is possible to fix a standard time for doing a particular task. To
encourage the workers to complete the work within the standard time. According to him
if a worker performs the work within or less than the standard time, he is paid a higher
piece rate, and if he does not complete the work within the standard time, he is given a
lower piece rate. Differential rates are usually as follows -
1. 80% of piece rate for below standard
2. 120% of piece rate for above standard.
Illustration:
Calculate the earnings of workers A and B under straight piece - rate system and Taylor's
differential piece - rate system from the following particulars.
Normal rate per hour - Rs 18
Standard time per unit - 20 seconds
differentials to be applied:
80% of piece rate for below standard
120% of piece rate for above standard.
Worker A produces 1,300 units per day and
Workder B produces 1,500 units per day.
solution:
Standard production per 20 seconds = 1 unit
18.00
Standard production per 1 minute = 180 = 3 unit
Standard production per 1 hour =3x 60 = 180 unit
Standard production per day of 8 hours = 180 x 8 = 1, 440 unit
t
-(Centre fOr Distance Education )>---ll j9~.8u-1
--...,( Acharya Nagaduna University)-
10p x 80
Low piece rate = 100 = 8 paisa
10p x 120
high piece rate = 100 = 8 paisa
Earnings of Worker A :
1,300 units X 8 paisa = Rs 104
Earning of worker B = 1500x 12 paisa = Rs 180
Low piece rate has been applied in case of worker A because worker A's daily production of
1,300 units is less than the standard daily production of 1,440 units.
High piece rate has been applied to worker B because worker
B's daily productions of 1,500 units is more than the standard daily production of 1440units.
Advantages of Taylor's differential piece rate plan :
i. An efficient worker can earn more wages.
ii. Worker try to adopt better methods of production to increase their production.
iii. Increased production will reduce fixed expenses.
Disadvantages of Taylor's differential piece rate plan :
i. Workers have the fear of losing wages if they are not able to work due to some
reason.
ii. Workers may work at a very high speed for a few days earn good wages and
then absent themselves for a few days, up setting the uniform flow of produc-
tion.
iii. Time is not guarented under this method.
iv. Under this system if a worker just fails to complete the work within the standard
time he earns much less wages than a worker who just completes the job
within the standard time.
B. Merrick's Multiple piece Rate system : This method seeks to make an improve-
ment in the Taylor's differential piece rate system. Under this method, three piece rates
are applied for workers with different levels of performance.
Percentage of standard Wage rate
Less than 83% Normal Piece rate
83% to 100% 110% of normal piece rate
More than 100 % 120% of normal piece rate
-(COST & MANAGMENT
ACCOUNTINGHL~9~.9UI:.,__--~CMETHODS OF PAYMENT...)-
This method is not as harsh as the Taylor's piece rate because penalty for slow workers is
relatively lower.
Illustration:
The following particulars apply to a particular job:
Standard production per hour 6 units: Normal rate per hour Rs. 1.20
In an 8 hour day Mohan produces 32 units, Sohan produces 42 units, Lakhan produces
SOunits.
Calculate the wages of the workers under merrick differentil piece rate system
Solution:
Standard production per hour 6 units.
Normal rate per hour Rs. 1.20.
Piece rate = = 0.20
Merrick differential piece rates are
efficiency Rate
upto83% Re 0.20
from 83% to 100% 110 % of Re 0.20 Le 0.22
above 100 % 120% of Re 0.20 = Re 0.24
earnings of workers :
Mohan produces 32 units which means his efficiency is x 100 = 67% i.e below 83%.
32
Hence first rate will apply to him. His earnings will be 48 = 32 x 0.20 = Rs. 6.40.
42
Sohan produces 42 units, which means his efficiency is 48 x100 = 87.5 %
Le. above 83% but below 100 % Hence second rate will apply to him.
His earnings will be = 42 x 0.22 = Rs 9.24.
50
Lakhan produces 50 units which means his efficiency is 48 x100 = 104 %
i.e above 100%. Hence third rate will apply to him.
His earnings will be = 50 x 0.24 = Rs. 12.00
-{Centre tpr Distance Education )~--11[J9[·n1O!JI----«(~A;9]chffia!Cry~ailN~a!9g~an[li·u!!!n~a
:gUnlnilY!ve~rs§!ity~r
9.3.4. Bonus plans of combination of Time and Piece Rates:
A. Gantt task Bonus plan :
This plan is based on careful time and motion study. A standard time is fixed for doing a
particular task, worker's actual performance is compared with the standard time and his efficiency
determined. If a worker takes more risk than the standard time to complete. The task he is given
wages for the time taken by him and if a worker takes the standard time to perform the task he is
given wages for the standard time and a bonus of 20% on the wages earned. If the worker com-
pletes the task in less than the standard time he is given wages for the standard time plus a bonus
of 20% of the wages for the standard time.
Production Wage Payment
production less than standard Time rate
standard production Time rate + 20 % Bonus
production more than standard High piece rate.
Thus with every reduction in time the plan ensures progressive increase in total wages.
For this reason the plan is also known as ' Progressive rate' system.
Illustration :
Form the following information of P,Q, R. workers calculate their wages under grantt task
method.
Monthly standard production of each worker - 100 units
unit rate - O.BO paisa
Actual production - P = BOO units
Q = 1000 units
R = 1200 units
Solution:
Pwage:
Standar production per month = 1000 units
per unit= O.BO paisa
P production = BOO units
800
efficiency level = 1000 x 100 = BO%
Since his efficiency is less than standard production, he gets guarantee wage i.e.
-(COST & MANAGMENT
ACCOUNTINGHu9~.1lJ1J"1--~( METHODSOF PAYMENT...)-
wage = standard units 0.80 = 800\
QWage:
Actual production = 1000 units
Standard production = 1000 units
Rate = 0.80
1000
efficiency level = 1000 x 100 = 100 %
Since his efficiency is 100% He gets 20% extra as bonus in addition to wage.
120
Wage = units produced x unit rate x 100
120
= 1000 x 0.80 x 100 = 960
wage = Rs 960
RWage:
Standard production = 1000 units
Actual production = 1200 units
Rate = 0.80 paisa
1200
efficiency level = 1000 x 100 = 120 %
Since his efficiency is more than 100% he gets 20% bonus along with piece wage.
120
Wage = units produced x unit rate x 100
120'
= 1200 x 0.80 x 100 = 1152
wage = Rs 1152
---;C Acharya Nagarjuna University)-
-{Centre fur Distance Education )I--~LI~9.:.l12f.t"1
Advantages :
i. It is simple to understand
ii. It is acceptable by workers because it gives gurantee wage.
iii. This system is advantageous to less efficient workers
iv. Inefficient workers are motivated to become efficient and earn more wages by
producing more.
Disadvantages :
i. Distinction is made between efficient and inefficient workers
ii. The quality of the output will suffer because workers will try to produce more to
earn more wages.
B. Emerson's efficiency bonus system : Under this bonus scheme bonus is paid ac-
cording to the efficiency of the worker.
Efficiency Bonus
a. below 66 2/3 % guaranteed time wage only
b. 66 2/3 % to 100 % a bonus increasing from 0.01% to 20%
above basic wage on 100 % efficiency.
c. over 100 % a bonus of 20% above basic wage plus
1% for each 1% increase in efficiency.
Under this system less efficient workers get guaranteed time wage.
C. Bedaux system : Under this bonus scheme the wage is calculated as-
If 75 % bonus is paid to the workers the formula is
Tx R + 75% OR)
( PaX
P = Points saved
T = Time taken
R = Rate
If 100 % bonus is paid, the formula is T x R + 100 % ( ---so-
PXR)
-(COST & MANAGMENTACCOUNTING)----1 9.131-1 --~(METHODS OF PAYMENT...)-
9.3.5. Group Bonus schemes:
Co partnership and profit sharing schemes:
These schemes are becoming very popular now - a - days. Under there schemes, worker
get a share of the yearly profits of the company. This is done with a view of getting the cooperation
of workers by giving then the feeling that they are to share the prosperity of the business. Workers
can be given their share of profits in the form of cash or shares in the company:
Advantages
i. Under these schemes workers get share in the profits
ii. If the company pay share of profit in the form of shares, workers get participation in the
company's management.
iii. Workers get interest in the future of the business.
Disadvantages
i. It is difficult to fix the percentage of profits to be given to workers. If the share is not given
to the satisfaction of the workers, they may resort to strikes.
ii. The share of profits is given to all workers, so no distinction is made between efficient
and inefficient workers.
The payment of bonus Act 1965 has mad profit sharing compulsory in all industries and
provides that to the eligible employees a minimum bonus of 8 1/3 % of gross annual earnings will
have to be paid irrespective of profits made or losses incurred.
9.4 SOLVED PROBLEMS :
1. From the following information calculate wage of a worker under Halsey premium plan.
Time Rate per hour = Rs. 2.
Standard time = 40 hours
Time taken = 20 hours
Bonus = 50 % of time saved.
Solution:
wage = T x R + 50 % ( S - T ) x 2
50
= 20 x 2 + 100 ( 40- 20) x 2
50
= 20 x 2 + 100 x 20 x 2
= 40 + 20 = Rs 60.
-(Centre for Distance Education) 1 9.141 (Acharya Nagaduna University)-
2. In order to finish a task, standard time of 15 hours was determined by time and motion study
Ram took 16 hours to finish the job while shyam took 12 hours. Time rate is Rs3. per hour
calculate the earnings of the workers if 50 :50 Halsey premium plan is in operation.
Solution:
The Formula is
E = RT x P ( S- T ) R
S = 15 hours
Ramwage:
Ram could not finsih his work within the standard time. So he will not be paid any
bonus. His earnings will be :
=16x3=Rs48.
Shyamwage:
Shayam's earnings for 12 hours will be as follows:
E = 12 x 3 + 50 % ( 15 - 12 ) 3
= 36 + 4.50 = Rs 40.50
3. The following particulars apply to a job:
Standard time = 10 hours
Time rate = Rs. 2 per hour
Time taken = 8 hours
Calculate earnings under Rowan plans.
Solution:
Under Rowan system earnings will be calculated as follows -
S-T
E =TxR+ SxTxR
10-8
=8x2+ 1"Ox8x2
2x8
= 16+~ x2
= 16 + 3.20 = Rs. 19.20
-{COST & MANAGMENTACCOUNTINGHL~~ ..ll15~1......---~C
METHODS OF PAYMENT... r
4. From the following information calculate wage of a worker under Rowan plan.
Standard time = 32 hours
Actual time = 28 hours
Time saved = 4 hour
Solution:
8-T
Wages =T x R + S xTxR
4
= 28x 1 + 32 x 28 x 1
= 28 + 3.S0
= 31.S0
Wage = Rs. 31.S0
S. Calculate the earnings of a worker from the following information under:
a. Time rate method
b. Piece rate method
c. Halsey plan
d. Rowan plan
Standand time = 30 hours
Time taken = 20 hours
Hourly rate of wages is Re 1 per hour Plux a dearnars allowance at SOpaise per hour worked.
Solution:
a. Earnings under time rate method - Rs.
Wages for 20 hours ( time taken) at Re 1 per hour 20
D. A for 20 hour at SOpaise per hour 10
Wage = Rs. 30
b. Earnings under piece rate method -
Wages for 30 hours at Re 1 per hour 30
D. A for 20 hour at SOpaise per hour 10
Wage = Rs. 40.
-(Centre for Distance Education ))-----11 9.16.... 1
---i(Acharya NagadunaUniversity}-
c. Earnings under Halsey plan Rs
Wages for 20 hours at Re 1 per hour 20
Bonus for half of the time saved
s- T 30-20
SxR= 2 x1 5
D. A at 50 paise for 20 hour 10
Wage = Rs. 35
d. Earnings under Rowan plan Rs
Wages for 20 hours at Re 1 per hour 20
S-T
Bonus S x TxR
30-20
i.e 30 x 20 x 1 6.67
D. A at paise 50 paise per hour (20x 0.50)
Wage = Rs. 36.67
6. In an Assembly shop of a Motor car factory a workmen A, B, C and D work together as a team
and are paid on group piece rate. They also work individually on daily rate jobs. In a 44 hour
week the following hours have been spent by A, B, C, and D on group piece work. Viz, A - 40
hour, B-40hours, C - 30 hours and D - 20 hours. The balance of the time has been booked by
each worker on day works jobs.
Their hourly rates are ;
A 0.50 paise
B 0.75 paise
C 1.00
D 1.00
The group piece rate is Re 1 per unit and the team has produced 150 units. Calculate the gross
weekly earning of each workman taking into consideration that each individual is entitled to
dearness allowance of Rs 20 per week.
-(COST & MANAGMENTACCOUNTINGH[9[.TI17~I----«]M~EITTHHOQjD~S[!02!F:JR~'I\~:VMMlE~N~TC
...)-
Solution:
Group wages for 150 units at Rs
Rs. 1 per unit 150
Less individual wages : Rs
Workman A - 40 hours x 0.50 20
Workman B - 40 hours x 0.75 30
Workman C- 30 hours x 1.00 30
Workman 0- 20 hours x 1.00 20 100
Group Bons 50
Group bonus is to be divided among workmen in proportion to their time wages i.e
20:30:30 :20
Rs
20
Workman A 's share 50x100 10
30
Workman B's share 50 x 100 15
Workman C's share 15
20
Workman D's share 50 x 100 10
-(Centre for Distance Education )1---"i1.J9~.1~8U'1----«(
Acharya Nagarjuna University)-
Statement of Gross weekly earnings
Worker Worker Worker Worker
A B C D
Time wages on group work 20 30 30 20
Time wages on day work
Jobs ( balance of the time
of the week of 44 hours 2 3 14 24
(4x50p) (4x75p) 14x 1Re) (24x1Re)
Share of bouns 10 15 15 10
Dearness allowonce 20 20 20 20
Gross 52 68 79 74
7. On the basis of the following information calculate the earnings of Ram and shyam under
straight piece basis and Taylor's Differential piece rate system.
Standard production 8 units per hour
Normal time rate Re. 0.40 per hour
Differential to be applied
80% of piece rate for below standard
120% of piece rate for above standard.
In a 9 hour day
Ram produces 54 units
Shyam produces 75·units
Solution:
1. Straight piece Basis
Earnings = No. of units x Rate per hour
Piece rate = 0.04 +8 = 5 paise
Ram's earnings = 54 x 5 paise = 2.70
Shyam's earnings = 75 x 0.05 = 3.75
9.1911---~(METHODS
-{COST & MANAGMENTACCOUNTING}--1 OF PAYMENT
... r
2. Tylor's piece rate basis
Standard production in a 9 hour day = 8x9 = 72 units
80
Low piece rate = 0.05 x 100 = 4 paise
120
high piece rate = 0.05 x 100 = 6 paise
Ram's earnings = 54 x 4 paise = 2.16
Shyam's earnings = 75x 6 paise = 4.50
9.5. SELF ASSESSMENT QUESTIONS
Five Marks Questions :
1. What is meant by an incentre plan? WAat are its features.
2. Explain different methods of payment of incentives in brief.
3. Describe Halsey premium plan
4. What is a Rowan plan.
5. What are the merits and demerits of Taylor's differential piece rate system.
6. Explain co partneship and profit sharing schemes
7. From the following information calculate wages under Halsey plan and Rowan plan.
Standard time - 24 hours
Time taken - 20 hours
Rate per hour - Rs. 10
8. From the following information calculate a worker's earnings under the following scheme's
a. Piece rate
b. Halsey premium plan
c. Rowan premium plan
d. Taylor differential piece rate
Working hours in a week = 48
Wage rate per hour = Rs. 3.75
Time per piece = 20 minutes
-{Centre for Distance Education )I----LI ~9..f!20~1---(C Acharya Nagaduna University}-
Standard production per week = 120 pieces
Actual production per week = 150 pieces
Differential piece rates
1. Lower pieces rate 80%
2. Higher pieces rate 120%
Ans • a) Rs 225, b) Rs 183.75 , c) Rs 187.20, d) Rs 270.
9. From the following information calculate wages of swetha, swathi, sruthi, Sravanthi
under merrick differential piece rate system
Standard production - 12 units per hour
Rate per hour - 60 paise
working hour per week = 8
Actual production
swetha - 64
swathi - 96
sruthi - 84
Sravanthi - 100
Ans· Rs 3.20, 5.28, 6.00, 6.00
10. From the following information calCJ.lli:Jte
wages of sita, geetha, neetha under merrick
differential piece rate system
Piece rate per unit - Rs. 1.20
Standard production units per hour- 1 unit
working hours per week = 40 ~
Actual production
sita - 25 units
geetha - 40 units
neetha - 60 units
-{COST & MANAGMENTACCOUNTINGHLlt9.~211J1t---~( METHODS OF PAYMENT....}-
11. Calculate the earnings of a worker from the following information as under:
a) Time Rate method
b) Piece Rate method
c) Halsey plan
d) Rowan plan.
Information -
standand time 30 hours
time taken 20 hours
hourly rate of wage is Re 1 per hour plus a dearness allowance @ 50 paise per
hour worked.
Ans • a) Rs 30, b) Rs 40 c) Rs 35, and d) Rs. 36.67
12. Calculate the earnings of workers A and B under straight piece rate system and Taylor's
differential piece rate system from the following particulars
Normal rate per hour Rs. 2.40
Standard time per unit 30 seconds
Differentials to be applied -
80% of piece rate for below standard
120% of piece rate for above standard.
Worker A produces 800 units per day
Workder B produces 1000 units per day.
Ans· [A- Rs. 16 and Rs 12.80 ; B - Rs 20 and Rs 24]
9. 6. BOOKS RECOMMENDED :
1. Cost & Management Accounting - S.P. Jain & K.L. Narang
2. Cost Accounting - P.K. Bar.
3. Practivcal costing - Khanna; Pandey; Ahuja.
4. Practical problems in Cost Accounting - S.P. Jain & K.L. Narang
Dr. K. Kanaka Durga
Cost and Management Accounting 10.1
13.1 Job Costing
Lesson - 10
13
JOB COSTING AND BATCH COSTING
JOB COSTING
13.0
10.0 OBJECTIVES
After going through this lesson, student can understand.
Meaning of Job Costing
Features of Job Costing
Merits and Demerits of jobCosting
Procedure of Job Costing System
Batch Costing.
Structure
13.1
10.1 Introduction
10.2 Job Costing
13.2
13.2.1 10.2.1
Features of Job Costing
Features of Job Costing
10.2.2
13.2.2 Advantages, Disadvantages of Job Costing
10.2.3
13.2.3 Procedure of Job Cost System.
10.2.4
13.2.4 Examples
13.3 Batch Costing
10.3
13.3.1 Examples
10.3.1
13.4
10.4 Summary
13.5 Terminology
10.5
13.6
10.6 Self Assessment Questions
13.7
10.7 Reference Books
13.1 Introduction
10.1
There are different methods of costing.
(i) Specific order costing (or job/ terminal costing)
(ii) Operation costing (or process/ period costing)
i. Specific order costing is the category of basic costing methods applicable where the work consists of
separate jobs, batches or constracts each of which is authorised by a specific order or contract. In this
category are included job costing consisting batch costing and contract costing. This is discussed in detail
in this lesson.
ii. Operation costing is the category of basic costing method applicable where standarised goods or ser-
vices result from a sequence of repetitive and more or less continuous operations or process to which
costs are charged before being averaged over the units produced during the period. In this category we
include process costing and service costing.
Centre for Distance Education 13.2
10.2 Acharya Nagarjuna University
13.2 Job Costing
10.2
Job Costing is that form of specific order costing which applies where the work is undertaken as
an identifiable unit.
Under this method each order is of comparatively short duration. The work is usually carried out
within a factory or workshop and moved through processes and operations as a continuously identificable
unit. The term may also be applied to work such as property repairs and the method may be used in the
costing of internal capital expenditure jobs.
The main purposes of job costing are to establish the profit or loss on each job and to provide a
valuation of W/P.
13.2.1 Features of Job Costing
10.2.1
Under the method, costs are collected and accumulated for each job, work order or project
separately. Each job can be separately identified and hence it becomes essential to analyse the costs
according to each job. The industries where this method of costing is applied, must posses these features
i.e. : (i) The production is generally against customer’s order but may be for stock. (ii) Each job has its own
characteristics and needs special treatment. (iii) There is no uniformity in the flow of production from
department to department. The nature of the job determines the departments through which the job has to
be processed. (iv) The work-in-progress differs from period to period according to the number of jobs in
hand. Thus cost is ascertained for each job separately. This method is applicable to printers, machine
tools manufacturers, foundries and general engineering workshops.
13.2.2 Advantages, Disadvantages of Job Costing
10.2.2
A cost accounting system should be so designed that it should be able to provide the necessary
information for achieving control of cost and performance. The advantages of job order cost accounting
are: (i) It provides a detailed analysis of cost of materials, wages and overhead classified by functions,
departments and nature of expenses which enable management to determine the operating efficiency of the
different factors of production, production centres and the functional units. (ii) It enables the management
to ascertain which of the jobs are more profitable than the others, which are less profitable and which are
incurring losses. (iii) It provides a basis for estimating the cost of similar jobs taken up in future and thus
helps in future production planning. (iv) Determination of predetermined overhead rates in job costing
necessitates the application of a system of budgetary control of overheads with all its advantages. (v)
Identification of spoilage and defectives with the respective production orders and departments may en-
able the management to take effective steps in reducing these to the minimum. (vi) The detailed records of
the past years be used for statistical purposes in ther determination of the trends of cost of the different
types of jobs and their relative efficiencies.
The disadvantages of weakness of job order cost accounting are: (i) It involves a great deal of
clerical work in recording daily the cost of materials issued, wages expended and overheads, chargeable
to each job or work order which adds to the cost of jobs and also increase the chances of errors. (ii)
Determination of overhead rates may involve budgeting of overhead expenses and the bases of overhead
apportionment and absorption but unless such budgeting is complete i.e., extended to material, labour and
expenses, its advatanges are considerably reduced. (iii) Job costing is a historical costing which ascertain
the cost of a job or product after it has been manufactured. It does not facilitate control of cost unless it is
used with standard or estimated costing.
Cost and Management Accounting 13.3
10.3 Job Costing
13.2.3 Procedure of Job Cost System.
10.2.3
Job order cost system is designed to show in detail their cost components of the total cost of
executing a job which may take the form of either a special order, or a batch of orders.
1. Production Order : For any job, the cost involved is estimated and on the basis of this estimate price
is quoted to the customers. If the job is accepted, a Production Order is made by the Planning Depart-
ment. It is in the form of instructions issued to the foreman to proceed with the manufacture of the product.
It forms an authority for starting the work. It contains all the information regarding production.
When an order is received, the Production Control Department allots a Production Order Num-
ber to it. Sometimes, the work may be sub-divided and sub-numbers may also be alloted to various
works constituting it, in addition to one master number.
2. Recording of Costs : The costs are collected and recorded for each job under separate Production
Order Number. Generally, Job Cost Sheet is maintained for each job. This is a document which is used
to record direct material, direct wages and overheads applicable to respective jobs. The basis of collec-
tion costs are:
(a) Materials. Materials Requisition, Bill of Materials or Materials Issue Analysis Sheet.
(b) Wages. Operation Schedule, Job Card or Wages Analysis Sheet.
(c) Direct Expenses. Direct expenses vouchers.
(d) Overheads. Standing Order Numbers or Cost Account Numbers.
All the basic documents will contain cross reference to respective production order numbers for
convenience in collection of costs.
3. Completion of Job : On completion of a job, a completion report is sent to costing department. The
expenditure under each element of cost is totalled and the total job cost is ascertained. The actual cost is
compared with the estimated cost so as to reveal efficiency or inefficiency in operation.
4. Profit or Loss on Job : It is determined by comparing the actual expenditure of cost with the price
obtained.
10.2.4
13.2.4 Examples
Example 1: A factory uses job costing. The following cost data is obtained from its books for the year
ended 31 December, 2004.
Rs. Rs.
Direct Materials 90,000 Direct Wages 75,000
Selling & Distribution 52,500 Administrative Overheads 42,000
Factory Overheads 45,000 Profit 60,900
Prepare Job cost sheet showing prime cost, works cost, cost of production, cost of sales and sale
price.
Centre for Distance Education 13.4
10.4 Acharya Nagarjuna University
In 2005, Factory got new job orders.
Direct Materials Rs.1,20,000
Direct Wages Rs. 75,000
Selling & Distribution Overheads increases 15% on the basis of previous rates factory
overheads are charged as percentage on direct wages administrative overheads on factory cost and selling
and distribution overheads as percentage on Factory Cost.
Cost Sheet as on 31st December, 2004
Rs.
Direct Materials 90,000
Direct Wages 75,000
Prime Cost 1,65,000
Factory Overheads 45,000
Factory Cost 2,10,000
Administrative Overheads 42,000
Cost of Production 2,52,000
Selling & Distribution Overheads 52,500
Total Cost 3,04,500
Profit 60,900
Selling Price 3,65,400
Estimated Job Cost Sheet as on 31st December, 2005
Rs.
Direct Materials 1,20,000
Direct Wages 75,000
Prime Cost 1,75,000
Factory Overheads- 60% on Direct Wages 45,000
Factory Cost 2,40,000
Administrative Overheads-20% on Factory Cost 48,000
Cost of Production 2,88,000
Selling & Distribution Overheads-
25% on FActory Cost and 15% increase 69,000
(2,40,000 x 25/100 = 60,000 x 15/100 = 9000)
Total Cost 3,57,000
1/6 of Cost of Sales or 1/5 of Selling Price 71,400
Selling Price 4,28,400
Cost and Management Accounting 13.5
10.5 Job Costing
Example 2 : A shop floor supervisor of a small factory presented the following cost for a job to determine
the selling price.
per unit Rs.
Materials 70
Direct wages 18 hrs at 2.50 45
(Dept X - X - 8hrs, Y - 6 hrs, Z - 4hrs)
Chargeable expenses
(Special stores items) 5
120
Add: 33 1/3% for expenses 40
Cost 160
Rs. Rs.
Materials 1,50,000 Seles less Returns 2,50,000
Direct Wages :
Dept. X 10,000
Dept. Y 12,000
Dept. Z 8,000 30,000
Special Stores item 4,000
Overheads :
Dept. X 5000
Dept. Y 9000
Dept. Z 2000 16,000
Works Cost 2,00,000
Gross Profit C/d 50,000
2,50,000 2,50,000
Selling expenses 20,000Gross Profit b/d 50,000
Net Profit 30,000
50,000 50,000
It is also noted that average hourly rates for 3 departments are similar.
(1) Draw up a job cost sheet.
(2) Draw up the entire revised cost sheet.
(3) Add 20% to otal cost to determine selling price.
Centre for Distance Education 13.6
10.6 Acharya Nagarjuna University
Solution :
Job Cost Sheet
_____________________________________________________
Rs. Rs.
Direct Materials 70.00
Direct Wages:
Dept. X - 2.50 x 8 hrs = 20.00
Dept. Y - 2.50 x 6 hrs = 15.00
Dept. Z - 2.50 x 4 hrs = 10.00 45.00
Chargeable Expenses 5.00
Prime Cost 120.00
Overheads
Dept. X - 5000/ 1000 = 50% of Rs.20 10.00
Dept. Y - 9000/ 12000 = 75% of Rs.15 11.25
Dept. Z - 9000/ 8000 = 25% of Rs.10 2.50 23.75
Works Cost 143.75
Selling Cost = 20000/ 2,00,000 = 10% on Works Cost 14.38
Total Cost 158.13
Profit 20% of total cost 31.63
Selling Price 189.76
Example 3
Following information is obtained from the books of a factory for the year ended 31st Dec., 2004.
Completed jobs (Rs.) Work-in-Progress (Rs.)
Raw material from stores 90,000 30,000
Wages 1,00,000 40,000
Chargeable Expenses 10,000 4,000
Materials transfered to WIP 2,000
Materials transferred to stores 1,000
Factory overheads and office overheads are charged at 80% of wages and 25% of factory cost
respectively. The value of completed job during 2004 was Rs. 4,10,000.
Cost and Management Accounting 13.7
10.7 Job Costing
Prepare consolidated completed job account and consolidated work-in-progress account.
Consolidated Job Account
Rs. Rs.
To Materials 90,000 By Contractee Account
Less: Transferred to WIP 2,000
80,000
Less: Returned to Stores 1,000 87,000
Wages 1,00,000
Chargeable expenses 10,000
Factory overheads (80% of wages) 80,000
Factory Cost 2,77,000
Administrative Overheads 69,500
(25% of Factory Cost)
Net Profit transferred to 63,750
Profit & Loss Account
4,10,000 4,10,000
Consolidated Work-in-Progress
Rs. Rs.
To Materials 30,000 By Balance c/d 1,35,000
Less: Transferred from
Completed jo 2,000 32,000
Wages 40,000
Chargeable expenses 4,000
Factory overheads (80% of 32,000
wages)
Factory Cost 1,08,000
Administrative Overheads 27,000
(25% of Factory Cost)
1,35,000 1,35,000
13.3 Batch Costing
10.3
Batch Costing is a form of specific order costing. Job costing refers to costing of jobs that are
executed against specific orders whereas in batch costing items are manufactured for stock of continuing
of production during lean season or production should be based on sales order. A finished product may
require different components for assembly and may be manufactured in economical batch lots. When
orders are received from different customers, there are common products among orders, then production
orders may be issued for batches, consisting a pre-determined quantity of each type of product.
Centre for Distance Education 13.8
10.8 Acharya Nagarjuna University
Determination of the economic lot size is important in industries where batch costing is employed.
The need for determining economic lot size arises as
1. Every time a product is to be made, setting up of the tool is involved. Because of this some loss in
product time will be there. Therefore maximum number of units are produced once the machine is set in
order to reduce the cost per unit.
2. Such large product at one run will lead to accumulation of inventory and the costs related thereto.
3. Thus there is a quantity for which reduced cost of production is just offset by costs carring the quantity
inventory.
The determination of most economical batch quantity requries consideration of many related fac-
tors of costs and economies. The factors that influence the decision in this respect are
(1) Set up
(2) Manufacturing Cost
(3) Interest on Capital
(4) Storage Cost
(5) Rate of Consumption
The formula to be used to calculate economic lot size
2US
Q
C
Where Q = Quantity or units of products in the economic batch.
U = Total number of units to the produced in the year.
S = Set up cost per batch.
C = Carrying cost per unit of production.
10.3.1
13.3.1 Examples
Eample 1: The demand of an item is uniform at a rate of 25 units p.m. The fixed or set up cost is Rs.30
each time a production is made. The production cost is Rs.3 per item and inventory carrying cost is 50
paise per unit p.m. If the shortage cost is Rs.3 per item p.m. Determine how often to make a production
run and of what size and also calculate Re-order level.
2US
Solution : Economic batch quanity or EBQ
C
2 x 300 x 30
=
50 x 12
= 55 Units
Cost and Management Accounting 13.9
10.9 Job Costing
Production run size
Duration = Monthly demand x 30
55
= x 30 = 66 days
25
55
= x 25 = 55 working days
25
Shortage Cost
Re-order level = EBQ x Carrying Cost per unit Shortage Cost Monthly demand
3
= 55 x 25
50 3
= 47 - 25
= 22 Units
Example 2 : The annual demand of a product is 24,000 units. It is produced in batches and largest size of
single batch is 6000 units. After each batch is complete the set up cost is Rs.750. The annual carrying cost
is Rs.2.25 per unit.
Assume average inventory as one-half of the number of units made in each batch. Selecting
4,6,8,12 and 24 batches per annum, detemine annual costs of each and state the optimum number of
batches minimize the total costs.
Solution :
No. of batches 4 6 8 12 24
Size of batch units 6000 4000 3000 2000 1000
Average Stock 3000 2000 1500 1000 500
Setup Cost Rs.3000 Rs.4500 6000 9000 18000
Carrying Cost Rs.6750 Rs.4500 3375 2250 1125
Total Cost 9750 9000 9375 11250 19125
Centre for Distance Education 13.10
10.10 Acharya Nagarjuna University
Optimum number is 6 batches per annum.
2US
Q
C
2 x 24000 x 750
Q 4000 Units
2.25
13.4 SUMMARY
10.4
Job costing is a method of costing where work is undertaken on customer’s specific requirement.
This method of costing is useful for detailed analysis of overhead classification and ascertainment of more
profitable jobs, determining the trends of cost of different types of jobs, estimating the cost of future jobs
etc.
Batch Costing is a form of specific order costing. Determination of economic lot size is important
in industries where batch costing is employed.
13.5
10.5 TERMINOLOGY
Job Costing : Specific order costing applies to manufacture of products to customers requirements.
Job Cost Sheet : A statement for the ascertainment of the cost of each job.
Batch Costing : Costing of items manufactured for stock or production in economic batch lots.
13.6 SELF ASSESSMENT QUESTIONS
10.6
Five Marks Questions
1. Explain the features of Job Costing.
2. What is meant by Economic Lot size.
2US
3. Explain Q
C
Ten Marks Questions
1. Draw the model Job Cost Sheet.
2. What is Batch Costing.
3. Explain the merits and demerits of Job Costing.
Twenty Marks Questions
1. Explain the procedure of Job Cost System.
Cost and Management Accounting 10.11
13.11 Job Costing
13.7
10.7 REFERENCE BOOKS
Advanced Cost Accounting & Cost Control Techniques S.P. Jain & K.L.Narang.
Cost Accounting S.P.Iyenger.
Cost Accounting N.K.Prasad
- Ch. Neela Krishnaveni
Cost and Management Accounting 15.1
11.1 Financial Statements
LESSON - 11
15
FINANCIAL STATEMENTS
15.0
11.0 Objective : After going through this lesson the student can know what are financial statements ?
What are their features ? What is the need for preparation for the financial statements ? And different types
of financial statements.
Structure :
15.1. Introduction.
11.1
11.2
15.2. Definition.
11.3
15.3. Nature of Financial statements.
11.4
15.4. Characteristics of Financial statements.
11.5
15.5. Different types of Financial statements.
15.6. Form and content of Balance Sheet.
11.6
15.7. Form and content of Income statement.
11.7
15.8. Importance of Financial statements.
11.8
15.9. Limitations of Financial statements.
11.9
15.10. Summary.
11.10
11.11 Self Assessment questions.
15.11.
15.12.
11.12 Recommended books.
15.1.
11.1 Introduction :
Accounting is the process of recording, classifying and summarising various business transactions.
These business transactions are summarised in the form of financial statements i.e. Profit & Loss account
and Balance sheet. These statements are the sources of information on the basis of which conclusions are
drawn about the profitability and the financial position of a concern. Financial statements are the basis for
decision making by the management as well as all other outsiders who are interested in the affairs of the
firm such as investors, creditors, customers, suppliers, financial institutions, employees, government and
the general public.
15.2. Definition:
11.2
John N. Myer defined financial statements as "The financial statements provide summery of the
accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a
certain date and the income statement showing the results of operations during a certain period".
Smith and Asburne define financial statements as "The end product of financial accounting is a set of
financial statements prepared by the accountant of a business enterprise - that purport to reveal the financial
position of the enterprise, the result of its recent activities and an analysis of what has been done with
earnings."
After going through the above definitions we may conclude, that financial statements are the outcome
of summarising process of accounting. They are in the form of two statements i.e. 1) Profit and loss account,
to know the operating results, 2) Balance sheet, to know the financial position of a firm by management
and other interested out-siders.
Centre for Distance Education 15.2
11.2 Acharya Nagarjuna University
15.3.
11.3 Nature of Financial statements :
The financial statements are prepared on the basis of recorded facts. These recorded facts are
those which can be expressed in monetary terms. These statements are prepared periodically,
generally for the accounting period.
The American Institute of certified public Accountants states the nature of financial statements
as "Financial statements are prepared for the purpose of presenting a periodical review of report on
progress by the management and deal with the status of investment in the business and the results
achieved during the period under review. They reflect a combination of recorded facts, accounting
principles and personal judgements”.
Acccording to John N.Myer" The financial statements are composed of data which are the
result of a combinations of 1) recorded facts concerning the business transactions 2) conventions
adopted to facilitate the accounting technique, 3) Postulates or assumptions made to and 4) Personal
judgements used in the application of the conventions and postulates".
For the better understanding of the above definitions and nature of financial statements, the
following points will help us.
1. Recorded Facts : The term 'recorded facts' refers to the data taken out from the accounting
records. The records are maintained on the basis of actual cost data. The figures of various accounts
such as cash in hand and at bank, Bills receivable, sundry debtors, fixed assets etc. are taken as per
the figures recorded in the accounting books. The assets purchased at different times and at different
prices are put together and shown at cost prices. As financial statement are not based on replacement
costs they do not show current financial condition of the concern.
2. Accounting conventions : Certain accounting conventions are followed while preparing financial
statements. Such as cost less depreciation principle, for valuation of fixed assets, cost or market price
whichever is lower, for valuation of stock, convention of materiality in case of small items like pencils,
pens, postage stamps etc. The use of accounting conventions makes financial statements comparable,
simple and realistic.
3. Assumptions : The accountant makes certain assumptions while making accounting records.
For example the concern is treated as a going concern. Another important assumption is to presume that
the value of money will remain the same in different periods. Though there is drastic change in purchasing
power of money.
4. Personal judgements : Personal judgements of the accountant plays an important role in the
preparation of financial statements. For example : there are a number of methods for valuing stock viz;
LIFO, FIFO, Average cost method, standard cost, base stock method etc, the accountant will use one of
these methods for valuing materials. The selection of depreciation method, determination of period for
writing off the intangible assets are some of the examples where judgement of the accoutant will play an
important role in choosing the most appropriate course of action.
15.4. Characteristics of Financial statements:
11.4
The financial statements are prepared with a view to show financial position of the concern. A
proper analysis and interpretation of these statements enables a person to judge the profitability and
financial position. The financial statements should be prepared in such a way that they are able to give a
clear and true picture of the concern. The ideal financial statements have the following characteristics.
Cost and Management Accounting 11.3
15.3 Financial Statements
1) Show true financial position : The information contained in the financial statements should be
such that a true and correct idea is taken about the financial position of the concern. No material information
should be withheld while preparing these statements.
2) Easy and effective presentation : The financial statements should be presented in a single way
so as to make them easily understandable. A person who is not well versed with accounting terminology
should also be able to understandable. A person who is not well versed with accounting terminology
should also be able to understand the statements without much difficulty. This characteristic will enhance
the utility of these statements.
3) Relevance : Financial statements should be relevant to the objectives of the enterprise. This will
be possible when the person preparing these statements is able to properly utilise the accounting information.
The information which is not relevant to the statements should be avoided.
4) Attractive : The financial statements should be prepared in such a way that important information
is underlined to attract the reader.
5) Concise : Financial statements should be prepared in a concise form. The calculation work
should be minimum possible, while preparing these statements. The size of the statements should not be
very large. The columns to be used for giving the information should also be less.
6) Comparability : The comparable figures will make the statements more useful. The financial
statements should be prepared in such a way to compare the current year figures with previous year. The
statement can also be compared with the figures of other concerns of the same nature.
7) Analytical Representation : The information should be analysed in such a way that similar data
is presented at the same place. This will be helpful in analysis and interpretation of data.
8) Brief : The financial statement should be presented in Brief. So the reader will form an idea
about the figures.
9) Promptness : The financial statements should be prepared and presented at the earliest possible
i.e. immediately at the end of the financial year.
15.5. Different types of Financial statements :
11.5
Financial statements primarily comprise two basic statements 1) position statement or balance sheet
2) Income statement or the profit and loss account. However, generally accepted accounting principles
specify that a complete set of financial statements must include.
1) A balance sheet.
2) An income statement.
3) A statement of changes in owner’s account.
4) A statement of changes in financial position.
Centre for Distance Education 15.4
11.4 Acharya Nagarjuna University
FINANCIAL STATEMENT
Position Statement Income statement Statement of Statement of
or or changes in Owner’s changes in
Balance sheet Profit & loss A/c equity or Retained Financial position
Earnings
Fund Flow Cash Flow
Statement Statement
Let us now briefly explain the meaning and significance of each of these statements.
A) Balance Sheet : The American Institute of certified Public Accountants defines Balance sheet
as “A tabular statement of summary of balances carried forward after an actual and constructive closing of
books of account and kept according to principles of accounting”. The purpose of balance sheet is to
show the resources that the company has i.e. is assets, and from where those resources come from i.e. its
liabilities.
The balance sheet is prepared on a particular date. The right hand side shows assets and the left
hand side shows the liabilities. The companies Act, 1956 has prescribed a particular form for showing
assets and liabilities in the balance sheet for companies registered under this Act. These companies are
also required to give figures for the previous year along with the current year’s figures.
2. Profit and Loss Account :
Income statement or profit and loss Account is prepared to know the operating results of the
concern for an year, whether it earned a profit or suffered a loss. It is a statement of revenues earned and
the expenses incurred for earning that revenue. If there is excess of revenues over expenditure it will show
a profit and if the expenditures are more than the income then there will be a loss.
The income statement may be prepared in the form of manufacturing account to find out the cost of
production, in the form of Trading Account to determine gross profit or gross loss, in the form of a profit
and loss account to determine net profit or net loss. A statement of Retained Earnings may also be prepared
to show the distribution of profits.
3. Statement of changes in owner’s Equity :
The term ‘owner’s Equity’ refers to the claims of the owners of the business i.e. shareholders against
the assets of the firm. It consists of two elements 1) paid-up share capital i.e. the initial amount of funds
invested by the shareholders; and 2) retained earnings, reserves and surplus representing undistributed
profits.
A statement of retained earnings is also known as profit and loss Appropriation Account or Income
Disposal statement. As the name suggests it shows appropriations of earnings. The previous year’s balance
is first brought forward. The net profit during the current year is added to this balance. On the debit side,
appropriations like interim dividend paid, proposed dividend, amounts transferred to various reserve
accounts are shown The balance in this account. Will show the amount of profit retained in hand and
carried forward.
Cost and Management Accounting 15.5
11.5 Financial Statements
4) Statement of changes in Financial position : The basic financial statements i.e., the balance
sheet and the profit and loss account or income statement of a business reveal the net effect of the various
transactions on the operational and financial position of the company. The balance sheet gives a static view
of the resources of a business and the uses to which these resources have been put. The profit and loss
account indicates the resources provided by operations. But there are many transactions that do not
operate through profit and loss account. Thus, for a better understanding another statement called statement
of changes in financial position has to be prepared to show the changes in assets and liabilities from the end
of one period to the end of another period of time. The objective of this statement is to show the movement
of funds (working capital) during a particular period. The statement of changes in financial position may
take any of the following two forms.
a) Funds Flow statement : The funds flow statement is designed to analyse the changes in the
financial condition of a business enterprise between two periods. The word ‘Fund’ is used to denote
working capital. This statement will show the sources from which the funds are received and the uses to
which these have been put. This statement enables the management to have an idea about the sources of
funds and their uses for various purposes. This statement helps the management in policy formulation and
performance appraisal.
Cash Flow statement : A statement of changes in the financial position of a firm on cash basis is
called Cash Flow statement. It summarises the causes of changes in cash position of a business enterprise
between dates of two balance sheets. This statement is very much similar to the statement of changes in
working capital i.e. Funds Flow statement. A cash flow statement focuses attention on cash changes only.
It describes the sources of cash and its uses.
15.6.
11.6 Form and contents of Balance Sheet :
There is no specific form for the preparation of balance sheet in the case of proprietory concerns
and partnership firms. The balance sheet can be prepared either on the basis of liquidity or on the basis of
permanency.
When the balance sheet is prepared on the basis of liquidity, on the assets side, more liquid assets
like cash in hand, cash at bank, investments etc., are shown first and the least liquid assets will be shown at
last. On the liabilities side, the liabilities to be paid in the short period are shown first, long-term liabilities
next and capital on the last. It is suitable to financial companies.
When the balance sheet is prepared on permanency basis, on asset side fixed assets are shown first
and liquid assets are shown at last. On liabilities side the capital is shown first, long-term liabilities next,
short term and current liabilities in the last.
The companies Act, 1956 has prescribed a form for the preparation of Balance sheet. This form is
setout in part I of schedule VI. The balance sheet of a company may be either in A/. in Horizontal or B/
. vertical form.
Centre for Distance Education 15.6
11.6 Acharya Nagarjuna University
Schedule VI - PART - I
Part (A) : Horizontal Form of Balance Sheet
Balance Sheet of .............(name of the company)
As at ............. (date onwhich balance sheet is prepared)
(1) (2) (3) (4) (5) (1)
Figures for Figures for Figures Figures
the previous Liabilties the current previous Assets current
year year year year
(Rs.) (Rs.) (Rs.) (Rs.)
Share capital Fixed Assets
Authorised : Good will
Shares of Rs... each Land
Issued : Building
Preference Share of Households
Rs.... each Railway Sidings
Equity Shares of Rs....each Plantand Machinery
Subscribed : Furniture
Preference Shares of Patents & Trade Marks
Rs..... each Livestock
Equity Shares of Rs.... each Vehicles
Less Calls Unpaid Investments
Reserves and Surplus Govt. or Trust
Capital Reserve Securities
Capital Redemption Shares, Debentures, Bonds
Reserve Current Assets
Share Premium Loans and Advances
Other Reserves A. Current Assets
Profit and Loss Account Interest Accrued
Secured Loans Stores and Spare parts
Debentures Loose Tools
Loan and Advances from Stock in Trade
Banks Work in Progress
Loans and Advancesfrom Sundry Debtors
Subsidiary Cash and Bank Balances
Other Loans and Advances B. Loans and Advances
Unecured Advances and Loans to
Loans Subsidiary
Fixed Deposits Bills Receivables
Short term Advance Payments
Loans and Advances Miscellaneous Expenditure
Other Loan and Advances Preliminary Expenses
Current Liabilities and Discount on issue of shares
Provisions and debentures
A Current Liabilities Other Deferred Expenses
Acceptances Profit and Loss Account
Sundry Creditors (Debit Balance)
Cost and Management Accounting 15.7
11.7 Financial Statements
(1) (2) (3) (4) (5) (1)
Figures for Figures for Figures Figures
the previous Liabilties the current previous Assets current
year year year year
(Rs.) (Rs.) (Rs.) (Rs.)
Outstanding Expenses
B. Provisions
Provision for Taxation
Proposed Dividends
For Contingencies
For Provident Funds Scheme
For insurances, pension and
other benefits
Part I (B) : Vertical Form of Balance Sheet
Name of the Company ...................
Balance Sheet as at ...................
Figures as at the Figures as at the
Schedule end of current end of previous
No. financial year (Rs.) financial year (Rs.)
I. Source of Funds
1. Shareholder’s Funds
(a) Capital
(b) Reserves and Surpluses
2. Loans Funds
(a) Secoured Loans
(b) Unsecured Loans
Total :
II. Application of Funds
1. Fixed Assets
(a) Gross Block
(b) Less : Depreciation
(c) Net Block
(d) Capital Work-in-Progress
2. Investments
3. Current Assets, Loans and Advances
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less : Current Liabilities and Provisions
(a) Liabilities
(b) Provisions
Net Current Assets
4. (a) Miscellaneous Expenditure to the extent
not written
(b) Profit and Loss Account (debit)
Total :
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Schedules : The details of various items are shown separately in schedules. The schedules will
incorporate all the information required under part 1A of schedule VI. The schedules, accounting policies
and other explanatory notes will form a part of the Balance sheet. A number of schedules are prepared to
supplement the information supplied in the Balance sheet.
Explanation of Balance sheet Items : 1) Share capital : The share capital is shown as a first
item on the liabilities side of the balance sheet. Authorised and issued capital is shown giving the number of
shares and their amount. The number of shares for which public has applied are mentioned along with the
type of capital i.e. preference share capital, Equity share capital. If the capital is issued for other than cash,
the amount of such capital is mentioned. The fact of issue of bonus share is also mentioned.
2) Reserves and surplus : Under this heading all those reserves which have been created out of
undistributed profits are shown. Reserves are classified as capital reserves and revenue reserves. Capital
reserves are those reserves which are not free for distribution as profits whereas revenue reserves are
created out of appropriations of profits. Various items included here are capital reserves, capital redemption
reserve, share premium account, other reserves, surplus i.e. P & L A/c, Sinking Fund etc. The word
“Fund” is used to indicate that reserve is for a specific purpose and the amount is invested outside the
concern.
3) Secured loans : All those loans against which securities are given are shown under this category.
Debentures are shown under this heading.
4) Unsecured loans : These are the loans and advances against which the company has not given
any security.
5) Current liabilities and provisions : These are divided into A/. current liabilities and B/. provisions.
In this category following items are included.
A) Current Liabilities : i) Acceptances ii) Sundry creditors iii) Subsidiary companies
iv) Advance payments v) unclaimed dividends vi) other liabilities if any viii) Interest accrued but not paid on
loans.
B) Provisions : Following items are included under provisions.
viii) Provisions for taxation ix) Proposed dividends x) Provision for contingencies xi) Provision for
provident fund scheme xii) Provision for insurance, Pension and similar staff benefits schemes. xii) Other
provisions.
Assets side : The assets are given under the following heads.
1) Fixed Assets : Fixed assets are those which are purchased for use over a long period. These
assets are meant to increase production capacity of the business. Fixed assets are shown distinctly from
each other e.g : goodwill, land and buildings, plant and machinery, Furniture etc. These assets are shown at
their original cost. Any additions and deductions during the year are shown separately. The amount of
depreciation upto the previous year and during the current year is separately deducted from the assets.
2) Investments : Investments are shown by giving their nature and mode of valuation.
Cost and Management Accounting 15.9
11.9 Financial Statements
3) Current Assets : Current assets are the assets which can be convertible into cash within a
period of twelve months. They are cash in hand and at bank, debtors, stock. The stock is valued at cost
or market price which ever is less, debtors are shown after providing provision, debtors of more than six
months old should be shown separately. The amount owed by directors should also be shown separately.
4) Miscellaneous Expenditures : Deferred expenditures are shown under this heading. These
are the expenses which are not debited fully to the profit and loss account of the year in which they have
been incurred. These expenses are spread over a number of years and the unwritten balance is shown in
the balance sheet. The items under this heading are preliminary expenses, discount allowed on issue of
shares or debentures, interest paid out of capital during construction etc.
15.7.
11.7 Form and content of Income statement :
In case of sole proprietory and partnership concerns there are no prescribed forms for income
statement. The preparation of this statement is not compulsory but desirable. In case of joint stock companies
the preparation of income statement for every financial year is compulsory. Sec 211 of the Act prescribes
the contents to be disclosed in this statement. It says that profit and loss account of a company shall give a
true and fair view of the profit and loss of the company for the financial year and shall comply with the
requirements of part II of schedule VI.
The manufacturing, Trading and profit and loss Accounts are generally prepared in T form. The
general forms of these accounts are given as follows.
Incase of joint stock companies, the heading of the account is profit and loss account and same
information which is given above is given here. Some items like provision for taxation, interest on debentures
etc are also shown as expenses in Profit and Loss Account. The figures of profit and loss account of the
previous year are also given along with the current figures.
Jointstock companies prepare profit and loss Appropriation Account also. This account is also
known as retained earnings account. This account is prepared to show how the profit of the company
have been used. The form of this account is given as follows :
15.8. Importance of Financial statements :
11.8
The financial statements reflects the financial position and operating strength or weakness of the
concern. These statements are useful to management, investors, creditors, bankers, workers, government
and public at large. The utility of financial statements to different parties is discussed in detail as follows :
1) Management : The management is able to exercise cost control through these statements as
these are useful for assessing the efficiency for different cost centres. The efficient and inefficient spots can
be located and the management is able to take necessary actions.
2) Creditors : The trade creditors are interested in current solvency of the concern. The calculation
of current ratio and liquid ratio will enable the creditors to assess the current financial position of the
concern.
3) Bankers : The Banker is interested to see that the loan amount is secure and customer is also
able to pay the interest regularly. For this purpose he analyse the balance sheet to determine the financial
strength of the concern.
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4) Investors : The investors include both short-term and long-term investors. They are interested
in the security of the principal amount of loan and regular interest payments by the concern. The investors
will study the long-term solvency of the concern with the help of financial statements.
5) Government : The financial statements are used to assess tax liability of business enterprises.
These statements enable the government to find out whether business is followed various rules and regulations
or not.
6) Trade Associations : These associations provide service and protection to the members.
They may analyse these statements for the purpose of providing facilities to their members.
7) Stock Exchange : The stock exchanges deal in purchase and sale of securities of different
companies. The financial statements enable the stock brokers to judge the financial position of different
concerns.
15.9. Limitations of Financial statements :
11.9
Though financial statements are relevant and useful for the concern, they are suffering from the
following limitations.
1) These statements do not give a final picture of the concern. The actual position can only
be known when the business is sold or liquidated.
2) The financial statements are expressed in monetary values, so they appear to give final and
accurate position. The value of fixed assets in the balance sheet neither represents the value for which fixed
assets can be sold nor the amount which will be required to replace these assets. The balance sheet is
prepared on the presumption of a going concern as a result of it, it is not giving the exact position.
3) The financial statement are prepared on the basis of historical costs. The value of assets
decreases with the passage of time, current price changes are not taken into account.
4) The impact of Non-monetary factors such as reputation of management, co-operation of
the employees etc are totally ignored because they can not expressed in monetary terms even though they
influence the profits.
15.10. Summary :
11.10
All the business concerns are interested to know the operating results and their financial position at
the end of the period. For the purpose of knowing the operating results in a particular year whether it is a
profit or loss they prepare the profit and loss account. For the purpose of ascertaining the financial
position, they prepare Balance Sheet. All the transactions or matters which can be measurable in monetary
value are included in these statements. By going through these statement a reader can easily understood
the strengths and weaknesses of the concern. These statements will serve to different sectors of the
society.
Cost and Management Accounting 15.11
11.11 Financial Statements
15.11.Self
11.11 Assessment5 questions :
1) What are financial statements ? Define.
2) Describe the features of financial statements.
3) What are the characteristics of financial statements.
4) Describe various financial statements.
5) What is the importance of financial statements.
6) Listout the limitations of financial statements.
15.12.
11.12 Reference Books:
1. Sharma, Gupta – Management Accounting.
2. I.M. Pande - Management Accounting
3. Manmohan & Goyal – Principles of Management Accounting.
4. Hom Green - Introduction to Management Accounting.
- Dr. Ch. Suravinda
Cost and Management Accounting 16.1
12.1 Financial Statements Analysis
LESSON - 12
16
FINANCIAL STATEMENTS ANALYSIS
16. Objective : After going through this lesson the student can know what is Financial Statement
12.0
analysis? What are the tools that are available to the management to Analyse Financial Statements etc.
Structure :
12.1 Introduction.
16.1
12.2 Definition of Financial Analysis.
16.2
16.3
12.3 Types of Financial Analysis
12.4 Procedure of Financial Statements Analysis
16.4
12.5 Tools of Financial Analysis
16.5
16.6
12.6 Comparative Statements
16.6.1 12.6.1 Comparative
Comparative BalanceBalance
Sheet Sheet
16.6.2 12.6.2
Comparative Income Statement
Comparative Income Statement
12.7
16.7 Trend Analysis
16.8
12.8 Common-size Statements
16.8.1 12.8.1
Common-size Balance Balance
Common-size Sheet. Sheet
16.8.2 12.8.2
Common-size Income Statements
Common-size Income Statements
12.9 Limitations of Financial Analysis
16.9
16.10
12.10 Summary
16.11
12.11 Self Assessment Questions
12.12 Exercises
16.12
12.13 Reference Books.
16.13
16.1. Introduction
12.1
Financial Statements are prepared primarily for decision making. But the information provided in the
financial statements alone cannot help to draw meaningful conclusions. However, the information provided
in the financial statements is of immense use in making decisions through analysis and interpretation of
financial statements. Financial analysis is the process of identifying the financial strengths and weaknesses
of the firm. There are various methods to analyse the financial statements, such as comparative statements,
trend analysis, common size statements, schedule of changes in working capital, Funds Flow and Cash
Flow analysis, cost – volume – profit analysis and ratio analysis.
16.2 Meaning and Concept of Financial Analysis:
12.2
The term ‘financial analysis, also known as analysis and interpretation of financial statements.
Metcalf and Titrad defines financial analysis as “analysing financial statements is a process of evaluating
the relationship between component parts of a financial statement to obtain a better understanding of a
firm’s position and performance”.
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Myers define it as “Financial Statement Analysis is largely a study of relationship among the various
financial factors in a business as disclosed by a single set of statements ,and a study of the trend of these
factors as shown in a series of statements”.
After going through the above definitions we may conclude that the purpose of financial analysis is
to diagnose the information contained in financial statements so as to judge the profitability and financial
soundness of the firm. Financial statement analysis is an attempt to determine the significance and meaning
of the financial statement data so that forecast may be made of the future earnings, ability to pay interest
and profitability.
The term ‘financial statement analysis’ include both ‘analysis’, and ‘interpretation’. A distinction
should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification
of financial data by methodical classification of the data given in the financial statements , ‘interpretation’
means, ‘explaining the meaning and significance of the data so simplified. Analysis and interpretation are
interlinked and complimentary to each other. Analysis is useless without interpretation and interpretation
without analysis is difficult or even impossible.
16.3 Types of Financial Analysis:
12.3
Financial Analysis can be classified on the basis of 1. Material used 2. On the basis of method of
operation.
TYPES OF FINANCIAL ANALYSIS
On the basis of Material used On the basis of operation
External Analysis Internal Analysis Horizontal Analysis Vertical Analysis
On the basis of material used financial analysis can be of two types i.e. 1) External analysis b)
Internal analysis.
a) External Analysis:
This analysis is done by outsiders who do not have access to the detailed internal accounting records
of the business firm. These outsiders include investors, potential investors, creditors, government agencies
and the general public. For financial analysis, these parties depend on the published financial statements.
b) Internal Analysis:
The persons who have access to the internal accounting records conduct this internal analysis.
These people are the executives and employees of the organisation as well as government agencies
which have statutory powers vested in them.
2) On the basis of method of operation:
According to the method of operation followed in the analysis financial analysis can be of two types
.a) horizontal analysis b) vertical analysis.
Cost and Management Accounting 16.3
12.3 Financial Statements Analysis
a) Horizontal Analysis:
Horizontal analysis refers to the comparison of financial data of a company for several years. The
figures for this type of analysis are presented horizontally over a number of columns. The figures of the
various years are compared with standard or base year. A base year is a year chosen as beginning point.
The horizontal analysis makes it possible to focus attention on items that have changed significantly during
the period under review. Comparison of an item over several periods with a base year may show a trend
developing.
b) Vertical Analysis:
Vertical Analysis refers to the study of relationship of the various items in the financial statement of
one accounting period. In this type of analysis the figures from financial statements of a year are compared
with a base selected from the same year’s statement. Common-size financial statements and financial
ratios are the two tools employed in vertical analysis.
16.4 Procedure of Financial Statements Analysis:
12.4
In the analysis of financial statements three steps are involved.
They are 1) selection 2) classification and 3) interpretation.
In the first step the data or information which is relevent to analyse the financial statements is selected.
In the second step this data is classified into groups and later in the third step conclusions are formed.
The following procedure is adopted for the analysis and interpretation of financial statements:
1) The analysis should be well versed with the concepts and principles of accounting. He should
know the plans and policies of the management so that he may be able to find out whether
these plans are properly executed or not.
2) He should know the object or aim of analysis to decide the sphere of work. If the aim is to find
out the earning capacity of the enterprise then analysis of income statement will be undertaken.
If financial position is to be studied then Balance Sheet analysis is required.
3) The data given in the financial statements should be re-organised and re-arranged into similar
groups.
4) A relationship is established among financial statements with the help of tools and techniques
of analysis such as ratios, trends, common size, Funds Flow etc.
5) The information is interpreted in a simple and understandable way.
6) The conclusion drawn from interpretation are presented to the management in the form of
reports.
16.5 Methods of Financial Analysis:
12.5
The analysis and interpretation of financial statements is used to determine the financial position
and results of operations as well. A number of methods are used to study the relationship between different
statements. The following methods of analysis are generally used:
1. Comparative Statements ;
2. Trend Analysis;
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3. Common-size Statements;
4. Funds Flow Analysis;
5. Cash Flow Analysis;
6. Ratio Analysis;
7. Cost Volume Profit Analysis.
The first three methods i.e., comparative statements, trend analysis and common -size statements
are discussed in this lesson.
12.6 1. Comparative Statements:
The comparative financial statements are statements of the financial position at different periods of
time. The elements of financial position are shown in a comparative form so as to give an idea of financial
position at two or more periods. Any statement prepared in a comparative form will be covered in
comparative statements. From practical point of view, generally, two financial statements i.e., balance
sheet and income statement are prepared in comparative form for financial analysis purposes. Not only the
comparison of the figures of two periods but also the relationship between balance sheet and income
statement enables an in depth study of financial position and operative results. The two comparative statements
are 1) Balance Sheet and 2) Income Statement.
6.1 Comparative Balance Sheet:
12.6.1
The comparative balance sheet analysis is the study of the trend of the same items, group of items
and computed items in two or more balance sheets of the same business enterprise on different dates. The
changes in periodic balance sheet items reflect the conduct of a business. The changes can be observed by
comparison of the balance sheet at the beginning and at the end of a period and these changes can help in
forming an opinion about the progress of an enterprise. The comparative balance sheet has four columns,
the first two columns for the data of balance sheets. Third column is used to show increases in figures. The
fourth column may be added for giving percentages of increases or decreases.
Guidelines for Interpretation of Comparative Balance Sheet:
While interpretation comparative Balance Sheet the interpreting is expected to study the following
aspects:
1) Current financial position and liquidity position.
2) Long-term financial position.
3) Profitability of the concern.
For studying current financial position or short-term financial position of a concern, one should see
the working capital in both the years. The excess of current assets over current liabilities will give the
figures of working capital. The increase in working capital will mean improvement in the current financial
Cost and Management Accounting 12.5
16.5 Financial Statements Analysis
position of the business. An increase in current assets accompanied by the increase in current liabilities of
the same amount will not show any improvement in the short-term financial position. A student should
study the increase or decrease in current asset and current liabilities and this will enable him to analyse the
current financial position. The second aspect which should be studied in current financial position is the
liability position of the concern. If liquid assets like cash in hand, cash at bank, bills receivables, debtors
etc; show an increase in the second year over the first year, this will improve the liquidity position of the
concern. The increase in inventory can be on account of accumulation of stocks for want of customers,
decrease in demand or inadequate sales promotion efforts. An increase in inventory may increase working
capital of the business but it will not be good for the business.
The long-term financial position of the concern can be analysed by studying the changes in fixed
assets, long-term liabilities and capital. The proper financial policy of concern will be to finance fixed assets
by the issue of either long-term securities such as debentures, bonds, loans from financial institutions or
issue of fresh share capital. An increase in fixed assets should be compared to the increase in long-term
loans and capital. If the increase in fixed assets is more than the increase in long term securities then part of
fixed assets has been financed from the working capital. On the other hand, if the increase in the long-term
securities is more than the increase in fixed assets then fixed assets have not only been financed from long-
term sources but part of working capital has also been financed from long-term sources. A wise policy will
be to finance fixed assets by raising long-term funds.
The nature of assets which have increased or decreased should also be studied to form an opinion
about the future production possibilities. The increase in plant and machinery will increase production
capacity of the concern. On the liabilities side, the increase in loaned funds will mean an increase in interest
liability whereas and increase in share capital will not increase any liability for paying interest. An opinion
about the longterm financial position should be formed after taking into consideration the above mentioned
aspects.
The study of increase or decrease in retained earnings, various resources and surpluses etc will
enable the interpreter to see whether the profitability has improved or not. An increase in the balance of
profit and loss account and other resources created from profits will mean an increase in profitability of the
concern. The decrease in such accounts may mean issue of dividend, issue of bonus shares or deterioration
in profitability of the concern.
After studying various assets and liabilities an opinion should be formed about the financial position
of the concern. One cannot say if short–term financial position is good then long term financial position will
also be good or vice – versa. A conclusion word about the overall financial position must be given at the
end.
Illustration I:
The following are the Balance sheets of a concern for the year 2007 and 2008. Prepare a comparative
Balance sheet and study the financial position of the concern.
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BALANCE SHEET AS ON 31ST DECEMBER
2007 2008 2007 2008
Rs. Rs. Rs. Rs.
Equity Land & Buildings 7,40,000 5,40,000
Share Capital 12,00,000 16,00,000 Plant & Machinery 8,00,000 12,00,000
Reserves & Furniture &
Surpluses 6,60,000 4,44,000 Fixtures 40,000 50,000
Debentures 4,00,000 6,00,000 Other Fixed Assets 50,000 60,000
Long -term Cash in hand
Loans on Mortgage 3,00,000 4,00,000 and at Bank 40,000 1,60,000
Bills payable 1,00,000 90,000 Bills Receivable 3,00,000 1,80,000
Sundry Creditors 2,00,000 2,40,000 Sundry Debtors 4,00,000 5,00,000
Other Current Stock 5,00,000 7,00,000
Liabilities 10,000 20,000 Prepaid Expenses - 4,000
28,70,000 33,94,000 28,70,000 33,94,000
Solution :
Comparative Balance Sheet of a company for the year ending December 31, 2007 and 2008.
Year ending Increase/ Increase
31 December Or Or
2007 2008 Decrease Decrease
Rs. Rs. Amount in (Percentage)
Rs.
Assets :
Current Assets :
Cash in hand and at Bank 40,000 1,60,000 + 1,20,000 + 300
Bills Receivables 3,00,000 1,80,000 –1,20,000 –40
Sundry Debtors 4,00,000 5,00,000 + 1,00,000 + 25
Stock 5,00,000 7,00,000 + 2,00,000 + 40
Prepaid Expenses – 4,000 + 4,000
Total Current Assets 12,40,000 15,44,000 + 3,04,000 + 24.52
Fixed Assets :
Land & Buildings 7,40,000 5,40,000 –2,00,000 –27.03
Plant & Machinery 8,00,000 12,00,000 + 4,00,000 + 50.00
Furniture & Fixtures 40,000 50,000 +10,000 +25.00
Other fixed Assets 50,000 60,000 +10,000 +20.00
Total Fixed Assets 16,30,000 18,50,000 +2,20,000 +13.49
Total Assets 28,70,000 33,94,000 +5,24,000 + 18.26
Cost and Management Accounting 16.7
12.7 Financial Statements Analysis
Liabilities & Capital :
Current liabilities :
Bills payable 1,00,000 90,000 –10,000 –10
Sundry Creditors 2,00,000 2,40,000 + 40,000 + 20
Other Current Liabilities 10,000 20,000 +10,000 +100
Total Current Liabilities 3,10,000 3,50,000 +40,000 + 12.9
Debentures 4,00,000 6,00,000 +2,00,000 +50
Long-term loans on Mortgage 3,00,000 4,00,000 +1,00,000 +33
Total Liabilities 7,00,000 10,00,000 +3,40,000 +33.66
Equity share capital 12,00,000 16,00,000 +4,00,000 + 33
Reserves & Surpluses 6,60,000 4,44,000 –2,16,000 –32.73
Total 28,70,000 33,94,000 +5,24,000 +18.26
Interpretation:
1. The comparative balance sheet of the company reveals that during 2008 there has been
an increased in fixed assets of Rs. 2,20,000 i.e. 13.49% while long – term liabilities to
outsiders have relatively increased by Rs. 3,00,000 and equity share capital has increased
by Rs. 4 lakhs. This fact depicts that the policy of the company is to purchase fixed
assets from the long – term sources of finance thereby not affecting working capital.
2. The current assets have increased by Rs. 3,04,000 i.e. 24.52% and cash has increased
by Rs.1,20,000 on the other hand, there has been an increase in inventories amounting
to Rs. 2 lakhs. The current liabilities have increased only by Rs. 40,000 i.e. 12.9%. This
further confirms that the company has raised long – term finances even for the current
assets resulting into an improvement in the liquidity position of the company.
3. Reserves and surpluses have decreased from Rs. 6,60,000 to Rs. 4,44,000 i.e. 32.73%
which shows that the company has utilised reserves and surpluses for the payment of
dividend to shareholders either in cash or by the issue of bonus shares.
4. The overall financial position of the company is satisfactory.
16.2. Comparative Income Statement:
12.6.2
The income statement gives the results of the operation of a business. The comparative income
statement gives an idea of the progress of a business over a period of time. The changes in absolute
data in money values and percentages can be determined to analyse the profitability of the business.
Like comparative balance sheet, income statement also has four columns. First two columns give
figures of various items for two years. Third and fourth columns are used to show increase or
decrease in figures in absolute amounts and percentages respectively.
Guidelines for Interpretation of Income statements:
The analysis and interpretation of Income statement will involve the following steps:
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1. The increase or decrease in sales should be compared with the increase or decrease in cost of
goods sold. An increase in sales will not always mean an increase in profit. The profitability
will improve if increase in sales is more than the increase in cost of goods sold. The amount of
gross profit should be studied in the first step.
2. The second step of analysis should be the study of operational profits. The operating expenses
such as office and administrative expenses, selling and distribution expenses should be deducted
from gross profit to find out operating profits. An increase in operating profit will result from
the increase in sale position and control of operating expenses. A decrease in operating profit
may be due to an increase in operating expenses or decrease in sales. The change in individual
expenses should also be studied. Some expenses may increase due to expansion of business
activities while others may go up due to managerial inefficiency.
3. The increase or decrease in net profit will give an idea about the overall profitability of the
concern. Non-operating expenses such as interest paid, losses from sale of assets, writing off
of deferred expenses, payment of tax etc; decrease the figure of operating profit. When all
non-operating expenses are deducted from operational profit, we get a figure of net profit.
Some non-operating incomes may also be there which will increase net profit. An increase in
net profit will give us an idea about the progress of the concern.
4. An opinion should be formed about profitability of the concern and it should be given at the
end. It should be mentioned whether the overall profitability is good or not.
We will examine these things with the following illustrations.
Illustration 2:
The income statements of a concern are given for the year ending on 31st Dec 2007 and 2008. Re-
arrange the figures in a comparative form and study the profitability position of the concern.
2007 2008
Rs.(000) Rs.(000)
Net Sales 3140 3600
Cost of goods sold 1800 2000
Operating Expenses :
General and administrative expenses 280 288
Selling expenses 320 360
Non-operating Expenses :
Interest paid 100 120
Income - tax 280 320
Cost and Management Accounting 16.9
12.9 Financial Statements Analysis
Solution :
Comparative Income Statement for the year ended December 31, 2007 and 2008.
Year ending Increase/(+) Increase(+)
31 December Or Or
2007 2008 Decrease(-) Decrease(-)
Rs. Rs. Amount in (Percentage)
( ,000) ( ,000) Rs. ( ,000)
Net Sales 3140 3600 + 460 + 14.6
Less : Cost of goods sold 1800 2000 + 200 + 11.0
Gross Profit 1840 1600 + 260 + 19.40
Operating Expenses :
General & Administrative
Expenses 280 288 +8 + 28
Selling Expenses 320 360 + 40 + 12.5
Total Operating Expenses 600 648 + 48 + 8.0
Operating Profit 740 952 + 212 + 28.65
Less : Other deductions interest paid 100 120 + 20 + 20.00
Net Profit before tax 640 832 + 192 + 30.00
Less : Income Tax 280 320 + 40 + 14.3
Net Profit After tax 360 512 + 152 + 42.22
Interpretation:
The comparative income statement given above reveals that there has been an increase in net
sales of 14.65% while the cost of goods sold has increased nearly by 11% there by resulting in an
increase in the gross profit of 19.4%. Although the operating expenses have increased by 8% the
increase in gross profit is sufficient to compensate for the increase in operating expenses and hence
there has been an overall increase in operational profits amounting to Rs.2,12,000 i.e.28.65% in
spite of an increase in financial expenses of Rs.20,000 for interest and Rs.40,000 for Income tax.
There is an increase in net profits after tax amounting to Rs1,52,000 i.e.42.22%. It may be concluded
that there is a sufficient progress in the company and the overall profitability of the company is
good.
Illustration 3:
Prepare comparative statements from the following data:
2007 2008
(Rs. In lakhs)
Net Sales 1200 1500
Cost of goods sold 800 1200
Admn. Expenses 40 40
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Selling Expenses 20 20
Net Profit 340 240
2007 2008
Balance Sheets (Rs. In lakhs)
Equity capital 800 800
6% preference share capital 600 600
Reserves 400 490
6% Debentures 200 300
Bill payable 100 150
Creditors 300 400
Tax Payable 200 300
2600 3040
Land 200 200
Buildings 600 540
Plant 600 540
Furniture 200 280
Stock 400 600
Cash ? ?
2600 3040
Solution :
Comparative Income Statement for the year ended 2007 and 2008.
Year ending Increase (+) Increase
31 December Decrease (-) Decrease (–)
2007 2008 Rs.Lakhs (Percentage)
Rs. (in lakhs) Rs. (in lakhs)
Net Sales 1200 1500 + 300 + 25
Less : Cost of goods sold 800 1200 + 400 + 50
a/. Gross Profit 400 300 – 100 – 25
Operating Expenses :
Administrative Expenses 40 40 – –
Selling Expenses 20 20 – –
Total Operating Expenses 60 60 – –
Operating Profit (a – b) 340 240 – 100 – 29.41
Cost and Management Accounting 16.11
12.11 Financial Statements Analysis
Less : Other Expenses – – – –
Net Profit 340 240 – 100 – 29.41
Comparative Balance Sheet for the year ended December 31, 2007 and 2008.
Year ending Increase/ Increase
31 December Or Or
2007 2008 Decrease Decrease
Rs. Amount in (Percentage)
Rs. (in lakhs) Rs. (in lakhs) Rs. (in lakhs) Assets :
Current Assets :
Cash 600 880 + 280 + 46.67
Stock 400 600 + 200 + 50.00
Total Current Assets 1,000 1,480 + 480 + 48.00
Fixed Assets :
Land 200 200 – –
Buildings 600 540 – 60 – 10
Plant 600 540 – 60 – 10
Furniture 200 280 + 80 + 40
Total Fixed Assets 2600 3040 + 440 + 16.92
Liabilities and Capital
Current Liabilities :
Bills Payable 100 150 + 50 + 50.0
Creditors 300 400 + 100 + 33.3
Tax Payable 200 300 + 100 + 50.0
Total Current liabilities 600 850 + 250 + 41.67
Debentures 200 300 + 100 + 50.0
Total Liabilities 800 1150 + 350 + 43.75
Equity share capital 800 800 – –
6% pref. Share capital 600 600 – –
Reserve 400 490 + 90 + 22.5
Total 2600 3040 + 440 + 16.92
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12.12 Acharya Nagarjuna University
Interpretation:
a) The comparative income statement reveals that there has been increase in not sales of 25% while
the cost of goods sold has increased disproportionately by 50% thereby resulting in a decrease of gross
profit of 25%. Although the operating expenses have remained constant, there has been decrease in net
profit of 29.41%. The company needs to took into the causes of increase in cost of goods sold and control
the same.
b) The comparative balance sheet of the company reveals that during 2008 there has been decrease
in fixed assets of Rs.40 lakhs, i.e.2.5% while long-term liabilities to outsiders have increased by Rs100
lakhs, i.e.50%. There has also been increase of Rs.90 lakhs, i.e 22.5% in reserves of the company. Thus,
the company has used long-term resources to finance additional working capital.
The current assets have increased by Rs.480 lakhs in 2008 i.e.48%. There has been sufficient
increase in balance of cash as well as stock. On the other hand current liabilities have increased by only
Rs.250 lakhs i.e.41.67%. This further confirms that the company has raised long –term finances even for
the current assets resulting into an improvement in the liquidity position of the company.
16.7 Trend Analysis:
12.7
The financial statements may be analysed by computing trends of series of information. This method
determines the direction upwards or downwards and involves the computation of the percentage relationship
that each statement item bears to same item in base year. The figures of the base year are taken as 100 and
trend ratios for other years are calculated on the basis of base year.
Procedure for calculating Trends:
1. One year is taken as a base year, generally, the first year is taken as base year.
2. The figures of base year are taken as 100.
3. Trend percentages are calculated in relation to base year.
The interpretation of trend analysis involves a cautious study. The mere increase or decrease in
trend percentage may give misleading results if studied in isolation. An increase of 10% in current assets
may be treated favourable. If this increase in current assets is accompanied by an equivalent increase in
current liabilities, then this increase will be unsatisfactory. The increase in sales may not increase profits if
the cost of production has also gone up.
The base period should be carefully selected, it should always be a normal period. The accounting
procedures and conventions used for collecting data and preparation of financial statements should be
similar, otherwise the figures will not be comparable.
Illustration 4:
Calculate the trend percentages from the following figures of X ltd. taking 2004 as the base and
interpret them:
Year Sales Stock Rs. in Lakhs
Profit before tax
2004 5,643 2,127 963
2005 7,020 2,343 1,305
2006 7,965 2,448 1,374
2007 9,063 2,832 1,581
2008 11,304 3,462 2,016
Cost and Management Accounting 16.13
12.13 Financial Statements Analysis
Solution :
Trend percentages. (Base year 2004 = 100)
Year Sales Stock Profit Before tax
(Amount Trend Amount Trend Amount Trend
(Rs.Lakhs) Percentage Rs.Lakhs Percentage Rs.Lakhs Percentage
2004 5,643 100 2,127 100 963 100
2005 7,020 124 2,343 110 1,305 136
2006 7,965 141 2,448 115 1,374 143
2007 9,063 161 2,832 133 1,581 164
2008 11,304 200 3,462 162 2,016 209
Interpretation:
1. The sales have continuously increased in all the years up to 2008. The percentage in
2008 is 200 as compared to 100 in 2004. The increase in sales is quite satisfactory.
2. The figures of stock have also increased from 2004 to 2008. The increase in stocks is
more in 2007 and 2008 as compared to earlier years.
3. Profit before tax has substantially increased. In five years period it has more than doubled.
The comparative increase in profits is much higher in 2007 and 2008, as compared to
2006.
The expansion of the firm is good and it has doubled its sales and profits in just five years
time. The profits have increased more than sales which shows that there is a proper control over
cost of goods sold, the overall performance of the concern is good.
12.8
3) COMMON SIZE STATEMENT:
The common-size statements, balance sheet and income statement, are shown in analytical
percentages. The figures are shown as percentages of total assets, total liabilities and total sales.
The total assets are taken as 100 and different assets are expressed as a percentage of the total.
Similarly, various liabilities are taken as a part of total liabilities. The short – comings in comparative
statements and trend percentages where changes in items could not be compared with the totals
have been covered up. The analyst is able to assess the figures in relation to total values. The
common – size statements may be prepared in the following ways.
1. The totals of assets or liabilities are taken as 100.
2. The individual assets are expressed as a percentage of total assets, i.e., 100 and different
liabilities are calculated in relation to total liabilities. For example, if total assets are Rs.
10 lakhs and venture value is Rs. 1 lakh, then it will be 10% of total assets.
F
G 1,00,000 I
100J
H10,00,000 K
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12.14 Acharya Nagarjuna University
1. COMMON SIZE-BALANCE SHEET
12.8.1
A statement in which balance sheet items are expressed as the ratio of each asset to total assets and
the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet.
The common-size balance sheet can be used to compare companies of differing size. The comparison
of figures in different periods is not useful because total figures may be affected by a number of factors.
Illustration 5:
The Balance Sheet of C & Co. and V & Co. or givan has follows.
Balance Sheet as on Dec 31, 2008
C & Co V & Co
Rs. ,000 Rs. ,000
Liabilities :
Preference share capital 960 1280
Equity share capital 1200 3200
Reserves & surpluses 112 144
Long - term loans 920 1040
Bills payable 16 -
Sundry Creditors 96 32
Outstanding Expenses 120 48
Proposed dividend. 80 720
3,504 6,464
Land and Buildings 640 984
Plant and Machinery 2,672 4,800
Temporary Investments 8 320
Inventories 80 200
Book- Debts 32 64
Prepaid expenses 8 16
Cash and Bank Balances 64 80
3,504 6,464
Cost and Management Accounting 16.15
12.15 Financial Statements Analysis
Solution :
COMMON SIZE BALANCE SHEETS
C.CO V & Co.
Amount % Amount %
(Rs.000) (Rs.000)
Assets :
Fixed Assets :
Land, Buildings 640 18.26 984 15.22
Plants & Machinery 2,672 76.24 4,800 74.62
Total Fixed Assets 3,312 94.52 5,784 89.48
Current Assets :
Temporary Investments 8 0.23 320 4.95
Inventories 80 2.28 200 3.08
Debtors 32 0.91 64 0.99
Prepaid expenses 8 0.23 16 0.25
Cash, Bank Balances 64 1.83 80 1.25
Total Assets 3,504 100.00 6,464 100.00
Capital - Reserves :
Preference capital 960 27.39 1,280 19.80
Equity share capital 1,200 34.25 3,200 49.50
Reserves, surpluses 112 3.19 144 2.23
Total Capital & Reserves 2,272 64.83 4,624 71.53
Long-term loans 920 26.25 1,040 16.09
Current liabilities :
Bill payable 16 0.46 – –
Creditors 96 2.74 32 0.49
Expenses Payable 120 3.44 48 0.74
Preposed Dividend 80 2.28 720 11.15
Total Current liabilities 312 8.92 800 12.38
Total liabilities 3,504 100.00 6,464 100.00
Comments:-
1. an Analysis of pattern of financing of both the companies shows that V & Co. is more
traditionally financed as compared to C & Co. The former company has depended more on its own funds
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12.16 Acharya Nagarjuna University
as it shown by balance sheet. Out of total investments, 71.53% of the funds are proprietor’s funds and
outsider’s funds account only for 28.47%. In C & Co., proprietor’s funds are 64.83% while outsider’s
share is 35.17% which shows that this company has depended more upon outsiders funds. In the present
day economic world, generally, companies depend more on outsiders funds.
2. Both the companies are suffering from in adequacy of working capital. The percentage of current
liabilities is more than the percentage of current assets in both the companies.
3. A close look at the balance sheets shows that investments in fixed assets have been financed from
working capital in both the companies.
In C & Co., fixed assets accounts for 94.52% of total assets while long – term funds account for
91.08% of total funds. In V & Co. fixed assets account for 94.52% of total funds. In V & Co., fixed assets
account for 89.48% whereas long term funds account for 87.62% of total funds instead of using long term
funds for working capital purposes the companies have used working capital for purchasing fixed assets.
4. Both the companies face working capital problem and immediate steps should be taken to issue
more capital or raise long-term loans to raise working capital position.
12.8.22. COMMON SIZE INCOME STATEMENT:-
The items in income statement can be shown as percentages of sales to show the relation of each
item to sales. A significant relationship can be established between items of income statement and volume
of sales. The increase in sales will certainly increase selling expenses and not administrative or financial
expenses. In case the volume of sales increases to a considerable extent, administrative and financial
expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So,
a relationship is established between sales and other items in income statement and this relationship is
helpful in evaluating operational activities of the enterprise.
Illustration 6:
Following are the Income statements of a company for the year ending
Dec.31-2007, and 2008.
2007 2008
(Rs.000) (Rs.000)
Sales 3,000 4,200
Other Incomes 120 90
3,120 4,290
Expenses
Cost of goods sold 1950 3060
Office expenses 120 150
Selling expenses 180 270
Interest 150 180
Net Profit 2,400 3,660
720 630
Cost and Management Accounting 16.17
12.17 Financial Statements Analysis
Solution :
Common size Income Statement
for the year ending Dec.2007 and 2008.
2007 2008
Rs.000 % Rs.100 %
Net Sales 3,000 100.00 4,200 100.00
Less : Cost of goods sold 1,950 65.00 3,060 72.86
Gross Profit 2,050 35.00 1,140 27.14
Less : Operating expenses
Office expenses 120 4.00 150 3.58
Selling expenses 180 6.00 270 6.42
Total operating expenses 300 10.00 420 10.00
Operating profit 1,750 25.00 720 17.14
Add : Other Incomes 120 4.00 90 2.14
Total Income 1,870 29.00 810 19.28
Less : Non operating expenses
Interest 150 5.00 180 4.28
Net profit 720 24.00 630 15.00
Interpretation:
1. In 2008, sales and gross profit has increased in absolute figures when compared to 2007 but
the percentage of gross profit to sales has gone down in 2008.
2. The increase in cost of sales as a percentage of sales has brought the profitability from 35 to
27.14%.
3. Operating expenses have remained the same in both the years but non-operating expenses
have decreased as a percentage in 2008. A slight decrease in non-operating expenses in
the latter year could not help to improve profits.
4. Net profits have decreased both in absolute figures and as a percentage in 2008 as
compared to 2007.
5. The overall profitability has decreased in 2008 and the reason is a rise in cost of sales.
The company should take immediate steps to control its cost of sales, otherwise the
company will be in trouble.
16.9.
12.9 Limitations of Financial Analysis:-
Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a
Centre for Distance Education 12.18
16.18 Acharya Nagarjuna University
firm. The financial analyst has also to be careful about the impact of price level changes, window – dressing
of financial statements, changes in accounting policies of a firm, accounting concepts and conventions and
personal judgement etc. some of the important limitations of financial analysis are:
1. It is only a study of interim reports.
2. Financial analysis is based upon only monetary information and non-monetary factors are
ignored.
3. It does not consider changes in price levels.
4. As the financial statements are prepared on the basis of a going concern, it does not give exact
position. Thus this has become as serious limitation to financial analysis.
5. Changes in accounting procedure by a firm may often make financial analysis misleading.
6. Analysis is only a means and not an end in itself. The analyst has to make interpretation and
draw his own conclusions. Different people may interpret the same analysis in different ways.
16.10. Summary:
12.10
Financial statements are prepared primarily for decision-making. By analysing these financial statements
one can know the financial strengths and weaknesses of the firm. It is the interpretation of financial statements.
On the basis of material used it may be an external and internal. On the basis of operation it may be
horizontal and vertical. A number of methods are used to study financial statements. The general methods
are
1. Comparative statements 2. Trend Analysis and 3. Common-size statements.
16.11. Self Assessment Questions:
12.11
1. What is financial analysis ?
2. What are the types of financial analysis?
3. What is the procedure of analysis and interpretation of financial statements ?
4. Write a brief note on comparative statements.
5. What is trend analysis?
6. Explain common-size statements.
7. What are the limitations of financial statement analysis?
8. What do you understand by the analysis and interpretation of financial statements ? Discuss
their utility and significance to the management ?
9. What are the different methods used for the analysis and interpretation of financial statements
?
10. What is common-size balance sheet and income statement ? Explain the technique of preparing
the common-size balance sheet ?
11. Explain the usefulness of trend percentages in interpretation of financial performance of a
company.
Cost and Management Accounting 16.19
12.19 Financial Statements Analysis
16.12.
12.12 Exercises :
1. The following are the Income statements of Achut Ltd for the years 2007 and 2008. Prepare a
comparative income statement and interpret it.
2007 2008 2007 2008
(Rs. 000) (Rs.000) (Rs. 000)
(Rs.000)
To Opening Stock 170 400 By Sales 2,000 2,400
To Purchases 1,000 1,100 By Closing Stock 400 450
To Wages 120 160 By Income
To Salaries 84 128 from Investments 24 30
To Rent, Rates &
Insurance 70 80 By Dividend 10 15
To Depreciation 80 120
To Selling expenses 24 24
To Discount 10 14
To Profit on sale
of plant – 16
To Interest paid 24 48
To Net Profit 852 825
2,434 2,894 2,434 2,894
2. In the basis of the balance sheets of a company, prepare a comparative Balance sheet and anlyse the
changes in Assets and liabilities.
Mar.31, 2007 Mar 31, 2008
(Rs.000) (Rs.000)
Equity share capital 1,500 3,000
Preference share capital 300 600
General Reserve 300 750
Expenses Payable 150 150
Bills Payable 300 600
Profit & Loss Account 600 900
3,150 6,000
Fixed Assets 1,200 3,000
Investments 900 300
Receivables 600 1,200
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16.20 Acharya Nagarjuna University
Stock 300 1,200
Cash 150 300
3,150 6,000
3. From the following income statements for the years, march 31, 2007 and 2008. Prepare a comparitive
Income Statement and write your interpretation.
Income Statements
2007 2008 2007 2008
Liabilities (Rs.) (Rs.) Assets (Rs.) (Rs.)
To Cost of goods
sold 18,00,000 19,00,000 By Sales 30,50,000 34,00,000
To Administrative
Expenses 1,86,500 1,91,980 By Interest & Dividend 15,000 12,400
To Selling expenses 3,80,000 4,18,000 By Profit on sale of
To Interest paid 16,000 14,000 fixed Assets 12,000 16,000
To Loss on sale
of machinery 5,000 1,600
To Income tax 1,70,000 3,36,000
To Net Profit 5,19,500 5,66,840
30,77,000 34,28,400 30,77,000 34,28,400
4. From the Balance sheets of the company for the years 2007 and 2008. Prepare a comparative balance
sheet and make a comment.
Balance Sheet
Mar.31, 2007 Mar 31, 2008
(Rs.000) (Rs.000)
Liabilities :
Preference share capital 1,500 2,700
Equity share capital 1,800 3,600
General Reserves 1,200 1,500
Profit & Loss Account 600 675
Long - term loans 600 3,000
Bills Payable 240 300
Creditors 60 75
6,000 11,850
Assets :
Fixed Assets 3,000 7,500
Investments 900 600
Cost and Management Accounting 12.21
16.21 Financial Statements Analysis
Current Assets :
Bills Receivables 600 1,050
Stock 1,200 1,800
Cash 300 900
6,000 11,850
5. Convert the following Balance Sheets into common size Balance Sheet and comment for the years
2007 and 2008.
Balance Sheet
2007 2008 2007 2008
Liabilities (Rs. 000) (Rs.000) Assets (Rs. 000) (Rs.000)
Equity Share capital 10,000 12,000 Fixed Assets :
Capital Reserve 900 1,850 Buildings 8,000 14,000
General Reserve 5,000 4,500 Land 1,980 3,450
Sinking Fund 900 1,000 Furniture 770 1050
Debentures 4,500 6,500 Current Assets :
Creditors 2,000 1,500 Debtors 4,500 3,900
Expenses Payable 150 200 Cash 2,000 150
Stock 3,200 2,500
Investments 3,000 2,500
23,450 27,550 23,450 27,550
6. The Balance Sheets of a company for the years 2007 and 2008 were as follows. Prepare a common
size Balance Sheet and make your comments.
Balance Sheet
2007 2008 2007 2008
Liabilities (Rs. 000) (Rs.000) Assets (Rs. 000) (Rs.000)
Share Capital 21,00,000 23,00,000 Goodwill 3,40,000 20,000
Reserves 10,08,000 10,08,000 Plant 17,04,000 16,52,000
Surplus 7,02,140 2,32,280 Patents 1,20,000 96,000
9% Debentures 5,00,000 4,00,000 Investments 4,20,000 1,00,000
Interest Payable 15,000 12,000 Cash 6,82,600 11,51,200
Creditors 4,48,000 5,72,000 Debtors 5,55,040 6,12,000
Dividends Stock 9,43,200 11,50,680
Payable – 1,00,000 Prepaid expenses 12,800 18,400
Provision for tax 32,000 1,92,000 Discount on Debentures 27,500 20,000
48,05,140 48,20,280 48,05,140 48,20,280
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16.22 Acharya Nagarjuna University
16.13. Reference Books :
12.13
1. Sharma, Gupta – Management Accounting.
2. I.M. Pande - Management Accounting
3. Manmohan & Goyal – Principles of Management Accounting.
4. Hom Green - Introduction to Management Accounting.
- Dr. Ch. Suravinda
Advanced Management
Cost and Management Accounting
Accounting 14.1
13.1 Marginal Costing
Chapter – 13
14
MARGINAL COSTING
Objectives :
After studying this unit you should be able to :
know the meaning and importance of marginal costing
distinguish between absorption costing and marginal costing
determine the margin of safety
understand the benefits and limitations of marginal costing
Structure :
13.1
14.1 Introduction
13.2
14.2 Marginal Costing
13.3
14.3 Absorption Costing and Marginal Costing
13.4
14.4 Benefits of Marginal Costing
13.5
14.5 Limitations of Marginal Costing.
13.6
14.6 Self Assessment Questions
13.7
14.7 Exercises
13.8
14.8 Reference Books
13.1
14.1 INTRODUCTION
Marginal Costing is a useful technique which guides management in pricing, decision
making and assessment of profitability. It classifies costs into fixed and variable ones. The
expenses which vary directly in proportion to the volume of production are termed as ‘variable
expenses’. The expenses which remain constant or unaffected by the change in output are called
‘fixed expenses’. This distinction forms the basis of marginal costing.
Profit is influenced by the changes infixed expenses and these expenses will remain
static and do not affect decision – making. More over they are largely uncontrollable. The
theory of marginal costing, therefore, argues that only variable expenses should be taken into
account for purposes of product pricing, inventory valuation and other important management
decisions.
13.1.1
14.1.1 Marginal Cost:
The Institute of Cost and Works Accountants, London, defined marginal costs as “the
amount at any given volume of output by which aggregate costs are changed, if the volume of
C.D.E. 14.2
13.2 Acharya Nagarjuna University
output is increased or decreased by one unit of output”. It is the additional cost of producing
one additional unit. It arises from the production of additional increments of output.
IIIu.1: A factory produces plastic cans. The variable cost of the can is Rs.5. The
fixed costs are Rs.5,000 per annum. Presently 200 cans are produced annually. The cost
sheet of 200 cans would be:
Rs.
Variable cost (200 Rs.5) 1,000
Fixed cost 5,000
Total cost 6,000
If production is increased by one plastic can, the cost sheet of 201 can would be:
Rs.
Variable Cost (201 5) 1,005
Fixed Cost 5,000
Total Cost 6,005
Marginal cost per unit is Rs.5 (i.e., the cost of producing one additional unit). Marginal
cost, thus consists of prime cost plus total variable overheads. It should also be remembered
that marginal cost takes into account only variable cost and excludes the fixed cost. With in the
capacity of an organisation, an increase of one unit in production, obviously, will cause an
increase in variable costs only. The following illustration will make this clear.
Illu.2: Following information relates to a factory, manufacturing good quality
fountain pens:
Total cost Production Direct Labour Other Fixed
(units) material variable costs
Rs. Rs. Rs. costs
Rs. Rs.
3,250 500 1,000 750 500 1,000
5,500 1,000 2,000 1,500 1,000 1,000
7,750 1,500 3,000 2,250 1,500 1,000
10,000 2,000 4,000 3,000 2,000 1,000
12,250 2,500 5,000 3,750 2,500 1,000
Calculate marginal cost of production.
Advanced Management
Cost and Management Accounting
Accounting 14.3
13.3 Marginal Costing
Solution:
Marginal Cost of Production
Production Total Costs Fixed Costs Marginal Cost
Units (a) (b) (c) = (a) – (b)
Total Per Unit Total Per Unit Total Per Unit
Rs. Rs. Rs. Rs. Rs. Rs.
500 3,250 6.50 1,000 2.00 2,250 4.50
1,000 5,500 5.50 1,000 1.00 4,450 4.50
1,500 7,750 5.17 1,000 0.67 6,750 4.50
2,000 10,000 5.00 1,000 0.50 9,000 4.50
2,500 12,250 4.90 1,000 0.40 11,250 4.50
The above table shows that with an increase in production the total cost per unit is
decreasing. This happens because the fixed overheads which are constant at all levels of
output are apportioned over larger outputs. Hence, cost of output per unit goes on declining
with every increase in volume of output. It will be seen that while the marginal cost of
production per unit remains constant (at Rs.4.50), the fixed cost per unit decreases from Rs.2
to Rs.0.40. Marginal cost has been calculated thus:
Marginal Cost = Direct Material Cost + Direct Labour Cost +
Direct expenses + Variable overheads
OR
Marginal Cost = Total Cost – Fixed Cost
13.2 MARGINAL COSTING
14.2.
Marginal Costing is a technique where only the variable costs are taken into account
while calculating the cost of product. The fixed costs are met against the total fund arising out of
excess of selling price over total variable cost. This fund is called Contribution. Let us know go
through various definitions given for Marginal Costing.
1. ICMA London: According to ICMA London, Marginal Costing is a technique where
only the variable costs are charged to cost units, the fixed cost attributable being
written off in full against the contribution for the period.
2. D. Joseph: Marginal Costing is a technique of determining the amount of change
in the aggregate cost due to an increase of one unit over the existing level of
production.
3. Horold J. Wheldon: Other things being equal, the fixed overhead will, in total
remain fixed during changes in production achieved and the rate per unit will
C.D.E. 14.4
13.4 Acharya Nagarjuna University
consequently vary, where as that variable overhead will remain constant per unit of
production and vary in total.
13.2.1
14.2.1 Characteristics of Marginal Costing:
1. It is a technique of analysis and presentation of cost rather than an independent
method of costing. It can be applied with any method of costing.
2. Basically it involves differentiation of variable costs from fixed costs. It considers
only variable costs in its analysis.
3. It guides pricing and other managerial decisions on the basis of contribution.
4. The stock of finished goods and work-in-progress are valued at marginal cost.
5. Fixed costs are charged against the contribution earned during a period. No portion
of fixed cost is carried forward to next period.
6. The difference between the contribution and fixed cost represents either profit or
loss, excess of contribution and fixed cost is the profit and the deficiency of
contribution to fixed cost is the loss.
13.3
14.3 ABSORPTION COSTING AND MARGINAL COSTING
Absorption Costing technique is also known as Traditional or Full Cost Method. In this
method, both fixed and variable costs are recovered from production. The variable costs, such
as those of direct materials, direct labour etc., are directly charged to the products, while fixed
costs are apportioned on a suitable basis over various products manufactured during a period.
All costs are, thus, identified with manufactured products.
Illu.3: A Company is manufacturing 3 products A, B and C. The costs of their
manufacture are as follows:
A B C
Rs. Rs. Rs.
Direct material pre Unit 3 4 5
Direct labour 2 3 4
Selling price 10 15 20
Output (Units) 1,000 1,000 1,000
The total overheads are Rs.12,000 out of which Rs.9,000 are fixed and rest are
variable. It is decided to apportion these costs over different products in the ratio of
output. You are required to prepare:
(a) A statement showing cost of each product and profit according to absorption
costing and
(b) A statement of cost and profit according to the Marginal costing technique.
Advanced Management
Cost and Management Accounting
Accounting 14.5
13.5 Marginal Costing
Solution: (A)
Statement Showing Cost and Profit
(According to Absorption Costing Technique)
Particulars A = 1,000 B = 1,000 C = 1,000
Per Total Per Total Per Total
Unit Rs. Unit Rs. Unit Rs.
Direct Material 3 3,000 4 4,000 5 5,000
Direct labour 2 2,000 3 3,000 4 4,000
Prime Cost 5 5,000 7 7,000 9 9,000
Add: Overheads:
Fixed 3 3,000 3 3,000 3 3,000
Variable 1 1,000 1 1,000 1 1,000
Total Cost 9 9,000 11 11,000 13 13,000
Profit 1 1,000 4 4,000 7 7,000
Sales 10 10,000 15 15,000 20 20,000
Total Profit = Rs.1,000 + Rs.4,000 + Rs.7,000 = Rs.12,000
The system of absorption costing has a number of limitations. It assumes that prices are
simply a function of costs. The demand side of the product is throughly discounted. Only past
costs are considered which arriving at pricing decisions. Further, it does not offer information
which helps decision making in a changing environment.
More importantly charging of fixed costs to different products on a suitable basis poses
innumerable problems. These costs have to be incurred whether there is production or not. In
other words, the cost of a product not only depends on expenses which have been incurred
directly but also on the volume of output. For example, if the cost of direct material and direct
labour for a product is Rs.2 and Rs.4 respectively and the volume of output is 500 units the total
cost of production will be as under:
Rs.
Costs of Direct material and labour 3,000
Fixed Overheads 1,000
Total Cost 4,000
The cost per unit comes to Rs.8. In case the output is only 400 units the cost of
production (400 6 + 10,000) would be Rs.3,400 and cost per unit would increases not
because prices of materials or labour have gone up, but because lower level of production.
Obviously, the whole exercise seems to be illogical. The technique of marginal costing is
employed to overcome this deficiency, by charging, fixed costs against the total fund arising out
of excess of selling price over variable cost.
C.D.E. 14.6
13.6 Acharya Nagarjuna University
(b) Marginal Cost Statement
Particulars A = 1,000 B = 1,000 C = 1,000
Per Total Per Total Per Total
Unit Rs. Unit Rs. Unit Rs.
Sales (S) 10 10,000 15 15,000 20 20,000
Less: Marginal Cost:
Direct Material 3 3,000 4 4,000 5 5,000
Direct Labour 2 2,000 3 3,000 4 4,000
Prime Cost 5 5,000 7 7,000 9 9,000
Variable Overheads 1 1,000 1 1,000 1 1,000
Total Marginal Cost (V) 6 6,000 8 8,000 10 10,000
Contribution (S-V) (C) 4 4,000 7 7,000 10 10,000
Selling Price 10 10,000 15 15,000 20 20,000
Thus, the total contribution from the three products, A, B and C is Rs.21,000. The profit
will now be computed as follows:
Rs.
Total Contribution 21,000
Fixed costs 9,000
Profit 12,000
13.3.3
14.3.3 Differences between Marginal Costing and Absorption Costing:
The difference between absorption costing and marginal costing, as the above
illustrations show, is based on the recovery to fixed overheads. In absorption costing both fixed
and variable overheads are charged to production. As a result, work in progress and finished
goods are valued at ‘works cost’ and ‘total cost of production’ respectively, giving effect to fixed
overheads. In marginal costing only variable overheads are charged to production, thereby
leading to under-recovery of overheads. This obviously leads to undervaluation of closing stock.
But this does not result in carrying over of fixed overheads of one period to another, as it
happens in absorption costing. The main points of difference between absorption costing and
marginal costing are given below:
Differences between Marginal and Absorption Costing
Basis of Difference Absorption Costing Marginal Costing
1. Fixed Costs Fixed overheads are Fixed costs are not
charged to the product to included while computing
be subsequently released cost per unit.
as a part of cost of goods
sold i.e., it is included in
cost per unit.
Cost and Management
Advanced ManagementAccounting
Accounting 14.7
13.7 Marginal Costing
Basis of Difference Absorption Costing Marginal Costing
2. Profit Profit is the difference Profit in marginal costing
between sales and cost of is ascertained by
goods sold. establishing the total
contribution and then
deducting therefrom the
total fixed expenses.
Contribution is the excess
of sales over variable
cost.
3. Classification of Costs Costs are rarely classified Cost – Volume – Profit
into variable and fixed. relationship is an
Although such a essential part of marginal
classification is possible, it costing. Costs have to be
fails to establish a cost – classified into fixed costs
volume profit relationship. and variable costs.
4. Valuation of If inventories increase If inventories increase
Inventories during a period, this during a period, this
method will reveal more method generally reports
profit than marginal costing. less income than
When inventories absorption costing, but
decrease, less profits are when inventories
reported because in this decrease this method
method closing stock is reports more net income.
valued at higher figures.
5. Recovery of Apportionment of fixed There is no arbitrary
Overheads costs is arbitrary and this apportionment of fixed
may result in under overheads, as fixed costs
recovery of overheads. are excluded.
13.3.4
14.3.4 Contribution:
Contribution represents the difference between sales and variable costs. It may be
considered as some sort of fund from out of which all fixed costs are to be met. The difference
between contribution and fixed costs represents either profit or loss, as the case may be.
Contribution is also called ‘Gross Margin’. Contribution can be expressed thus:
Contribution = Selling Price – Variable cost
Or
Fixed Cost + Profit or Loss
Profit/Los = Contribution – Fixed Cost
C.D.E. 14.8
13.8 Acharya Nagarjuna University
13.3.5
14.3.5 Marginal Cost Equation:
The algebraic expression of contribution is known as Marginal Cost Equation. It can be
expressed as follows:
S–V=F+P
Where
S = Selling Price
V = Variable Cost
F = Fixed Cost
P = Profit
IIIu.4: From the following information find out the amount of profit earned during
the year using marginal cost technique.
Fixed cost Rs.5,00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1,50,000 units.
Solution:
Sales = 1,50,000 units 15 = Rs.22, 50,000
Variable cost = Rs.1,50,000 10 = Rs.15,00,000
Fixed cost = Rs.5,00,000
S–V=F+P
Rs.22,50,000 – Rs.15,00,000 = 5,00,000 + P
Rs.7,50,000 – 5,00,000 = P
Rs.2, 50,000 = P
P = Rs.2, 50,000
13.4 BENEFITS OF MARGINAL COSTING
14.4.
The technique of marginal costing is of immense use to the management in taking various
decisions. It helps the management in taking the following decisions:
1. Helps in determining level of output: Marginal costing helps in finding out the
output which is most profitable for running a concern. This, in turn, helps in utilising
plant capacity in full, and realise maximum profits. By determining the most
profitable relationships between cost, price and volume, marginal costing helps a
business to determine most competitive prices for its product.
2. Help in selection of most suitable product mix: By applying marginal costing
techniques, the most suitable production line could be determined. The profitability
Cost and Management
Advanced ManagementAccounting
Accounting 14.9
13.9 Marginal Costing
of various products can be compared and the most products which languish behind
and which do not seem to be feasible (in view of their inability to recover marginal
cost) may be eliminated from the production line by keeping the capacity and
resources constrains in mind. It will also serve as a guide in arriving at the price for
new products.
3. Helps in determining Make or Buy decisions: The marginal cost of producing an
article inside the factory serves as a useful guide while arriving at make or buy
decisions. The costs of manufacturing can be compared with the costs of buying
outside and a suitable decision can be arrived at easily.
4. Helps in the selection of method of production – Manual or Machine Based: In
case a particular product can be produced by two or more methods, ascertaining
the marginal cost of producing the product by each method will help in deciding as
to which method should be followed. The same is true in case of decisions to use
machine power in place of manual labour.
5. Helps in decision making during Recessionary period: In periods of trade
depression, marginal costing helps in deciding whether production in the plant
should be suspended temporarily or continued in spite of low demand for the firm’s
product.
6. Help in product planning: Marginal costing helps in determining the no-profit no-
loss point. The efficiency and economy of various products, plants, departments can
also be determined. This helps in profit planning as well as cost control.
13.5 LIMITATIONS OF MARGINAL COSTING
14.5
Marginal costing has the following limitations:
1. Difficulty in Classifications: In marginal costing, costs are segregated into fixed
and variable. In actual practice, this classification scheme proves to be superfluous in that
certain costs may be partly fixed and partly variable and certain other costs may have no
relation to volume of output or even with the time. In short, the categorization of costs into fixed
and variable elements is a difficult and tedious job.
2. Difficulty in Application: The marginal costing technique cannot be applied in
industries where large stocks in the form of work in progress (job and contracting firms)
3. Defective Inventory Valuation: Under marginal costing, fixed costs are not
included in the value of stock of finished goods and work in progress. As fixed costs are also
incurred, these should form part of the cost of the product. By eliminating fixed costs from
C.D.E. 14.10
13.10 Acharya Nagarjuna University
finished stock and work in progress, marginal cost is objectionable because of other reasons
also:
i. In case of loss by fire, full loss cannot be recovered from the insurance company.
ii. Profits will be lower, than that shown under absorption costing and hence may
be objected by taxation authorities.
iii. Circulating assets will be estimated in the balance sheet.
4. Objectionable basis of Pricing: In marginal costing, sale prices are arrived at on
the basis of contribution alone. This is an objectionable practice. For example, in the long run,
the selling price should not be fixed on the basis of contribution alone as it may result in losses
or low profits. Other important factors such as fixed costs, capital employed should also be
taken into account while fixing selling prices. Further, it is also not correct to lay more stress in
selling function, as is done in marginal costing and relegate production function to the
background.
5. Limited scope: The utility of marginal costing is limited to short run profit planning
and decision making. For decisions of far reaching importance, one is interested in special
purpose cost rather than variable cost. Important decisions on several occasions, depend on
non-cost considerations also, which are thoroughly discounted in marginal costing.
In view of these limitations marginal costing needs to be applied with necessary care and
caution. Fruitful results will emerge only when management tries to apply the technique in
combination with other useful techniques such as budgetary control and standard costing.
13.6
14.6 QUESTIONS
I. Short Questions:
1. Defined the term ‘marginal costing’.
2. How can the cost be classified on the basis of variability?
3. What is contribution?
II. Essay type questions:
1. Explain the advantages and disadvantages of marginal costing.
2. Discuss the applications of the marginal costing technique.
3. Define Marginal Costing. Explain the advantages and limitations of Marginal Costing.
4. Define Marginal Costing. Explain the differences between Marginal Costing and
absorption costing.
5. What is marginal costing? Explain the advantages and disadvantages of marginal costing.
Cost and Management
Advanced ManagementAccounting
Accounting 14.11
13.11 Marginal Costing
13.7 EXERCISES
14.7
1. What is the amount of Fixed Costs when sales in Rs.2,40,000; Direct Material is
Rs.80,000; Direct Labour is Rs.50,000, Variable overheads are Rs.20,000 and profit is
Rs.50,000?
[Ans.: Fixed Costs: Rs.40,000]
2. From the following information, calculate margin of safety.
Rs.
Sales (4,000 units @ Rs.25 each) 1,00,000
Variable cost 72,000
Fixed expenses 16,800
[Ans.: Margin of Safety Rs.40,000]
3. Given, fixed cost of Rs.5,00,000; variable cost as Rs.10 per unit; selling price of Rs.15 per
unit and output as 1,50,000 units, find the profit earned.
[Ans.: Profit Rs.2,50,000]
4. Using the information given below, prepare operating statements for the months of June
and July, 2007 using.
(i) Marginal costing technique and (ii) Absorption costing
Per unit
Rs.
Selling price 50
Direct material cost 18
Direct labour cost 4
Variable production overhead 3
Monthly costs:
Fixed production overheads 99,000
Fixed selling expenses 15,000
Fixed administration expenses 25,000
C.D.E. 14.12
13.12 Acharya Nagarjuna University
Variable selling costs are 10% of sales revenue and normal production capacity is 11,000
units per month. The other details are:
Sales Production
(units) (units)
June 10,000 12,000
July 12,000 10,000
[Ans.: Profits: (i) Rs.61,000; Rs.1,01,000; (ii) Rs.81,670; 80,330]
5. The following data are obtained from the records of a factory:
Rs. Rs.
Sales 4,000 units at Rs.25 each 1,00,000
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
72,000
Fixed overheads 18,000 90,000
Profit 10,000
It is proposed to reduce the selling price by 20%. What extra units should be sold
to obtain the same amount of profit as above?
[Ans.: Units sold: (a) 14,000 units; Extra units to be sold: 14,000 4,000 =
10,000 units]
6. On the basis of the following data prepare a Marginal cost statement:
Variable Cost Rs. Rs.
Direct Material 4,500
Direct Wages 2,500
Factory overhead 1,050
Administration, selling and distribution overhead 1,600 9,650
Fixed Cost
Factory overhead 400
Administration, selling and distribution overhead 670 1,070
Total Cost 10,720
Profit 4,280
Sales 15,000
[Ans.: Profit Rs.4,280]
Advanced Management
Cost and Management Accounting
Accounting 14.13
13.13 Marginal Costing
7. Takur Ltd., produces 1 standard type of article. The results of last 4 months of 2007 are as
follows.
September October November December
Output in Units 200 300 400 600
Prime Cost is Rs.10 per unit
Variable expenses are Rs.2 per unit
Fixed expenses are Rs.36,000 p.a.
Find out cost per unit of each month.
[Ans.: Cost per unit: Oct. Rs.10; Nov. Rs.7.50; Dec. Rs.5]
8. Calculate the fixed cost from the following information:
2006 2007
Sales (Rs.) 4,00,000 6,00,000
Profit (Rs.) 80,000 2,00,000
[Ans.: Rs.1,60,000]
13.8
14.8 REFERENCE BOOKS
1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting –
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
Cost and Management
Advanced ManagementAccounting
Accounting 15.1 Marginal Costing - CVP Analysis
14.1
Chapter – 14
15
MARGINAL COSTING – CVP ANALYSIS
Objectives :
After reading this lesson you should be able to :
understand the break even analysis and profit/volume ratio
know the meaning and importance of margin of safety
prepare break even chart of an organization
Structure :
14.1
15.1 Break Even Analysis
14.2
15.2 Profit/Volume Ratio
14.3
15.3 Margin of Safety
14.4
15.4 Break Even chart
14.5
15.5 Advantages of Break-Even Analysis
14.6
15.6 Limitations of Break-Even Analysis
14.7
15.7 Self Assessment Questions
14.8
15.8 Exercises
14.9
15.9 Reference Books
14.1 BREAK-EVEN ANALYSIS
15.1.
Break even analysis is a specific method of presenting and studying the inter relationship
between costs, volume and profits. (Hence, it also known as Cost – volume – Profit Analysis –
C.V.P Analysis). It is an important tool of financial analysis whereby the impact on profit of the
changes in volume, price, costs and mix can be found out with a certain amount of accuracy. A
business is said to break even when its total sales are equal to its total costs. Break even point
is a point of no profit or no loss. At this point contribution is just sufficient to recover the fixed
costs. Break even point can be calculated in units or sales. It can be calculated with the help of
any of the following formulae.
Fixed cost
1. B.E.P. (in Units) =
Contributi on per unit
Fixed cost
=
Selling price per unit - Variable cost per unit
Fixed cost
2. B.E.P. (Sales) = Selling price per unit
Contributi on per unit
Fixed cost FS
3. Total sales (Or)
Total contributi on S- V
C.D.E. 14.2
15.2 Acharya Nagarjuna University
Fixed cost Fixed cost
4. Variable Cost per unit = P/V Ratio
1-
Selling Price per unit
Fixed cost
5. B.E.P. = Sales
Fixed costs net profit
At break-even point the desired profit will be zero. Where the volume of output sales is to
be calculated so as to earn a desired amount of profit, the amount of desired profit has to be
added to the fixed cost.
Fixed cost Desired Profit
Units to earn a desired profit: =
Contributi on Per Unit
Fixed cost Desired Profit
Sales to earn a desired profit: =
P/V Ratio
Illu.1: From the following particulars calculate the Break-even point in terms of
both quantity and value:
Production in units 10,000
Sales price Rs.5.00 per unit
Variable costs Rs.20,000
Fixed costs Rs.12,000
Solution: Calculation of Break-even Point
Break-even Point (in terms of quantity):
Fixed Expenses Rs.12,000
= = = 4,000 Units.
Selling Price pr unit - Variable Cost Per Unit 5.00 - 2.00
Break-even Point in quantity = 4,000 Units
Break-even Point in Value = Break-even Point in Quantity Selling price per unit
= 4,000 Units Rs.5.00 = Rs.20,000.
Rs.20,000
Note: Variable Cost per unit = = Rs.2.00
10,000 units
14.2 PROFIT/VOLUME RATIO
15.2.
The profitability of business operations could be found out by calculating the profit –
volume ratio (P/V Ratio). It is the ratio of contribution to sales. It is also known as marginal –
income ratio, contribution – Sales ratio or variable – profit ratio. The ratio can be shown in
the form of a percentage also.
Cost and Management
Advanced ManagementAccounting
Accounting 15.3
14.3 Marginal Costing - CVP Analysis
Contributi on Sales - Variable Costs
P/V Ratio = or
Sales Sales
C S-V FP
= or or
S S S
Variable Costs
= 1-
Sales
The ratio can also be shown by comparing the change in contribution to change in sales,
or change in profit to change in sales. Any increase in contribution, obviously, would mean
increase in profit, as fixed expenses are assumed to be constant at all levels of production.
Change in Contributi on Change in Profit
P/V Ratio = =
Change in Sales Change in Sales
The importance of P/V Ratio lies in its use for evaluating the profitability of alternative
products or proposals. A higher ratio shows grater profitability. Management should, thereforce,
try to increase P/V Ratio by widening the gap between the selling price and the variable costs.
This can be achieved by increasing sale price, reducing variable costs or switching over to
more profitable products.
IIIu.2: A Company producing a single article sells at Rs.20 each. The marginal costs
of production is Rs.12 each and fixed cost is Rs.8,000 p.a. calculate I) the P/V ratio, ii)
sales required to break – even.
Solution:
(i) Calculation of P/V. Ratio:
Rs.
Fixed Cost 8,000
Selling price per unit 20
Margin cost per unit 12
Sales - Margin Cost
P/V. Ratio = 100
Sales
20 - 12
= 100 = 40%
20
P/V. Ratio = 40%
Fixed Cost 8,000 100
(ii) Sales Required to Break-even: 8,000 Rs.20,000
P.V. Ratio 40% 40
Sales Required to Break-even = Rs.20,000.
C.D.E. 15.4
14.4 Acharya Nagarjuna University
Illu.3: Calculate margin of safety and the amount of actual sales from the following:
Rs.
(i) Profit 10,000
(ii) PV Ratio 50%
(iii) BEP Sales 20,000
Solution:
(i) Calculation of Margin of safety and the amount of actual Sales:
Profit 10,000 100
Margin of Safety = 10,000 Rs.20,000
P.V. Ratio 50% 50
Margin of Safety = Rs.20,000
(ii) The amount of actual sales:
Margin of Safety = Actual Sales – Break-even-Point sales
Rs.20,000 = Actual Sales – Rs.20,000
Actual Sales = Rs.20,000 + 20,000
Actual Sales = Rs.40,000
Illu.4: The following figures relating to Sales and profits of a company are of two
periods.
Sales
Profit(Rs.)
(Rs.)
Year ending 31-12-2001 1,00,000 15,000
Year ending 31-12-2002 1,20,000 23,000
Calculate (a) P.V. ratio (b) Fixed cost, (c) Break-even point.
Solution:
Change in profit
i. P.V. Ratio = 100
Change in Sales
8,000
= 40%
20,000
40
ii. S(P.V.Ratio) = F+P; 1,00,000 ( ) = F + 15,000;
100
40,000 = F + 15,000; 40,000 – 15,000 = F; 25,000 = F, F = Rs.25,000
F 25,000 25,000 100
iii. BEP Sales = = = = Rs.62,500
P.V .Ratio 40% 40
40
iv. S (P.V. Ratio) = F + P; 1,25,000 ( ) = 25,000 + P;
100
Advanced Management
Cost and Management Accounting
Accounting 14.5
15.5 Marginal Costing - CVP Analysis
50,000 = 25,000 + P = 50,000 – 25,000 = P; 25,000 = P
P = Rs.25,000
40
S(P.V Ratio) = F + P, S ( ) = 25,000 + 20,000
100
40 100
S( )= 45,000; S = 45,000 = Rs.1,12,500
100 40
14.3 MARGIN OF SAFETY
15.3
Total sales minus the sales at break even point is known as the margin of safety. Lower
break – even point means a higher margin of safety. Margin of safety can also be expressed as
a percentage of total sales. The formula is:
Margin of Safety = Total Sales – Sales at BEP
Or
Profit
P/V ratio
Margin of safety
Margin of Safety (as a percentage) = 100
Total sales
Higher margin on safety shows that the business is sound. Even when sales substantially
come down the business may earn profit. Lower margin of safety, means that when sales come
down slightly profit position may affect adversely. Thus, margin of safety can be used to test the
soundness of a business. In order to improve the margin of safety, a business can increase
selling prices (without affecting demand, of course) reducing fixed or variable costs and
replacing unprofitable products with profitable ones.
Illu.5: From the following information calculate:
(a) P/V Ratio.
(b) Break Even Point
(c) Margin of Safety.
Rs.
Total Sales 3,60,000
Selling price per unit 100
Variable Cost per unit 50
Fixed Costs 1,00,000
(d) If selling prices is reduced to Rs.90, by how much is the margin of safety is
reduced?
C.D.E. 15.6
14.6 Acharya Nagarjuna University
Solution:
(a) Calculation of Break-even-point:
Fixed Costs
Break-even point =
Selling price per unit - Variable cost per unit
1,00,000 1,00,000
Break-even-Point = = = 2,000 units
100 - 50 50
Break even Sales = 2,000 units @ Rs.100 per unit
= Rs.2,00,000
S-V
(b) P.V. Ratio = 100
S
3,60,000 - (3,600 50)
= 100
3,60,000
1,80,000
= 100
3,60,000
P.V. Ratio = 50%
(c) Margin of Safety = Actual Sales – Break even sales
= Rs.3,60,000 – 2,00,000 = Rs.1,60,000
(d) If Selling price is reduced to Rs.90, the Margin of safety is reduced by:
Margin of Safety = Actual Sales – Break even sales
= Rs.3,60,000 – (2,500 Units 90)
= Rs.3,60,000 – 2,25,000 = Rs.1,35,000
Illu.6: A manufacture has supplied the following information relating to one of his
product.
Total variable costs Rs.30,000
Total sales Rs.60,000
Units sold 20,000
Total Fixed Costs Rs.18,000
Calculate:
a. Contribution per unit
b. Break-even point
c. Margin of Safety
d. Profit
e. Volume of sales to earn a profit of Rs.24,000
Cost and Management
Advanced ManagementAccounting
Accounting 15.7
14.7 Marginal Costing - CVP Analysis
Solution:
a. Contribution = S-V; C = 60,000 – 30,000 = Rs.30,000
30,000
Contribution per unit = = 1.50 p.
20,000 units
F S 18,000 60,000
b. BEP Sales = ; = Rs.36,000
S V 60,000 - 30,000
c. Margin of Safety = Actual Sales – BEP Sales.
= 60,000 – 36,000 = Rs.24,000
d. Profit = S-V = F+P; 60,000 – 30,000 = 18,000+P;
= 30,000 = 18,000 + P; 30,000 – 18,000 =P.
= 12,000 = P; P = Rs.12,000
e. Volume of Sales to earn a profit of Rs.24,000
C 30,000
P.V. Ratio = 100; 100 = 50%.
S 60,000
50
S( ) = 18,000 + 24,000
100
50 100
S( ) = 42,000; S = 42,000 = Rs.84,000
100 50
Sales Amount 84,000
Units = = = 28,000 units.
Selling Price Rs.3
IIIu.7: In 2006, Srikanth Ltd., sold its products worth Rs.40 lakhs and made a profit
of Rs.4 lakhs. But in 2002, the sales dipped to Rs.30 lakhs due to competition in the
market and the profit is reduced to 3 lakhs. Calculate Break – even points and profit
volume rations in 2006 and 2007.
Solution:
Change in Profit
Profit/Volume Ratio = 100
Change in Sales
Change in Profit = Rs.1,00,000
Change in Sales = Rs.10,00,000
1,00,000
P.V. Ratio = 100 = 10%
10,00,000
Fixed Expenses: Sales (P/V ratio) = F + P
2001: When profit and sales of 2001 are taken:
10
40,00,000 = F + 4,00,000
100
4,00,000 = F + 4,00,000
4,00,000 – 4,00,000 = F
F=0
C.D.E. 15.8
14.8 Acharya Nagarjuna University
F 0 0
Break-even Point = P.V. Ratio 10 10 0
100
2002: When Profit and sale of 2002 are taken.
S(P/V Ratio) = F + P
10
30,00,000 = F + 3,00,000
100
3,00,000 = F + 3,00,000
3,00,000 – 3,00,000 = F
F=0
F 0 100
B.E. Point = 0 0
P.V. Ratio 10% 10
Illu.8: The sales and profits during two periods are as under:
Period I : Sales Rs.20 lakhs; profit Rs.2 lakhs
Period II: Sales Rs.30 lakhs; Profit Rs.4 lakhs.
Calculate: (a) P/V Ratio (b) Break even point (c) Sales required to earn a profit of
Rs.5 lakhs (d) Profit when sales are Rs.50 lakhs, and (e) Margin of safety at a profit of
Rs.2.5 lakhs.
Solution:
Change in Profit
a. P/V Ratio = 100
Change in Sales
2,00,000
= 100 = 20%
10,00,000
Fixed Expenses = S P.V. Ratio = F + P
Rs.20,00,000 20% = F + Rs.2,00,000
Rs.4,00,000 = F + Rs.2,00,000
Rs.4,00,000 – Rs.2,00,000 = F
F = Rs.2,00,000
F
b. Break-even Point =
P.V. Ratio
2,00,000
= = Rs.10,00,000
20%
c. Sales (P/V Ratio) = F + P
20
S = Rs.2,00,000 + Rs.5,00,000
100
20
S = Rs.7,00,000
100
100
S = Rs.7,00,000 = Rs.35,00,000
20
Cost and Management
Advanced ManagementAccounting
Accounting 15.9
14.9 Marginal Costing - CVP Analysis
d. Sales P.V. Ratio = F + P
20
S = Rs.2,00,000 + P
100
20
Rs.50,00,000 = Rs.2,00,000 +P
100
Rs.10,00,000 = Rs.2,00,000 + P
Rs.10,00,000 – Rs.2,00,000 = P
P = Rs.8,00,000
Profit
e. Margin of Safety =
P.V. Ratio
2,50,000 100
= = Rs.2,50,000 = Rs.12,50,000
20% 20
Illu.9: The following information was extracted from the books of Giridhar Mft. Co.
Ltd.
Rs.
Sales 1,80,000
Less: Variable Costs 1,44,000
Contribution 36,000
Less: Fixed costs 24,000
Net Profit 12,000
Calculate the following (a) P/V ratio (b) Break-even point (c) Net profit earned at
sales of Rs.2,70,000 (d) Sales required to earn a profit of Rs.24,000.
Solution:
C 36,000
(a) P.V. Ratio = 100 100 20%
S 1,80,000
F 24,000 24,000
(b) B.E.P = 100 = 1,20,000
P.V. Ratio 20% 20
(c) S P/V Ratio = F + P
20
Rs.2,70,000 = Rs.24,000 + P
100
Rs.54,000 = Rs.24,000 + P
Rs.54,000 = Rs.24,000 + P
P = Rs.30,000
(d) S P/V. Ratio = F + P
20
S = Rs.24,000 + Rs.24,000
100
C.D.E. 15.10
14.10 Acharya Nagarjuna University
20
S = Rs.48,000
100
100
S = Rs.48,000 = Rs.2,40,000
20
Illu.10: The price structure of a cycle made by the Cycle Company Ltd., is as
follows.
Per Cycle
Rs.
Materials 60
Labour 20
Variable Overhead 20
100
Fixed Overheads 50
Profit 50
Selling Price 200
This is based on the manufacture of one lakh cycles per annum.
The company excepts that due to competition they will have to reduce selling
prices, but they want to keep the total profits intact. What level of production will have to
be reduced i.e., how many cycles will have to be made to get the same amount of profit
if:
a. The Selling price is reduced by 10%
b. The selling price is reduced by 20%
Solution:
(a) If Selling price is reduced by 10% Rs.
Selling Price 200
Less: Price 20
Present Selling Price 180
V = 100 (60+20+20); P = 50;
C 80
P.V. Ratio = 100 100 44.44%
S 180
Sales to get the same level of profit Rs.50,00,000.
S (P.V. Ratio) = E + P
44.44
S( ) = 50,00,000 + 50,00,000
100
44.44
S( ) = 1,00,00,000
100
Cost and Management
Advanced ManagementAccounting
Accounting 15.11
14.11 Marginal Costing - CVP Analysis
100
S = 1,00,00,000 = 22502250
44.44
Sales Amount 22502250
Selling Units = = = 1,25,013 units
Selling Price Per unit 180
If Selling Price is reduced by 20% Rs.
Selling Price 200
Less: 20% reduction 40
Present Selling Price 160
V = Rs.100; P = Rs.50;
C 60
P.V. Ratio = 100 100 37.5%
S 160
Sales to get the same level of profit Rs.50,00,000.
S(P.V.Ratio) = E + P
37.5
S( ) = Rs.50,00,000 + 50,00,000
100
37.5
S( ) = Rs.1,00,00,000
100
100
S = 1,00,00,000 = 26666666
37.5
Sales Amount 26666666
Selling Units = = = 1,66,667 units.
Selling Price Per unit 160
Ilu.11: Find P/V Ratio and Margin of Safety – when sales, variable cost, fixed costs
are Rs.Ten lakhs, Four lakhs, Four lakhs respectively.
Solution:
S- V
(i) P.V. Ratio = 100
S
10 lakhs - 4 lakhs
= 100
10 lakhs
10 - 4 6
= 100 100 60%
10 10
P.V. Ratio = 60%
Profit ?
(ii) Margin of Safety =
P.V. Ration 60%
Profit = Contribution – Fixed cost
Profit = (Sales – Variable Cost) – Fixed Cost
= (Rs.10 lakhs – Rs.4. lakhs) – Rs.4 lakhs
= Rs.2 lakhs
2 Lakhs
Margin of Safety = = Rs.3,33,333.33
60%
C.D.E. 14.12
15.12 Acharya Nagarjuna University
Illu.12: Fixed expenses Rs.1,50,000 percentage of variable expenses on sales is
2
66 %. Normal sales at 100% capacity is Rs.9,00,000.
3
Calculate,
a. P/V Ratio
b. Break even point at what percentage of sales
c. Profit at 80% of sales capacity.
Solution:
S-V Rs.9,00,00 0 - Rs.6,00,00 0 1 1
a. P/V Ratio = 100 = 100 33 or
S Rs.9,00,00 0 3 3
Fixed Expenses 1,50,000
b. B.E. Point = 50%
Sales - Variable Costs 9,00,000 - 6,00,000
c.Profit at 80% sales capacity:
Profit = Contribution – Fixed Expenses
= (Sales – Variable cost) – Fixed Expenses
= (Rs.7,20,000 – Rs.4,80,000) – Rs.1,50,000 = Rs.90,000
80 2
Note: Sales = 9,00,000 = Rs.7,20,000; Variable Costs = 7,20,000 = Rs.4,80,000
100 3
Illu.13: Sri Sai Ram Limited furnishes you the following information relating to the
half year ended 30th June 1996:
Rs.
Fixed expenses 45,000
Sales value 1,50,000
Profit 30,000
During the second half of the year, the company has projected a loss of Rs.10,000.
Calculate:
(a) The Break-even point and Margin of safety for six months ending 30th June
1996.
(b) Expected sales volume for second half of the year assuming that P/V ratio and
fixed expenses remain constant in the second half year also.
(c) The Break-even point and Margin of safety for the whole year 1996.
Advanced Management
Cost and Management Accounting
Accounting 15.13
14.13 Marginal Costing - CVP Analysis
Solution:
Fixed Expenses Profit
(a) P.V. Ratio = 100
Sales
Rs.45,000 Rs.30,000
= 100 = 50%
1,50,000
Fixed Cost Rs.45,000
Break-Even Point = Rs.90,000
P.V. Ratio 50%
Margin of Safety = Actual Sales – Break-Even sales
Rs.1,50,000 – Rs.90,000 =
Rs.60,000
Alternatively
Profit
Margin of Safety =
P.V. Ratio
Rs.30,000
= = Rs.60,000
50%
(b) Expected Sales volume for second half year:
Expected Sales Contributi on Fixed Cost Profit
= or
Volume P.V. Ratio P.V. Ratio
Fixed Cost - Loss Rs.45,000 10,000
=
P.V. Ratio 50%
= Rs.70,000
(c) Break-even Point and Margin of Safety for the whole year 1996:
Fixed Expenses Rs.45,000 Rs.45,000
Break-even Point = = = Rs.1,80,000
P.V. Ratio 50%
Profit Rs.30,000 - 10,000
Margin of Safety = = = Rs.40,000
P.V. Ratio 50%
Alternatively:
Margin of Safety = Actual Sales – Break Even Sales
= (Rs.1,50,000 + 70,000) Rs.1,80,000 = Rs.40,000
Illu.14: The following figures relate to a company manufacturing a varied range of
products.
Total Sales Total Cost
Rs. Rs.
Year ended 31st March, 2001 22,23,000 19,83,600
Year ended 31st March, 2002 24,51,000 21,43,200
C.D.E. 15.14
14.14 Acharya Nagarjuna University
Assuming stability in prices, with variable costs carefully controlled to reflect
predetermined relationships, and an unvarying figure for fixed costs, calculate:
a. the profit/volume ratio, to reflect the rates of growth for profit and sales; and
b. any other cost figures to be deduced from the data.
Solution:
Sales Cost
Rs. Rs.
2001 22,23,000 19,83,600
2002 24,51,000 21,43,200
Difference 2,28,000 1,59,600
1,59,600
Variable cost (% of sales) = 100 =70%
2,28,000
(or in other words, variable cost is 70 paise per Re.1.00 of sales
70
Variable cost for the year 2001 = 22,23,000 = Rs.15,56,100
100
70
Variable cost for the year 2002 = 24,51,000 = Rs.17,15,700
100
S V
a. P/V ratio = 100
S
6,66,900
2001 = 100 = 30%
22,23,000
7,35,300
2002 = 100 = 30%
24,51,000
b. Other cost figures:
i) Fixed Cost (Total Cost – Variable cost):
2001 = Rs.19,83,600 – 15,56,100 = Rs.4,27,500
2002 = Rs.21,43,200 – 17,15,700 = Rs.4,27,500
ii) Fixed cost % of sales:
4,27,500
2001 = 100 = 19% (approx.)
22,23,000
4,27,500
2002 = 100 = 17% (approx.)
24,51,000
F 4,27,500
iii) Break-even point = = Rs. = Rs.14,25,000
P.V. Ratio 30%
iv) Margin of safety:
2001 = 22,23,000 – 14,25,000 = Rs.7,98,000
2002 = 24,51,000 – 14,25,000 = Rs.10,26,000
Advanced Management
Cost and Management Accounting
Accounting 15.15
14.15 Marginal Costing - CVP Analysis
Illu.15: From the following data calcualte:
i) P/V ratio
ii) Profit when sale are Rs.20,000
iii) New Break-even point if selling price is reduced by 20%.
Fixed expenses Rs.4,000
Break-even point Rs.10,000
Solution:
Fixed expenses
i. Break-even sales =
P/V Ratio
Fixed expenses 4,000
P/V Ratio = = 40%
Break - even sales 10,000
ii. Profit when sales are Rs.20,000
Profit = Sales P/V ratio – Fixed expenses
= Rs.20,000 40% - Rs.4,000
= Rs.8,000 – Rs.4,000 = Rs.4,000
iii. New break-even point if selling price is reduced by 20%. If the selling price Rs.100,
now it will be Rs.80. Variable cost per unit Rs.60 (i.e., 100 – 40% old P/V ratio)
80 - 60
New P/V Ratio = = 25%
80
4,000
Break-even point will be = = Rs.16,000
25%
14.4 . BREAK-EVEN CHART
15.4
The break even point can also be shown graphically through the break even chart. The
break even chart shows the profitability or otherwise of an undertaking at various levels of
activity and as a result indicate the point at which neither profit nor loss is made. It shows the
relation ship, through a graph between cost, volume and profit. The break even point lies at the
point of intersection between the total cost line and the total sales line in the chart.
In a nut shell break – even charts are often used to depict the following.
1. Cost volume profit relationships and break-even point.
2. Profit volume ratio and margin of safety
3. The impact of change in the level of sales on likely costs and profit.
4. Profit appropriations and expense analysis.
5. For controlling profits and level of activity by comparing the budgeted with actual
sales and profit.
6. For deriving the figures of optimum output.
C.D.E. 14.16
15.16 Acharya Nagarjuna University
14.4.1 Preparation of break – even Charts:
15.4.1
These charts are shown on the graph paper by drawing lines at the point which are to be
plotted. The sales in units are depicted on the horizontal line i.e., X-X’ and costs and revenue on
the vertical line i.e., Y-Y’. Both are expressed in monetary values.
First of all a line is drawn parallel to X-axis showing the fixed costs. Then the total cost
line is drawn and inserted upon the fixe cost line. Thereafter the sales line is drawn diagonally
touching the zero at the orgin point and the highest point on the vertical scale. The point at
which this sales line interests the total cost line, is the break even point. The right sector of this
point shows the profits and the left sector shows the loss. This is a simple break even chart.
Suitable description regarding variable costs, fixed costs, profit or loss and break-even point are
usually written on this chart.
14.4.2
15.4.2 Angle of Incidence:
It is an angle at which sales line cuts the total costs line. A high angle denotes high rate of
profit while a low angle reflects poor rate of return. Obviously management must plan for high
angle of incidence which can only be when variable costs bear a low proportion of cost of sales.
X
Total Sales
BEP Angle of incidence
Sales and cost
Margin Actual Fixed
of Safety cost Cost
O Break Even chart Y
If the angle is large, the firm is said to be making profits at a high rate or vice versa. A
large angle of incidence together with a high margin of safety indicate sound business
conditions. Therefore, the management’s aim will be to have as large an angle as possible;
because this shows a high rate of profit once the fixed costs are met. A narrow angle, on the
other hand would show that even after absorbing the fixed costs the rate of profit is
comparatively low. In other words, it indicates that the variable costs form a large part of the
total costs.
Advanced Management
Cost and Management Accounting
Accounting 15.17
14.17 Marginal Costing - CVP Analysis
Illu.16 : From the following information draw up a chart to show break-even points.
Rs.
Fixed costs (Total) 40,000
Variable costs (per unit) 2
Selling price (per unit) 3
Solution:
Contribution = Selling price – Variable cost per unit
Rs.3 – 2 = Rs.1
Fixed costs 40,000
BEP = = = 40,000 units.
Contributi on 1
40,000 units selling price per unit i.e., Rs.3 = Rs.1,20,000 when output is 40,000 units.
Total cost and Total sales will be Rs.1,20,000.
In the graph given below the horizontal scale OX shows volume of production expressed
in units. The vertical scale OY shows sales and cost in Rs.10,000. In the chart three lines are
drawn. The first line shows fixed cost which is parallel to the base scale and has not relation
with the output.
25
Amount in Ten thousand rupees
20
Profit
15 Sale
12
Total Cost BEP
10
5 Loss Fixed Cost
Margin of Safety
0 10,000 20,000 30,000 40,000 50,000 60,000 70,000
Output in Units
The sales line (total sales) is drawn from the point where there are no sales (zero
intersection of horizontal and vertical scales).
C.D.E. 15.18
14.18 Acharya Nagarjuna University
The total cost line (variable costs + fixed costs) is drawn from the point of fixed costs. The
total costs and total sales lines intersect each other at point “P” which is a B.E.P. from this point
perpendicular is drawn which touches out put at R (40,000 units) and Revenue at Q
(Rs.1,20,000). If the output is below 40,000 units there will be a loss. If output exceeds 40,000
units there will be a profit. Output in excess of 40,000 units i.e., RX shows margin of safety.
Illu.17: The following figures relate to one year’s working at 100% capacity level in
a manufacturing business.
Rs.
Fixed Overheads 30,000
Variable Overheads 50,000
Direct Wages 40,000
Direct Materials 1,00,000
Sales 2,50,000
Represent that above figures on a break-even chart and determine from the chart
the break-even point. Verify your result by calculations.
Solution:
250
200
Cost and revenue (in 000)
150 Sale (Variable Cost
+ Fixed Cost
125
Total Cost BEP
100
50 Fixed Cost
0 10 20 30 40 50 60 70 80 90 100
CAPACITY (%)
Verification:
F
BEP =
P/V Ratio
F = Rs.30,000
C S V 2,50,000 1,90,000
P/V Ratio =
S S 2,50,000
Cost and Management
Advanced ManagementAccounting
Accounting 14.19
15.19 Marginal Costing - CVP Analysis
60,000 6
= =
2,50,000 25
30,000
BEP Sales = 25 = Rs.1,25,000
6
Cash Break-Even Chart:
This chart is prepared to show the cash needs of a concern. Fixed expenses are to be
classified as those involving cash payments and those not involving cash payments like
depreciation. As the cash break even chart is designed to include only actual payments and not
expenses incurred, any time lag in the payment of items included under variable cost must be
taken into account. Equal care must be shown on the period of credit allowed to the debtor for
the purpose of calculating the amount of cash to be received from them, during a particular
period. Cash break-even point is used to assess the liquidity position of the firm. It can be
calculated as under:
Cash Fixed Costs
Cash Break-even Point =
Cash contributi on per unit
14.4.3
15.4.3 Assumptions of Break even Analysis:
Break even analysis is based on the following assumptions.
i Fixed cost remains constant at all levels of output.
ii Variable costs fluctuate in direct proportion to volume of output.
iii Selling prices do not change as volume changes.
iv There is only one product and in the case of multiple products, the sales mix
remains constant.
v There will be no change in general price level.
vi Productivity per worker will remain unchanged.
vii There is synchronization between productions and sales, i.e., whatever is
produced is sold out.
14.5 ADVANTAGES OF BREAK EVEN ANALYSIS
15.5.
The break even analysis is a simple tool employed to graphically represent accounting
data. The data revealed by financial statements and reports are difficult to understand and
intepret. But when the same are presented through break even charts, it becomes easy to
understand them. Break even charts help in:
1. Determining total cost, variable cost and fixed cost at a given level of activity;
2. Finding out break even output or sales;
C.D.E. 15.20
14.20 Acharya Nagarjuna University
3. Understanding the cost, volume, profit relationship;
4. Making inter-firm comparisons;
5. Forecasting profits;
6. Selecting the best product mix; and
7. Enforcing cost control.
Thus, the break even analysis can be used to find out the effect of all these changes
which influence total revenue and total cost and thereby the profitability of a business. The
marginal cost approach, which is better termed as relevant cost approach, is vital for making a
choice out of various alternatives. But to make all decision on the basis of marginal cost would
be wrong. Normal prices for example are based on full costs and not marginal cost.
14.6
15.6. LIMITATIONS OF BREAK EVEN ANALYSIS
On the negative side, break even analysis suffers from the following limitations.
1. Difficulty in segregation of Costs: It is very difficult, if not impossible, to
segregate costs into fixed and variable components. Further, fixed costs to not
always remain constant. They have a tendency to rise to some extent after
production reaches certain level. Like wise, variable costs do not always vary
proportionately.
2. Complicated Calculations: The application of break even analysis to a multi-
product firm is very difficult. A lot of complications are involved.
3. Limited Importance: The break even point has limited importance. At best it would
help management to indulge in cost reduction in times of dull business. Normally, it
is not the objective of business to break even, because no business is carried on in
order to break even. Thus, the BEP ‘Provides neither a standard of performance nor
a guide for executive decisions.
4. Limitations application in long-range planning: Break even analysis is a short
run concept, and it has a limited application in the long range planning.
Despite these limitations, break even analysis has some practical utility in that it helps
management in profit planning. According to Wheldon, “if the limitations are accepted, and the
chart is considered as being an instantaneous photograph of the present position and possible
trends, there are some very importance conclusions to be drawn from such a chart”.
Illu.18: A factory engaged in manufacturing plastic buckets is working at 40%
capacity and produces 10,000 buckets for annum.
Advanced Management
Cost and Management Accounting
Accounting 15.21
14.21 Marginal Costing - CVP Analysis
The present cost break-up for one bucket is as under:
Rs.
Material 10
Labour Cost 3
Overheads 5(60% fixed)
The selling price is Rs.20 per
bucket.
If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At
90% capacity the selling price falls by 5% accompanied by a similar fall in the prices of
material.
You are required to calculate the profit at 50% and 90% capacities and also the
break-even points for the same capacity productions.
Solution:
Statement showing profit and break-even point at different capacity levels
50% 90%
Capacity level Production 12,500 22,500
(Units) Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
a) Sales 19.40 2,42,500 19.00 4,27,500
Variable cost material 10.00 1,25,000 9.50 2,13,750
Wages 3.00 37,500 3.00 67,500
Variable overhead 2.00 25,000 2.00 45,000
b) Total varibale cost 15.00 1,87,500 14.50 3,26,250
c) Contribution (S-V)
Or (a-b) 4.40 55,000 4.50 1,01,250
Less: Fixed cost 30,000 30,000
Net profit 25,000 71,250
Break-even point at 50% 90%
Fixed cost 30,000 30,000
Units = = 6,818 units = 6,667 units
Contributi on per unit 4.40 4.50
Sales value Rs.1,32,269 Rs.1,26,673
Illu.19 : From the following data calculate:
i) P/V ratio
ii) Profit when sales are Rs.20,000
iii) New Break-even point if selling price is reduced by 20%.
C.D.E. 15.22
14.22 Acharya Nagarjuna University
Fixed expenses Rs.4,000
Break-even point Rs.10,000
Solution:
Fixed expenses
i. Break-even sales =
P/V Ratio
Fixed expenses 4,000
P/V Ratio = = 100 = 40%
Break - even sales 10,000
ii. Profit when sales are Rs.20,000
Profit = Sales P/V ratio – Fixed expenses.
= Rs.20,000 40% - Rs.4,000
= Rs.8,000 – Rs.4,000 = Rs.4,000
iii. New break-even point if selling price is reduced by 20%. If the selling price Rs.100,
now it will be Rs.80. Variable cost per unit Rs.60 (i.e. 100-40% old P/V ratio)
80 - 60
New P/V Ratio = = 25%
80
4,000
Break-even point will be = = Rs.16,000
25%
Illu.20: The sales and profit during the years were as follows.
Sales Profit
Rs. Rs.
2001 1,50,000 20,000
2002 1,70,000 25,000
You are required to calculate
a. P/V Ratio
b. Break even level
c. Sales required to earn a profit of Rs.40,000
d. Margin of Safety at a profit of Rs.2,50,000
e. Profit made when sales are Rs.50,000
f. Variable Cost in the two periods.
Solution:
Change in Profit in 2 periods
a) P.V. Ratio = 100
Change in Sales in 2 periods
Rs.25,000 - 20,000 5,000
= 100 = 100 25%
Rs.1,70,00 0 - 1,50,000 20,000
Fixed Cost
b) Break Even Level =
P.V. Ratio
Cost and Management
Advanced ManagementAccounting
Accounting 15.23
14.23 Marginal Costing - CVP Analysis
Fixed Cost = Contribution – Profit
Fixed Cost = (Sales P.V. Ratio) – Profit
25
= (1,50,000 )-20,000 = Rs.17,500
100
Rs.17,500
Break Even Level = = Rs.70,000
25%
c) Sales required to earn a profit of Rs.40,000
Fixed expenses Required Profit Rs.17,500 40,000
= =
P.V. Ratio 25%
100
= Rs.57,500 = Rs.2,30,000
25
d) Margin of Safety at a profit of Rs.2,50,000
Profit 2,50,000
Margin of Safety = = = Rs.10,00,000
P.V. Ratio 25%
e) Profit when sales are Rs.2,50,000
Profit = Contribution – Fixed Cost
= (Sales P.V. Ratio) – Fixed Cost
25
= (Rs.2,50,000 ) – Rs.17,500 = Rs.45,000
100
f) Variable Cost in the two periods:
Variable Cost = Sales – Profit – Fixed Cost
2001 = Rs.1,50,000 – 20,000 – 17,500 = Rs.1,12,500
2002 = Rs.1,70,000 – 25,000 – 17,500 = Rs.1,27,500
Illu.21: Assuming that the cost structure and selling prices remain the same in
periods I and II find out:
(a) Profit volume ratio, (b) Profit when sales are Rs.1,00,000.
Periods Sales Profit
Rs. Rs.
I 1,20,000 9,000
II 1,40,000 13,000
C.D.E. 15.24
14.24 Acharya Nagarjuna University
Solution:
Change in Profit 4,000
a. P/V Ratio = 100; 100 20%
Change in sales 20,000
Calculation of Fixed Expenses:
20
S (P/V Ratio) = F + P; 1,20,000 ( ) = F + 9,000; 24,000 = F + 9,000; 24,000 – 9,000 =
100
F; 15,000 = F; F = Rs.15,000
20
b. S (P/V Ratio) = F + P; 1,00,000 ( ) = 15,000 + P; 20,000 = 15,000 + P; 20,000 –
100
15,000 = P; 5,000 = P; P = Rs.5,000
14.7 SELF ASSESSMENT QUESTIONS
15.7
I. Short Questions:
1. What is break-even point?
2. What is margin of safety?
3. What is profit-volume ratio?
4. What is contribution?
5. What is angle of incidence?
6. What is Cash break-even point?
II. Essay type questions:
1. Explain cost-volume profit analysis.
2. Explain the ways by which profit-volume ratio can be improved.
3. Explain the uses of break-even analysis in profit planning.
4. What assumption are made to construct a simple Break-even Chart?
5. Explain the utility of Break-even Analysis in Managerial Decisions
6. What do you meant by Break-even level of output?
7. What are the limitations of the break-even charts?
8. What are the managerial uses of break-even analysis?
9. What is Profit volume ratio and Profit Volume graph? How is Profit-volume graph
technique helpful to management.
10. What is C.V.P.? Analyse and state its uses and applications.
11. Explain ‘Break-Even Analysis’. Discuss the assumptions that underline the
technique and the practical usefulness of Break-even analysis.
12. Define Break-even-Point and explain its advantage and limitations.
13. What do you mean by P/V Ratio? What are its uses?
14. What are the assumptions of Break-even-Analysis?
15. Explain the concepts of marginal costing and Break-even analysis.
16. Explain about Break-even Analysis. What are its applications?
Advanced Management
Cost and Management Accounting
Accounting 15.25
14.25 Marginal Costing - CVP Analysis
14.8 EXERCISES
15.8
1. From the following particulars calculate the Break-even point interms of both quantity and
value:
Production in units 10,000
Sales price Rs.5,00 per
unit
Variable costs Rs.20,000
Fixed costs Rs.12,000
[Ans.: (a) 4,000 units; (b) Rs.20,000]
3. What is the break-even-point when sales is Rs.6.0 lakhs; Fixed expenses are Rs.1.5 lakhs
and Variable costs are Rs.4.0 lakhs?
[Ans.: Rs.4.5 lakhs]
4. Find P/V Ratio and Margin of Safety – when sales, variable cost, fixed costs are Rs. Ten
lakhs, Four lakhs, Four lakhs respectively.
[Ans.: P.V. Ratio = 60%; MOS = Rs.3,33,333]
5. The following information is extracted from the books of Harish Ltd.
Year Sales Cost
Rs. Rs.
2006 2,00,000 1,40,000
2007 2,40,000 1,60,000
Calculate B.E.P.
[Ans.: BEP Rs.80,000; P.V. Ratio = 50%; Fixed Cost Rs.40,000]
6. A company estimates that next year it will earn a profit of Rs.50,000. The budgeted fixed
costs and sales are Rs.2,50,000 and Rs.9,93,000 respectively. Find out Break-Even point.
[Ans.: Rs.8,27,500]
C.D.E. 15.26
14.26 Acharya Nagarjuna University
7. From the following information, calculate margin of safety.
Rs.
Sales (4,000 units @ Rs.25 each) 1,00,000
Variable cost 72,000
Fixed expenses 16,800
[Ans.: Margin of Safety Rs.40,000]
8. From the following details calculate BEP, Margin of safety:
Rs.
Sales 4,20,000
Fixed cost 90,000
Variable cost ratio 55% of sales
[Ans.: BEP Rs.2,00,000; Margin of Safety Rs.2,20,000]
9. From the following particulars calculate the margin of safety Sales units: 15,000; Fixed
costs Rs.34,000; Selling price per unit Rs.10; Variable cost per unit Rs.6.
[Ans.: Margin of Safety Rs.65,000]
10. From the following information calculate:
(a) Break-even point
(b) Turnover required to earn a profit of Rs.36,000.
(c) Margin of safety for Rs.36,000 profit. Fixed overhead Rs.1,80,000 Variable cost per
unit Rs.2 Selling price per unit Rs.20.
[Ans.: (a) Rs.10,000 units; Value Rs.2,00,000; (b) 12,000 units; Value
Rs.2,40,000; (c) Rs.40,000]
11. Sri Sai Ram Limited furnishes you the following information relating to the half year ended
30th June 2007:
Rs.
Fixed expenses 45,000
Sales value 1,50,000
Profit 30,000
During the second half of the year, the company has projected a loss of Rs.10,000.
Calculate:
Advanced Management
Cost and Management Accounting
Accounting 15.27
14.27 Marginal Costing - CVP Analysis
(a) The Break-even point and Margin of safety for six months ending 30th June 2007.
(b) Expected sales volume for second half of the year assuming that P/V ratio and fixed
expenses remain constant in the second half year also.
(c) The Break-even point and Margin of safety for the whole year 2007.
[Ans.: (a) BEP Rs.90,000; MOS Rs.60,000; (c) BEP Rs.1,80,000; MOS Rs.40,000]
12. You are given the following data for the year of a company.
Rs. %
Variable costs 6,00,000 60
Fixed costs 3,00,000 30
Net profit 1,00,000 10
10,00,000 100
Find out
(a) Break even point
(b) P/V Ratio.
(c) Margin of safety.
[Ans.: (a) Rs.7,50,000; (b) 40%; (c) Rs.2,50,000]
13. The following information relates to an article produced by EM EM Ltd:
Rs.
Total fixed costs 18,000
Total variable costs 30,000
Total sales 60,000
Units sold 20,000
From the above information find out (a) Per unit contribution (b) Break-even-point
(c) Safety margin and (d) Sales required to earn a profit of Rs.24,000.
[Ans.: (a) Rs.1.50 (b) 12,000 units Rs.36,000; (c) 8,000 units – Rs.24,000; (d)
28,000 units value Rs.84,000]
14. From the following figures, calculate P/V ratio, BEP, profit on estimated sales of
Rs.1,25,000 and sales required to earn a profit of Rs.20,000:
C.D.E. 15.28
14.28 Acharya Nagarjuna University
Sales Profit
Rs. Rs.
Period I 1,00,000 15,000
Period II 1,20,000 23,000
[Ans.: P.V. Ratio = 40%; BEP Rs.62,500; Profit Rs.25,000; Sales required
Rs.1,12,500]
15. The following data are obtained from the records of a factory:
Rs. Rs.
Sales 4,000 units at Rs.25 each 1,00,000
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
72,000
Fixed overheads 18,000 90,000
Profit 10,000
It is proposed to reduce the selling price by 20%. What extra units should be sold
to obtain the same amount of profit as above?
[Ans.: Units sold: (a) 14,000 units; Extra units to be sold: 14,000 4,000 =
10,000 units]
16. From the following particulars calculate:
(a) Contribution
(b) P/V Ratio
(c) Break-even in units and in Rupees
(d) What will be the selling price per unit if the break-even is brought down to 25,000
units?
Rs.
Fixed Expenses: 1,50,000
Variable cost per unit 10
Selling price per unit 15
1 1
[Ans.: (a) Rs.5; (b) 33 or (c) 30,000 units; Rs.4,50,000; and (d) Rs.16]
3 3
17. Bhargavi Ltd. incurred a total cost of Rs.40,000 on a sales of Rs.45,000 in the 1st half year
and Rs.43,000 cost on sales of Rs.50,000 in the 2nd half year.
Assuming that costs and prices remained the same, calculate for the entire year:
Advanced Management
Cost and Management Accounting
Accounting 15.29
14.29 Marginal Costing - CVP Analysis
(i) P.V. Ratio (ii) Fixed Expenses
(iii) Break-even sales (iv) % of margin of safety.
[Ans.: (i) 40%; (ii) Rs.26,000; (iii) Rs.65,000; (iv) Rs.30,000 and 31.58%]
18. The sales and profit during two years are as follows:
Year Sales Profit
Rs. Rs.
2006 3,00,000 30,000
2007 4,00,000 50,000
You are required to calculate (i) p/v ratio (ii) Break even sales (iii) Margin of Safety at a
Profits of Rs.40,000.
1
[Ans.: (i) 20% or ; (ii) Rs.1,50,000 (iii) Rs.2,00,000]
5
19. From the following data, determine the net profits, if actual sales are 10% and 15% above
the Break-Even volume:
Selling Price per unit : Rs.10
Trade discount : 5%
Fixed overheads : Rs.10,000
Variable cost per unit : Rs.7
[Ans.: B.E.P = 4,000 Units; Net Profit = Rs.1,000; Rs.1,500]
20. The following figures are available from the records of Sindhu enterprises as at 31st
December:
2006 2007
Rs. in lakhs Rs. in lakhs
Sales 150 200
Profit 30 50
Calculate:
(a) The p/v ratio and total fixed expenses.
(b) The break-even level of sales.
(c) Sales required to earn a profit of Rs.90 lakhs.
(d) Profit or loss that would arise if the sales were Rs.280 lakhs.
[Ans.: (a) 40% & Rs.30,00,000; (b) Rs.75,00,000 (c) Rs.3,00,00,000 (d) 82,00,000]
C.D.E. 15.30
14.30 Acharya Nagarjuna University
21. Calculate the Break-even point from the following particulars:
Budgeted output 70,000 units
Fixed cost (Rs.) 4,00,000
Variable cost per unit (Rs.) 12
Selling price per unit (Rs.) 22
If the selling price is reduced to (Rs.) 20 per unit what will be the revised Break-even
point?
[Ans.: BEP = 40,000 units Value Rs.8,80,000; Revised BEP = 50,000 units Value
Rs.10,00,000]
22. From the following data, determine the net profits, if actual sales are 10% and 15% above
the Break-Even Volume:-
Selling price per unit: Rs.10
Trade discount: 5%
Fixed overheads: Rs.10,000
Variable cost per unit Rs.7
[Ans.: BEP = 400 Units: Profits Rs.(i) Rs.1,000; (ii) Rs.1,500]
23. Sales of a product amount to 200 units per month at Rs.10 per unit. Fixed overhead is
Rs.400 per month and variable cost Rs.6 per unit. There is a proposal to reduce prices by
10%. Calculate present and future P/V ratio, how many units must be sold to maintain
total profit.
1
[Ans.: Present and future P/V ratios 40% and 33 %, Units to maintain total
3
Profit = 267]
24. From the following particulars calculate the P/V ratio Break-even sales and Fixed Costs.
Profit Rs.2,000 which represents 10% of sales Margin of safety = Rs.10,000.
1
[Ans.: P/V ratio = ; Break-even sales Rs.10,000; Fixed cost Rs.2,000]
5
25. From the following particulars calculate (a) Fixed costs (b) Break Eve Sales (c) Total
Sales and (d) Profit.
Margin of Safety = Rs.10,000 (which represents 40% of sales) P/V Ratio = 50%.
[Ans.: (a) Rs.7,500; (b) 15,000; (c) Rs.25,000; (d) Rs.5,000.]
Cost and Management
Advanced ManagementAccounting
Accounting 15.31
14.31 Marginal Costing - CVP Analysis
26. Given:
Sales 10,000 units
Variable cost Rs.1,00,000
Sales value Rs.2,00,000
Fixed cost Rs.40,000
Selling Price per unit Rs.20
You are required to calculate:
(a) P/V Ratio (b) Break-even point (c) Margin of safety (d) Sales to earn a profit of
Rs.30,000.
[Ans.: (a) 50% (b) Rs.80,000 (c) Rs.1,20,000 (d) Rs.1,40,000]
27. Assuming that the cost structure and selling prices remain the same in Periods I and II,
find out:
(a) Profit Volume Ratio;
(b) Fixed Cost;
(c) Break Even Point for Sales;
(d) Profit when Sales are of Rs.1,00,000;
(e) Sales required to earn a Profit of Rs.20,000; and
(f) Margin of Safety at a profit of Rs.15,000;
(g) Variable cost in Period II
Period Sales Profit
Rs. Rs.
I 1,20,000 9,000
II 1,40,000 13,000
[Ans.: (a) 20% (b) Rs.15,000 (c) Rs.75,000 (d) Rs.5,000 (e) Rs.1,75,000 (f)
Rs.75,000 (g) Rs.1,12,000]
28. The sales turnover and profit of M/s Sreenivasa & Co. Ltd. during the two years 2006 and
2007 were as follows:
Sales Profit
(Rs.) (Rs.)
2006 4,50,000 60,000
2007 5,10,000 75,000
You are required to calculate:
1. Profit-volume ratio.
2. Break-even point.
3. The sales required to earn a profit of Rs.1,20,000.
C.D.E. 15.32
14.32 Acharya Nagarjuna University
4. The profit made when sales are Rs.7,50,000.
5. Margin of safety at a profit of Rs.1,50,000.
6. Variable costs of the two periods.
[Ans.: (1) 25% (2) Rs.2,10,000 (3) Rs.6,90,000 (4) Rs.1,35,000 (5) Rs.6,00,000 (6) 1989
= Rs.3,37,500; 1990 = Rs.3,82,500]
29. Following are the particulars of Pennar Tubes Ltd:
Sales Rs.30,00,000; Fixed costs Rs.9,00,000; Variable costs Rs.15,00,000. Calculate (a)
P/V ratio, (b) Break-even point (c) Margins of safety and (d) Margin of safety ratio.
[Ans.: (a) 50% (b) Rs.18,00,000 (c) Rs.12,00,000 (d) 40%]
30. M Ltd., manufacturing and selling industrial boxes. It is proposed to decrease the prices
due to heavy competition. By decreasing the selling prices by 10% and 15%, how many
units to be sold to maintain the current level of profit. The additional information is given:
Current sales 30,000 units Rs.3,00,000
Variable cost 30,000 units 1,80,000
Fixed cost 70,000 2,50,000
Net profit 50,000
[Ans.: Sale of Units at 10% reduction in selling price 40,000; Sale of Units at
15% reduction in selling price 48,000]
31. From the following details calculate:
(a) P/V Ratio
(b) BE Point
(c) Margin of safety
(d) Effect of 10% increase in SP on BEP.
(e) Effect of 10% decrease in SP on BEP.
Rs.
Sales 60,000
Variable Cost 30,000
Fixed Cost 15,000
[Ans.: (a) 50, (b) Rs.30,000; (c) Rs.30,000; (d) BEP Rs.27,500; (e) Rs.33,750
32. From the following particulars find
Cost and Management
Advanced ManagementAccounting
Accounting 14.33
15.33 Marginal Costing - CVP Analysis
(i) Contribution, (ii) P/V Ratio:
Variable cost per unit Rs.20; Selling price per unit Rs.40; Fixed expenses
Rs.1,00,000; Output 5,000 units.
[Ans.: Contribution per unit Rs.20; P.V. Ratio: 50%]
33. Ramachandra sells a line of Men’s footwears for Rs.18 a pair. Each pair that is sold
contributes Rs.6 to the recovery of fixed costs and to profits. His fixed costs amounts to
Rs.84,000 a year.
You are asked to (a) show how many pairs must be sold in a year to Break
Even. (b) Break Even sales revenue at the Break Even Point. (c) Desired sales to earn a
profit of Rs.54,000.
[Ans.: (a) 14,000 units (b) Rs.2,52,000 (c) Rs.4,14,000]
34. From the following details, compute: (i) P.V. Ratio (ii) Profit
Fixed Costs Rs.50,000
Sales Rs.3,00,000
2
Variable costs 66 % of sales.
3
1
[Ans.: (i) 33 % (ii) Rs.50,000]
3
35. From the following details compute: (a) Variable Costs; (b) P/V Ratio.
Rs.
Sales 3,00,000
Fixed Costs 70,000
Profit 80,000
[Ans.: (a) Rs.1,50,000 (b) Rs.50%]
36. From the following data, you are required to calculate
a. P/V Ratio
b. Break even sales with the help of P/V ratio
c. Sales required to earn a profit of Rs.4,50,000
Fixed expenses Rs.90,000
Variable cost per unit:
Direct material = Rs.5
Direct Labour = Rs.2
Direct overheads = 100 per cent of direct labour
Selling price per unit = Rs.12
[Ans.: (a) 25% (b) 3,60,000 (c) Rs.21,60,000]
C.D.E. 15.34
14.34 Acharya Nagarjuna University
37. From the following information pertaining to the years, calculate:
a. P/V ratio
b. Amount of sales to earn profit of Rs.40,000
c. Profit on sales Rs.1,20,000
Years Sales Profit
Rs. Rs.
2006 1,40,000 15,000
2007 1,60,000 20,000
[Ans.: (a) 25% (b) Rs.2,40,000 (c) Rs.10,000]
38. From the following data relating to a company, calculate:
i. The break-even sales; and
ii. Sales required to earn a profit of Rs.6,000 per period.
Period Total Sales Total Cost
Rs. Rs.
1. 42,500 38,700
2. 39,200 36,852
[Ans.: (i) Rs.33,863.64 (ii) Rs.47,500]
39. The following information was extracted from the books of Giridhar Mft. Co. Ltd.
Rs.
Sales 1,80,000
Less: Variable Costs 1,44,000
Contribution 36,000
Less: Fixed costs 24,000
Net Profit 12,000
Calculate the following (a) P/V ratio (b) Break-even point (c) Net profit earned at
sales of Rs.2,70,000 (d) Sales required to earn a profit of Rs.24,000.
[Ans.: (a) 20% (b) Rs.1,20,000 (c) Rs.30,000 (d) Rs.2,40,000]
40. By making and selling 7,000 units of its product, a company would lose Rs.10,000;
whereas in the case of 9,000 units it would make a profit of Rs.10,000 instead. Calculate:
(a) The amount of fixed expenses.
Advanced Management
Cost and Management Accounting
Accounting 15.35
14.35 Marginal Costing - CVP Analysis
(b) Number of units of Break-Even.
(c) Profit or Loss for 10,000 units.
(d) Number of units to earn a profit of Rs.40,000.
[Ans.: P.V. Ratio = 10%; (a) 80,000 (b) 8,000 units (c) Rs.20,000 (d) 12,000 units]
41. M/s Haripriya Ltd., sold its products worth Rs.180 lakhs and made a profit of rS.18 lakhs in
2006. But in 2007, the sales cam down to Rs.140 lakhs due to serve competition in the
market. The fall in profit was Rs.4 lakhs. Calculate break-even points and profit volume
ratios in 2006 and 2007.
)
[Ans.: BEP = 0; P.V. Ratio : 2001 – 10%; 2002 – 10%]
42. Two competing companies P Ltd. and Q Ltd. produce and sell the same type of product in
the same market. For the year ended March 2008, their forecasted profit and loss
accounts are as follows:
P. Ltd. Q. Ltd.
Rs. Rs. Rs. Rs.
Sales 3,00,000 3,00,000
Selling Price Expenses 2,00,000 2,25,000
Fixed Cost 50,000 2,50,000 25,000 2,50,000
50,000 50,000
You are required to calculate the following:
(a) Profit volume ratio, Break-even Point and Margin of Safety of each business.
(b) Sales volume at which each business will earn a profit of Rs.30,000.
(c) Explain, giving reasons which business is likely to earn greater profits in conditions
of (i) heavy demand for the product, (ii) low demand for the product.
[Ans.: (a) P.V. Ratio : P Ltd. 33.33%; Q Ltd. 25%; BEP Sales : P Ltd.,
Rs.1,50,015; Q Ltd., Rs.1,00,000; Margin of safety : P Ltd. Rs.1,50,015; Q Ltd.,
Rs.2,00,000; (b) P Ltd. Rs.2,40, 024; Q Ltd. Rs.3,00,000 (c) (i) In case of heavy
demand the product of P Ltd., is more profitable, because P.V. ratio of P Ltd.,
is greater than Q Ltd. (ii) In case of low demand, the product Q Ltd., is more
preferable since it provides more profit. It is because BEP of Q Ltd., is lower
than the BEP of P Ltd.]
43. Following information has been obtained from the revenue account of Balaji Ltd. for the
year ended 31st December, 2007:
Rs. Rs.
C.D.E. 15.36
14.36 Acharya Nagarjuna University
Sales 6,00,000
Direct materials 1,80,000
Direct wages 1,20,000
Variable overheads 48,000
Fixed overheads 1,72,000 5,20,000
Profit 80,000
It is proposed to reduce the selling price by 5%. What would be the sales volume
if the present level of Profit is to be maintained. Assume no change in cost structure.
[Ans.: Old P.V. Ratio : 42%; New P.V. Ratio : 38.95%; Sales Volume at present
level of profit Rs.6,46,938]
14.9 REFERENCE BOOKS :
15.9
1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting –
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
Cost andManagement
Advanced Management Accounting
Accounting 16.1
15.1 Marginal Costing - Managerial Decisions
Chapter – 15
16
MARGINAL COSTING -
MANAGERIAL DECISIONS
Objectives
After studying this chapter you should be able to
understand the uses of marginal costing and taking various managerial decisions
explain the problems relating to profit planning, introduction of new product, planning
the level of activity. Key factor, suitable product mix, pricing decisions etc.
Structure :
15.1
16.1 Marginal Costing and Decision making
15.2
16.2 Buy or Make Decisions
15.3
16.3 Self Assessment Questions
15.4
16.4 Exercises
15.5
16.5 Reference Books
15.1 MARGINAL COSTING AND DECISION MAKING
16.1.
Marginal costing techniques may be applied in various fields to aid management in
arriving at many important policy decisions. These include:
1. Profit planning
2. Introduction of new product
3. Planning of level of activity
4. Key factor
5. Determination of suitable product – mix
6. Pricing Decisions
7. Foreign Market offer
8. Make or buy decisions
15.1.1
16.1.1 Profit Planning:
Profit planning is the planning of future operations so as to attain maximum profit. The
contribution ratio shows the relative profitability of various sectors of the business whenever
there is a change in selling price, variable costs or product mix. There are four important ways
to improve the profit performance of a business.
C.D.E. 16.2
15.2 Acharya Nagarjuna University
(i) By increasing volume
(ii) By increasing selling price
(iii) By reducing variable costs, and
(iv) By reducing fixed costs.
Illu.1: The following are the budgeted data relating to AB Ltd., and CD Ltd.,
producing identical products.
Rs. Rs. Rs. Rs.
Sales 1,50,000 1,50,000
Less: Variable cost 1,20,000 1,00,000
Fixed Cost 15,000 1,35,000 35,000 1,35,000
Net Profit 15,000 15,000
a. Calculate break-even points, P/V ratio and margin of safety of each company:
b. State which company is likely to earn greater profits in conditions of (i) heavy
demand and (ii) low demand of the product.
Solution:
FS
a.(i) B.E.P. Sales =
S V
15,000 1,50,000
AB Ltd. = = Rs.75,000
1,50,000 - 1,20,000
35,000 1,50,000 Rs.1,05,00
CD Ltd. = =
1,50,000 - 1,00,000 0
S V
ii. P.V. Ratio = 100
S
1,50,000 - 1,20,000
AB Ltd. = 100 = 20%
1,50,000
1,50,000 - 1,00,000
CD Ltd. = 100 = 33.33%
1,50,000
Actual BEP
iii. Margin of Safety = -
Sales Sales
Rs.1,50,00
AB Ltd. = - 75,000 = Rs.75,000
0
CD Ltd. = Rs.1,50,00 - 1,05,000 = Rs.45,000
(b) In case of heavy demand, CD Ltd., will earn higher profit since the P/V Ratio is higher for
the company. In case of low demand, AB Ltd., may earn higher profit since its break even
point is low and margin of safety is higher.
Advanced
Cost andManagement
ManagementAccounting
Accounting 15.316.3 Marginal Costing - Managerial Decisions
15.1.2
16.1.2 Introduction of New Product:
Sometime, a product may be added to the existing lines of products with a view to utilise
idle facilities to capture new market or for any other purpose. The profitability of this new
product has to be found out initially. Usually, the new product will be manufactured if it is
capable of contributing something towards fixed costs and profit after meeting its variable costs.
Illu.2: A firm manufacturing Product X has provided the following information.
Rs.
Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable overhead 10,000
Fixed overhead 15,000
In order to increase its sales by Rs.25,000, the firm wants to introduce the Product
Y, and estimates the costs in connection therewith as under:
Rs.
Direct materials 10,000
Direct labour 8,000
Variable overhead 5,000
Fixed overhead Nil
Advise whether the Product Y will be profitable or not.
Solution:
Marginal Cost Statement
X Y Total
Rs. Rs. Rs.
Sales 75,000 25,000 1,00,000
Less: Material cost:
Direct materials 30,000 10,000 40,000
Direct labour 10,000 8,000 18,000
Variable overhead 10,000 5,000 15,000
50,000 23,000 73,000
Contribution 25,000 2,000 27,000
Fixed Costs 15,000
Profit 12,000
C.D.E. 16.4
15.4 Acharya Nagarjuna University
Commentary: If product Y is introduced, the profitability of product X is not affected in
any manner. On the other hand, product Y provides a contribution of Rs.2,000 towards fixed
cost and profit. Therefore, Product Y should be introduced.
15.1.3
16.1.3 Planning the Level of Activity:
Marginal costing is of great help while planning the level of activity. Maximum contribution
at a particular the level of activity will show the position of maximum profitability.
IIIu.3: Excellent company is currently working at 50% capacity and produces 10,000
units.
At 60% capacity, raw material cost increases by 2% and selling price falls by 2%.
At 80% working, raw material cost increase by 5% and selling price falls by 5%. At 50%
capacity working, the product costs Rs.180 per unit and is sold at Rs.2.00 per unit.
The unit cost of Rs.180 is made up as follows.
Materials Rs.100
Wages Rs.30
Factory overheads Rs.30(40% fixed)
Administrative overheads Rs.20 (50% fixed)
You are required to work out the material cost, fixed cost, total cost and profit for
three capacity levels.
Solution:
Statement Showing Material Cost, Fixed Cost, Total cost
and Profit at three Capacity Levels
Output Capacity 50% 60% 70%
Sales (A) 20,00,000 23,52,000 30,40,000
Marginal Cost:
Material Cost 10,00,000 12,24,000 16,80,000
Wages 3,00,000 3,60,000 4,80,000
Factory Overheads 1,80,000 2,16,000 2,88,000
Administrative Overheads 1,00,000 1,20,000 1,60,000
Total Marginal Cost (B) 15,80,000 19,20,000 26,08,000
Contribution (A-B) (C) 4,20,000 4,32,000 4,32,000
Less: Fixed Expenses:
Factory Overheads 1,20,000 1,20,000 1,20,000
Administrative Overheads 1,00,000 1,00,000 1,00,000
Total Fixed Expenses (D) 2,20,000 2,20,000 2,20,000
Total Cost (B+D) (E) 18,00,000 21,40,000 28,28,000
Profit/Loss (C-D) (F) 2,00,000 2,12,000 2,12,000
Cost andManagement
Advanced Management Accounting
Accounting 16.5
15.5 Marginal Costing - Managerial Decisions
Note: Statement showing material cost, fixed cost, total cost; and profit per unit at three
capacity levels.
Output Capacity 50% 60% 70%
Selling Price (A) 200 196 190
Marginal Cost:
Materials 100 102 105
Wages 30 30 30
Factory Overheads 18 18 18
Administrative Overheads 10 10 10
Total Marginal Cost (B) 158 160 163
Contribution (A-B) (C) 42 36 27
Less: Fixed Expenses:
Factory Overheads 12 10 7.50
Administrative Overheads 10 8.33 6.25
Total Fixed Expenses (D) 22 18.33 13.75
Profit/Loss (C-D) (E) 20 17.67 13.25
Illu.4: Two companies which have the following operating details decide to merge:
Company I Company II
Capacity utilisation 90% 60%
Sales (Rs.Lakhs) 540 300
Variables cost (Rs.Lakhs) 396 225
Fixed cost (Rs.Lakhs) 80 50
Assuming proposal is implemented, calculate:
(a) Break-even sales of the merged plant and the capacity utilisation at that
stage.
(b) Profitability of the merged plant at 80% capacity utilisation.
(c) Sales turnover of the merged plant to earn a profit of Rs.75 lakhs.
Solution:
Statement of the merged company at 100% and 80% Capacity
Capacity Company A Company B Merged
Company
90% 100% 90% 100% 100% 80%
Sales 540 600 300 500 1,100 880
Variable Cost 396 440 225 375 815 652
Contribution (S-V) 144 160 75 125 285 228
Fixed Cost 80 80 50 50 130 130
Profit 64 80 25 75 155 98
C.D.E. 15.6
16.6 Acharya Nagarjuna University
a. BEP of merged Plant:
C 285
P.V. Ratio = 100; 100 = 25.91%
S 1,100
F 130
BEP Sales = = = Rs.501.75 lakhs.
P.V.Ratio 25.91%
100
Capacity Utilisation = Rs.501.75 lakhs = 45.6%
1,100
b. Profitability of the merged company at 80% capacity utilisation.
Profit 98
= 100; 100 11.14%
Sales 880
c. Sales required to earn a profit of Rs.75 lakhs.
Desired Profit = Rs.75 lakhs. Fixed Cost of merged Co. = Rs.130 lakhs
Desired Contribution = 75 + 130 = Rs.205 lakhs.
205
Sales to earn Rs.205 lakhs contribution = = Rs.791.23 lakhs.
25.91%
15.1.4
16.1.4 Key Factor:
A concern would produce and sell only those products which offer maximum profit. This is
based on the assumption that it is possible to produce any quantity without any difficulty and
sell like wise. However, in actual practice, this seems to be unrealistic as several constraints
come in the way of manufacturing as well as selling. Such constraints that come in the way of
management’s efforts to produce and sell in unlimited quantities are called ‘Key factors’ or
‘limiting factors’.
The limiting factors may be materials, labour, plant capacity, or demand. Management
must as certain the extent of influence of the key factor for ensuring maximisation of profit.
Normally, when contribution and key factors are known, the relative profitability of different
products or processes can be measured with the help of the following formula.
Contributi on
Profitability =
Key factor
Illu.5: From the following data, which product would you recommend to be
manufactured in a factory, time being the key factor?
Cost andManagement
Advanced Management Accounting
Accounting 16.7
15.7 Marginal Costing - Managerial Decisions
Per unit of Per unit of
product X product Y
Rs. Rs.
Direct material 24 14
Direct labour at Re.1 per hour 2 3
Variable overhead at Rs.2 per hour 4 6
Selling price 100 110
Standard time to produce 2 hours 3 hours
Solution:
Product X Product Y
Per unit Per unit
Rs. Rs. Rs. Rs.
Selling price 100 110
Less: Marginal cost:
Direct materials 24 14
Direct labour 2 3
Variable overhead 4 30 6 23
Contribution 70 87
Standard time to produce 2 hours 3 hours
70 87
= =
Contribution per hour 2 3
Rs.35 Rs.29
Contribution per hour of product X is more than that of product Y by Rs.6. Therefore,
product X is more profitable and is recommended for manufacturing.
15.1.5
16.1.5 Suitable Product Mix:
Normally, a business concern will select the product mix which gives maximum profit.
Product mix is the ratio in which various products are produced and sold. The marginal costing
technique helps management in taking appropriate decisions regarding the produce mix, i.e., in
changing the ratio of product mix so as to maximise profits. The technique not only helps in
dropping unprofitable products from the mix but also helps in dropping unprofitable
departments, activities etc.,
IIIu.6: Present the following information to show to the management: a) the
marginal product cost and the contribution per unit; b) the total contribution and profits
resulting from each of the following sales mixtures:
C.D.E. 16.8
15.8 Acharya Nagarjuna University
Product Per Unit
Rs.
Direct materials A 10
B 9
Direct wages A 3
B 2
Fixed expenses Rs.800
Variable expenses are allocated to products as 100% of direct wages.
Rs.
Sales Price A 20
B 15
Sales mixtures:
i) 1000 units of product A and 2000 units of B
ii) 1500 units of product A and 1500 units of B
iii) 2000 units of product A and 1000 units of B
Solution:
a) Marginal Cost Statement A B
Rs. Rs.
Direct materials 10 9
Direct wages 3 2
Variable overheads (100%) 3 2
Marginal Cost 16 13
Sales Price 20 15
Contribution 4 2
(b) Product mix choice 1000 A + 2000 B 1500 A + 1500 B 2000 A + 1000 B
(i) (ii) (iii)
Rs. Rs. Rs.
Total Sales (1000 20 + 2000 15) (1500 20 + 1500 (2000 20 + 1000
= 50,000 15) = 52,500 15) = 55,000
(1000 16 + 2000 13) (1500 16 + 1500 (2000 16 + 1000
= 42,000 13) = 43,500 13) = 45,000
Less: Marginal Cost
Contribution 8,000 9,000 10,000
Less: Fixed Costs 800 800 800
Profit 7,200 8,200 9,200
Cost andManagement
Advanced Management Accounting
Accounting 15.916.9 Marginal Costing - Managerial Decisions
Therefore, sales mixture (iii) will give the highest profit; and as such mixture (iii) can be
adopted.
15.1.6
16.1.6 Pricing Decisions:
Marginal costing techniques helps a firm to decide about the prices of various products in
a fairly easy manner. Let’s examine the following cases.
(i) Fixation of Selling Price.
Illu.7: P/V ratio is 60% and the marginal cost of the product is Rs.50. What will be
the selling price?
S V V C
Solution: P/V Ratio = 1
S S S
Variable cost 40
= 40% or
Sales 100
50 50 100
Selling price = = Rs.125
40% 40
ii. Pricing during Recession:
Illu.8: Hindustan Engineering Company is working well below normal capacity due
to recession. The directors of the company have been approached with an enquiry for
special job. The costing department estimated the following in respect of the job.
Direct materials – Rs.10,000
Direct labour – 500 Hours @ Rs.2 per hour.
Overhead costs : Normal recovery rates.
Variable – Re. 0.50 per hour
Fixed – Rs.1.00 per hour.
The directors ask you to adise them on the minimum price to be charged. Assume
that there are no production difficulties regarding the job.
Solution:
Calculation of Marginal Cost:
Rs.
Direct materials 10,000
Direct labour 1,000
Variable overhead @ Re.0.50 per 250
hour
Marginal cost Rs.11,250
C.D.E. 16.10
15.10 Acharya Nagarjuna University
Commentary: Here the minimum price to be quoted is Rs.11,250, which is the marginal
cost. By quoting so, the company is sacrificing the recovery of the profit and the fixed costs.
The fixed costs will continue to be incurred even if the company does not accept the offer. So
any price above Rs.11,250 is welcome.
(iii) Selling below marginal cost:
Selling below marginal cost, normally, is not feasible. However, under the following
circumstances this can be practised.
1. when a new product is introduced.
2. when competitors have to be edged out of the market.
3. when company deals with perishable products.,
4. when the product is used as a loss leader.
5. when labour engaged cannot be retrenched.
6. when foreign market is to be explored to earn foreign exchange.
7. when there is cut-throat competition.
8. when the plant has to be kept in a running condition.
15.1.7
16.1.7 Foreign Market Offer:
The acceptance or rejection of an offer from a foreign market depends upon the
incremental cost and incremental revenue.
Illu.9: Chola Pen Co. Ltd. produces and markets Micro tipped pens. The selling
price per pen is Rs.5.50 made up as follows:
Rs.
Direct materials 2.00
Direct labour 1.50
Variable overheads 0.50
Fixed overheads (Rs.90,000 1,20,000) 0.75
Total cost 4.75
Profit 0.75
Selling price 5.50
The installed capacity is 1,50,000 pens per month. At present, it is producing and
selling, on an average, 1,20,000 pens per month. The company has received an export
order for 30,000 pens per month for two years but at a price of Rs.4.50. the management
is hesitant to accept this order because it does not cover the total cost. There are no
government subsidies to meet the deficit. It is unlikely that the domestic market will
expand in the next two years. Advise them with necessary supporting data.
Cost andManagement
Advanced Management Accounting
Accounting 16.11
15.11 Marginal Costing - Managerial Decisions
Solution:
Marginal Cost per unit:
Rs.
Direct material 2.00
Direct labour 1.50
Variable overheads 0.50
Total Variable Cost 4.00
Selling price of the export order Rs.4.50
If the foreign order is accepted for each unit the firm gets a profit. of Rs.0.50 (Rs.4.50 –
4.00). The total profit if the foreign order is accepted = Rs.15,000 (30,000 0.50). So it is better
to accept foreign order.
15.2 MAKE OR BUY DECISIONS
16.2
A company might be having unused capacity which may be utilised for making component
parts or similar items instead of buying them from the market. In arriving at such a ‘make or buy’
decision, the cost of manufacturing component parts should be compared with price quoted in
the market. If the variable costs are lower than the purchase price, the component parts should
be manufactured in the factory itself.
Fixed costs are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However, I there is an increase in
fixed costs and any limiting factor is operating they should also be taken into account. Consider
the following illustration, throwing light on these aspects.
Illu.10: A manufacturing company finds that while the cost of making a component
part is Rs.10, the same is available in the market at Rs.9 with an assurance of continuous
supply. Give your suggestion whether to make or buy this part. Give also your views in
case the supplier reduces price from Rs.9 to Rs.8.
The cost information is as follows:
Particulars Rs.
1. Material 3.50
2. Direct Labour 4.00
3. Other Variable expenses 1.00
4. Fixed expenses 1.50
10.00
C.D.E. 16.12
15.12 Acharya Nagarjuna University
Solution:
Make or Buy Decision Statement
Purchasing Price (A) 9
Manufacturing Cost:
Material 3.50
Direct Labour 4.00
Variable Expenses 1.00
Total Manufacturing Cost (B) 8.50
Saving in Manufacturing (A-B) (C) 0.50
Advise:
1. It is better to manufacture rather than buying from outside Market.
2. If the component is supplied at Rs.8 it is better to purchase it rather than
manufacturing it. By purchasing, the profit will increase by Rs.0.50 (Rs.8.50 – 8.00)
per unit.
Illu.11: A company engaged in the manufacturing radios incurs Rs.6.25 per piece
for producing part A. But the same part is available for at Rs.5.75 only per piece in the
market. Its supply will also be alright. Particulars of expenses are as follows:
Rs.
Material per piece 2.75
Labour per piece 1.75
Other variable expenses per piece 0.50
Depreciation and fixed overheads per piece 1.25
6.25
(a) Do you manufacture that part or purchase it in the market?
(b) In case the supplier offers the same at Rs.4.85 only per piece, what is your
decision?
Solution:
Make or Buy Statement for Part A
Rs.
Buying Price (A) 5.75
Manufacturing Cost:
Material 2.75
Labour 1.75
Variable Expenses 0.50
Total Manufacturing Cost (B) 5.00
Saving in Manufacture (A-B) (C) 0.75
Cost andManagement
Advanced Management Accounting
Accounting 15.1316.13 Marginal Costing - Managerial Decisions
Advise:
a. It is better to manufacture rather than buying this. It is because the buying price per
unit is Rs.5.75 and manufacturing price is Rs.5.00. In manufacturing the product the
firm has a saving of Rs.0.75 per product.
b. If the computer supply price is Rs.4.85 then it is better to purchase it rather than
manufacturing it due to a saving of Rs.0.15 per unit.
Illu.12: ABC company has just been formed. A company has a special process
which will enable it to produce a unique product, the demand for which is uncertain.
Their estimated costs are:
Material per unit Rs.2
Labour per unit Rs.6
Variable manufacturing expenses per unit Rs.3
Variable selling expenses per unit Re.1
Fixed manufacturing expenses Rs.24,000
Fixed Administrative and selling expenses Rs.72,000.
(a) If the selling price is Rs.20, how many units they have to sell to (i) break even
(ii) make a profit of Rs.32,000 (iii) make a profit of 20 per cent of sale?
(b) If the demand for the product is 10,000 units, what price must they charge in
order to (i) break-even (ii) make a profit of Rs.24,000 (iii) make a profit of 20 per cent of
sales?
Solution:
Total variable Expenses = 2 + 3 + 6 + 1 = Rs.12
Total Fixed Expenses = Rs.24,000 + Rs.72,000 = Rs.96,000
Sales Price Rs.20
F 96,000 96,000
(a) (i) B.E.P. = = = = 12,000 units.
S V 20 - 12 8
(ii) Sales required to get a profit of Rs.32,000
FP 96,000 32,000 1,28,000
= = = 16,000 units
S V 20 - 12 8
(iii) Required sales amount to get a profit of 20% on Sales. Sales units is assumed as S.
20
Total Sales = 20S; Estimated profit 20% S; 20S = 4S
100
FP 96,000 4 S
S= = = 8S = 96,000 + 4S = 8S-4S = 96,000
S V 20 - 12
C.D.E. 16.14
15.14 Acharya Nagarjuna University
96,000
4S = 96,000S = = 24,000 Units
4
(b) (i) B.E.P. 10,000 units. Selling Price is assumed as S.
96,000
10,000 = = 10,000 S – 1,20,000 = 96,000;
S 12
10,000S = 96,000 + 1,20,000 ; 10,000S = 2,16,000;
2,16,000
S= = 21.60; S = Rs.21.60.
10,000
(ii) Selling price to get a profit of Rs.24,000
96,000 24,000
10,000 = = 10,000S – 1,20,000 = 1,20,000
S 12
2,40,000
10,000S = 1,20,000 + 1,20,000 = 10,000S = 2,40,000; S = = S = Rs.24
10,000
(iii) Selling Price to get profit of 20% on Sales.
Total Sales amount for 10,000 Units = 10,000S
20
On 10,000S; 20% Profit = 10,000S = 2,000S
100
96,000 2,000S
10,000 = = 10,000S – 1,20,000 = 96,000 + 2,000S or
S 12
8,000S = 2,16,000; S = Rs.27.
Illu.13: A firm is selling X product, whose variable cost per unit is Rs.10 and fixed
cost is Rs.6,000. It has sold 1,000 articles during one month at Rs.20 per unit. Market
research shows that there is a great demand for the product if the price can be reduced.
If the price can be reduced to Rs.12.50 per unit, it is expected that 5,000 articles can be
sold in the expanded market. The firm has to take a decision whether to produce and sell
1,000 units at the rate of Rs.20 or to produce and sell for the growing demand of 5,000
units at the rate of Rs.12.50. Give your advice to the management in taking the decision.
Solution:
1,000 5,000
units units
Selling Price (A) 20 12.50
Less: Variable cost (B) 10 10.00
Contribution per unit (A-B) (C) 10 2.50
Total Contribution 10,000 12,500
Less: Fixed Cost 6,000 6,000
Profit 4,000 6,500
The management may be advised to reduce the selling price to Rs.12.50. It is also
advised
Cost andManagement
Advanced Management Accounting
Accounting 16.15
15.15 Marginal Costing - Managerial Decisions
to produce and sell, 5,000 units because it gives an additional profit of Rs.2,500 (Rs.6,500 -
4,000)
Illu.14: A Toy manufacturer earns an average net profit of Rs.3 per piece in a selling
price of Rs.15 by producing and selling 60,000 pieces at 60% of the potential capacity.
Composition of cost of sales is as follows:
Rs.
Direct Materials 4.00
Direct Wages 1.00
Factory overhead 6.00
(50% Fixed)
Sales overhead 1.00
(25% varying)
During the current year, he intends to produce the same number of toys but
anticipates that:
(a) His fixed charges will go up by 10%.
(b) Rates of Direct labour will increase by 20%
(c) Rates of Direct Material will increase by 5%
(d) Selling price cannot be increased.
Under these circumstances, he obtains an order for a further 20% of his capacity.
What minimum price will you recommend for accepting the order to ensure the
manufacturer an overall profit of Rs.1,80,500.
Solution:
Calculation of Current year Marginal Cost Statement:
Rs.
Selling Price (A) 15.00
Less: Marginal Cost:
5
Direct Material [4 + (4 )] 4.20
100
Direct Wages [1 + (1 20 )] 1.20
100
Factory Overheads (6 50 ) 3.00
100
25
Sales Overheads (1 ) 0.25
100
Total Marginal Cost (B) 8.65
Contribution per unit (A-B) (C) 6.35
Total Contribution for 60,000 units = 60,000 6.35 = Rs.3,81,000
C.D.E. 16.16
15.16 Acharya Nagarjuna University
Calculation of Total Fixed Cost:
Rs.
Fixed factory overheads per unit 3.00
Fixed sales overheads per unit 0.75
Total fixed cost per unit 3.75
Total fixed cost for 60,000 units = 60,000 units 3.75 = Rs.2,25,000
Current year total fixed cost = 2,25,000 10 + 2,25,000 = Rs.2,47,500
100
Current year profit for 60,000 units = Total contribution – Fixed expenses
= 3,81,000 – 2,47,500 = Rs.1,33,500
Calculation of New Selling Price for 20% Capacity:
Rs.
Given required Profit 1,80,500
Less: Profit earned for 60,000 units 1,33,500
Profit to be acquired for 20% capacity 47,000
When the firm is at 60% capacity the output is 60,000 units.
For additional 20% capacity the required units 20,000
New Selling Price is assumed at ‘S’ per unit.
For 20,000 units sales amount = 20,000 units S = 20,000 S
Variable Cost per unit = 8 – 65
Total Variable Cost = 20,000 units Rs.8-65 = Rs.1,73,000
S–V=F+P
20,000S – 1,73,000 = Nil + 47,000
20,000S – 1,73,000 + 47,000
20,000S = 2,20,000
2,20,000
S= = Rs.11
20,000
The minimum recommended Selling Price to the company to accept the order is Rs.11.
Illu.15: Budgeted Results to X Ltd. include the following.
Sales Amount Variable cost as
(Rs. Lakhs) % of sales value
A 5.0 60%
B 4.0 50%
C 8.0 65%
D 3.0 80%
E 6.0 75%
26.0 65.17%
Cost andManagement
Advanced Management Accounting
Accounting 15.1716.17 Marginal Costing - Managerial Decisions
Fixed cost for the period are Rs.9.1 lakhs. You are required to (a) Produce a
statement showing the amount of loss expected and (b) Recommend a change in sales
volume of each product which will eliminate the expected loss that sales of only one
product can be increased at a time.
Solution:
(a) Statement of Profit/Loss Expected
(Amount in lakhs)
Product Sales Variable Variable P.V. Ratio Contribution
Cost Ratio Cost (or) C%
A 5 60 3.0 40 2.0
B 4 50 2.0 50 2.0
C 8 65 5.2 35 2.8
D 3 80 2.4 20 0.6
E 6 75 4.5 25 1.5
17.1 8.9
Calculation of Expected loss:
Total Contribution 8.9
Less: Fixed Expenses 9.1
Expected loss 0.2
b. Assume only one product can be increased at a time. The amount of sales of each
product to be increased as follows.
Under recovery of fixed costs
Sales required =
P.V. Ratio
Rs.
Product A
20,000
20,000 100 50,000
40% 40
Product B
20,000
20,000 100
40,000
50% 50
Product C
20,000
20,000 100
57,143
35% 35
Product D
20,000
20,000 100
1,00,000
20% 20
100
Product E
20,000
20,000 80,000
25% 25
Note: For (a)
Variable Cost Ratio
i. Variable cost = Sales = 5 60 = Rs.3
100 100
ii. P.V. ratio = 100 – Variable Cost Ratio = 100 – 60 = 40
iii. Contribution = Sales P.V. Ratio = 5 40 = 2
100
C.D.E. 16.18
15.18 Acharya Nagarjuna University
Note: For (b)
Under recovery of fixed expenses = Expected loss = Rs.20,000
Illu.16: The following figures are extracted from the records of a company.
Departments
A B C D Total
Rs. Rs. Rs. Rs. Rs.
Sales 200 400 600 800 2,000
Costs:
Direct Material 80 200 360 580 1,220
Direct Labour 40 150 180 140 510
Direct Expenses 4 6 8 10 28
Prime Cost 124 356 548 730 1,758
Overheads:
Variable 20 30 24 20 94
Fixed 10 20 10 8 48
30 50 34 28 142
Total cost 154 406 582 758 1,900
Profit/Loss 46 (-) 6 18 42 100
On the basis of the above information, the management is inclined to discontinue
department B. What will be your advice to management?
Solution:
Comparative Statement of Profitability
With Dept. B Without Dept. B
Total Rs. Total Rs.
Sales 2,000 1,600
Less: Variable cost 1,852 1,466
Contribution 148 134
Less: Fixed expenses 48 48
Profit 100 86
Advise: It Department B is discontinued we have a total profit of Rs.86. If it is continued the
total profit is Rs.100. Hence it is better to continue will be Department B.
Note: It is assumed that the total fixed costs remains the same.
Illu.17: Hindustan Limited is engaged in manufacturing and selling industrial boxes.
It is proposed to reduce the prices due to heavy competition. By decreasing the selling
Cost andManagement
Advanced Management Accounting
Accounting 16.19
15.19 Marginal Costing - Managerial Decisions
price by 10% and 15%, how many units are to be sold to maintain the current level of
profit?
Rs. Rs.
Current Sales (15,000 units) 1,50,000
Variable Cost (15,000 units) 90,000
Fixed Costs 35,000 1,25,000
Net Profit 25,000
Solution:
Calculation of Selling Price per unit, Variable Cost per unit
and Contribution Per unit
Total Per unit
Current Sales (15,000 units) 1,50,000 Rs.10
Variable Cost (15,000 units) 90,000 Rs.6
Contribution per unit 60,000 Rs.4
Calculation of required sales in units to earn a profit of Rs.25,000 when selling price is
reduced by 10% and 15%.
10% 15%
Decrease Decrease
New Selling Price per (10 9
) (10 15
)
100 Rs.9 100 8.50
unit
Variable Cost Per unit 6 6
Contribution per unit 3 2.50
Required sales to earn
profit of Rs.25,000
(F Desired Profit
( 35,000 25,000 ) 20,000 ( 25,000 30,000 ) 24,000
Contributi on per unit 3 2.50
Units Units
Illu.18: Assume you are the Management Consultant of XYZ Co. Ltd. The Managing
Director of the company seeks your advice on the following problem:
The XYZ Ltd., produces a variety of products each having a number of component
parts. Product “B” takes 5 hours to produce on machine No.99 working at full capacity.
“B” has a selling price of Rs.50 and a marginal costs of Rs.30 per unit. “A-10” a
component part could be made on the same machine in 2 hrs. for marginal cost of Rs.5
per unit. The supplier’s price is Rs.12.50 per unit. Should the company make or buy “A-
10”?
C.D.E. 16.20
15.20 Acharya Nagarjuna University
Assume that machine hour is the limiting factor.
Solution:
In this problem the cost of new product plus contribution lost during the time for
manufacturing “A-10” should be compared with the supplier’s price to arrive at a decision.
Rs.
B- Selling Price 50.00
Less: Marginal Cost 30.00
Contribution 20.00
It takes 5 hours to produce one unit of “B”
20
Contribution earned per hour on Machine No.99 is Rs. = Rs.4
5
“A-10” takes two hours to be manufactured on machine which is producing “B”.
If “A-10” is produced, contribution lost will be = 2 hours Rs.4 = Rs.8
Real cost of “A-10” to the company = Marginal cost of “A-10” plus contribution lost for
using the machine for “A-10”.
Rs.5 + Rs.8 = Rs.13
This is more than the seller’s price of Rs.12.50 and so it is advisable for the company to
buy the product from outside.
15.3 SELF ASSESSMENT QUESTIONS
16.3
1. Explain the specific decision-making areas where the principles of marginal costing could
be applied.
2. What is the signification of Contribution of marginal costing? State its uses in managerial
decision making.
3. What is Marginal Costing? How is it useful to the manufacturing organization?
4. Bring out the significance of imputed costs and out pocket costs for managerial decision
making.
15.4
16.4 EXERCISES
1. A company is considering expansion. Fixed costs amount to Rs.4,20,000 and are
expected to increase by Rs.1,25,000 when plant expansion is completed. The present
plant capacity is 80,000 units a year. Capacity will increase by 50 per cent with the
expansion. Variable costs are currently Rs.6.80 per unit and are expected to go down
by Rs.0.40 per unit with the expansion. The current selling price is Rs.16 per unit and
is expected to remain same under either alternative. What are the break-even points
under either alternative? Which alternative is better and why?
Advanced
Cost andManagement
ManagementAccounting
Accounting 15.2116.21 Marginal Costing - Managerial Decisions
[Ans.: It is better to go for expansion because the profit will double]
2. Arjun Electronic decided to effect a 10% reduction in the price of its product because it
is felt that such a step may lead to a greater volume of sales. It is anticipated that
there are no prospects of a change in total fixed costs and variable cost per unit. The
director wish to maintain net profits at the present level.
The following information has been obtained from its books.
Sales : 10,000 units Rs.2,00,000
Variable Costs: Rs.15 per unit
Fixed Costs Rs.40,000
How would management proceed to implement this decision?
[Ans.: Sales Rs.3,00,000]
3. Vimala Company produced and sold 10,000 units under the following Cost structure
during the year 2006:
(a) Prime Cost Rs.80 per unit.
(b) Variable Overheads Rs.10 per unit.
(c) Fixed expenses Rs.1,50,000.
(d) Advertising Rs.25,000.
(e) Selling Price Rs.150 per unit.
For the year 2007 the following changes are proposed to be made:
(i) Advertising to be discontinued.
(ii) Reduction in direct labour cost by Rs.3 per unit.
(iii) Reduction in variable administration expenses by Rs.3 per unit.
(iv) New selling price: Rs.120 per unit.
(v) Increase in production and sales by 100%.
You are required to find out (1) The P/V ratio (2) The Break-even point and (3)
The amount of profit for the year 2007, taking into account the proposed changes.
[Ans.: (1) 30% (2) Rs.5,00,000 (3) Rs.5,70,000]
4. The cost of manufacturing of 8,000 units of ‘X’ product is given below:
Direct materials Rs.8,000; labour Rs.64,000; Variable overheads Rs.32,000; Fixed
overheads Rs.40,000; Fixed overhead is included Rs.24,000, that continues
regardless of the decision. The same product is available in the market for Rs.16 per
unit. Should the company make or buy the product?
[Ans.: Manufacturing is more profitable than purchase because due to
manufacture the profit is more by Rs.32,000]
C.D.E. 16.22
15.22 Acharya Nagarjuna University
5. . The management of Pioneer Products Corporation Limited requests assistance from
you in arriving at a decision whether to continue manufacturing a certain part of an
assembly or to buy it from an outside supplier who had been quoting a price of Rs.8
per unit.
The Corporation’s annual requirements is 5,000 units and the costs accumulated
for their special manufacture are:
Rs.
Direct Materials 17,500
Direct labour 28,000
Indirect Labour 6,000
Power (Electricity) 300
Others 640
If the parts are purchased from outside, the present machinery used to
make the parts could be sold and its value would be realised. This step would
reduce the total machinery depreciation by Rs.2,000 and property taxes and
insurance by Rs.1,000.
If the parts are purchased from the outside supplier, the following
additional costs would be incurred:
Freight Rs.0.50 per unit and material received charges @ Rs.1 per unit.
From the above information you are required to prepare a statement
comparing the costs of manufacturing the parts, with the costs of purchasing
them from the outside supplier and guide management for a make or buy
decision.
[Ans.: It is better to purchase 5,000 units instead of manufacturing it due to
the saving of Rs.7,440]
6. A company produces variety of products and components. Following components with
relevant manufacturing costs are under consideration for purchase outside:
Component Direct Material Direct Labour Variable Fixed Bought out
Rs. Rs. overheads Costs price
Rs. Rs. Rs.
XY 600 200 100 300 800
PR 200 800 200 1,000 2,300
MN 100 300 200 500 1,200
Select the components which should be bought from outside, indicating the reasons for
choice.
Cost andManagement
Advanced Management Accounting
Accounting 15.2316.23 Marginal Costing - Managerial Decisions
[Ans.: (a) It is better to purchase XY Product (b) It is better to manufacture PR
product (c) It is better to manufacture MN Product.]
7. A manufacturer has planned his level of operation at 50% of his plant capacity of 30,000
units. His expenses are estimated as follows, if 50% of the plant capacity is utilised.
Rs.
(i) Director materials 8,280
(ii) Direct wages 11,160
(iii) Variable and other manufacturing expenses 3,960
(iv) Total fixed expenses irrespective of capacity 6,000
utilisation
The expected selling price in the domestic market is Rs.2 per unit. Recently the
manufacturer has received a trade enquiry from an overseas organisation interested in
purchasing 6,000 units at a price of Rs.1.45 per unit.
As a professional management accountant, what would be your suggestion
regarding acceptance or rejection of the offer? Support your suggestion with suitable
quantitative information.
[Ans.: 15,000 units: Profit Rs.600; 6,000 units : Loss Rs.660; Total 21,000 units
: Loss Rs.60; It is not profitable to accept the foreign offer.]
8. A company currently operating at 80% capacity has the following particulars.
Rs.
Sales 32,00,000
Direct materials 10,00,000
Direct labour 4,00,000
Variable overheads 2,00,000
Fixed overheads 13,00,000
An export order has received that would utilise half the capacity of the factory.
The order cannot be split, i.e., it has either to be taken in full and executed at 10% below
the normal domestic prices are rejected totally.
The alternative available to the management are:
1. Reject the order and continue with the domestic sales only; (at as present); or
2. Accept the order, split capacity between overseas and domestic sales and turn
away excess domestic demand; or
3. Increase capacity to accept the export order and maintain the present domestic
sales by:
C.D.E. 16.24
15.24 Acharya Nagarjuna University
(a) buying an equipment that will increase capacity by 10%. This will result in an
crease of Rs.1,00,000 in fixed costs; and
(b) Work overtime to met balance of required capacity. In that case, labour will be
paid at one and half times the normal wage rate.
Prepare a comparative statement of profitability and suggest the best alternative.
[Ans.: Profit I Rs.3,00,000; II Rs.5,00,000; III Rs.9,50,000. Alternative III is the
best because it results in the highest amount of profit.]
9. Prestige company private limited, manufacturing pressure cookers has drawn up the
following budget for the year 2006-07.
Rs.
Raw materials 20,00,000
Labour, stores, power and other variable 6,00,000
costs
Manufacturing overheads 7,00,000
Variable distribution costs 4,00,000
General overheads including selling 3,00,000
Total 40,00,000
Income from sales 50,00,000
Budgeted profits 10,00,000
The General Manager suggests to reduce selling price by 5% and expects to
achieve an additional volume of 50%. There is sufficient manufacturing capacity. More
intensive manufacturing programme will involve additional costs of Rs.50,000 for
production planning. It will also be necessary to open an additional sales office at the cost
of Rs.1,00,000 per annum.
The Sales Manager, on the other hand, suggests to increase selling price by
10%, which it is estimated will reduce sales volume by 10%. At the same time saving in
manufacturing overheads and general overheads at Rs.50,000 and Rs.1,00,000 per
annum respectively is expected on this reduced volume.
Which of these two proposals would you accept and why?
[Ans.: Proposal I : Profit Rs.14,75,000; Proposal II Rs.14,00,000; Proposal I is
acceptable as it gives higher profit.]
10. The following production/sales mix are capable of achievement in a factory.
i. 2,000 units of Product A and 2,000 units of product C.
ii. 4,000 units of product B.
iii. 1,000 units of product A, 2,000 units of product B and 1,600 units of product C.
Advanced
Cost andManagement
ManagementAccounting
Accounting 16.25
15.25 Marginal Costing - Managerial Decisions
Cost per unit is as follows.
A B C
Rs. Rs. Rs.
Direct material 20 16 40
Direct wages 8 10 20
Fixed cost is Rs.20,000 and variable overheads per unit of A, B and C are Rs.2,
Rs.4 and Rs.4 and Rs.8 respectively. Selling prices of A, B and C are Rs.36, Rs.40 and
Rs.100 per unit respectively. Determine the marginal contribution per unit of A, B and C
and the profits resulting from product mixed (i), (ii) and (iii).
[Ans.: Marginal Contribution per unit; A Rs.6; B Rs.10; C Rs.32; Sales mix (iii)
is profitable as it is yields the highest amount of contribution and profit.]
15.5 REFERENCE BOOKS :
16.5
1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting –
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
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