COST ACCOUNTING

FIRST EDITION

PREPARED BY: DAVID SAMUEL THOLLEY

MODULE 1

Pg1 Introduction

Cost Accounting is a branch of accounting and has been developed due to limitations of
financial accounting. 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 financial accounting reports help
the management to control in a general way the various functions of the business but it
fails to give detailed reports on the efficiency of various divisions. The limitations of
Financial Accounting which led to the development of cost accounting are as follows.

Limitations of Financial Accounting

1. No clear idea of operating efficiency: Sometimes profits in an organization may be

less or more because of inflation or trade depression and not due to efficiency or
inefficiency. But financial accounting does not give a clear reason for profit or loss.

2. Weakness not spotted out by collective results: Financial Accounting shows the net
result of an organization. When the profit and loss account of an organization, shows
less profit or a loss, it does not give the reason for it or it does not show where the
weakness lies.

3. Does not help in fixing the price: In Financial Accounting, we get the total cost of
production but it does not aid in determining prices of the products, services,
production order and lines of products.

4. No classification of expenses and accounts: In Financial Accounting, we don’t get

data relating to costs incurred by departments, processes separately or per unit cost of
product lines, or cost incurred in various sales territories. Further expenses are not
classified as direct or indirect, controllable and uncontrollable overheads and the value
added in each process is not reported.
Pg2 5. No data for comparison and decision making:

It does not supply useful data to management for comparison with previous period and
for taking various financial decisions as introduction of new products, replacement of
labour by machines, price in normal or special circumstances, producing a part in the
factory or buying it from outside market, production of a product to be continued or
given up, priority accorded to different products, investment to be made in new
products or not etc.

6. No control on cost: Financial Accounting does not help to control materials, supplies,
and wages, labor and overhead costs.

7. Does not provide standards to assess the performance: Financial Accounting does
not help in developing standards to assess the performance of various persons or
departments. It also does not help in checking that costs do not exceed a reasonable
limit for a given quantum of work of the requisite quality

. 8. Provides only historical information: Financial Accounting records only the historical
costs incurred. It does not provide day-to-day cost information to the management for
making effective plans for the future

9. No analysis of losses: It does not provide complete analysis of losses due to defective
material, idle time, idle plant and equipment etc.. In other words, no distinction is made
between avoidable and unavoidable wastage.

10. Inadequate information for reports: It does not provide adequate information for
reports to outside agencies such as banks, government, insurance companies and trade
associations. 11. No answer for certain questions: Financial Accounting will not help to
answer questions like:-

(a) Should an attempt be made to sell more products or is the factory operating to
capacity?(b) if an order or contract is accepted, is the price obtainable sufficient to show
a profit? (c) if the manufacture or sale of product A were discontinued and efforts make
to increase the sale of B, what would be the effect on the net profit?

(d) Why the profit of last year is of such a small amount despite the fact that output was
increased substantially? Etc
 Pg3 Costing and Cost Accounting:

The costing terminology of C.I.M.A., London defines costing as the “the techniques and
processes of ascertaining costs”. These techniques consist of principles and rules which
govern the procedure of ascertaining cost of products or services. The techniques to be
followed for the analysis of expenses and the processes by which such an analysis
should be related to different products or services differ from industry to industry.
These techniques are also dynamic and they change with time. The main object of
traditional cost accounts is the analysis of financial records, so as to subdivide
expenditure and to allocate it carefully to selected cost centers, and hence to build up a
total cost for the departments, processes or jobs or contracts of the undertaking. The
extent to which the analysis of expenditure should be carried will depend upon the
nature of business and degree of accuracy desired. The other important objective of
costing are cost control and cost reduction.

Cost Accounting may be regarded as “a specialized branch of accounting which involves

classification, accumulation, assignment and control of costs.” The costing terminology
of C.I.M.A, London defines cost accounting as “the process of accounting for costs from
the point at which expenditure is incurred or committed to the establishment of its
ultimate relationship with cost centers and cost units. In its widest usage, it embraces
the preparation of statistical data, the application of cost control methods and the
ascertainment of profitability of activities carried out or planned”

. Weldon defines cost accounting as “classifying, recording and appropriate allocation of

expenditure for determination of costs of products or services and for the presentation
of suitably arranged data purposes of control and guidance of management”. It is thus a
formal mechanism by means of which costs of products or services are ascertained and
controlled.

General Principles of Cost Accounting :The following may be considered as the General
Principles of Cost Accounting:

1. A cost should be related to its causes: Cost should be related as closely as possible
to their causes so that cost will be shared only among the cost units that pass
thorough the department of which the expenses are related.

2. A cost should be charged only after it has been incurred: While determining the cost
of individual units those costs which have actually been incurred should be considered.
Pg4. For example, a cost unit should not be charged to the selling costs, while it is still
in the factory. Selling costs can be charged with the products which are sold.

3. The convention of prudence should be ignored: Usually accountants believe in

historical costs and while determining cost, they always attach importance to historical
cost. In Cost Accounting this convention must be ignored, otherwise, the management
appraisal of the profitability of the projects may be vitiated. According to W.M. Harper,
“a cost statement should, as far as possible, give facts with no known bias. If a
contingency needs to be taken into consideration it should be shown separately and
distinctly”.

4. Abnormal costs should be excluded from cost accounts: Costs which are of abnormal
nature (eg. Accident, negligence etc.) should be ignored while computing the cost,
otherwise, it will distort costs figures and mislead management as to working results of
their undertaking under normal conditions.

5. Past costs not to be charged to future period: Costs which could not be recovered or
charged in full during the concerned period should not be taken to a future period, for
recovery. If past costs are included in the future period, they are likely to influence the
future period and future results are likely to be distorted.

6. Principles of double entry should be applied wherever necessary: Costing requires a

greater use of cost sheets and cost statements for the purpose of cost ascertainment
and cost control, but cost ledger and cost control accounts should be kept on double
entry principle as far as possible.

Objectives of Cost Accounting

Cost accounting aims at systematic recording of expenses and analysis of the same so as
to ascertain the cost of each product manufactured or service rendered by an
organization. Information regarding cost of each product or service would enable the
management to know where to economize on costs, how to fix prices, how to maximize
profits and so on. Thus, the main objectives of cost accounting are the following.

1. To analyse and classify all expenditure with reference to the cost of products and
operations.
2. To arrive at the cost of production of every unit, job, operation, process, department
or service and to develop cost standard.
Pg5.3. To indicate to the management any inefficiencies and the extent of various forms
of waste, whether of materials, time, expenses or in the use of machinery, equipment
and tools. Analysis of the causes of unsatisfactory results may indicate remedial
measures.

4. To provide data for periodical profit and loss accounts and balance sheets at such
intervals, e.g. weekly, monthly or quarterly as may be desired by the management
during the financial year, not only for the whole business but also by departments or
individual products. Also, to explain in detail the exact reasons for profit or loss revealed
in total in the profit and loss accounts.

5. To reveal sources of economies in production having regard to methods, types of

equipment, design, output and layout. Daily, Weekly, Monthly or Quarterly information
may be necessary to ensure prompt constructive action.

6. To provide actual figures of costs for comparison with estimates and to serve as a
guide for future estimates or quotations and to assist the management in their price
fixing policy.

7. To show, where Standard Costs are prepared, what the cost of production ought to
be and with which the actual costs which are eventually recorded may be compared.

8. To present comparative cost data for different periods and various volume of output
and to provide guidance in the development of business. This is also helpful in
budgetary control.

9. To record the relative production results of each unit of plant and machinery in use as
a basis for examining its efficiency. A comparison with the performance of other types
of machines may suggest the necessity for replacement.

10. To provide a perpetual inventory of stores and other materials so that interim Profit
and Loss Account and Balance Sheet can be prepared without stock taking and checks
on stores and adjustments are made at frequent intervals. Also to provide the basis for
production planning and for avoiding unnecessary wastages or losses of materials and
stores.

Last but not the least, to provide information to enable management to make short
term decisions of various types, such as quotation of price to special customers or
during a slump, make or buy decision, assigning priorities to various products.
 Pg6 Cost Accounting and Financial Accounting-
Both financial accounting and cost accounting are concerned with systematic recording
and presentation of financial data. Financial accounting reveals profits and losses of the
business as a whole during a particular period, while cost accounting shows, by analysis
and localization, the unit costs and profits and losses of different product lines. The
main difference between financial accounting and cost accounting are summarized
below.

1. Financial accounting aims at safeguarding the interests of the business and its
proprietors and others connected with it. This is done by providing suitable information
to various parties, such as shareholders or partners, present or prospective creditors
etc. Cost accounting on the other hand, renders information for the guidance of the
management for proper planning, operation, control and decision making.

2. Financial accounts are kept in such a way as to meet the requirements of the
Companies Act, Income Tax Act and other statues. On the other hand cost accounts are
generally kept voluntarily to meet the requirements of the management. But now the
Companies Act has made it obligatory to keep cost records in some manufacturing
industries

3. Financial accounting emphasizes the measurement of profitability, while cost

accounting aims at ascertainment of costs and accumulates data for this very purpose.

4. Financial accounts disclose the net profit and loss of the business as a whole, whereas
cost accounts disclose profit or loss of each product, job or service. This enables the
management to eliminate less profitable product lines and maximize the profits by
concentrating on more profitable ones.

5. Financial accounting provides operating results and financial position usually gives
information through cost reports to the management as and when desired.

6. Financial accounts deal mainly with actual facts and figures, but cost accounts deal
partly with facts and figures, but cost accounts deal with facts and figures and partly
with estimates.

7. In case of financial accounts stress is on the ascertainment and exhibition of profits

earned or losses incurred in the business. On account of this reason in financial
pg7accounts, thetransactions are recorded, classified and analyzed in a subjective
manner i.e. according to the nature of expenditure. In cost accounts the

emphasis is more on aspects of planning and control and therefore transactions are
recorded in an objective manner.

8. Financial accounts are concerned with external transactions i.e. transactions

between the business concern on one side and third parties on the other. These
transactions form the basis for payment or receipt of cash. While cost accounts are
concerned with internal transactions which do not form the basis of payment or receipt
of cash.

9. The costs are reported in aggregate in financial accounts but costs are broken into
unit basis in cost accounts.

10. Financial accounts do not provide information on the relative efficiencies of various
workers, plants and machinery while cost accounts provide valuable information on the
relative efficiencies of various plants and machinery.

11. In financial accounts stocks are valued at cost or market price whichever is less,
whereas stocks are valued at cost price in cost accounts.

Importance of Cost Accounting

The limitations of financial accounting have made the management to realize the
importance of cost accounting. Whatever may be the type of business, it involves
expenditure on labour, materials and other items required for manufacturing and
disposing of the product. The management has to avoid the possibility of waste at each
stage. It has to ensure that no machine remains idle, efficient labour gets due incentive,
by-products are properly utilized and costs are properly ascertained. Besides the
management, the creditors and employees are also benefited in numerous ways by
installation of a good costing system. Cost accounting increases the overall productivity
of an organization and serves as an important tool, in bringing prosperity to the nation,
thus, the importance of cost accounting can be discussed under the following headings:

a) Costing as an aid to management: Cost accounting provides invaluable aid to

management. It provides detailed costing information to the management to
enable them to maintain effective control over stores and inventory, to increase
 pg8 efficiency of the organization and to check wastage and losses. It facilitates
delegation of responsibility for important tasks and rating of employees.
For all these the management should be capable of using the information
provided by cost accounts in a proper way. The various advantages derived by the
management from a good system of costing are as follows:

1. Cost accounting helps in periods of trade depression and trade competition. In

periods of trade depression, the organization cannot afford to have wastages which
pass unchecked. The management must know areas where economies may be sought,
waste eliminated and efficiency increased. The organization must wage a war not only
for its survival but also continued growth. The management should know the actual
cost of their products before embarking on any scheme of price reduction. Adequate
system of costing facilitates this.

2. Cost accounting aids price fixation. Although the law of supply and demand
determines the price of the product, cost to the producer does play an important role.
The producer can take necessary guidance from his costing records in case he is in a
position to fix or change the price charged.

3. Cost accounting helps in making estimates. Adequate costing records provide a

reliable basis for making estimates and quoting tenders.

4. Cost accounting helps in channelizing production on right lines. Proper costing

information makes it possible for the management to distinguish between profitable
and non-profitable activities; profits can be maximized by concentrating on profitable
operations and eliminating non-profitable ones.

5. Cost accounting eliminates wastages. As cost accounting is concerned with detailed

breakup of costs, it is possible to check various forms of wastages or losses.

6. Cost accounting makes comparisons possible. Proper maintenance of costing

records provides various costing data for comparisons which in turn helps the
management in formulating future lines of action.

7. Cost accounting provides data for periodical Profit and Loss Account. Adequate
costing records provide the management with such data as may be necessary for
preparation of Profit and Loss Account and Balance Sheet at such intervals as may be
desired by the management.
8. Cost accounting helps in determining and enhancing efficiency. Losses due to
wastage of materials, idle time of workers, poor supervision etc will be disclosed if the
various operations involved in the production are studied carefully. Efficiency can be
measured, cost controlled and various steps can be taken to increase the efficiency.

9. Cost accounting helps in inventory control. Cost accounting furnishes control which
management requires, in respect of stock of materials, work in progress and finished
goods.

b) Costing as an aid to Creditors: Investors, banks and other money lending

institutions have a stake in the success of the business concern are therefore benefitted
immensely by the installation of an efficient system of costing. They can base their
judgment about the profitability and future prospects of the enterprise on the costing
records.

c) Costing as an aid to employees: Employees have a vital interest in their

employer’s enterprise in which they are employed. They are benefited by a number of
ways by the installation of an efficient system of costing. They are benefited, through
continuous employment and higher remuneration by way of incentives, bonus plans,
etc.

d) Costing as an aid to National Economy: An efficient system of costing

brings prosperity to the business enterprise which in turn brings prosperity to the
business enterprise which in turn results in stepping up of the government revenue.
The overall economic development o f a country takes place as a consequence of
increase in efficiency of production. Control of costs, elimination of wastages and
inefficiencies led to the progress of the industry and, in consequence of the nation as a
whole

Cost units- The Chartered Institute of Management Accountants, London, defines a

unit of cost as “a unit of quantity of product, service or time in relation to which costs
may be ascertained or expressed”. The forms of measurement used as cost units are
usually the units of physical measurements like number, weight, area, length, value,
time etc. Following are some examples of cost unit.
 Industry/product Cost unit basis

Automobile Numbers

Brick works per 1000 bricks

Cement per Tonne

Chemicals Littre, gallon,

, kilogram tonne

Steel Tonne

Sugar Tonne

Transport Passenger-kilometer, tonne kilometer

Cost centre – According to Chartered Institute of Management Accountants, London,

cost centre means “a location, person or item of equipment (or group of these) for
which costs may be ascertained and used for the purpose of cost control”. Cost centre
is the smallest organizational sub- unit for which separate cost collection is attempted.
Thus cost centre refers to one of the convenient unit into which the whole factory
organization has been appropriately divided for costing purposes. Each such unit
consists of a department or a sub-department or item of equipment or , machinery or a
person or a group of persons.

For example, although an assembly department may be supervised by one foreman, it

may contain several assembly lines. Some times each assembly line is regarded as a
separate cost centre with its own assistant foreman.

The selection of suitable cost centres or cost units for which costs are to be ascertained
in an undertaking depends upon a number of factors which are listed as follows.
1. Organization of the factory

2. Conditions of incidence of cost

3. Requirements of the costing system ie. Suitability of the units or centres for cost
purposes.

4. Availability of information

5. Management policy regarding making a particular choice from several alternatives.

Profit centre – A profit centre is that 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. Difference between Profit centre and Cost centre The
various points of

Difference between Profit centre and cost centre are as follows.

Cost centre is the smallest unit of activity or area of responsibility for which costs are
collected whereas a profit centre is that segment of activity of a business which is
responsible for both revenue and expenses.

(i) Cost centres are created for accounting conveniences of costs and their control
whereas as a profit centre is created because of decentralization of operations
i.e., to delegate responsibility to individuals who have greater knowledge of local
conditions etc. (ii) Cost centers are not autonomous whereas profit centres are
autonomous. (iii) A cost centre does not have target cost but efforts are made to
minimize costs, but each profit centre has a profit target and enjoys authority to
adopt such policies as are necessary to achieve its targets. (iv) There may be a
number of cost centres in a profit centre in a profit centre as production or
service cost centres or personal or impersonal but a profit centre may be a
subsidiary company within

Cost classification

Costs can be classified or grouped according to their common characteristics. Proper

classification of costs is very important for identifying the costs with the cost centers or
cost units. The same costs 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. According to this classification the costs are classified into
three categories i.e., Materials, Labour and Expenses. Materials can further be sub-
classified as raw materials components, spare parts, consumable stores, packing
materials etc. This helps in finding the total cost of production and the percentage of
materials (labour or other expenses) constituted in the total cost. It also helps in
valuation of work-in-progress.

2. By Functions: This classification is on the basis of costs incurred in various functions

of an organization ie. Production, administration, selling and distribution. According to
this classification, costs are divided into Manufacturing and Production Costs and
Commercial costs.

Manufacturing and Production Costs are costs involved in manufacture, construction

and fabrication of products. Commercial Costs are (a) administration costs (b) selling
and distribution costs.

3. By Degree of Traceability to the Product: According to this, costs are divided indirect
costs and indirect costs. Direct Costs are those costs which are incurred for a particular
product and can be identified with a particular cost centre or cost unit. Eg:- Materials,
Labour. Indirect Costs are those costs which are incurred for the benefit of a number of
cost centre or cost units and cannot be conveniently identified with a particular cost
centre or cost unit. Eg:- Rent of Building, electricity charges, salary of staff etc.

4. By Changes in Activity or Volume: According to this costs are classified according to

their behavior in relation to changes in the level of activity or volume of production.
They are fixed, variable and semi-variable. Fixed Costs are those costs which remain
fixed in total amount with increase or decrease in the volume of the output or
productive activity for a given period of time. Fixed Costs per unit decreases as
production increases and vice versa. Eg:- rent, insurance of factory building, factory
manager’s salary etc. Variable Costs are those costs which vary in direct proportion to
the volume of output. These costs fluctuate in total but remain constant per unit as
production activity changes. Eg:- direct material costs, direct labour costs, power,
repairs etc. Semi-variable Costs are those which are partly fixed and partly variable. For
example; Depreciation, for two shifts working the total depreciation may be only 50%
more than that for single shift working. They may change with comparatively small
changes in output but not in the same proportion.

5. Association with the Product: Cost can be classified as product costs and period
costs. Product costs are those which are traceable to the product and included in
inventory cost, thus product cost is full factory cost. Period costs are incurred on the
basis of time such as rent, salaries etc. thus it includes all selling and administration
costs. These costs are incurred for a period and are treated as expenses.

6. By Controllability: The CIMA defines controllable cost as “a cost which can be

influenced by the action of a specified member of an undertaking” and a non-
controllable cost as “a cost which cannot be influenced by the action of a specified
member of an undertaking”

. 7. By Normality: There are normal costs and abnormal costs. Normal costs are the
costs which are normally incurred at a given level of output under normal conditions.
Abnormal costs are costs incurred under abnormal conditions which are not normally
incurred in the normal course of production.Eg:- damaged goods due to machine break
down, extra expenses due to disruption of electricity, inefficiency of workers etc.

8. By Relationship with Accounting Period: There are capital and revenue expenses
depending on the length of the period for which it is incurred. The cost which is
incurred in purchasing an asset either to earn income or increasing the earning capacity
of the business is called capital cost, for example, the cost of a machine in a factory.
Such cost is incurred at one point of time but the benefits accruing from it are spread
over a number of accounting years. The cost which is incurred for maintaining an asset
or running a business is revenue expenditure. Eg:- cost of materials, salary and wages
paid, depreciation, repairs and maintenance, selling and distribution.

9. By Time..Costs can be classified as 1) Historical cost and 2) Predetermined Costs. The

costs which are ascertained and recorded after it has been incurred is called historical
costs. They are based on recorded facts hence they can be verified and are always
supported by evidences. Predetermined costs are also known as estimated costs as
they are computed in advance of production taking into consideration the previous
periods’ costs and the factors affecting such costs. Predetermined costs when
calculated scientifically become standard costs. Standard costs are used to prepare
budgets and then the actual cost incurred is later-on compared with such
predetermined cost and the variance is studied for future correction.

Types, Methods and Techniques of Costing

The general fundamental principles of ascertaining costs are the same in every system
of cost accounting, but the methods of analysis and presenting the costs vary from
industry to industry. Different methods are used because business enterprises vary in
their nature and in the type of products or services they produce or render. Basically,
there are two principal methods of costing, namely (i) Job Costing, and (ii) Process
costing.

1. Job costing: It refers to a system of costing in which costs are ascertained in terms
of specific jobs or orders which are not comparable with each other. Industries where
this method of costing is generally applied are Printing Process, Automobile Garages,
Repair Shops, Ship- building, House building, Engine and Machine construction, etc. Job
Costing includes the following methods of costing:

(a) Contract Costing: Although contract costing does not differ in principle from job
costing, it is convenient to treat contract cost accounts separately. The term is usually
applied to the costing method adopted where large scale contracts at different sites are
carried out, as in the case of building construction.

(b) Bach Costing: This method is also a type of job costing. A batch of similar products
is regarded as one job and the cost of this complete batch is ascertained. It is then used
to determine the unit cost of the articles produced. It should, however, be noted that
the articles produced should not lose their identity in manufacturing operations.

(c) Terminal Costing: This method is also a type of job costing. This method emphasizes
the essential nature of job costing, ie, the cost can be properly terminated at some
point and related to a particular job.

(d) Operation Costing: This method is adopted when it is desired to ascertain the cost
of carrying out an operation in a department, for example, welding. For large
undertaking, it is frequently necessary to ascertain the cost of various operations

. 2. Process Costing: Where a product passes through distinct stages or processes,

the output of one process being the input of the subsequent process, it is frequently
desired to ascertain the cost of each stage or process of production. This is known as
process costing. This method is used where it is difficult to trace the item of prime cost
to a particular order because its identity is lost in volume of continuous production.
Process costing is generally adopted in textile industries, chemical industries, oil
refineries, soap manufacturing, paper manufacturing, tanneries, etc.

3. Unit or single or output or single output costing: This method is used where a
single article is produced or service is rendered by continuous manufacturing activity.
The cost of the whole production cycle is ascertained as a process or series of processes
and the cost per unit is arrived at by dividing the total cost by the number of units
produced. The unit of costing is chosen according to the nature of the product. Cost
statements or cost sheets are prepared under which various items of expenses are
classified and the total expenditure is divided by total quantity produced in order to
arrive at unit cost of production. This method is suitable in industries like brick-making,
collieries, flour mills, cement manufacturing, etc. this method is useful for the assembly
department in a factory producing a mechanical article eg. Bicycle. [School of Distance
Education] Cost Accounting

4. Operating Costing: This method is applicable where services are rendered rather
than goods produced. The procedure is same as in the case of single output costing. The
total expenses of the operation are divided by the units and cost per unit of services is
arrived at. This method is employed in Railways, Road Transport, Water supply
undertakings, Telephone services, Electricity companies, Hospital services, Municipal
services, etc.

5. Multiple or Complete Costing: Some products are so complex that no single

system of costing is applicable. It is used where there are a variety of components
separately produced and subsequently assembled in a complex production. Total cost is
ascertained by computing component costs which are collected by job or process
costing and then aggregating the costs through use of the single or output costing
system. This method is applicable to manufacturing concerns producing Motor Cars,
Aeroplanes, Machine tools, Type-writers, Radios, Cycles, Sewing Machines, etc.

6. Uniform Costing: It is not a distinct method of costing by itself. It is the name given
to a common system of costing followed by a number of firms in the same industry.
This helps in comparing performance of one firm with that of another.
 7. Departmental Costing: When costs are ascertained department by department,
the method is called “Departmental Costing”. Usually, for ascertaining the cost of
various goods or services produced by the department, the total costs will have to be
analysed, say, by the use of job costing or unit costing. In addition to the above
methods of costing, mention can be made of the following techniques of costing which
can be applied to any one of the above method of costing for special purposes of cost
control and policy making:

a) Standard or Predetermined Costs.

b) Marginal Costs

Elements of Cost- The management of an organization needs necessary data to

analyze and classify costs for proper control and for taking decisions for future course
of action. Hence the total cost is analyzed by elements of costs ie by the nature of
expenses. The elements of costs are three and they are materials, labour and other
expenses. These can be further analyzed as follow

Element of cost

Material labour other expenses

Direct –indirect direct- indirect direct- indirect

Overheads

Production of works administration distribution

Overheads overheads overheads

By grouping the above elements of cost, the following divisions of cost are obtained.

.1 Prime cost = Direct Materials + Direct Labour+ Direct Expenses

2. Works or Factory Cost = Prime Cost + Works or Factory Overheads

3. Cost of Production = Works Cost + Administration Overheads

4. Total Cost or Cost of Sales = Cost of Production + Selling and Distribution Overheads
The difference between the cost of sales and selling price represents profit or loss.

Overheads =indirect materials +indirect labour + indirect expenses

Illustration 1. Find the Prime Cost, Works Cost, Cost of production, total Cost and profit
from the following:- Direct Materials Le.20000; Direct Labour Le. 10000; Factory
Expenses Le. 7000; Administration Expenses Le. 5000; Selling Expenses le. 7000 and
Sales Le.60, 000.

Solution: Prime Cost = Direct Materials + Direct Labour = Le.20,000 + Le.10,000 = prime
cost.30,000.

Works Cost = Prime Cost + Factory Expenses = Le.30,000 + Le.7,000 = Le.37,000.

Cost of Production = Works Cost + Administration Expenses=Le.37000+ Le.5, 000 =

Le.42, 000.

Total Cost or Cost of sales= Cost of Production + Selling Expenses = Le.42, 000+ Le.7, 000
= Le.49, 000.

Profit = Sales - Total Cost = Le.60,000 - Le.49,000=Le.11, 000.

These terms can be explained as follows

1. Direct Materials are those materials which can be identified in the product and can
be conveniently measured and directly charged to the product. For example, bricks in
houses, wood in furniture etc. Hence all raw materials, materials purchased specifically
for a job or process like glue for book making, parts or components purchased or
produced like batteries for radios and tyres for cycles, and primary packing materials are
direct materials.

2. Indirect Materials are those materials which cannot be classified as direct materials.
Examples are consumables like cotton waste, lubricants, brooms, rags, cleaning
materials, materials for repairs and maintenance of fixed assets, high speed diesel used
in power generators etc.

3. Direct Labour is all labour expended in altering the construction, composition,

confirmation or condition of the product. Thus direct wages means the wages of labour
which can be conveniently identified or attributed wholly to a particular job, product or
process or expended in converting raw materials into finished goods. Thus payment
made to groups of labourers engaged in actual production, or carrying out of an
operation or process, or supervision, maintenance, tools setting, transportation of
materials, inspection, analysis etc is direct labour
. 4. Direct Expenses are expenses directly identified to a particular cost centre. Hence
expenses incurred for a particular product, job, department etc are direct expenses.
Example royalty, excise duty, hire charges of a specific plant and equipment, cost of any
experimental work carried out especially for a particular job, travelling expenses
incurred in connection with a particular contract or job etc.

5. 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 ot specific cost units. Overheads may be sub-divided into (i) Manufacturing
Overheads; (ii) Administration Overheads; (iii) Selling Overheads; (iv) Distribution
Overheads; (v) Research and Development Overheads

Cost sheet or Statement of Cost: When costing information is set out in the form of a
statement, it is called “Cost Sheet”. It is usually adopted when there is only one main
product and all costs almost are incurred for that product only. The information
incorporated in a cost sheet would depend upon the requirement of management for
the purpose of control.

Specimen of Cost Sheet or Statement of Cost

Direct materials Total cost Unit cost

Direct labour Xxx Xxx
xxx xxx
Prime cost xxx xxx
Add works overheads xxx xxx
Work cost xxx xxx
Add: administrative overheads xxx xxx
Cost of production xxx xxx
Add: selling and distributive overheads xxx xxx
Total cost or total sales xxx xxx

Direct Materials Le1, 00,000 Consumable stores Le2, 500

Direct Wages Le30,000 Manager’s Salary Le5,000

Wages of Foreman Le2,500 Directors’ fees Le1,250

Electric power Le500 Office Stationery Le500

Lighting: Factory Le 1,500 Telephone Charges Le 125

Office Le500 Postage and Telegrams Le250

Storekeeper’s wages Le1,000 Salesmen’s salary Le 1,250

Oil and water Le500 Travelling expenses Le 500

Rent: Factory Le 5,000 Advertising Le1,250

Office Le2,500 Warehouse charges Le 500

Repairs and Renewals: Sales Le1, 89,500

Factory plant Le 3,500 Carriage outward Le375

Transfer to Reserves Le 1,000 Dividend Le 2,000

Discount on shares written off Le500 Depreciation: Factory Plant Le 500

Office Premises 1,250

Solution

STATEMENT OF COST AND PROFIT

Le Le

Direct Materials 1,00,000

Direct Wages 30,000

Prime Cost 1,30,000

Add: Factory Overheads:

Wages of foreman 2,500

Electric power 500

Storekeeper’s Wages 1,000

Oil and Water 500

Factory rent 5,000

Repairs and renewals-Factory Plant 3,500

Factory lighting 1,500

Depreciation-Factory Plant 500

2,500

Consumable stores 17,500

Factory Cost 1, 47,500

Add: Administration Overheads:

Office rent 2,50

Repairs and Renewals-Office Premises 500

Office lighting 500

Depreciation: Office Premises 1,250

Manager’s Salary 5,000

Director’s fees 1,250

Office Stationery 500

Telephone charges 125

Postage and telegrams 250

11,875

Cost of Production
1, 59,375

Add: Selling and 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

Module II

Materials
Materials: - The materials are a major part of the total cost of producing a product and
are one of the most important assets in majority of the business enterprises. Hence the
total cost of a product can be controlled and reduced by efficiently using materials. The
materials are of two types, namely:

(i) Direct materials: The materials which can be easily identified and
attributable to the individual units being manufactured are known as
direct materials. These materials also form part of finished products. All
costs which are incurred to obtain direct materials are known as direct
material costs.
(ii) Indirect materials: Indirect materials, on the other hand, are those
materials which are of small value such as nuts, pins, screws, etc. and do
not physically form part of the finished product. Costs associated with
indirect materials are known as indirect material costs. Factory supplies,
office supplies and selling supplies are generally termed as stores.

Purchasing Control and Procedure: Purchasing is an art. Wrong purchases increase

the cost of materials, store equipments and the finished goods. Hence it is
imperative that purchases should be effectively, efficiently and economically
performed.

Dr. Walters defines scientific purchasing as the “Procurement by purchase of the

proper materials, machinery, equipment and supplies of stores used in the
manufacture of a product, adapted to marketing in the proper quantity and quality
at the proper time and the lowest price consistent with the quality desired”.

According to Alford and Beatty, “Purchasing is the procuring of materials, supplies,

machines tools and services required for the equipment, maintenance and operation
of a manufacturing plant”.

The major objectives of scientific purchasing it to purchase the right quantity at the
best price, materials purchased should suit the objective, production should not be
held up, unnecessarily capital should not be locked up in stores, best quality of
materials should be purchased and company’s competitive position and its
reputation for fairness and integrity should be safeguarded. Only scientific
purchasing will help in achieving the above objectives. With proper plans, materials
can be purchased at a lower price than competitors, turnover of investment in
inventories can be high, purchasing department can advise regarding substitute
materials, new products, change in trends, creating goodwill etc.

Methods of Purchasing

Purchasing can be broadly classified as centralized and localized purchasing.

(a) Centralized Purchasing: In a large organization, manufacturing units are many. In

such cases centralized purchasing is beneficial. The advantages of centralized
purchasing are:

1. Specialized and expert knowledge is available.

2. Advantages arise due to bulk purchases.

3. The cost of purchasing can be reduced and selling price can be lowered.

4. As there is good knowledge of market conditions, greater control can be

exercised.

5. When materials have to be imported, it is advantageous to centralize the buying.

6. Economy and ease in compilation and consultation of results.

7. It can take advantage of market changes

. 8. Investment in inventories can be reduced.

9. Other advantages include undivided responsibility, consistent buying policies.

Factors to be considered when decision regarding centralization has to be taken are
geographical separation of plants, homogeneity of products, type of material
bought, location of supplies etc.

(b) Decentralization of Purchases: The advantages of localized purchasing or

decentralization of purchases are:-

1. Each plant may have its own particular need. This can be given special attention

. 2. Direct contact can be established with suppliers.

3. The time lag between indenting and receiving materials can be reduced.

4. Technical requirements of each plant can be ascertained.

Purchase Procedure: The steps usually followed for purchase of materials may be
enumerated as follows:-

1. Indenting for materials: The stores department prepares indents for the purchase
of materials for replenishment of stocks (regular indents) or for a special job(special
indents) and sends it to the purchase department. Regular indents are prepared
periodically and placed when the ordering level for different items of stocks are
reached. The quantity indented is equal to the ordering quantity fixed for each item.
The special indents are based on the demands received either from the planning or
production department

XYZ Co. Ltd. MATERIAL PURCHASE INDENT Date: For the Period: Indent No: Demand
Note No: Regular/Special
Sl. No Description Stores Code Quantity Last Pur. Special
No. Order No remarks

For purchase Dept: use

 Store Keeper Tender
no.
Issued
2. Issue of tenders to suppliers: The purchase department issue tenders to suppliers or
publish them in papers. The suppliers quote their terms of price and
delivery/payment. After the last date for receipt of quotations is over, the tenders
are opened and a comparative statement is prepared. Tenders are prepared in
triplicate. Of them, two are sent to the suppliers and one is retained with the
purchase department. The supplier mentions his terms in the original.

While considering the tenders, the reliability of the supplier has to be taken into
account. The quality of goods and time taken to deliver the goods on previous occasions
should be checked. The financial stability and capacity to deliver goods should be
ensured.

Sometimes purchases may be made without inviting quotations. The circumstances are
when prices are controlled, or purchases are made under long term contracts, or
catalogue prices are available or when there is a cost plus contract. If purchase is made
under cost plus profit basis, the cost composition and reasonableness of price should be
checked

INVITATION TO TENDER Indent No:

Tender No:
Date: Date:
To XYZ Co.Ltd
. ……………. ……………. Dear Sirs, The stores mentioned below are required to be delivered
at our works godown. The terms and conditions of supply are mentioned overleaf. The
first copy of this tender should be returned to us duly filled in before…………………. A
security deposit of Rs…………should also accompany your reply which will be returned if
we do not place an order with you.

Yours
faithfully,
For ABC
Co.Ltd.
Particulars Quantity Place of Date of Quantity
Of stores/ required Delivery delivery which can Per Unit Price
Supplies required be
supplied
We agree to supply the above on terms mentioned below.
Special conditions: Place: For XYZ Co. Ltd.

3. Placing of purchase orders: Normally six copies of purchase order are made. The
supplier, stores, inspection department, store accounting section, purchase
department and progress department are sent one copy each. The purchase order
has legal and accounting significance. From legal point of view, it binds both the
parties to the terms of the contract. Form the accounting point of view; it signifies
the

amount which has to be spent. It signifies the stores department to accept the goods
and the accounts department to accept the bill.

A.B.C. CO. LTD.

MATERIALS PURCHASE ORDER
Order No: Indent No: Store
Receipt No:
Date: Quotation No:
Inspection Note No
To
………………………
……………………..
This is in response to your quotation against our Tender No:…………….. The terms and
conditions mentioned overleaf will be applicable. Please supply the following items at
the prices indicated below:
Sl. No Description Stores Specification Quantity Unit Price
Code

Terms of Delivery: Please send bill

to:
Terms of Payment:
Special Conditions: For A.B.C. Co.
Ltd.
4. Inspection: The supplier delivers goods at the place specified. Two delivery challans
are prepared by the supplier one of which is returned. It is a proof of delivery. After
receiving the goods, the inspection department or production department or
maintenance department (as the case may be) is intimated. The inspector checks that
the materials are in accordance with the quality required, standard expected,
tolerances allowed etc. After inspection an inspection note is prepared in triplicate, one
copy is sent to the supplier, one to the stores, and one to the inspection department.

5. Receiving Stores: The stores department prepares a Stores Receipt Note for the
quantity of stock accepted in inspection. After issuing of the Stores Receipt, the
Storekeeper is

responsible for the stocks. The stores receipt is the document for the posting of receipts
in Bin Card and the Stores Ledger. It is prepared in quadruplicate and sent to the
supplier; stores accounting section and purchase department and one copy are retained
with the stores. The supplier encloses this copy along with his bill. The stores accounting
section compares the note with the purchase order.

ABC CO. Ltd.

STORES RECEIPT NOTE
S.R. No: P.O.No: Inspection Note No:
Date: Date: Date
Received form M/s ___________________under their delivery challan no:_________ dated
_______the following items of stores against the above purchase order:
Stores Code Description Unit Quantity Price Value
No:

Bin Card ………………. Stores Ledger………………… Signature

of

Storekeeper……………….

6. Checking and passing of bills for payment: Bills received by the purchase department
are forwarded to the stores accounting section to check the authenticity regarding
quantity and price and the arithmetical accuracy. Special items included in the bills eg:-
freight, packing charges are verified with the purchase order. The bill is later passed for
payment. Storekeeping:

Store keeping: is a service function. The storekeeper is a custodian of all the items kept
in the store. The stores should be maintained properly and cost minimized. The main
objectives of store keeping are:-

i) To protect stores against losses

ii) To keep goods ready for delivery/issue
iii) To provide maximum service at minimum cost.

The duties and functions of Store-keeper can be summarized as follows:

i) Materials should be received, unloaded, inspected and then moved to stores.

The materials have to be stored in appropriate places and records the receipts in
proper books

. ii) The stores records should be maintained in an efficient and orderly manner so that
materials can be easily located and information can be obtained for various
departments.

iii) The stores should provide maximum protection and safety and accessibility and
utilize minimum space. Suitable storage devices should be installed.

iv) The materials should be given special covering to prevent damage due to
atmospheric conditions.

v) All issues should be properly recorded, efficiently, promptly and accurately. All issues
should be duly authorized and procedures laid down should be duly followed.

vi) The storekeeper is responsible for co-ordination with materials control according to
the type of production, size of the company, the organization structure etc.

vii) Ensure that all transactions are posted in the Bin Card see that the Bin Card is up-to-
date.

viii) All items should be in its proper place.

ix) Maintenance of stores at required levels.

x) Neatness in stores to facilitate physical verification.

 xi) Co-ordination and supervision of staff in the stores department

. xii) Periodical review of various scales, measuring instruments, conversion ratios etc.

xiii) Protect stores from fires, rust, erosion, dust, theft, weather, heat, cold, moisture
and deterioration etc.

Requisitioning for Stores

One of the duties of the storekeeper is to send requisitions for materials for
replenishment in time so that the production is not held up due to shortage of
materials. The storekeeper should also see that there is no unnecessary blocking of
capital due to overstocking of materials. For this he keeps a check on the re-order level,
economic ordering quantity, and the maximum and minimum quantity which he is
authorized to store in respect of each kind of material

(a) Re-ordering Level:

Re-ordering level is that point of level of stock of a material where the storekeeper
starts the process of initiating purchase requisition for fresh supplies of those materials.
This level is fixed somewhere between the maximum and minimum levels in such a way
that the difference of quantity of the material between the re-ordering level and
minimum level will be sufficient to meet the requirements of production until the fresh
supply of the materials is received.

Re-ordering Level= Minimum Level + Consumption during the time required to get the
fresh delivery

According to Weldon

, Re-ordering Level= Maximum Level x Minimum re-order period.

Here, maximum re-order period means the maximum period taken to get the material
once the order for new material is placed. Weldon has taken the maximum period and
maximum consumption during that period so that factory may not stop production due
to shortage of materials.

Illustration: 3. Calculate the ordering level of material A from the following particulars:
Minimum Limit 1,000 units. Maximum Limit 5,000 units. Daily requirement of material
200 units. Time required for fresh delivery 10 days
Ordering Level=Minimum limit + Consumption during the time required for fresh
delivery = 1000 units+ 200 units x 10 days = 3000 units Order for the purchase of
material should be placed when the material in stock reaches 3,000 units.

Illustration: 4. Calculate the re-ordering level from the following information

Maximum consumption = 500 units per day

Minimum consumption = 400 units per day

Re-order period = 10 to 12 days

Solution

Re-order Level = Maximum consumption x maximum re-order period

= 500 units x 12 days = 6000 units

b) Economic Ordering Quantity: 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 minimize the cost of ordering and carrying the stock. The total costs of a material
usually consist of: Total acquisition cost + total ordering cost + total carrying cost. Since
the acquisition cost per unit of material is same whatever is the quantity purchased, it is
usually excluded when deciding the quantity of a material to be ordered at one time.
The only costs to be taken care of are the ordering costs and carrying costs which vary
with the quantity ordered.

Carrying Cost: It is the cost of holding the materials in the store and includes:

1. Cost of storage space which could have been utilized for some other purpose.

2. Cost of bins and racks

3. Cost of maintaining the materials to avoid deterioration.

4. Amount of interest payable on the amount of money locked up in the materials.

5. Cost of spoilage in stores and handling.

6. Transportation cost in relation to stock.

7. Cost of obsolescence of materials due to change in the process or product.

8. Insurance cost

9. Clerical cost etc.

In India all these costs amount to 20 to 25 % of the cost of materials per year. Hence it
becomes necessary to reduce such carrying cost for efficient operations.

Ordering Cost: It is the cost of placing orders for the purchase of materials and includes:

1. Cost of staff posted in the purchasing department, inspection section and stores
accounts department.

2. Cost of stationary postage and telephone charges

Thus, this type of costs includes cost of floating tenders, cost of comparative evaluation
of quotations, cost of paper work, and postage involved in placing the order, cost of
inspection and cost of accounting and making payments. In other words, the cost varies
with the number of orders. When the quantity of materials ordered is less, the cost of
carrying will decrease but ordering cost will increase and vice versa

a =/2co

Q = Quantity to be ordered

C = Consumption of the material concerned in units during a year.

O = Cost of placing one order including the cost of receiving the goods i.e. the cost of
getting an item into the firms inventory

I = Interest payment including variable cost of storing per unit per year i.e holding costs
of inventory.

Illustration 4: Find out the economic ordering quantity (EOQ) from the following
particulars

Annual usage: Le6000

units Cost of material per unit: Le 20

Cost of Placing and receiving one order:Le60

Annual carrying cost of one unit: 10% of inventory value

Solution

EOQ=/2CO

Where C = Annual usage of material ie6,000 units

O = Cost of placing one order ie Le60

I = Annual carrying cost of one unit 20 X 10 =Le2

b) Minimum Level or Safety Stock level:

The minimum level is the minimum quantity of the material which must be
maintained in hand at all times. The quantity is fixed so that the production is not
held up due to shortage of the materials. In fixing this level, the following factors
should be considered:

1. Lead time i.e. time lag between indenting and receiving of the material. It is the time
required to replenish the supply.

2. Rate of consumption of the material during the lead time.

3. Nature of the material. Minimum level is not required in case of a special material
which is required against customer’s specific order.

Formula for calculating minimum level or safety stock level given by Wheldon is as
follows:

Minimum Stock Level = Re-ordering level – (Normal consumption x Normal Re-order

period)

c) Maximum Level

It is the maximum of stock which should be held in stock at any time during the year.
The quantity is fixed so as to avoid overstocking as it leads to the following
disadvantages.
1. Overstocking leads to increase in working capital requirement which could be
profitable used somewhere else.

2. Overstocking will need more godown space, so more rent will have to be paid.

3. It may also lead to obsolescence on account of overstocking.

4. There are chances that the quality of materials will deteriorate because large stock
will require more time before they are consumed.

5. There may be fear of depreciation in market values of the overstocked materials

According to Wheldon, Maximum Stock level = Reordering level + Re-ordering Quantity

– (Minimum consumption x Minimum re-ordering period)

d) Danger Level

This level means that level of stock at which normal issues of the material are
stopped and issues are made only under specific instructions. The purchase officer
will make special arrangements to get the materials which reach at their danger levels
so that the production may not stop due to shortage of materials. Danger Level =
Average consumption x Max.re-order period for emergency purchases.

f) Average Stock Level

The average stock level is calculated by the following formula

Average Stock Level = Minimum Stock Level + ½ of Re-order Quantity

Or ½ (Minimum Stock Level + Maximum Stock Level)

Illustration 5: Calculate the minimum stock level, maximum stock level, re-ordering level
and average stock level from the following information:

(i) Minimum consumption = 100 units per day

(ii) Maximum consumption = 150 units per day

(iii) Normal consumption = 120 units per day

(iv) Re-order period = 10-15 days

(v) Re-order quantity = 1,500 units

(vi) Normal re-order period = 12 days

Solution

Re-ordering Level = Maximum Consumption x Maximum re-order period

= 150 units x 15 days = 2,250 units

Minimum Stock Level = Re-ordering Level-(Normal consumption x Normal re-order

period)

= 2,250 – (120 x12) = 810 units

Maximum Stock Level = Re-ordering Level + Re-order Quantity – (Minimum

Consumption Minimum

Re-Order Period)

= 2,250 + 1500 – (100 x 10)= 2,750 units

Average stock Level = Minimum Stock Level + ½ Re-order Quantity

= 810 units + ½ x 1500 units = 1,560 unit

Stores (or Materials) records

In the stores the most important two records kept are bin cards and stores ledger.

(a) Bin Card. A bin card is a record of the receipt and issue of material and is prepared
by the store keeper for each item of stores. A bin card is also known as bin tag or stock
card and is usually kept in the rack where the material is kept. In a bin card not only the
receipt and issue of material is recorded, minimum quantity, maximum quantity and
ordering quantity are stated on the card. This helps the store keeper to send the
material requisition for the purchase of material in time.

(b) Stores Ledger: This ledger is kept in the costing department and is identical with the
bin card except that receipts, issues and balances are shown along with their money
values. This provides the information for the pricing of materials issued and the money
value at any time of each item of stores.

Perpetual Inventory System

The Chartered Institute of Management Accountants, London, defines the perpetual
inventory as “a system of records maintained by the controlling department, which
reflects the physical movements of stocks and their current balance”. Thus this is a
system in which, with the help of Bin Cards and Stores Ledger, the balance of stock is
ascertained after every receipt and issue of materials. This is helps in avoiding closing
down of firm for physical verification. Advantages of the Perpetual Inventory System
The following are the advantages of the perpetual inventory system:

1. It avoids the disruption of production for physical checking of all items of stores at the
end of the year.

2. The preparation of Profit and Loss Account and Balance Sheet is possible without
physical verification of stock.

3. A detailed and more reliable control on the materials in store is obtained.

4. As the work of recording and continuous stocktaking is carried out systematically and
without undue haste, the figures are more reliable.

5. Continuous stocktaking will make the storekeeper and the stores accountant more
vigilant in their work and they will try to keep the records accurate and up-to-date.

6. Planning of production can be done without any fear of shortage as the management
is constantly informed of the stores position. [School of Distance Education] Cost
Accounting Page 29

7. An inbuilt system of internal check will be in operation as bin cards and the stores
ledger keep a check on each other.

8. Errors and shortage of stock are readily discovered and efforts are made to avoid the
shortage of stock in future.

9. The capital invested in the stores can be kept under control and efficiently used as
stock can be compared with the minimum and maximum levels.

10. It makes available correct stock figures for claim to be lodged with the insurance
company for loss on account of stock destroyed by f

ABC Analysis
 Under ABC Analysis, the materials in stock are divided into three categories for the
purpose of control. Generally it is seen that the materials which constitute the least
percentage of items in stock may contribute to a large percentage of value and a large
percentage of items may represent a smaller percentage of value of items consumed.
Between these two items are those items, the percentage of which is more or less equal
to their value in consumption. Items falling in the first category are treated as ‘A’ items,
of the second category as ‘B’ items and items of the third category are taken as ‘C’
items. Such an analysis of material is known as ABC analysis. This technique of stock
control is also known as stock control according to value method or Always Better
Control method or Proportional Parts Value Analysis method. Thus, under this technique
of material control, materials are listed in

‘A’, ‘B’ and ‘C’ categories in descending order based on money value of consumption.
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” (CIE). The
report of the Indian Productivity Team on “Stores and Inventory Control in U.S.A., Japan
and West Germany” gives the following example of ABC Analysis:

Group Percentage of Items Percentage

of Costs

A 8%
75%

B 25%
20%

C 67%
5%

The significance of this analysis is that a very close control is exercised over the items of
‘A’ group 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

. Issue of materials Materials issued from 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. But what is the value of materials? Theoretically
the value includes the invoice price less trade discount, the freight, cartage, octroi and
insurance on incoming materials, expenses of purchase, receiving, storing and record
keeping and carriage from the stores up to the process plant. However,

in practice, it involves minute calculations for including all these expenses and is a big
task compared to the benefit derived from it.

Moreover the price changes according to the market conditions and at any given time
there will be stock of materials purchased at different times at different prices. Hence
the problem as to at what price the materials should be issued?

There are many methods of pricing material issues. The most important being: FIFO,
LIFO, simple and weighed average methods.

) First in First Out (FIFO) Under this method material is first issued from the earliest
consignment on hand and priced at the cost at which that consignment was placed in
the stores. In other words, 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. This method is most suitable in times of falling
prices because the issue price of materials to jobs or work order will be high while the
cost of replacement of materials will be low. But in case of rising prices this method is
not suitable because the issue price of materials to production will be low while the cost
of replacement of materials will be high. The following example will illustrate how issues
of materials are valued under this method. Illustration

6: The received side of the Stores Ledger Account shows the following

particulars:

Jan. 1 Opening Balance: 500 units @ Rs.4

Jan. 5 Received from vendor: 200 units @ Rs.4.

25 Jan.12 Received from vendor: 150 units @ Rs.4.

10 Jan.20 Received from vendor: 300 units @ Rs.4.50

Jan.25 Received from vendor: 400 units @ Rs.4

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.

Issues are to be priced on the principle of “first in first out”. Write the Stores Ledger
Account in respect of the materials for the month of January

Solution:

2) Last in Last out (LILO

Under this method, issues are priced in the reverse order of purchase i.e., the prices of
the latest available consignment is taken. 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. Valuing material issues at the price of the latest
available consignment will help the management in fixing the competitive selling prices
of the products.

LIFO Method Store Ledger Account

DATE Particulars RECEIPT ISSUS BALANCE

Quantity Total Unit Quantity Total Unit Quantity Amoun

(Units) Cost(Rs) cost(Rs (units) Cost(Rs) cost(Rs) (units) (Rs)
Per Balance _ _ _ _ _ _ 500 2000
unit(Rs) b/d
Jan 4 Requisition _ _ _ 200 800 4 300 1200
slip no

Jan 5 Goods 200 800 4.25 _ _ _ 300 1200

received
note no
200 580
Jan 10 Requisition _ _ _ 300 1200 4
slip no.
……..
Jan 12 Goods 150 615 4.10 _ _ _ 100 425
received
note no. …
150 615
Jan 15 Requisition _ _ _ 100 425 4.25 150 615
 slip no.
Jan 19 Requisition 100 410 4.10 50 205
slip no
Jan 20 Goods 300 1350 4.50 _ _ _ 50 205
received
note no
300 1350
Jan 25 Goods 400 1600 4.00 _ _ _ 50 204
received
note no
300 1350
400 1600
Jan 26 Requisition _ _ _ 200 800 4.00 50 200
slip no
300 1350
200 800
an 30 Requisition _ _ _ 200 800 4.00 50 200
slip no
_ _ _ 50 225 4.50 250

Module III

Labour

Labour cost is a second major element of cost. The control of labour cost and its
accounting is very difficult as it deals with human element. Labour is the most
perishable commodity and as such should be effectively utilized immediately.
 Importance of Labour Cost Control Labour is of two types (a) direct labour, (b) indirect
labour. Direct Labour is that labour which is directly engaged in the production of goods
or services and which can be conveniently allocated to the job, process or commodity or
process. For example labour engaged in spinning department can be conveniently
allocated to the spinning process. 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 examples of indirect labour are supervisors,
sweepers, cleaners, time-keepers, watchmen etc. The cost of indirect labour cannot be
conveniently allocated to a particular job, order, process or article. The distinction
between direct and indirect labour must be observed carefully because payment of
direct labour is a direct expenditure and is a part of prime cost whereas payment of
indirect labour is an item of indirect expenditure and is shown as works, office, selling
and distribution expenditure according to the nature of the time spent by the indirect
worker. Management is interested in the labour costs due to the following reasons.

 To use direct labour cost as a basis for increasing the efficiency of workers.
 To identify direct labour cost with products, orders, jobs or processes for
ascertaining the cost of every product, order, or process
 To use direct labour cost as a basis for absorption of overhead, if percentage of
direct labour cost to overhead is to be used as a method of absorption of
overhead.
 To determine indirect labour cost to be treated as overhead and
 To reduce the labour turnover.

Hence control of labour cost is an important objective of management and the

realization of this objective depends upon the co-operation of every member of the
supervisory force from the top executive to foremen.

Time keeping

Time-keeping will serve the following purposes:

1. Preparation of Pay Rolls in case of time-paid workers.

2. Meeting the statutory requirements.

3. Ensuring discipline in attendance.

4. Recording of each worker’s time ‘in’ and ‘out’ of the factory making distinction
between normal time, overtime, late attendance, early leaving.

5. For overhead distribution when overheads are absorbed on the basis of labour hours.

Methods of Time-keeping

There are two methods of time-keeping. They are the manual methods and the
mechanical methods. Whichever method is used it should make a correct record of the
time and the method should be cost effective and minimize the risk of fraud. The
manual methods of time keeping are as follows:

a) Attendance Register Method, and b) Metal Disc Method

Attendance Register Method

This is the traditional method where an attendance register or muster roll is kept at the
time office near the factory gate or in each department. The timekeeper records the
name of the worker, the worker’s number, the department in which he is working, the
rate of wages, the time of arrival and departure, normal time and overtime. If the
workers are literate, they may make a record of time themselves in the presence of a
time-keeper or foreman.

This method is simple and inexpensive and can be used in small firms where the
number of workers is not large. However recording the time of workers who work at
customers’ premises and places which are situated at a distance from the factory is not
practical in this method.

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. These boards can be maintained separately for
each department so that the workers can remove the token without delay and put it in a
tray or box kept near the board. Immediately after the scheduled time for entering the
factory, the box is removed and the latecomers will have to give their tokens to the
timekeeper and their exact time of arrival is recorded. The tokens or disc left on the
board will represent the absentee workers. Later the timekeeper records the
attendance in the attendance register and subsequently it is passed on to the Pay Roll
Department.
Mechanical Methods: The mechanical methods that are generally used for the
recording of time of workers may be as follows: (a) Time Recording Clocks (b) Dial Time
Records

Time Recording Clocks: The time recording clock is a mechanical device which
automatically records the time of the workers. Under this method, each worker is given
a Time Card which is kept 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 space against the particular day. This procedure is
repeated for recording time of departure for lunch, return from lunch and time of
leaving the factory in the evening. Late arrivals and overtime are recorded in red to
attract the attention of the management.

Dial Time Records: Under this method, a dial time recorder machine us used. It has a
dial with number of holes (usually about 150) 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 recorded provides a running account of the worker’s time and it
can calculate the number of hours and prepare the wage sheets. However, the high
installation cost of the dial time recorder and its use for only a limited number of worker
are the drawbacks of this method

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 attendance in the factory.
The objects of time booking are:

1. To ensure that time spent by a worker in a factory is properly utilized on different

jobs or work orders.

2. To ascertain the labour cost of each individual job or work order.

3. To provide a basis for the apportionment of overhead expenses over various jobs or
work orders when the method for the allocation of overheads depends upon time spent
on different jobs.

4. To ascertain unproductive time or idle time so as to make efforts to keep it in limit.

 5. To know the time taken to complete a particular job so that bonus can be paid as per
the incentive schemes.

6. To know the efficiency of workers, it is necessary to make the comparison of actual

time taken with time allowed for completing a particular task

Following documents are generally used for time booking:

1. Daily Time Sheets 2. Weekly Time Sheets 3. Job Tickets or Job Cards. Daily time
sheets are given to each worker where he records the time spent by him on each job or
work order. Weekly time sheets record the same particulars for a week and hence one
card is required for a week. Job cards are 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
ascertained

Idle Time :There is always a difference between the time booked to different jobs or
work orders and the time recorded at the factory gate. This difference is known as idle
time. Idle time is of two types. (a) Normal Idle Time (b) Abnormal Idle Tim

Normal Idle Time: This represents the time, the wastage of which cannot be avoided
and, therefore, the employer must bear the labour cost of this time. But every effort
should be made to reduce it to the lowest possible level. Examples of normal idle time
are: time taken in going from the factory gate to the department in which the worker is
to work and back at the end of the day, time taken in picking up the work for the day,
time between the completion of one work and the start of another work, time taken for
personal needs like tea or toilet, time taken for machine maintenance, time taken for
waiting for instructions, printouts, machine set-up time etc. Normal Idle Time is
unavoidable cost as such should be included in cost of production. The cost of normal
idle time can be treated as an item of factory expenses and recovered as an indirect
charge or added to labour cost

Abnormal Idle Time: It is that time the wastage of which can be avoided if proper
precautions are taken. Example: time wasted due:- to breakdown of machinery on
account of inefficiency of the works engineer, failure of the power supply, shortage of
materials, waiting for instructions, waiting for tools and raw materials, strikes or lock-
outs in the factory.
It is a principle of costing that all abnormal expenses and losses should not be included
in costs and as such wages paid for abnormal idle time should not form part of the cost
of production. Hence it is debited to Costing Profit and Loss Account.

Over Time: - It is the work done beyond the normal working period in a day or week. For
overtime done, the workers are given double the wages for the overtime done. The
additional amount paid on account of overtime is known as overtime premium.
Overtime increases the cost of production and should not be encouraged as it has the
following disadvantages

1. Overtime is paid at higher rate.

2. Overtime is done at late hours when workers have become tired and efficiency will it
be as much as during the normal working hours.

3. Workers will develop the habit of working slowly during normal hours and complete
the work using overtime to earn more wages.

4. Expenses like lighting, cost of supervision, and wear and tear of machines will
increase disproportionately

Overtime should be recorded separately and thoroughly investigated to see that it is

incurred only when genuinely required.

The treatment of overtime depends on the situation. If overtime is incurred for because
of the sequence of jobs, then normal wages is charged to labour cost for the overtime
also but if it is a rush job, then the overtime wages is added to the cost of labour. On the
other hand if overtime arises due to any abnormal reason like breakdown of machinery
or power failure, overtime premium is excluded from the cost of production and is
debited to the Costing Profit and Loss Account

Illustration 8: Calculate the normal and overtime wages payable to a workman from the
following data:

Days Hours Worked

Monday 8 hrs.

Tuesday 10 hrs.

Wednesday 9 hrs.
 Thursday 11 hrs

. Friday 9 hrs

Saturday 4 hrs.

Total 51 hrs

Normal Working Hours 8 hours per

day

Normal rate Re.1 per

hour

Overtime rate up to 9 hours in a day at single rate and over 9

hours in a day at

double rate; or up to 48 hours in a week at single

rate and over 48

hours at double rate whichever is more beneficial

to the workman

Days Total Hours Normal Working Overtime Hours

Hours At Single rate At Double rate

Monday 8 8 - -
Tuesday 10 8 1 1
Wednesday 9 8 1 -
Thursday 11 8 1 2
Friday 9 8 1 -
Saturday 4 4

Total 51 44 4 3
Normal Wages for 44 hours @ Re.1 Rs.44

Overtime Wages:

At single rate for 4 hours @ Re.1 = Rs.4

At double rate for 3 hours @ Rs.2 = Rs.6 Rs.10

Total Wages Rs.54

Or

Normal Wages for 48 hours @ Re.1 per hour = Rs.48

Overtime Wages for 3 hours @ Rs.2 per hour= Rs. 6

Rs.54

Therefore, whichever method is followed, the amount of the wages payable to the
worker is Rs.54.

System of Wage Payment

There is no single method of wage payment which is acceptable both to the employers
and the workers. The system of wages should result into higher production, improved
quality of output and a contented labour force.

There are two principal wage systems: (i) Payment on the basis of time spent in the
factory irrespective of the amount of work done. This method is known as time wage
system. (ii) Payment on the basis of the work done irrespective of the time taken by the
worker. This method is called piece rate system. Other methods called premium plans or
bonus and profit sharing schemes are used with either of the two principal methods of
wage payment.

Time Wage System

Under this method of wage payment, the worker is paid at an hourly, daily, weekly or
monthly rate. This payment is made according to the time worked irrespective of the
work done. This method is highly suitable for following types of work:

1. Where highly skilled and apprentices are working.

2. Where quality of goods produced is of extreme importance eg., artistic goods

3. Where the speed of work is beyond the control of the workers

. 4. Where close supervision of work is possible.

5. Where output cannot be measured.

The disadvantages of this method are

: 1. Workers are not motivated. 2. Workers will get payment for idle time.

3. Efficient workers will become inefficient in the long run as all of them get same
wages.

4. Employer finds it difficult to calculate labour cost per unit as it varies as production
increases and decreases.

5. Strict supervision is necessary to get the work done.

6. Inefficiency results in upsetting the production schedule and increases the cost per
unit.

7. It will encourage a tendency among workers to go slow so as to earn overtime wages.

Thus this method does not establish a proportionate relationship between effort and
reward and the result is that it is not helpful in increasing production and lowering
labour cost per unit.

Piece Rate System (payment by result)

Under this system of wage payment, a fixed rate is paid for each unit produced, job
completed or an operation performed. Thus, payment is made according to the quantity
of work done no consideration is given to the time taken by the workers to perform the
work. There are four variants of this system.

a) Straight piece rate system

b) Taylor’s differential piece rate system

c) Merrick’s multiple piece rate system

d) Gant’s task and bonus plan

(a) Straight piece rate system Payment is made as per the number of units produced at
a fixed rate per unit. Another method is piece rate with guaranteed time rate in which
the worker is given time rate wages if his piece rate wages is less than the time rate
Advantages

1. Wages are linked to output so workers are paid according to their merits.

2. Workers are motivated to increase production to earn more wages

3. Increased production leads to decreased cost per unit of production and hence profit
per unit increases.

4. Idle time is not paid for and is minimized.

5. The employer knows his exact labour cost and hence can make quotations
confidently.

6. Workers use their tools and machinery with a greater care so that the production may
not be held up on account of their defective tools and machinery.

7. Less supervision is required because workers get wages for only the units produced.

8. Inefficient workers are motivated to become efficient and earn more wages by
producing more. Disadvantages

1. Fixing of piece work rate is difficult as low piece rate will not induce workers to
increase production. 2. Quality of output will suffer because workers will try to produce
more quickly to earn more wages.

3. There may not be an effective use of material, because of the efforts of workers to
increase the production. Haste makes waste. Thus there will be more wastage of
material.

4. When there is increased production, there may be increased wastage of materials,

high cost of supervision and inspection and high tools cost and hence cost of production
might increase.

5. Increased production will not reduce the labour cost per unit because the same rate
will be paid for all units. On the other hand, increased production will reduce the labour
cost per unit under the time wage system.

6. Workers have the fear of losing wages if they are not able to work due to some
reason.
7. Workers may work for long hours to earn more wages, and thus, may spoil their
health.

8. Workers may work at a very high speed for a few days, earn good wages and then
absent themselves for a few days, upsetting the uniform flow of production.

9. Workers in the habit of producing quality goods will suffer because they will not get
any extra remuneration for good quality.

10. The system will cause discontentment among the slower workers because they are
not able to earn more wages.

This method can be successfully applied when:

1. The work is of a repetitive type.

2. Quantity of output can be measured.

3. Quality of goods can be controlled.

4. It is possible to fix an equitable and acceptable piece rate

5. The system is flexible and rates can be adjusted to changes in price level.

6. Materials, tools and machines are sufficiently available to cope with the possible
increase in production.

7. Time cards are maintained so that workers are punctual and regular so that
production may not slow down

(b) Taylor’s Differential Piece Rate system

This system was introduced by Taylor, the father of scientific management to encourage
the workers to complete the work within or less than the standard time. Taylor
advocated two piece rates, so that 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.

Illustration 9: Calculate the earnings of workers A and B under Straight Piece-rate

System and Taylor’s Differential Piece-rate System form the following particulars.

Normal rate per hour = Le.1.80

Standard time per unit = 20 seconds

Differentials to be applied

: 80 % of piece rate below standard

120% of piece rate at or above standard.

Worker A produces 1,300 units per day and worker B produces 1,500 units per day

SOLUTION

Standard production per 20 seconds = 1 unit

Standard production per minute = 60/20= 3 units

Standard production per hour = 3 x 60 = 180 units

Standard production per day of 8 hrs(assumed) = 180 x 8 = 1440 units

Normal rate per hour = Le.1.80

Normal piece rate = Le.1.80/ 180 units = 1 paisa

Low piece rate below standard production 1P x 80 = 0.8 paise

100

High piece rate at or above standard 1P x 120 = 1.2 paise

100

Earning of worker A

Under straight piece rate system

1300 units @ 1P = 1300 x 1 = Le.13

100

Under Taylor’s Differential Piece-rate System

1300 units @ 0.8 P = 1300 x 0.8 = Le.10.40

 100

Low piece rate has been applied because worker A’s daily production of 1300 units is
less than the standard daily production of 1,440 units.

Earnings of Worker B

Under Straight Piece-rate System

1300 units @ 1P = 1300 x 1 = Le.13

100

Under Taylor’s Differential Piece-rate System

1300 units @ 0.8 P =1300 x 0.8 =Rs.10.40

100

High piece-rate has been applied because worker B’s daily production of 1500 units is
more than the standard daily production of 1440 units.

c) Merrick’s Multiple Piece Rate System

This method seeks to make an improvement in the Taylor’s differential piece rate
system. Under this method, three piece rates are applied for workers with different
levels of performance. Wages are paid at ordinary piece rate to those workers whose
performance is less than 83% of the standard output, 110% of the ordinary piece rate is
given to workers whose level of performance is between 83% and 100% of the standard
and 120% of the ordinary piece rate is given to workers who produce more than 100%
of the standard output. This method is not as harsh as Taylor’s piece rate because
penalty for slow workers is relatively lower.

Illustration 10: Calculate the earnings of workers A, B and C under straight piece rate
system and Merrick’s multiple piece rate system from the following particulars:

Normal rate per hour Rs.1.8

Standard time per unit1 minute

Output per day is as follows:

Worker A : 384 units

Worker B : 450 units

Worker C : 552 units

Wording hours per day are 8

SOLUTION

Standard output per minute = 1 unit

Standard production per hour = 60 units

Standard production per day of 8 hours= 480 units( 8 x 60)

Normal rate per hour = Rs.1.80

Normal output per hour = 60 units

Normal piece rate = Rs. 1.80 = 3 paise

60

Calculation of level of performance:

Standard output per day = 480 units

Worker A’s output per day = 384 units

Worker A’s level of performance = 384 x 100 = 80%

480

Worker B’s output per day = 450 units

Worker B’s level of performance = 450 x 100 = 93.75%

Worker C’s output per day = 552 units

Worker C’s level of performance = 552 x 100 = 115%

480

Earnings of Worker A
Under straight piece rate system:

For 384 units @ 3 paise per unit = 384 x 0.03 = Rs.11.52

Under Merrick’s multiple piece rate system:

For 384 units @ 3 paise per unit =384 x 0.03 = Rs.11.52

Earnings of Worker B

Under straight piece rate system:

For 450 units @ 3 paise per unit = 450 x 0.03 = Rs.13.50

Under Merrick’s multiple piece rate system:

For 450 units @ 3.3 paise per unit =450 x 0.033= Rs.14.85

Earnings of Worker C

Under straight piece rate system:

For 552 units @ 3 paise per unit = 552 x 0.03 = Rs.16.56

Under Merrick’s multiple piece rate system:

For 552 units @ 3.6paise per unit =552 x 0.036 = Rs.19.87

Worker C’s level of performance is 115% which is more than 100% of standard output;
so he is

entitled to get 120% of normal piece rate (ie. 120% of 3 paise or 3.6 paise per unit)

Premium and Bonus Plan

The object of a premium plan is to increase the production by giving an inducement to

the workers in the form of higher wages for less time worked.

Under a premium plan, a standard time is fixed for the completion of a specific job or
operation at an hourly rate plus wages for a certain fraction of the time saved by way of
a bonus. The plan is also known as incentive plan because a worker has the incentive to
earn more wages by completing the work in less time.
This system of wage payment is in between the time wage system and piece work
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 time saved whereas in a premium
plan both the worker and the employer share the labour cost of the time saved. The
following are some of the important premium plans

(i) Halsey Premium Plan: Under this method, the worker is given wages for the actual
time taken and a bonus equal to half of wages for time saved. The standard time for
doing each job or operation is fixed. In practice the bonus may vary from 33⅓ % to

66⅔ % of the wages of the time saved. Thus if S is the standard time, T the time taken, R
the labour rate per hour, and % the percentage of the wages of time saved to be given
as bonus, total earnings of the worker will be:

T x R + % (S-T) R

Under Halsey-Weir plan, the premium is set at 30% of the time saved.

Illustration 11:

Rate per hour = Rs.1.50 per hour

Time allowed for job = 20 hours

Time taken = 15 hours

Calculate the total earnings of the worker under the Halsey Plan. Also find out effective
rate of earnings.

SOLUTION:

Standard time (S) = 20 hours

Time taken (T) = 15 hours

Rate per hour (R)= Rs.1.50 per hour

Total Earnings = T x R + 50% (S-T) x R

= 15 X Rs. 1.50 + 50 (20-15) x Rs.1.50

100
 =Rs.26.25

Total wages for 15 hours = Rs.26.25

Therefore, effective rate of earning per hour

= Total Wages = Rs.26.25 = Rs.1.75

Actual Time Taken

(The percentage of bonus is taken as 50% when not given)

The advantages of the Halsey Premium Plan are:

It is simple to understand and relatively simple to calculate.

1. It guarantees time wages to workers.

2. The wages of time saved are shared by both employers and workers, so it is helpful in
reducing labour cost per unit.

3. It motivates efficient workers to work more as there is increasing incentive to

efficient workers.

4. Fixed overhead cost per unit is reduced with increase in production

. 5. The employer is able to reduce cost of production by having reduction in labour cost
and fixed overhead cost per unit. So, he is induced to provide the best possible
equipment and working conditions

Disadvantages

1. Quality of work suffers because workers are in a hurry to save more and more time to
get more and more bonus.

2. Workers criticize this method on the ground that the employer gets a share of wages
of the time saved.

(ii) Rowan Plan: The difference between Halsey plan and Rowan Plan is the calculation
of the bonus. Under this method also the workers are guaranteed the time wages but
the bonus is that proportion of the wages of the time taken which the time saved bears
to the standard time allowed.
Total Earnings = T x R + S-T x T x R

Illustration 12:

A worker completes a job in a certain number of hours. The standard time allowed for
the job is 10 hours, and the hourly rate of wages is Rs.1. The worker earns a 50% rate of
bonus of Rs. 2 under Halsey Plan. Ascertain his total wages under the Rowan Premium
Plan.

Solution: The worker earns Rs.2 as bonus at 50%; so total bonus at 100% should be Rs.4.
The hourly rate of wages being Re.1, the time saved should be 4 hours.

Standard time allowed 10 hours

Less: Time Saved 4 hours

Time Taken 6 hours

Earnings under the Rowan Premium Plan

Earnings =T x R + S-T x T x R

Where, T = 6 hours

S = 10 hours

R = Re.1 per hour

Earnings = 6 x 1 + 10-6 x 6 x 1

10

= 6 + Rs.2.40 = Rs.8.40

Advantages

1. It guarantees time wages to workers

2. The quality of work does not suffer as they are not induced to rush through
production as bonus increases at a decreasing rate at higher levels of efficiency.
3. Labour cost per unit is reduced because wages of time saved are shared by employer
and employee. 4. Fixed overhead cost is reduced with increase in production.

Disadvantages

1. The Rowan plan is criticized by workers on the ground that they do not get the full
benefit of the time saved by them as they are paid bonus for a portion of the time
saved.

2. The Rowan plan suffers from another drawback that two workers, one very efficient
and the other not so efficient, may get the same bonus.

Overheads:

- Cost related to a cost center or cost unit may be divided into two ie. Direct and Indirect
cost. The Indirect cost is the overhead cost and is the total of indirect material cost,
indirect labour cost, indirect expenses. CIMA defines indirect cost as “expenditure on
labour, materials or services which cannot be economically identified with a specific
salable cost per unit”. Indirect costs are those costs which are incurred for the benefit of
a number of cost centers or cost units. So any expenditure over and above prime cost is
known as overhead. It is also called ‘burden’, ‘supplementary costs’, ‘on costs’, ‘indirect
expenses’.

Classification of Overheads

Overheads can be classified on the following basis:

i) Function-wise classification: Overheads can be divided into the following

categories on functional basis.
ii) (a) Manufacturing or production overheads eg:- indirect materials like lubricants,
cotton wastes, indirect labour like salaries and wages of supervisors, inspectors,
storekeepers, indirect expenses like rent, rates and insurance of factory, power,
lighting of factory, welfare expenses like canteen, medical etc.

(b) Administration overheads eg:- indirect materials like office stationery and printing,
indirect labour salaries of office clerks, secretaries, accountants, indirect expenses rent,
rates and insurance of office, lighting heating and cleaning of office, etc.
 (c) Selling and Distribution overheads eg:- indirect materials like catalogues, printing,
stationery, price list, indirect salary of salesmen, agents, travellers, sales managers,
indirect expenses like rent, rates and insurance of showroom, finished goods,

godown etc., advertising expenses, after sales service, discounts, bad debts etc.

ii) Behavior-wise classification: Overheads can be classified into the following categories
as per behavior pattern.

(a) Fixed overheads like managerial remuneration, rent of building, insurance of

building, plant etc.

(b) Variable overheads like direct material and direct labour.

(c) Semi-variable overheads like depreciation, telephone charges, repair and

maintenance of buildings, machines and equipment etc.

iii) Element-wise classification: Overheads can be classified into the following categories
as per element. (a) Indirect materials (b) Indirect labour (c) Indirect expenses

Allocation and Apportionment of Overhead to Cost Centres (Depart-mentalisation of

Overhead)

When all the items are collected properly under suitable account headings, the next
step is allocation and apportionment of such expenses to cost centres. This is also
known as departmentalization or primary distribution of overhead.

A factory is administratively divided into different departments like Manufacturing or

Producing department, Service department, partly producing departments.

Allocation of Overhead Expenses

Allocation is the process of identification of overheads with cost centres. An expense

which is directly identifiable with a specific cost centre is allocated to that centre. Thus it
is allotment of a whole item of cost to a cost centre or cost unit. For example the total
overtime wages of workers of a department should be charged to that department. The
electricity charges of a department if separate meters are there should be charged to
that particular department only. [School of Distance Education] Cost Accounting

Apportionment of Overhead Expenses

 Cost apportionment is the allotment of proportions of cost to cost centres or cost units.
If a cost is incurred for two or more divisions or departments then it is to be
apportioned to the different departments on the basis of benefit received by them.
Common items of overheads are rent and rates, depreciation, repairs and maintenance,
lighting, works manager’s salary etc

. Basis of Apportionment

Suitable bases have to be found out for apportioning the items of overhead cost to
production and service departments and then for reapportionment of service
departments costs to other service and production departments. The basis selected
should be correlated to the expenses and the expense should be measurable by the
basis. This process of distribution of common expenses over the departments on some
equitable basis is known as ‘Primary Distribution’. The following are the main bases of
overhead apportionment utilized in manufacturing concerns:

Direct Allocation. Under direct allocation, overheads are directly allocated to the
department for which it is incurred. Example overtime premium of workers engaged in a
particular department, power, repairs of a particular department etc.

(i) Direct Labour/Machine Hours. Under this basis, overhead expenses are distributed
to various departments in the ratio of total number of labour or machine hours worked
in each department. Majority of general overhead items are apportioned on this basis.

(ii) Value of materials passing through cost centres. This basis is adopted for expenses
associated with material such as material handling expenses.

(iii) Direct wages. Expenses which are booked with the amounts of wages eg:-
worker’s insurance, their contribution to provident fund, worker’s
compensation etc. are distributed amongst the departments in the ratio of
wages.

Illustration 13:

The Modern Company is divided into four departments: A, B and C are producing
departments, and D is a service departments. The actual costs for a period are as
follows
Rent Rs.1000 Repairs to Plant
Rs.600

Supervision Rs. 1500 Fire Insurance in respect of Stock

Rs.500

Depreciation of Plant Rs.450 Power

Rs.900

Light Rs.120 Employers’ liability for insurance

Rs.150

The following information is available in respect of the four departments;

Dept.A Dept.B Dept C

Dept.D

Area (sq.mtrs) 1,500 1,100 900

500

Number of Employees 20 15 10
5

Total Wages (Rs.) 6,000 4,000 3,000

2,000

Value of Plant (Rs.) 24,000 18,000 12,000

6,000

Value of stock (Rs.) 15,000 9,000 6,000

-

H.P. of Plant 24 18 12
6

Apportion the costs to the various departments on the most equitable basis.

SOLUTION

Overhead distribution summary

Items Basis of Total Products departments Service
apportionment Amount A Le B Le C Le Department
Le D Le
Rent Floor Area 1,000 375 275 225 125
Supervision No. of 1,500 600 450 300 150
Employees
Depreciation Plant Value 450 180 135 90 45
Light Floor area 120 45 33 27 15
Repairs to Plant Value 600 240 180 120 60
Plant
Fire Stock Value 500 250 150 100 -
Insurance
Power HP. Of Plant 900 360 270 180 90
Employer’s No. of 150 60 45 30 15
Liability Employees
Total 5,220 2,110 1,538 1,072 500

Re-apportionment of Service Department Costs to Production Departments

Service department costs are to be reapportioned to the production departments or

the cost centres where production is going on. This process of re-apportionment of
overhead expenses is

known as ‘Service Distribution’. The following is a list of the bases of apportionment

which may be accepted for the service departments noted against

Service Department Cost

1. Maintenance Department -Hours worked for each department
2. Payroll or time-keeping department -Total labour or Machine hours or
3. Store keeping department number of employees in each
4. Employment or Personnel epartment. department
5. Purchase Department - no. of requisitions or value of materials
6. Welfare, ambulance, canteen service, of each department.
recreation room expenses. - Rate of labour turnover or number of
7. Building service department employees in each department.
8. Internal transport service or overhead -no. of purchase orders or value of
crane service materials -No. of employees in each
9. Transport Department department.
 10. Power House (Electric power cost) -Relative are in each department
-Weight, value graded product handled,
weight and distance travelled.
-crane hours, truck hours, truck mileage,
truck tonnage, truck tonne-hours,
tonnage handled, number of packages. –
wattage, horse power, horse power
machine hours, number of electric points
etc

The following are the various methods of re-distribution of service department costs to
productiondepartments.

1. Direct re-distribution method

2. Step distribution method

3. Reciprocal Services method

a. Simultaneous Equation Method

b. Repeated Distribution Method

c. Trial and Error Method

Direct re-distribution method

Under this method, the costs of service departments are directly apportioned to
production departments without taking into consideration any service from one service
department to another service department. Thus, proper apportionment cannot be
done on the assumption that service departments do not serve each other and as a
result the production departments may either be overcharged or undercharged. The
share of each service department cannot be ascertained accurately for control
purposes. Budget for each department cannot be prepared thoroughly. Therefore,
Department Overhead rates cannot be ascertained correctly.

Illustration 14:In an Engineering factory, the following particulars have been collected
for the three months’ period ended on 31st March, 2007. You are required to prepare
Production Overheads Distribution Summary showing clearly the basis of
apportionment where necessary.

Production Service Departments

Departments
A B C D E
Direct Wages 2000 3000 4000 1000 2000
Rs.
1000 2000 2000 1500 1500
Direct Material
Rs. 100 150 150 50 50

Staff 4000 3000 2000 1000 1000

Nos.
10 16 4 6 4
Electricity
Kwh. 60,000 40,000 30,000 10,000 10000

Light Points 150 250 50 50 50

No.

Asset Value
Rs

. Area Occupied
Sq.m.

The expenses for the period were: Motive power Rs.550; Lighting Power Rs.100; Stores
Overheads Rs.400; Amenities to Staff Rs.1500; Depreciation Rs.15,000; Repairs and
Maintenance Rs.3,000; General Overheads Rs.6000; and Rent and Taxes Rs. 275.

Apportion the expenses of service department E in proportion of 3:3:4 and those of

service department D in the ratio of 3:1:1 to departments A, B and C respectively.
SOLUTION PRODUCTION OVERHADS DISTRIBUTION SUMMARY

For the quarter ending 31st March, 2007

Solution

Production overhead distribution Summary

Service Total
Production Departments
Departments Le
A B C D E
Le Le Le Le Le

Direct Wages 1000 2000 3000

Direct Materials 1500 1500 3000

Motive Power @ 5p.per Kwh 200 150 100 50 50 550

Lighting Power @ Rs.2.50per Point 25 40 10 15 10 100

Stores Overhead @ 5% of Direct 50 100 100 75 75 400

Material
300 450 450 150 150 1500
Amenities to staff @ Rs.3 per
employee 6000 4000 3000 1000 1000 15000

Depreciation @ 10% of the value of 1200 800 600 200 200 3000
asset.
1000 1500 2000 500 1000 6000
Repairs and maintenance @ 2% of
value 75 125 25 25 25 275

General Overheads @ 50% of

Direct Wages
Rent and Taxes @Re.0.50 per
sq.meter

Total 8,850 7,165 6,285 4,515 6,010 32,82

5
Dept. E ( 3: 3 : 4) 1,803 1,803 2,404 (6,010
)
Dept. D (3 : 1 : 1) 2,709 903 903 (4,515
Total 13,36 9,871 9,592 32,82
2 5
Step Distribution Method

Under this method, the cost of most serviceable department is first apportioned to
other service departments and production departments. The next service department is
taken up and its cost is apportioned and this process goes on till the cost of the last
service department is apportioned. Thus, the cost of last service department is
apportioned only to production departments.

Illustration 15: A manufacturing company has two Production Departments, P1 and P2

and three Service Departments, Time-keeping, Stores and Maintenance. The
Departmental Summary showed the following expenses for July, 2007 .

Production Departments Service Departments

(in order of their importance)

P1 P2 S1 S2 S3

(Time-keeping) (Stores)
(Maintenance)

Le Le Le Le
Le

16,000 10,000 4,000 5,000

3,000

The other information relating to departments were:

 S1 (Time- S2 S3(Mainte P1 P2
keeping) (Stores) nance)
No. of Employees - 20 10 40 30

No. of Stores requisitions - - 6 24 20

Machine Hours - - - 2400 1600

Note:

basis of apportionment (a) Time-keeping – No. of employees (ie. 2:1:4:3) (b) Stores –
No. of stores requisitions ( ie. 3:12:10) (c) Maintenance- Machine Hours (ie. 3:2) The
most important limitation of this method is that the cost of one service centre to other
service cost centres is ignored and thus the cost of individual cost centres are not truly
reflected.

Reciprocal Services Method

In order to avoid the limitation of Step Method, this method is adopted. This method
recognizes the fact that if a given department receives service from another
department, the department receiving such service should be charged. If two
departments provide service to each other, each department should be charged for the
cost of services rendered by the other. There are three methods available for dealing
with inter-service departmental transfer:

a. Simultaneous Equation Method

b. Repeated Distribution Method

c. Trial and Error Method

(a) Simultaneous Equation method

Under this method, the true cost of the service departments are ascertained first with
the help of simultaneous equations; these are then redistributed to production
departments on the basis of given percentage. The following illustration may be taken
to discuss the application of this method

Illustration 16: A company has three production departments and two service
departments, and for a period the departmental distribution summary has the following
totals.
 Le

Production Departments

P1- Rs. 800; P2- Rs. 700; P3- Rs.500 2000

Service Departments:

S1 – Rs. 234; S2- Rs.300 534

2534

The expenses of the service departments are charged out on a percentage basis as
follows;

P1 P2 P3 S1
S2

Service Department S1 20% 40% 30% -

10%

Service Department S2 40% 20% 20% 20%

-

Prepare a statement showing the apportionment of two service departments expenses

to production departments by Simultaneous Equation Method.

By Simultaneous Equation Method

Let x = total overheads of department S1

y = total overheads of department S2

Then,

x=Rs.234+. 2y

y=Rs.300+. 1x

Rearranging and multiplying to eliminate decimals;

10x-2y=Rs.2,340 ………….(1)

-x+10y=Rs.3,000…………….(2)
Multiplying equation (1) by 5 and add result to (2), we get

49x=Rs.14,700

x=Rs.300

Substituting this value in equation (1), we get

y=Rs.330

All that now remains to be done is to take these values x=Rs.300 and y=Rs.330 and
apportion them on the basis of the agreed percentage to the three production
departments; thus:

Total P1 P2 P3
Per distribution summary 2,000 800 700 500

Service department S1 270 60 120 90

Service department S2 264 132 66 66

2,534 992 886 656
This method is recommended in more than two service departments if the data is
processed with computers and in two service departments only where the data is
processed manually.

b) Repeated Distribution Method

Under this method, the totals are shown in the departmental distribution summary, are
put out in a line, and then the service department totals are exhausted in turn
repeatedly according to the agreed percentages until the figures become too small to
matter.

By solving illustration 16 by Repeated Distribution Method, we get the Secondary

Distribution Summary which is given as follows:

SECONDARY DISTRIBUTION SUMMARY

P1 P2 P3 S1 S2
Le Le Le Le Le
 .
As per summary 800 700 700 234 300

Service Department S1 47 94 94 (234) 23

Service Department S2 129 65 65 64 (323)

Service Department S1 14 25 25 (64) 6

Service Department S2 2 2 2 - (6)

992 886 656 _ _
(c) Trial and Error Method :Under this method, the cost of one service department is
apportioned to another centre. The cost of another centre plus the share received from
the first centre is again apportioned to the first cost centre and this process is repeated
till the balancing figure becomes negligible. By solving illustration 16 by Trial and Error
Method, we get the following

Service Departments

S1 S2

Original apportionment Rs. Rs.

234 300

(23) 23 (10% of 234)

(20% of 323) (323)

(65) 7 (10% of 65)

1(20% of 7) (7)
Total of positive figures 300 330

ABSORPTION OF OVERHEAD

Absorption means the distribution of the overhead expenses allotted to a particular

department over the units produced in that department. Overhead absorption is
accomplished by overhead rates. Methods of Absorption of Manufacturing Overhead
The following are the main methods of absorption of manufacturing or factory
overheads.

(a) Direct Material Cost Method. Under this method percentage of factory expenses to
value of direct materials consumed in production is calculated to absorb manufacturing
overheads

The formula is Overhead Rate = Production Overhead Expenses

(Budgeted)

Anticipated Direct Material Cost

If in a factory the anticipated cost of direct material is Rs. 4,00,000 and the over head
budgeted expenses are Rs. 1,00,000, then the overhead rate will be 25% ie.( Rs.1,00,000
÷ Rs.4,00,000) of the materials used. It is assumed that relationship between materials
and factory expenses will not change. This method is simple and can be adopted under
the following circumstances:

(i) Where the proportion of overheads to the total cost is significant. (ii) Where the
prices of materials are stable. (iii) Where the output is uniform ie. Only one kind of
article is produced

(b) Direct Labour Cost (or Direct Wages) Method. This is a simple and easy method and
widely used in most of the concerns. The overhead rate is calculated as under:

Overhead Rate = Production Overhead Expenses

Direct Labour Cost

If from past experience, the percentage of factory expenses to direct wages is 50%, then
the factory expenses in the next year is taken as 50% of the direct wages. This method is
suitable under the following situations:

(i) Where direct labour constitutes a major proportion of the total cost of production.

(ii) Where production is uniform.

(iii) Where labour employed and types of work performed are uniform.

(iv) Where the ratio of skilled and unskilled labour is constant.

(v) Where there are no variations in the rates of pay ie., the rates of pay and the
methods are the same for the majority of the workers in the concern. In some concerns
a separate rate is calculated for the fringe benefits and applied on the basis of direct
labour cost

(c) Prime Cost Method. Under this method the recovery rate is calculated dividing the
budgeted overhead expenses by the aggregate of direct materials and direct labour cost
of all the products of a cost centre. The formula is

Overhead Recovery Rate = Production Budgeted Overhead Expenses

Anticipated Direct Materials and Direct Labour Cost

Suppose if the budgeted overheads are Rs.50,000 and the estimated values of direct
materials and direct labour are Rs.30,000 and Rs.20,000, then overhead recovery rate
will be 100%

i.e., 50000 x 100

30000+20000

d) Direct Labour (or Production) Hour Method. This rate is obtained by dividing the
overhead expenses by the aggregate of the productive hours of direct workers. The
formula is

Overhead rate = Production Overhead Expenses

Direct Labour Hours

If in a particular period the overhead expenses are Rs.50,000 and direct labour hours are
1,00,000, then overhead labour rate will be Re.0.50 (i.e., Rs.50,000 ÷1,00,000). This rate
is suitable where:

(i) The production is done using more of labour and less technology is used.

(ii) It is desired to taken into consideration the time factor.

(iii) The rate may not be affected by the method of wage payment or the grade or the
rate of workers.

Illustration17: From the following particulars find out “Direct Labour Rate”
(a) Total number of labourers working in the department. 400

(b) Total working days in a year 300

(c) Number of working hours per day 8

(d) Total departmental overheads per year Rs. 1,82,400

(e) Normal idle time allowed. 5%

SOLUTION: CALCULATION OF DIRECT LABOUR RATE FOR DEPARTMENTAL OVERHEADS

Total working days in a year 300

Number of working hours per day 8

Total working hours available per worker per year 2,400 (300 x 8)

Less: normal idle time allowed (5% of 2,400hrs)

120

Effective working hours per worker per year (2400-120) 2,280

Number of workers working in the department t 400

Total effective working hours in the department (2280 x 400) 9,12,000

Total departmental overheads per year Rs.1,82,000

Direct Labour Rate for absorption of overheads per hour Re.0.20

(Rs.182,400÷9,12,000hrs=Rs.0.20)

(e) Machine Hour Rate. Machine hour rate is the cost of running a machine per hour. It
is one of the methods of absorbing factory expenses to production. There is a basic
similarity between the machine hour and the direct labour hour rate methods, in so far
as both are based on the time factor. The choice of one or the other method depends
on the actual circumstances of the individual case. In respect of departments or
operations, in whichmachines predominate and the operators perform a relatively a
passive part, the machine hour rate is more appropriate. This is generally the case for
operations or processes performed by costly machines which are automatic or semi-
automatic and where operators are needed merely for feeding and tending them rather
than for regulating the quality or quantity of their output. In such cases, the machine
hour rate method alone can be depended on to correctly apportion the manufacturing
overhead expenses to different items of production. What is needed for computing the
machine hour rate is to divide overhead expenses for a specific machine or group of
machines for a period by the operating hours of the machine or the group of machines
for the period. It is calculated as follows:

Machine hour rate = Amount of overheads

Machine hours during a given period

The following steps are required to be taken for the calculation of machine hour rate:

1) Each machine or group of machine should be treated as a cost centre.

2) The estimated overhead expenses for the period should be determined for each
machine or group of machines.

3) Overheads relating to a machine are divided into two parts i.e., fixed or standing
charges and variable or machine expenses.

4) Standing charges are estimated for a period for every machine and the amount so
estimated is divided by the total number of normal working hours of the machine during
that period in order to calculate an hourly rate for fixed charges. For machine expenses,
an hourly rate is calculated for each item of expenses separately by dividing the
expenses by the normal working hours.

5) Total of standing charges and machines expenses rates will give the ordinary
machine hour rate. Some of the bases which may be adopted for apportioning the
different expenses for the purpose of calculation of machine hour rate are given below.

Some of the expenses and the basis of apportionment are given below.

1. Rent and Rates - Floor area occupied by each machine including the surrounding
space.

2. Heating and Lighting - The number of points used plus cost of special lighting or
heating for any individual machine, alternatively according to floor area occupied by
each machine.

3. Supervision – estimated time devoted by the supervisory staff to each machine.

4. Lubricating Oil and Consumable Stores – On the basis of past experience.

5. Insurance – Insurable value of each machine 6. Miscellaneous Expenses – Equitable

basis depending upon facts.

Machine Expenses

1. Depreciation – cost of machine including cost of stand-by equipment such as spare

motors, switchgears etc., less residual value spread over its working life.

2. Power – Actual consumption as shown by meter readings or estimated consumption

ascertained from past experience.

3. Repairs – Cost of repairs spread over its working life

Illustration 18: A machine is purchased for cash at Rs.9,200. Its working life is estimated
to be 18,000 hours after which its scrap value is estimated at Rs.200. it is assumed from
past experience that:

(i) The machine will work for 1,800 hours annually.

(ii) The repair charges will be Rs.1,800 during the whole period of life of the machine.

(iii) The power consumption will be 5 units per hour at 6 paisa per unit.

(iv) Other annual standing charges are estimated to be:

Le

(a) Rent of department (machine occupies 1/5th of total space)

780

(b) Light (12 points in the department-2 points engage d in the machine)
288

(c) Foreman’s salary (1/4th of his time is occupied in the machine)

6000

(d) Insurance premium (fire) for machinery

36
(e) Cotton waste
60

Find out the machine hour rate on he basis of above data for allocation of the works
expenses to all jobs for which the machine is used.

SOLUTION:

CALCULATION OF MACHINE HOUR RATE

Standing Charges: Le Le
156
Rent[ Rs.780 ÷Rs.5]
48
Light [ 2/12 x Rs.288]

Insurance Charges 36
Cotton waste 60
1,500
Total Standing 1,800
Charges
Hourly rate of standing charges Rs.1800
Rs.1800 1.00
Machine Expenses 0.50
Depreciation (Rs.9,200-Rs.200)÷18,000 = Rs.9000 ÷18,000 0.06
Repairs and Maintenance (Rs.1,080÷18,000) 0.30
Power (0.06 x 5)

Machine Hour Rate 1.86

(f) Rate Per Unit of Production. This method is simple, direct and easy. It is suitable for
mining and other extractive industries, foundries and brick laying industries, where the
output is measured in convenient physical units like number, weight, volume etc. the
rate is calculated as under:

Overhead Rate= Overhead expenses (budgeted)

Budgeted production

For example, if the overhead expenses (budgeted) are Rs. 30,000 and the budgeted
production is 10,000 tonnes, then overhead rate according to this method will be Rs. 3
per tonne.

The main limitation of this method is that it is restricted to those concerns which
produce only one item of product or a few sizes, qualities or grades of the same
product. If more than one item are produced, then it is essential to express dissimilar
units against a common denominator on weightage or point basis.

g) Sale Price Method: Under this method, budgeted overhead expenses are divided by
the sale price of units of production in order to calculate the overhead recovery rate.
The formula is sale price of units of production in order to calculate the overhead
recovery rate, the formula is

verhead Recovery Rate= Budgeted overhead expenses

Sale value of units of production

The method is more suitable for apportioning of administration, selling and distribution,
research, development and design costs of products. It can also be used with advantage
for the appropriation of joint products costs.

Module IV

Methods of Costing

1. UNIT COSTING

It is an important method of costing. It is also known as output costing or single costing.

It is used to ascertain the cost of producing a unit of output.. This method is called ‘unit’
costing since every unit of production is identical in all respects and the cost unit is a
standard product.
According to J.R Batliboi, “Single or output cost system is used in business where a
standard product is turned out and it is desired to find out the cost of a basic unit of
production.

Features:

1. It is used where output can be measured in convenient physical unit

2. It is followed in concern s engaged in the production of a single product

3. It is followed in industries where manufacturing process is continuous

4. It is followed where all units of production are identical

Cost sheet:

Cost sheet is a device used to determine and present the cost under unit costing. It is a
statement of costs incurred at each level of manufacturing a product or service. In a
Cost sheet all the elements of cost is taken into consideration. It includes Prime cost,
Factory/manufacturing cost, cost of production, cost of sale Profit/loss etc

Items excluded from Cost Sheet:

1. Pure financial expenses like interest on capital, interest on loan, discount on

debentures, loss on sale of fixed asset provision for bad debts and doubtful debts,
writing off goodwill, copyright, preliminary expenses etc.

2. Pure financial incomes like interest received, profit on sale of investment, dividend
received, rent received, commission received, discount received etc. In addition to the
above, no appropriation items will include in cost sheet

Form of a Cost Sheet: Cost sheet for the period ending as at that date

Direct material Xxxxxxxx Xxxxxxxx

Direct wages Xxxxxxxx

 Xxxxxxxx
Direct Expenses Xxxxxxxx
Xxxxxxxx Xxxxxxxx

Prime Xxxxxxxx Xxxxxxxx

Cost Xxxxxxxx
Add: factory Overhead Xxxxxxxx Xxxxxxxx
Factory cost Xxxxxxxx Xxxxxxxx
Xxxxxxxx
Add: administrative overhead Xxxxxxxx Xxxxxxxx
Cost of production Xxxxxxxx

Xxxxxxxx
Add: selling and distribution overhead Xxxxxxxx
Total cost/cost of sales

Treatment of Stock:
While preparing a cost sheet we have to consider the opening and closing stocks of the
following
three items

1. Stock of Raw materials

2. Stock of finished goods
3. Stock of work in progress

Stock of Raw materials: In order to get the cost of material consumed, opening stock of
material
is added to the cost of raw materials purchased and closing stock of raw materials is
deducted from
it.

Opening stock of raw materials xxx

Add Purchase of RM xxx
-------
xxx
Less closing stock of RM xx
-------
Cost of materials consumed xxx
=====
Stock of Work – in – progress: The Cost of work in progress are adjusted at the work
cost stage

Prime cost xxx

Add works OH xxx
--------
Xxx
Add opening stock of WIP xx
--------
xxx
Less closing stock of WIP xx
-------
Works cost xxxx
=====

Stock of finished goods: It is adjusted immediately after ascertaining the cost of

production.

Cost of production xxx

Add opening stock of FG xx
-------
Xxxx
Less closing stock of FG xxx
-------
Cost of Goods sold xxxx
=====

Illustration 1
From the following particulars prepare a cost sheet for the month of March 2008.
Le.
Stock in hand 1st March
Raw materials 26,000
Finished goods 18,300

Work in Progress 9,200

Stock on hand – 31st March
Raw materials 27,200
Finished goods 16,700
Work in Progress 10,100
Purchase of Raw materials 23,000
Carriage on purchases 1,500
Direct wages 18,500
Indirect wages 1,000
Sale of finished goods 76,000
Chargeable expenses 2,200
Factory overheads 9,500
Administration OH 4,000
Selling and Distribution OH 5,200

Solution Cost sheet for the month of March 2008

Le Le

Opening stock of materials 26,000

Add Purchases 23,000
Add carriages on Purchases 1,500
50,500
Less closing stock of materials 27,200
Cost of materials consumed
,
,Direct wages 23,300
Chargeable expenses 18,500
PRIME COST 2,200

Factory OH 44,000
Indirect wages 9,500
Add opening stock of WIP 1,000
9,200
Less closing stock of WIP
Factory Cost 63,700
Add Administration OH 10,100
53,600
Cost of Production 4,000
Add opening stock of finished goods 57,600
Less closing stock of finished goods 18,300
Cost of goods sold
75,900
Add selling and distribution OH 16,700

Total cost 59,200

Profit 5,200
Sales 64,400
11,600
76,000
=========
Tenders or Quotations: A tender or quotation is an offer made by a person to supply
certain goods
At a specified price. It is an estimated price which is determined in advance of
production. A
Reasonable margin of profit is added to the estimated cost to get the tender price. A
tender has to be
Prepared very carefully as the receipts of orders depend upon the acceptance of
quotations or
Tenders supplied by the manufacturers. It requires information regarding Prime cost,
works cost,
Administration and selling overhead cost and profit of the preceding period.
Computation of Tender price
I. Calculation of Tender price on the basis of Percentages of Overheads
In this case a cost sheet is prepared for the past period with the total amount of different
elements of cost. Here Indirect or overhead costs are charged on a percentage basis. The
percentage is calculated on the basis of the past year’s cost sheet. These are calculated
as follows:
a. Factory OH is charged as a percentage if direct wages. =Factory OH x 100
Direct wages

b. Administration OH is charged as a percentage of Factory cost

= Administration OH x 100
Factory Cost

c. Selling and Distribution OH is charged as percentage of Factory cost

= Selling and Distribution x 100
Factory cost

Profit may be calculated either as a percentage of cost or selling price. If the given
percentage of profit is on selling price, the percentage of profit on selling price should be
converted
into percentage of profit on cost.
Illustration 1. Following particulars relates to the manufacture of machines by ABC Co
Ltd for the
year ending 31st March 2011

Materials used 2,50,000

Direct wages 1,90,000
Factory OH 38,000
Establishment charges 35900

Prepare a cost sheet showing the cost of Production of the Machines. What price the
company
should quote to manufacture a machine which, it is estimated will require an expenditure
of Rs.
12,000 in material and Rs. 10,000 in wages so that it will yield a profit of 20% on selling
price.
Solution Cost sheet for the year ending 31st March 2011

Le
Materials used 2,50,000
Direct wages 1,90,000
Prime cost 4,40,000
Factory Over head 38,000
Factory Cost 4,78,000
Establishment charges 35,900
Cost of Production 5,13,900
a. Percentage of factory overhead on direct wages = 38,000 x 100

1,90,000

=20%

b. Percentages of establishment charges on factory OH

= 35900 x100
4,78,000
= 7.5%

Estimated Cost Sheet

Le
Materials 12,000

Direct wages 10,000

Prime Cost 22,000

Factory OH (20% on direct wages) 2,000

Factory Cost 24,000

Establishment charges (7.5% on factory cost) 1,800

Cost of Production 25,800

Profit (20 % on selling price or 25% on cost) 6,450

Selling price 32,250
 ==========

II. Computation of Tender price on the basis of Previous year’s per unit cost:
Under this situation , previous periods cost and output figures are available. Tender
price is fixed by multiplying the quantity with previous periods per unit cost and adding
the required percentage of profit. There are three different situations under this method.
a. When there is no change in past cost and past percentage of profit. In this case a
detailed probable cost sheet is prepared by multiplying previous period’s cost of
each unit with the quantity of tender. Profit is added at the same percentage of
profits of the past period.
b. When there is change in past cost, but no change in past percentage of profit: -
Here the cost of the tender is calculated by making necessary adjustments in the
elements of cost. Same percentage of cost is added as profit to get tender price.
c. When there is change in past cost and past percentage of profit: - Here the total
cost tender is calculated by making necessary adjustments in the cost and the tender
price is then calculated by adding the required percentage of profit.

Illustration II. The following is the Trading and Profit and loss account of XYZ Co. for
the year
ending 31st March 2011 in which half year 1000 refrigerators manufactured and sold.
Trading and Profit & Loss Account

Le Le
To materials 80,000 By sales 4,00,000
To wages 1,20,000
To Manufacturing exp 50,000
To G/P C/D 1,50,000
4,00,000 ------------
4,00,000
60,000 By GP/b/d
To staff salaries 30,000
“Selling Exp 20,000
“ General Exp 10,000
“ Rent & Taxes 30,000 -------------
1,50,000 1,50,000
======= =======
For the year ending 31st March 2012, it is estimated that:
1. The price of raw materials will increase by 20% on the previous year’s level.
2. Rate of wages will rise by 5%
3. The output and sale will be 1,200 Refrigerators
4. Selling exp. Per unit will remain constant.
5. Manufacturing OH will rise in proportion to combined cost of material and wages
6. Other expenses remain unaffected by the rise in output.
You are required to prepare an estimated cost sheet for the year 2012, showing the prices
at
which a refrigerator should be sold keeping a net profit of 10% on the selling price.
Solution: Cost sheet for the year ended 31st March 2011

Total Rs(1000) Per unit

cost(Rs.)
Material 80,000 80
Labour 1,20,000 120
Prime cost 2,00,000 200
Manufacturing OH 50,000 50
2,50,000 250
Factory cost
90,000
Office OH 3,40,000 340
30,000 30
Cost of Production
3,70,000 370
Selling Exp.
30,000 30
Cost of Sale
Profit 4,00,000 400
Sales ======== ======

Estimated cost sheet for the year ended 31st March 2012

Total Per
(1200)Rs unit(Rs)
Material (80+20) 1,15,200 96

Labour (120+5) 1,51,200 126

2,66,400 222
Prime Cost
66,600 55.5
Manufacturing OH(50x 222/200)
3,33,000 277.5
Factory Cost
90,000 75
Office OH (9o,000/1,200) 4,23,000 352.5
Cost of Production
36,000 30
Selling exp. 4,59,000 382.5
Cost of Sale

Profit (10% of selling price, ie 1/9 of cost) 51,000 42.5

Sales 5,10,000 425

III Calculation of Tender price based on fixed and variable costs: Here, costs are
classified
according to variability into three types,, fixed, variable and semi variable. Tender price
is
calculated on the basis of degree of variability
Illustration III The Cost of manufacturing 5000 units of a commodity comprises Material
cost Rs.
40,000, wages Rs. 50,000 Direct expenses Rs. 800, Variable OH Rs. 8000 and fixed OH
Rs.
32,000. For the manufacturing of every 1000 extra units of the commodity, the cost of
production
increases as follows:
a. Fixed OH Rs. 400 extra
b. Direct expenses proportionately
c. Wages 10% less than proportionately
d. Materials proportionately
e. Variable OH 25% less than proportionately.
Calculate the estimated cost of producing 8,000 units of the commodity

Solution:
Statement of Cost

5000 units 3000 extra 8000 units

Le) units(Le) (Le)

Materials 40,000 24,000 64,000

Wages 50,000 27,000 77,000

Direct expenses 800 480 1,280
Prime Cost 90,800 51,480 1,42,280

Fixed OH 32,000 1,200 33,200

Variable OH 8,000 3,600 11,600

1,30,800 56,280 1,87080
======== ======== ========

Increase in the Value of Materials = 40,000/5000 x 3000 = Rs. 24,000

“
Wages = 50000/5000 x3000 – 10% = Rs. 27,000

“ Direct expenses = 800/5000 x 3000 = Rs. 480

“ Fixed Expenses = 400 x3 =Rs. 1200

“

Variable expenses = 8000/5000 x 3000 - 25% = Rs. 3,600

JOB COSTING

It means ascertaining costs of an individual job, work order or project separately.

According to
ICMA London, “job costing is that form of specific order costing which applies where
work is
undertaken to customer’s specific requirements and each order is of comparatively of
short
duration.” Under this method of costing, each job is considered to be a distinct cost unit.
As such,
each job is separately identifiable.
In the case of a job, work is usually carried out within the factory or workshop.
Sometimes,
a job is accomplished even in the customer’s premises. This method of costing is
applicable to ship
building, printing, engineering, machine tools, readymade garments, shoes, hats,
furniture, musical
instruments, interior decorations etc.
Features

1. Each job has its own characteristics, depending up on the special order placed by the
customer.
2. Each job is treated as a cost unit.
3. A separate job cost sheet is made out for each job on the basis of distinguishing
numbers.
4. A separate work in progress ledger is maintained for each job.
5. The duration of the job is normally a short period.
6. Profit or loss is determined for each job independently of others

Advantages of Job costing:

1. It helps to distinguish profitable jobs from unprofitable jobs
2. It helps to identify defective work and spoilage with a department or person
3. Selling price of special orders can easily be fixed.
4. It helps to prepare estimates of cost for submitting quotations and tender for similar
jobs
5. It helps to control future cost

Requisites of Job costing system:

1. A sound system of production control

2. An effective time booking system
3. Clearly defined cost centre
4. Appropriate overhead absorption rate, and
5. Proper material issue pricing method.

Procedure for Job order costing system:

The Procedure for job order costing system may be summarized as follows:-

1. Receiving an enquiry from the customer regarding price, quality etc

2. Make an estimation of the price of the job after considering the cost incurred for the
execution of similar job in the previous year
3. Receiving an order, if the customer is satisfied with the quotation price and other terms
of
execution.
4. If the job is accepted, a production order is made by the Planning department.
5. The costs are collected and recorded for each job under separate production order
Number,
and a Job Cost Sheet is maintained for that purpose.
6. On completion of job, a completion report is sent to costing department.

Illustration I
From the following particulars calculate the cost of Job No.505 and price for the job to
give a profit
of 25% on the selling price.
Material: Rs. 6820
Wage details:
Department
X : 60 hrs @ Rs. 3 per hr
Y : 50 hrs @ Rs. 3 per hr
Z : 30 hrs @ Rs. 5 per hr
The variable Overheads are as follows:
Department
X : Rs. 5000 for 5000 hrs
Y : Rs. 4000 for 2000 hrs
Z : Rs. 2000 for 500 hrs

The total fixed expenses amounted to Rs. 20,000 for 10,000 working hours.
Calculate the cost of Job No. 505 and price for the job to give a profit of 25% on selling
price
Solution:

Job Cost Sheet No. 505 Le

Direct Material 6,820

Wages:
Department X 60x3=180
Department Y 50x3=150
Department Z 30x5=150 480
------------------

Prime Cost 7,300

Overheads: - Variables
Department X 60 x1 = 60
Department Y 50 x2= 100
Department Y 30x 4= 120 280

------------------

7,580

Fixed OH 140 x 2 = 280(60+50+30 x 2) 280

------------------
Total cost 7,860

Profit 25% on selling price ie 1/3 of cost 7860 x1/3 2, 620

 -----------------

Selling price 10,480

Practical problem 1

The following information is extracted from the Job ledger in respect of Job No. 205
Materials Rs. 8,500
Wages : 80 hours @ Rs. 6 per hour
Variable OH incurred for all jobs is Rs. 10,000 for 4,000 labour hours. Find the profit if
the job is
billed for Rs. 8,400.
Practical Problem 2
From the following information, ascertain the work cost of Job No. 505
The job was commenced on 10th January 2011 and completed on 1st Feb.2011. Materials
used were
Rs. 2,400 and labour charges were Rs. 1,600. Other details were as follows:
1. Indirect labour cost in the factory amounted to Rs. 1,200
2. Machine X was used for 50 hours @ Rs. 20 per hour
3. Machine Z was used for 40 hours @ Rs. 22 per hour

CONTRACT COSTING
Meaning

It is a special form of job costing and it is the most appropriate method to be adopted in
such industries as building and construction work, civil engineering, mechanical
fabrication and
ship building. In other words, it is a form of specific order costing which applies where
the work is
undertaken to customer’s requirements and each order of long duration as compared to
job costing.
It is also known as terminal costing.
The official CIMA terminology defines contract costing as “ a form of specific order
costing in which costs are attributed to individual contracts.”
Basic features:
1. Each contract itself a cost unit.
2. Work is executed at customers site
3. The existence of sub contract
4. Most of the expenses incurred upon the contracts are direct.
5. Cost control is very difficult in contract costing.

Types of contracts
Generally there are three types of contracts:
1. Fixed price contracts: Under these contracts both parties agree to a fixed contract price.
2. Fixed price contract with Escalation clause
3. Cost plus contract: Under this contract no fixed price could be settled for a contract.
Contract Account
A contract account is a nominal account in nature. It is prepared to find out the cost of
contract and
to know profit or loss made on the contract. A contractor may undertake a number of
contracts at a
time. For each contract a separate account is opened. In the contract account all direct
cost such
as material, labour and other direct expenses incurred during an accounting period are
debited and
the indirect expenses are apportioned on an equitable basis. The differences between the
two sides
are known as Notional profit or notional loss.

SPECIAL TERMS IN CONTRACT ACCOUNT

1. Work in Progress: It is the unfinished contract at the end of the accounting period and
it
includes amount of work certified and amount of work uncertified. Work in progress is
an
asset, shown in the balance sheet by deducting there from any advance received from the
contractee.
2. Work certified: The sales value of work completed as certified by the architect is
known as
‘work certified’. In the case of contracts of long duration, the amount payable by the
customer to the contractor is based on the sales value of work done as certified by the
architect. At the end of the financial year, the total sales value of work done and certified
by the architect is credited to the contract account.

3. Work Uncertified: It means work which has been carried out by the contractor but has
not
been certified by the architect. Sometimes, work which is complete remains uncertified at
the end of the financial year. The reasons for the same may be
a. Work not sufficient enough to be certified
b. Work has not reached the stipulated stage to qualify for certification
It is always valued at cost and credited to the contract account.
4. Retention money: - Regardless of the amount of work certified, the contractor is paid
a
specified percentage of the same and the balance is held or retained by the contractee.
This
is because of the fact that the contractee has to safe guard himself against any
contingency
arising from the non fulfillment of the terms of the contract by the contractor. The unpaid
balance of work certified or the amount held back or retained by the contractee is known
as
‘retention money’.

5. Sub contract: Sometimes the contractor enters into contracts with another contractor
to
give a portion of work undertaken by him. In such cases the work performed by the
subcontractor s forms a direct charge to the contract concerned. Sub contract cost will be
shown on the debit side of the contract account.
6. Escalation clause: This is clause which is provided in the contract to cover up any
increase
in the price of the contract due to increase in the prices of raw material or labour or in the
utilization of any other factors of production. If material and labour utilization exceeds a
particular limit, the customer agrees to bear the additional cost occasioned by excessive
utilization. Here, the contractor has to satisfy the customer that excessive utilization is not
the result of decreased efficiency.

SPECIMEN FORM OF CONTRACT ACCOUNT (Unfinished contract)

Contract A/C

To materials Xxx By work in progress:

To Labour Xxx Work certified Xxx
To Plant Xxx Xxx
To Overheads Xxx Work uncertified Xxx
To cost of sub contracts Xxx Xxx
To Notional Profit c/d(B/F) Xxx By material returned xxx
Xxx
plant Xxx
xxx By
Xxx
xxx
To Profit and Loss A/C Less: Depreciation
To WIP (B/F) xx Xxx
xxx By material lying at site ========
xxx
Xxx
======= By Notional profit B/d

Treatment of Plant and Machinery:

One of the distinguishing features of a contract is the use of special plant and machinery.
The cost
of these is capital expenditure, but yet, the usage of these should be reflected in the form
of
depreciation. There are two distinct methods of charging depreciation.
1. At the time of issue of plant to contract the contract account is debited with the full
value of
the plant. At the end of the period contract account is credited with the depreciated value.
This method is used when plant and machinery is used at the contract site for a long
period.
2. In the second method, contract account is debited with an hourly rate of depreciation
for the
number of hours the plant is used on the contract. A cost centre is set up for each
machine.
An estimate is made is made of the cost such as maintenance, depreciation, driver’s wage
etc to be incurred. The total of this cost is divided by the number of hours that the
machine
is expected to be used.

Profit on Incomplete Contract:

In the case of a small contract extending over the financial period, profit or loss on the
same may be
ascertained by crediting it with the contract price due by the contractee. This procedure
cannot be
adopted in the case of contracts extending beyond the accounting period, and taking a
long time for
completion. If there is any profit upon the incomplete contract, it cannot be taken as
actual profit.
The profit upon the incomplete contract is called notional profit.
For the purpose of determining the amount of profit to be transferred to profit and loss
account and making provision for future contingencies, the following guidelines may be
kept in
mind.

1. When the work has not reasonably advanced (1/4 or less than ¼) : - No profit
should be
taken to the credit of p/L account in the case of contracts which have just commenced and
a
small portion of the work is complete.
2. Where the work is complete more than ¼ but less than ½ of contract price: In this
case
1/3 of the notional profit as reduced by the percentage of cash received may be credited
to
profit and loss account. The usual formula is
Notional profit x1/3 x Cash received
Work certified
The balance of notional profit shall be kept as reserve till the completion
3. If the contract completed is more than 1/2 but less than 90%: Here 2/3 rd of the
notional
profit should be taken to profit and loss account.
Notional profit x2/3 x Cash received

Work certified

The balance of notional profit shall be transferred to work in progress as reserve. It is to

be
noted that in order to find out how much portion of contract is completed, work certified
should be compared with contract price.
4. If the contract is nearing completion: Here, estimated profit may be ascertained by
deducting the total cost of contract to date plus estimated additional expenses to complete
the contract , from the contract price. It is calculated by using the following formula

Estimated profit x Cash received

Contract price

The loss on incomplete contract should be fully transferred to profit and loss account.
Example 1
The following was the expenditure on a contract for Rs. 6,00,000

Material 1,20,000
Wages 1,64,000
Plant 20,000
Overheads 8,600

Cash received on account of the contract was Rs. 2,40,000 being 80% of the work
certified. The
Value of material in hand was Rs. 10,000. The plant has undergone 20% depreciation.
Solution

CONTRACT ACCOUNT

Le Le

To materials 1,20,000 By material in hand 10,000

To Wages 1,64,000 By plant on hand 16,000
To Plant 20,000 By work certified
To overheads 8,600 (2,40,000x100/80) 3,00,000
To Notional profit 13,400

----------

______
3,26,000 3,26,000

====== =====

To P/L account 7,147 By notional profit b/d 13,400

To Balance c/d 6,253

---------- ---------
13, 400 13,400

Example 2
XY Ltd undertook a contract, the following was the expenditure on a contract for Rs.
6,00,000.
Material issued to contract Rs. 1,02,000
Plant issued for contract Rs. 30000
Wages Rs.1,62,000
Other expenses Rs. 10,000
Cash received on account of contract up to 31st march 2011 amounted to Rs. 2,56,000
being
80% of work certified. Of the plant and material charged to the contract plant costing Rs.
3000 and
material costing Rs. 4000/ were lost. On Ist March 2011, Plant which cost Rs. 2,000 was
returned
to the store, the cost of work done but not certified was Rs. 3000 and material costing Rs.
2,500
were in hand on site. Provide 10% depreciation on plant, reserve 1/3 of profit received
and prepare
contract account from the above particulars.

Solution

CONTRACT ACCOUNT

To materials 1,02,000 By work in progress:

To Plant 30,000 Work certified
256000x100/80 320,000
3,20000
To wages 1,62,000 Work uncertified
To other expenses 10,000 3000

By P & L Account 7000

Plant lost 3000
Material lost 4000
------ 1,800
By plant returned:
2,000 2,500
Less: depreciation
To Notional profit c/d (B. 52800 200
F) By material in hand
By material in hand

By plant at site(30000-3000-
2000) 25000 22500
356800 Less: depr 2500 356800
52 800
28160 By notional profit B/d
To P/L Account
52800x2/3x80/100 24640
52 800 52 800
Reserve BF

WORK IN PROGRESS ACCOUNT

To contract A/c 3 23,000 By Contract A/c 24640

(reserve) 2,98,360
 By Balance c/d 3,23,000
==========
3,23,000
==========

Note: It is assumed that the contract has begun on 1/4/10.

Example- 3
Mr. A has undertaken several contract works. He maintains a separate record for each
contract.
From the records for the year ending 31-12-98, Prepare contract account for Contract
No.50 and
find the amount transferred to profit and loss account

Direct purchase of material 1,80,000

Material issued from stores 50,000
Wages 2,44000
Direct expenses 24,000
Machinery purchased 1,60,000
Establishment charges 54,000

The contract price was Rs. 15,00,000. Cash received up to 31-12-2008 was Rs. 6,00,000
which is
80% of work certified . Material at site Rs. 16,000. Depreciation for Machine Rs. 16,000.

Solution:

To materials: By material at site 16,000

Direct purchase 1,80,000 Machinery on hand (1,60,000- 1, 44,000

Issued from stores 50,000 16000)
Wages 2,44,000 Work certified 7, 50,000
Direct expenses 24,000
Machinery purchased 1,60,000
Establishment 54,000
Notional profit 1,98,000
9,10,000 9, 10,000
1,98,000
1,05,600 By notional profit b/d 1,98,000
To P/L account 92,400 =======
Work in progress A/c =======
PROCESS COSTING
Process costing is the method of costing applied in the industries engaged in continuous
or
mass production. Process costing is a method of costing used to ascertain the cost of a
product at
each process or stage of manufacturing.
According to ICMA terminology, “Process Costing is that form of operation costing
which
applies where standardized goods are produced”.
So it is a basic method to ascertain the cost at each stage of manufacturing. Separate
accounts are maintained at each process to which expenditure incurred. At the end of
each process
the cost per unit is determined by dividing the total cost by the number of units produced
at each
stage. Hence, this costing is also called as “Average Costing” or “Continuous Costing”.
Process
Costing is used in the industries like manufacturing industries, chemical industries,
mining works
and public utility undertakings.

Characteristics of Process Costing

1. Production is continuous
2. Products pass through two or more distinct processes of completion.
3. Products are standardized and homogeneous.
4. Products are not distinguishable in processing stage.
5. The finished product of one process becomes the raw material of the subsequent
process.
6. Cost of material, labour and overheads are collected for each process and charged
accordingly

Advantages of Process Costing

1. It is easy to compute average cot because the products are homogeneous in Process
Costing.
2. It is possible to ascertain the process costs at short intervals.
3. Process Costing is simple and less expensive in relation o job costing.
4. By evaluating the performance of each process effective managerial control is possible.
Disadvantages of Process Costing
1. Valuation of work in progress is difficult.
2. It is not easy to value losses, wastes, scraps etc.
3. The apportionment of total cost among joint products and by-products is difficult.
4. Process cost are not accurate, they are only average costs
5. Process costs are only historical.
Principles of Process Costing

The following points are considered while determining the cost under Process Costing.
1. Production activity should be divided into different processes or departments.
2. A separate account is opened for each process.
3. Both direct and indirect costs are collected for each process.
4. The quantity of output and costs are recorded in the respective process accounts.
5. The cost per unit is determined by dividing the total cost at the end of each process by
the
number of output of each process.
6. Normal loss and abnormal loss are credited in the process account
7. The accumulated cost of each process is transferred to subsequent process along with
output. The output of the last process along with cost is transferred to the finished goods
account.
8. In case of by-products and joint products their share in joint cost should be estimated
and
credited to the min process.
9. When there is work in progress at the end of the period the computation of inventory is
made I terms of complete units.
Difference between Process Costing and Job Costing

Process Costing Job Costing

1. Production is continuous 1. Production is according to
2. Production is for stock customers’ orders
3. All units produced are identical or 2. Production is not for stock
homogeneous 3. Each job is different from the other
4. There is regular transfer of cost of one 4. There is no regular transfer of cost
process to subsequent processes from one job to another
5. Work in progress always exists 5. Work in progress may or may not
exist
Procedure for Process Costing
1. Each process is separately identified. Separate process account is opened for each
process.
2. Along with ‘Particulars Column’, two columns are provided on both sides of the
process
account – units (quantity) and amount (Rupees).
3. All the expenses are debited in the respective process account

4. Wastage, sale of scrap, by-products etc are reordered on the credit side 0f the process
account.
5. The difference between debit and credit side shows the cost of production and output
of that
particular process which is transferred to the next process.
6. The cost per unit in every process is calculated by dividing the net cost by the output.
7. The output of last process is transferred to the Finished Stock Account.
8. Incomplete units at the end of the each period ion every process s converted in terms of
completed units.

Specimen of Process Account

Process Account

Units Rs. Units Rs.

To Direct materials By Loss in weight
To Direct Wages (Normal
To Direct Expenses Loss)
To Indirect expenses By sale of Scrap
To Other Expenses (if any) By Next Process
Account(Transfer)
Preparation of Process Accounts
The preparation of Process Account depends upon the following situations
1. Simple Process Account
2. Process costing with normal process loss
3. Process costing with abnormal process loss
4. Process costing with abnormal process gains
5. Inter – process profits.
Simple Process Account
Under this case it is very easy to prepare process account. A separate account is opened
for
each process. All costs are debited to the process account. The total cost of the process is
transferred to the next process. At the end of each process the cost per unit is obtained by
dividing
the total cost by the number of units.
Illustration 1: Product A requires three distinct processes and after the third process the
product is
transferred to finished stock. Prepare various process accounts from the following
information.

Total P1 P2 P3
Direct Materials 5000 4000 600 400
Direct Labour 4000 1500 1600 900
Direct Expenses 800 500 300
Production overheads 6000

Production overheads to be allocated to different processes on the basis of 150% of direct

wages. Production during the period was 200 units. Assume 5here is no opening or
closing stock

Solution: Process I Account

Units Le Units Le
To Direct materials 200 4000 By Process II
To Direct Wages 1500 Account(Transfer) 200 8250
To Direct Expenses 500
To Production overheads 2250 Cost per unit 8250 = 200 8250
(1500x150%) 200 8250 41.25
200
Process Account II

Units Le Units Le
To Process I A/c 200 8250 By Process III 3150
To Direct materials 600 200
To Direct Wages 1600 Account(Transfer)
To Direct Expenses 300
To Production overheads 2400 Cost per unit 13150 =
(1600x150%) 200 3150 65.75 200 3150
200
Process Account III

Units Le Units Le
To Process II A/c 200 13150 By Finished stock A/c 200 15800
To Direct materials 400 (Output Transferred )
To Direct Wages 900 Cost per unit 15800 = 79
To Production overheads 1350 200
(900x150%)
200 15800
200 15800

Process losses
The process loss is classified into two- normal process loss and abnormal process loss.
Normal process loss
This is the loss which is unavoidable on account of inherent nature of production process.
It
arises under normal conditions. It is usually calculated as a certain percentage of input.
Normal
process los includes either waste or scrap r both. Waste is unsalable and has no value.
Loss in
weight is an example of waste. Loss in weight should be credited to the concerned
process account.
It should be recorded only in terms of quantity.
Loss in weight = Opening Stock + output from the preceding process – (output of the
Concerned process + closing stock)
Illustration 2: From the following figures, show the cost of three processes of
manufacture. The
production of each process is passed on to the next process immediately on completion.

Process Process Process

A B C
Wages and Materials 30400 12000 29250
Works Overhead 5600 5250 6000
Production ion units 36000 37500 48000
Stock on 1 July 2012 (units from preceding
process) 4000 16500
Stock on 31 July 2012 (units from preceding
process) 1000 5500
Solution:
Process A Account

Units Rs. Units

To Wages and Materials 36000 30400 By Process B A/c
To Works Overhead 5600 (Transfer )
36000 36000
Cost per unit 36000 = 1 36000 36000
36000
36000 36000

Process B Account

Units Rs. Units Rs.

To Opening Stock (Re.1 4000 4000 By loss in weight (Bal. 1500 8250
p.u) 36000 36000 fig) 1000
To Process A A/c 12000 By Closing stock @
(transfer) 5250 Re.1
To Wages and Materials p.u
To Works Overhead 37500 108000
54000 116250 By Process C A/c 54000 116250
(Transfer )
Cost per unit 56250 =
1.50
37500

Illustration 3: Bihar Chemicals Ltd produced three chemicals during the month of July
2012 by
three consecutive processes. In each process 2% of the total weight put in is lost and 10
% is scrap
which from process 1 and 2 realizes Rs.100 a ton and from process 3Rs.20 a ton.
The product of three processes is dealt with as follows:

Process1 Process2 Process3

Passed on to the next process 75% 50%
Sent to warehouse for sale 25% 50% 100%
Expenses incurred:

Rs Tons Rs Tons Rs Tons

Raw materials 120000 1000 28000 140 107840 1348
Manufacturing wages 20500 18520 15000
General expenses 10300 7240 3100
Prepare Process Cost Accounts showing the cost per ton of each product.
Solution:
Process 1 Account

Units Rs. Units Rs.

To Raw materials 1000 120000 By loss in weight (2%) 20 10000
To Manufacturing wages 20500
To General expenses 10300 By Sale of scrap (10%) 100 35200

By Warehouse - transfer 220 105600

(880x25%)

By Process 2 660
A/c(Transfer )
Cost per unit 140800 =
160
800

1000 150800 1000 150800

Process 2 Account
 Units Rs. Units Rs.
To Process 1 660 105600 By loss in weight (2%) 16 8000
A/c(Transfer ) By Sale of scrap (10%) 80 75680
140 28000 By Warehouse - 75680
To Raw materials transfer 352
18520 (704x50%)
To Manufacturing wages By Process 2 352
7240 A/c(Transfer )
To General expenses Cost per unit 151360 =
800 159360 70 800 159360
215

Units Rs. Units Rs.

To Process 2 352 352 By loss in weight (2%) 34
A/c(Transfer ) 1348 1348 By Sale of scrap (10%) 170 3400
To Raw materials
To Manufacturing By Warehouse - transfer 1496 198220
wages Cost p unit 198220
To General expenses =132.5
1700 201620 1496 1700 201620

Process 3 Account

Abnormal Process Loss

Any loss caused by unexpected or abnormal conditions such as plant break don,
substandard
materials, carelessness, accident etc. or loss in exceeds of the margin anticipated for
normal process
loss can be called as abnormal process loss. It is controllable and avoidable. When actual
loss in the
process is greater than the estimated normal loss, it is a case of abnormal loss. It may also
be
determined by comparing actual output with expected or normal output. If actual output
is les than
the normal output, the difference is abnormal loss.
Value of Abnormal loss = Normal cost of normal output x Units of Abnormal loss
Normal output
Normal cost of normal output = Total expenditure (i.e., total debit of process A/c) – Sale
Proceeds of scrap (i.e. Value of normal loss)
Normal output = Input – Units of normal loss
Illustration 4: In process A 100 units of raw materials were introduced at a cost of
Rs.1000. the
other expenditure incurred by the process was Rs. 602. Of the units introduced 10% are
normally
lost in the course of manufacture and them posses a scrap value of Rs.3 each. The output
of process
A was only 75 units. Prepare Process A A/c and Abnormal loss A/c.
Solution:

Process A A/c

Units Rs. Units Rs.

To Raw Materials 100 1000 By normal loss-
To Other expenses 602 100x10% @rs.3 each 10 30
By Abnormal loss
(Bal.Fig) 15 262*
By Process B A/c
(transfer 75 1310
100 1602 100 1602

Working Note:
Normal cost of normal output = Total expenditure – Sale Proceeds of scrap
= 1602-30= 1572
Normal output = Input – Units of normal loss
= 100 – 10 = 90

Value of Abnormal loss = Normal cost of normal output x Units of Abnormal loss
Normal output
= 1572 x 15 = Rs. 262
90

To Process A 15 262 By Cash (scrap value of 15

loss @ Rs.3) 45
By Costing P&L A/c
217

15 262 15 262

Abnormal Gain (or Abnormal Effective)

Sometimes actual loss or wastage in a process is less than expected normal loss. In this
case
the difference between actual loss and expected loss is known as abnormal gain or
abnormal
effective. It is the excess of actual production over normal output.
Abnormal gain is valued in the same manner as abnormal loss. The value of abnormal
gain
is debited to process A/c and credited to abnormal gain A/c. the value of scrap is debited
to
abnormal gain A/.c and credited to normal loss A/c. finally abnormal loss A/c is closed
by
transferring the credit balance to Costing P&L A/c.

Value of Abnormal Gain = Normal cost of normal output x Units of Abnormal gain
Normal output

Normal cost of normal output = Total expenditure– Sale Proceeds of scrap

Normal output = Input – Units of normal loss
Units of Abnormal gain = Normal loss- Actual loss
Or = Actual output - Normal output

Illustration 5: Product X is obtained after it passes through three distinct processes. 2000
kg of
materials at Rs.5 per kg were issued to the first process. Direct wages amounted to
Rs.900 and
production overhead incurred was Rs.500. Normal loss is estimated at 10% of input. This
wastage
is sold at Rs.3 per kg. The actual output is 1850 kg. Prepare process I A/c and Abnormal
Gain/
Abnormal loss A/c as the case may be.
Solution:

Process I Account

Kg Rs. Kg Rs.
To Materials 2000 10000 By Normal loss (Sale of
To Direct wages 900 scrap ) 200 600
To Production OH 500 By Process II - transfer 1850 111002
To Abnormal gain (Bal.) 501 3003
2050
2050 11700 11700

Abnormal Gain A/c

To Normal loss (loss of 50 150 By Process I A/c 50 300
income) 150
To Costing P&L A/c
(Bal.)
50 300 50 300
Working note:
1. (200+1850)-2000=50
2. (10000+900+500)-600 = Rs.6
1850-50
1850x6=11100
3. 50x6=30

Illustration 6: The product of a company passes through three distinct processes to

completion –
A,B and C. from the past experience it s ascertained that los s incurred in each process as
– A-2%,
B-5% and C-10%.
In each case the percentage of loss is computed on te number of units entering the process
concerned. The loss of each process possesses a scrap value. The los of processes A and
B sold at
Rs.5 per 100 units and that of C at Rs.20 per 100 units.
The output of each process passes immediately to the next process and the finished units
are
passed from process C into stock.

Process A Process B Process C

Materials consumed 6000 4000 2000
Direct labour 8000 6000 3000
Manufacturing 1000 1000 1500
expenses

20000 units have been issued to process A at a cost of Rs.10000. the output of each
process
has been as under:
A-19500, B- 18800 and C - 16000.
Process A Account
Units Rs. Units Rs.
To Units introduced 20000 10000 By Normal loss 400 20
To Materials 6000
To Direct labour 8000 By Abnormal loss 100 127
To Manufacturing 1000 (Bal.)
Expenses 19500 24853
By Process B - transfer
20000 25000 20000 25000
Process B Account

Units Rs. Units Rs.

To Process A A/c 19500 24853 By Normal loss 975 49
To Materials 4000 By Process C - transfer 18800 36336
To Direct labour 6000
To Manufacturing 1000
Expenses 532
To abnormal gain 275
19775 36385 19775 36385
Process C Account

Units Rs. Units Rs.

To Process B A/c 18800 36336 By Normal loss 1880 376
To Materials 2000 By To abnormal loss 920 2309
To Direct labour 3000 By Finished stock A/c - 16000 40151
To Manufacturing 1500 transfer
Expenses
18800 42836 18800 42836
Finished Stock A/c

Units Rs. Units Rs.

To Process C A/c 16000 40151
16000 40151 16000 40151
Abnormal Loss A/c

Units Rs. Units Rs.

To Process A 100 127 By Cash (100@Rs.5 1020 189
To Process C 920 2309 per 2247
1020 2436 100+920@Rs.20per 1020 2436
100)
By Costing P&L A/c

Normal loss A/c

 Units Rs. Units Rs.
To Process A 400 20 By Abnormal Gain 275 14
By Cash/Debtors A/c 2980 431
To Process B 975 49

To Process C 1880 376

3255 445 3255 445

Abnormal Gain A/c

Units Rs. Units Rs.

To Normal loss (loss 275 14 By Process C A/c 275 532
of
income) 538
To Costing P&L A/c
(Bal.) 275 532 275 532
Working note:
Process A:
Value of Abnormal loss = Rs.24980/19600 units x 100 units = Rs. 127.
Process B:
Value of Abnormal gain = Rs.35804/18525 units x 275 units = Rs. 532.
Process C:
Value of Abnormal loss = Rs.42460/16920 units x 920 units = Rs. 2309.
Work-in-Progress
In most of the firms manufacturing is on a continuous basis and the problem of work-
inprogress
is quite common. The work-in-progress consists of direct materials, direct wages and
production overhead.
Equivalent Production
Equivalent production represents the production of a process in terms of completed units.
In
other words, it means converting the incomplete units into its equivalent of completed
units. It is
also known as effective production. For calculating equivalent production, work-in-
progress needs
to be inspected. Then an estimate is made of the degree of completion, usually on a
percentage
basis.
Steps and procedure of computation of Equivalent Production
1. Ascertain Equivalent Production in respect of opening work-in-progress, if any. In this
case the
Equivalent Production is computed by taking into consideration the percentage of work
required to
finish now in the process. The following formula is used.
Opening WIP (Units) x % of work needed to complete.
2. Find the units introduced and completed and add this to (1). It is calculated as follows:
Units completed and transferred – Opening work-in-progress.
3. Convert the equivalent production of closing work-in-progress and add to the above.
The formula is:
Closing work-in-progress (units) x% of work completed.
4. Obtain the total Equivalent Production terms of materials, labour and overhead
separately (if
degree of completion is different). For this, ‘Statement of Equivalent Production’ is
prepared.
5. Find out the net process costs, element wise- materials, labour and overheads.

6. Ascertain the cost per unit of Equivalent Production for each element of cost
separately.
Material cost per unit= Material cost
Equivalent Production in respect of materials

Labour cost per unit = Labour cost

Equivalent Production in respect of labour

Overhead cost per unit = Overhead cost

Equivalent Production in respect of overhead

For this purpose ‘Statement of Cost is prepared’

7. Find out the value of opening work-in-progress, finished units and closing work-in-
progress. The
formula is:
Equivalent Production in respect of materials x Material cost per unit
Equivalent Production in respect of labour x Labour cost per unit
Equivalent Production in respect of overhead x Overhead cost per unit

For this purpose ‘Statement of Evaluation or Apportionment’ is prepared.

In short, the following three statements are to be prepared:
1. Statement of Equivalent Production
2. Statement of Cost
3. Statement of Evaluation.
I. When there is only closing work-in-progress but with no process losses
Under this case the closing work-in-progress is converted into equivalent units on the
basis
of estimate as regards degree of completion o materials, labour and production overhead.
Illustration 7: Input 3800 units, Output 3000 units and closing work-in-progress 800
units.
 Degree of Process costs
completion Rs.
Materials 80% 7280
Labour 70% 10680
Overheads 70% 7120
Find out Equivalent Production, Cost per unit of equivalent production and prepare the
Process A A/c assuming that there is no opening work-in-progress and process loss.
Solution:
Statement of Equivalent Production

Input Output Equivalent Production

Items Units Items Units Materials Labour &
Overhead
Units Units completed & Units % Units %
introduced transferred 3000 3000 100 3000 100
Work in progress 800 640 80 560 70
3800
3800 3640 3560

Statement of Cost

Elements of cost Cost Equivalent Production Cost per

(Rs.) (units completed
unit
Materials 7280 3640 2.00
Labour 10680 3560 3.00
Overheads 7120 3560 2.00

25080 7.00
Statement of Evaluation

Finished goods 3000x7 21000

Work-in-progress:

Materials 640x2 1280

Labour 560x3 1680

 4080
Overhead 560x2 1120

Process A A/c

Units Rs. Units Rs.

To Materials 3800 7280 By Finished stock A/c - 3000 21000
To Labour 10680 transfer 4080
To Overhead 7120 By Work-in-progress 800

3800 25080 3800 25080

II.When there is only closing work-in-progress but with process losses
In case of normal loss, nothing should be added as equivalent production. However,
abnormal loss should be considered as production of good units completed during the
period.
Illustration 8: During January 2000 units were introduced into Process I. the normal loss
was
estimated at 5% on input. At the end of the month, 1400 units had been produce and
transferred to the next process, 460 units were uncompleted and 140 units had been
scrapped. It was estimated that uncompleted units had reached a stage in production as
follows:
Material 75% completed
Labour 50% completed
Overheads 50% completed
The cost of 20000 units was Rs.5800
Direct material introduced during the process Rs.1440
Direct wages Rs.3340
Production overheads incurred were Rs. 1670
Units scrapped realized Re.1 each.

Units scrapped passed through the process, so were 100% completed as regards material,
labour
and overhead.
Find out Equivalent Production, Cost per unit and prepare the necessary accounts.

Solution:
Statement of Equivalent Production

Input Output Units Equivalent Production

Materials Labour &
Overhead
Units
 Units % Units %
2000 Normal loss 100 40 100 40 100
Abnormal loss 40 1400 100 1400 100
Finished production 1400 345 75 230 50
Work in progress 460

2000 2000 1785 1670

Statement of Cost

Elements of cost Cost Equivalent Cost per

(Rs.) Production (units) completed
unit
Materials

Cost of units introduced 5800

Direct Materials 1440

7240 1785 4
Less: Scrap vale of normal loss 100 1670 2
7140 1670 1
Direct wages 3340 7

Overheads 1670
12150
Total

Statement of Evaluation

Production Cost Equivalent Production Cost Cost Total

Elements per unit Cost
Abnormal Material 40 4 160
loss
Labour 40 2 80 280

Overheads 40 1 40
Finished Material 1400 4 5600
production
Labour 1400 2 2800 9800

Overheads 1400 1 1400

Work-in Material 345 4 1380
progress
 Labour 230 2 460 2070
12150
Overheads 230 1 230

Process I A/c

Units Rs. Units Rs.

To Units introduced 2000 5800 By Normal loss 100 100

To Materials 1440 By abnormal loss 40 280

To Labour 3340 By Finished production 1400 9800

To Overhead 1670 By Balance c/d 2070

2000 12250 (Work-in-progress) 460
2000 12250
Finished Production A/c

Units Rs. Units Rs.

To Process I A/c 40 280 By Cash (sale @ Re.1 40 40
40 280 p.u) 40 240
By Costing P&L A/c 280
(loss
III.When there is opening as well as closing work in progress but with no process loss.
Sometimes in a continuous process there will be opening as well as closing work in
progress which are to be converted into equivalent of completed units for apportionment
of process
costs. The procedure of conversion of opening work in progress will vary depending
upon whether
average cost or FIFO or LIFO method of apportionment of costs is followed.
Illustration 9: From the following details, prepare statement of equivalent production,
statement of
cost, statement of evaluation and process A/c by following FIFO method.
Opening work-in-progress (2000 units):
Materials (100% complete) Rs. 5000
Labour (60% complete) Rs. 3000
Overheads (60% complete) Rs. 1500
Units introdu4ed into the process Rs. 8000
There are 2000 units in progress and the stage of completion is estimated to be:
Materials 100%
Labour 50%
Overheads 50%
8000 units are transferred to the next process:
The process costs for the period are:
Materials Rs.96000
Labour Rs. 54600
Overheads Rs. 31200

Solution:
Statement of Equivalent Production

Units Equivalent Production

Output Materials Labour &
Overhead
Units % Units %
Opening WIP 2,000 800 40

Completed processed during the 6,000 6000 10

period(8000-2000) 2,000 2000 0 6000 100
Closing WIP 10,000 8,000 10 1000 50
Total 0 7,800
Statement of Cost

Elements of cost Equivalent Cost per

Production (units) completed
unit
Materials 96000 8000 12

Labour 54600 7800 7

Overheads 31200 7800 4

Total 181800 23

Statement of Evaluation

Opening Work-in-progress (current cost)

Materials
Labour 800x7
Overhead 800x4
Opening Work-in-progress (current cost) 8800
Materials 5600
 3200
Labour 800x7
Overhead 800x4
Closing WIP 24000
Materials 2000x12 7000 35000
Labour 1000x7 4000 138000
Overhead 1000x4 181800
units completely processed during the period 6000@23
Process A/c

To Opening WIP 2000 9500 By Finished stock

To Materials 8000 96000 transferred 8000
To Labour 54600 to next process 2000 156300
To Overhead 31200 (9500+8800+138000) 10000 35000
10000 191300 By Closing WIP 191300
IV. When there is opening as well as closing work-in-progress but with losses.
Under this equivalent production units regarding opening and closing work in progress
are
to be calculated with due adjustment for process losses.
Illustration 10: Following data are relating Process A for March 2012.
Opening WIP – 1500 units for Rs.15000
Degree of completion:
Materials 100%, Labour and overheads 33 1/3%
Input of materials 18500 units at Rs.52000
Direct labour Rs. 14000
Overheads Rs. 28000
Closing WIP - 5000 units.
Degree of completion: Materials 90% and labour and overheads 30%.
Norma process loss is 10% of total input (opening WIP units + units put in)
Scrap value Rs. 2 per unit.
Unit transferred to the next process 15000 units.
Compute equivalent units of production, cost per equivalent unit for each cost element
and
cost of finished output and closing WIP. Also prepare Process and other accounts.
Assume that
FIFO method is used by the company and the cost of opening WIP is fully transferred to
the next
Process

Solution:
Statement of Equivalent Production and Cost
Input Output Units Equivalent Production
Units Materials Labour Overhead
Units % Units % Units %

Opening WIP
1000
transfer 1500 1000 662/3 66
2/3
Normal loss 2000 13500 100
90 13500
Finished goods 13500 4500 13500 100 100
18000 100 1500 30
Closing WIP 5000 2000 1500 30 16000
22000 16000 16000 100 2000
less: Abnormal 2000 2000 14000
gain 20000 48000 14000 100
Materials 52000 28000
less: scrap value 4000 Rs.3 14000
Cost per Rs.2
equivalent unit Rs.1

Statement of Evaluation

Opening Work-in-progress
Materials
Labour 1000x1 1000
Overhead 1000x2 2000 3000
Finished goods 13500x6 81000
Abnormal gain 2000x6 12000

Closing WIP
Materials 4500x3 13500
Labour 1500x1 1500
Overhead 1500x2 3000 18000
Process I A/c

Units Rs. Units Rs.

To Opening WIP 1500 15000 By normal loss 2000 4000
To Materials 18500 52000 By Finished stock
To Labour 14000 (18000+81000)
To Overhead 28000 By Closing WIP 15000 99000
To Abnormal gain 2000 12000 5000 18000
22000 121000 22000 121000
 Normal loss A/c

Units Rs. Units Rs.

To Process I 2000 4000 By Abnormal Gain 2000 4000

Abnormal Gain A/c

To Normal loss (loss of 2000 4000 By Process I A/c 2000 12000

income)
To Costing P&L A/c 8000
(Bal.) 2000 12000 2000 12000

OPERATING COSTING
(SERVICE COSTING)

It is the costing procedure used for determining the cost of per unit of service rendered. It
is a
method of costing applied to undertaking which provides service rather than production
of
commodities. The services may be in the form of transport, supply service, welfare
service, etc.
There is a difference between operating costing and operation costing. Operating costing
is a
method of costing designed to find out the cost of operating or rendering a service. On
the other
hand, operation costing is a method of costing applied to determine the total cost and unit
cost of

each operation. Though service undertakings are of different types, but here we discuss
only
transport operating costing.
Transport costing:
Transport industries include Air, Water, Rail and Road. They render services to the
community at
large. We have to give utmost care while selecting the cost unit. The cost unit of other
forms
operation costing is quite different from that of a service undertaking. The cost unit of a
service
organization is a composite unit. The important factors to be considered includes the
number of
passengers, tonnage carried, distance covered etc.
Classification of Costs:
Operating costs of a transport undertaking comprising different items, which are
classified under
the following three groups.
1. Standing or fixed charges: These charges are incurred in spite of the kilometers run.
It is
fixed in nature. Eg. Insurance, Motor vehicle tax, license fee, rent, salary of operating
manager etc.
2. Maintenance charges: It includes semi variable expenses Eg. Tyres and tubes, repairs
and
paintings etc.
3. Operating and running charges: These charges vary more or less in direct proportion
to
kilometers. All the variable charges of running vehicles are included in this group.
Generally it includes, petrol, oil,, grease etc., wages of driver, attendant if payment is
related
to time or distance of trip etc.
In the place of the above classification, all expenses can be divided into two – fixed cost
and
variable costs. Here, both maintenance charges and running charges are considered as
variable charges.
Selection of Unit:
In transport costing, a composite unit such as passenger mile or passenger kilometer or
tone
kilometer is often selected. Such unit takes into account both the number of passengers or
weight
of goods carried and distance run.
Absolute passenger or commercial passenger/ tone km:
It is calculated by multiplying every part of distance travelled/covered with either weight
carried or
passenger carried.. After getting the product of each journey we add all the products. The
total is
absolute ton/quintal km
In the case of goods transport the equation is
Distance of each part of journey x weight carried
In the case of passenger transport, the following formula is used
Distance of each part of journey x No. of passengers taken for the same distance
Commercial method:
The following steps are used to find out the commercial tone km
a. Find out average trip load
b. Find out total distance of journey
c. Multiply a and b , the resultant figure is commercial tone km

Example 1
A truck starts with a load of 10 tonnes of goods from station P. It unloads 4 tonnes at
station Q and
rest of the goods at station R. It reaches back directly to station P after getting reloaded
with 8
tonnes of goods at station R. The distance between P to Q, Q to R and then from R to P
are 40
kms, 60 kms, and 80 kms respectively. Compute absolute tone kms and commercial tone-
km .
Absolute ton/ km = Total distance x weight carried

= (40x10) + (60x6) + (80x8) =400+360+640= 1400

Commercial tone/km = Distance x average load

= [40+60+80] x{10+6+8/3}= 180x8=1440

Example 2
A bus with a capacity of 50 passengers makes a return trip from P to Q via station X
every day.
The distance between P and X is 60 kms where as between X and Q is 40 40 km. During
the
onward journey, the bus is full to capacity up to station X but only 60% full between X
and Q. On
the other hand, on return trip it is full from Q to X but only comes 40% of the capacity
between X
and P.
Compute the total passenger kms of service the bus renders every day.
Solution:
Total passenger kms per day:
Onward journey:

P to X 60kms X 50 =3000
X to Q 40kmsX50X60% =1200

Total (A) 4200

Return Trip:
 Q to X 40 kms X 50 X 100% =2000
X to P 60 kms X 50 X 40 % =1200

Total (B) 3200

Total passenger kms every day= (A) + (B) =4200+3200= 7400 kms

Preparation of Operating Cost sheet:

An operating cost sheet is prepared periodically in order to ascertain the cost per unit.
Here, the
total fixed, maintenance and running costs are collected and allocated under respective
heads and
these are then divided by total units.
The Performa of a operating cost sheet is given below

Particulars Total cost Cost per unit

A. Fixed or standing charges:
Garage rent
License fee
Insurance
Motor vehicle tax
Interest on capital
Supervision
Office establishment
Administrative overheads
Salary of foreman , manager etc
Total
B. Maintenance charges:
Repairs and renewals
Tyres and tubes
Paintings
Overhauling
Cleaning
Gas and electric charges
Spare parts and accessories
Total
C. Operating charges:
Petrol
Engine oil
Lubricating oil, grease etc
Wages of operators
Depreciation
Salaries of running staff
Water
Total

Calculation of Depreciation:
If the rate of depreciation is not given, depreciation is calculated as follows:
Depreciation =Cost- scrap
Life in years
Depreciation per mile, or km = Depreciation p.a
Kms/miles run p.a

Example 3
From the following data calculate the cost per mile of a vehicle:

Value of vehicle Rs. 15,000

Road license for the year 500
Insurance charges per year 100
Garage rent per year 600
Drivers’ wages per month 200

Cost of petrol per litre 0.80

Miles per litre 8
Proportional charge for tyre and maintenance per mile 0.20
Estimated life 1,50, 000 miles
Ignore interest on capital

Solution:
Operating cost statement

Particulars Annual Cost per

cost unit
Fixed expenses:

Road license fee 500 0.08

Insurance charge 100 0.02

600 0.10
Garage rent
Maintenance charges:
0.20 0.20
Cost of tyre and maintenance of per mile

Operating /running charges:

0.10
Cost of petrol per mile 80p/8
0.40
Drivers wage per mile 2400/6000
0.10
Depreciation of vehicle 15000X6000/1,50,000 1.00
=========
Example 4
Mathrubhumi Transport Co. is running four buses between two towns which are fifty
miles apart,
seating capacity of each bus is 40 passengers.
The following particulars were obtained from their books for the month of November
2010.

Salaries of office and supervisory staff Rs. 3000

Diesel oil and other oils Rs/ 4000
Wages of Drivers and conductors Rs. 2400
Repairs and maintenance Rs. 800
Taxation, insurance etc Rs. 1600
Depreciation Rs. 2600
Interest and other charges Rs. 2000
-----------
16,400

Actual passengers carried were 75% of the seating capacity. All the four buses ran on 30
days in a
month, each bus made one round trip per day.
Prepare an operating cost statement for the month showing cost per passenger mile

Operating cost sheet for the month of November 2010

Particulars Total cost

Salaries of office staff 3000

Wages of driver’s , conductors etc 2400

Diesel oil and other oils 4000

Repairs and maintenance 800

Taxation , insurance etc 1600

Depreciation 2600
Interest and other charges 2000

16400
=====

Cost per passenger mile =16400/3,60,000= 0.04 paise

Working note:-
Passenger miles = No. of Trips per day X No. of days in a month X percentage of
capacity X
mileage per trip

= 4x 1 x 30 x (75% of 40) x (50 x 2)

4 x 1 x 30 x 30 x 100 = 3,60,000 passenger miles.

Practical problem 1
Work out in appropriate cost sheet form the unit cost per passenger km for the year 2009-
10 for a
fleet of passenger buses run by a transport company from the following figures extracted
from its
books:-
5 passenger buses costing Rs.60,000, Rs.1,20,000, Rs.50,000, Rs. 65,000 and Rs. 45,000.
respectively. Yearly depreciation of vehicles is 20% of cost.
Annual repairs, maintenance and spare parts is 80% of depreciation. Wages of 10 drivers
@Rs.
100 each per month, wages of 20 cleaners @ Rs. 50 each per month. Yearly rate of
interest @ 4%
on capital. Rent of 6 garages @ Rs. 50 each per month. Directors fees @ Rs.400 per
month, office
establishment @ Rs. 1000 per month, license and taxes@ Rs.1000 every six months,
realization by
sale of old tyres and tubes @ Rs. 3,200 every six months, 900 passengers were carried
over 1,600
kms during the year.

Module V
 Cost Control Techniques

BUDGET AND BUDGETORY CONTROL

Meaning and definition of budget:
A budget is a plan of action for a future period. It simply means a financial plan
expressed in terms
of money. The budget pertaining to any of the activities of business is always forward
looking.
The term ‘budget’ has been derived from the French word, ”bougette”, which means a
leather bag
into which funds are appropriated to meet the anticipated expenses.
The CIMA Official Terminology defines a budget as “ A quantitative statement, for a
defined
period of time, which may include planned revenues, expenses, assets, liabilities and cash
flows.”
Budgeting and Budgetary control:
Budgeting simply means preparing budgets. It is a process of preparation,
implementation and the
operation of budget. Being a plan of action, a budget guides every manager in the
decision making
process.
In the words of Rowland Harr, “Budgeting is the process of building budgets”.
Budgetary control is a system of using budgets for planning and controlling costs. The
official
terminology of CIMA defines the term ‘budgetary control , as “ the establishment of
budgets
relating to the responsibilities of executives to the requirement of a policy, and the
continuous
comparison of actual with budgetary result, either to secure by individual action the
objectives of
that policy or to provide a basis for its revision.” Thus, when plans are embodied in a
budget and
the same is used as the basis for regulating operations, we have budgetary control. As
such
budgetary control starts with budgeting and ends with control.
Objectives of Budget and Budgetary control:
The following points reveal the objectives of Budget and budgetary control:-
1. To aid the planning of annual operations
2. To co ordinate the activities of the various parts of the organization
3. To communicate plans to the various responsibility centre managers
4. To motivate managers to strive to achieve the organizational goals.
5. To control activities
6. To eliminates the wastes of all kinds
7. To provide a yard stick against which actual results can be compared
8. To evaluate the performance of managers.
9. To reduce the uncertainties
Meaning of Estimate forecast and Budget:

An estimate is predetermination of future events either on the basis of simple guess work
or
following scientific principles.
Forecast is an assessment of probable future events. Budget is based on the implication of
a
forecast and related to planned events. To establish a realistic budget, it is necessary to
forecast a
wide range of factors like sales volume, sales prices, material availability, wage rate, the
cost of
overheads etc.

Steps involved in Budgetary Control:

The following steps may be considered necessary for a comprehensive budgetary control
programme:-
1. Laying down organizational goals or objectives
2. Formulating the necessary plans to ensure that the desired objectives are achieved.
3. Translating plans into budget
4. Relating the responsibilities of executives to the requirements of a policy.
5. Recording and reporting actual performance
6. Continuous comparison of actual with budgeted results
7. Ascertainment of deviations, if any
8. Focusing attention on significant deviations
9. Investigation into deviations to establish causes
10. Presentation of information to management, relating the variations to individual
responsibility.
11. Taking corrective action to prevent recurrence of variations.
12. Provide a basis for revision of budgets.

Essentials of a Budgetary Control system: Successful implementation of a budgetary

control
system depends up on the following essentials.
1. Support by top management: The wholehearted support of all managerial persons is
very
necessary for the success of a budgetary control system.
2. Formal organization: The existence of a formal and sound organizational structure is
of an
absolute necessity for an effective system of budgetary control.
3. Budget centers: For budgetary control purposes, the entire organization will be split
into a
number of departments, area or functions, known as ‘centres’, and budgets will be
prepared
for each such centers
4. Clear cut objectives and reasonably attainable goals:- If goals are too high to be
attained, the purpose of budgeting is defeated. On the other hand, if the goals are so low
that they can be attained very easily, there will be no incentive to special effort.
5. Participative budgeting: Every executive responsible for the implementation of
budgets
should be given an opportunity to take part in the preparation of budgets.
6. Budget committee: The work of preparing a budget manual should be entrusted to a
Budget committee. The work of scrutinizing the budgets as well as approving of the same
should be the work of this committee.
7. Comprehensive budgeting: Budgeting should not be partial, it should cover all the
functions .
8. Adequate accounting system: There should be an adequate accounting system for the
successful budgetary control system, because those who are involved in the preparation
of
estimates depend heavily on the accounting department.
9. Periodic reporting: - There should be a prompt and timely communication and
reporting
system for the effective implementation of a budgetary control system.

Budget manual:
CIMA England, defines a budget manual as “ a document , schedule or booklets which
sets out;
inter alia, the responsibilities of the persons engaged in the routine of and the forms and
records
required for budgetary control”. In other words, it is a written document which guides the
executives in preparing various budgets.
Budget period: This may be defined as the period for which a budget is prepared and
employed.
The budget period will depend on the type of business and the control aspects. There is
no general
rule governing the selection of the budget period.
Classification of Budget
1. Classification according to time factor
2. Classification according to flexibility factor
3. Classification according to function.
I. Classification according to time factor: - On this basis, budgets can be of three types:
1. Long term budget – for a period of 5 to 10 years
2. Short term budgets – Usually for a period of one to two years
3. Current budgets - Usually covers a period of one month or so,

II. Classification according to flexibility: It includes

1. Flexible budgets and
2. Fixed budgets
Flexible budgets: It is a dynamic budget. It gives different budgeted cost for different
levels of
activity. It is prepared after making an intelligent classification of all expenses between
fixed ,
semi variable and variable because the usefulness of such a budget depends up on the
accuracy
with which the expenses can be classified.
Steps in preparing flexible budgets:
1. Identifying the relevant range of activity
2. Classify cost according to variability
3. Determine variable cost
4. Determine fixed cost
5. Determine semi variable cost
6. Prepare the budget for selected levels of activity

Example 1
The expenses budgeted for production of 10,000 unit in a factory are furnished below:
Per unit in Rs
Material cost 70
Labour cost 25
Variable factory over head 20
Fixed over head (Rs. 1,00,000) 10
Variable expenses (Direct) 5
Selling expenses (20% fixed) 15
Distribution overhead (10% fixed) 10
Administration expenses (Rs, 50,000) 5

Prepare a flexible budget for production of 8,000 units.

Out put 10,000 Out put 8,000

Per units Per units
unit(Rs) Total unit(Rs) Total(Rs.)
Material 70.00 70.00 70.00 5,60,000
Labour 25.00 25.00 25.00 2,00,000
Direct expe, (variable) 5.00 5.00 40,000
5.00 100.00
100.00 10,00,000 100.00 8,00,000
Factory overhead :
Variable 20.00 2,00,000 20.00 1,60,000
Fixed 10.00 1,00,000 12.50 1,00,000
130.00 13,00,000 132.50 10,60,000
Administrative expenses: 5.00 50,000 6.25 50,000

Selling expenses:
Fixed (20% of 15) 3.00 30,000 3.75 30,000
Variable (80% of 15) 12.00 1,20,000 12.00 96,000

Distribution expenses:
Fixed (10% of Rs. 10) 1.00 10,000 1.25 10,000
Variable (90% of 10) 9.00 90,000 9.00 72,000
160.00 16,00,000 164.75 13,18,000

Fixed Budget
It is a budget which is designed to remain unchanged irrespective of the level of activity
attained. It
does not change with the change in the level of activity. This type of budget are most
suited for
fixed expenses. It is a single budget with no analysis of cost.
III. Classification according to function: It includes:
1. Functional budgets and
2. Master budgets
Functional budgets are those which are prepared by heads of functional department s for
their
respective departments and are subsidiary to the master budget. Functional budget may
be
Operating budgets or financial budget. Operating budgets are those budgets which
relate to the
different activities or operations of a firm. These are the primary budgets. Financial
budgets are
those which incorporate financial decisions of an organization. They show in detail the
inflow and
outflow of cash and the overall financial position.

Master budget is the summary of all functional budgets. It summarizes sales, production,
purchase,
labour, finance budgets etc. It is considered as the overall budget of the organization.
Different types of functional budgets:
1. Sales budget: It is forecast of total sales expressed in quantities and money. It is
prepared
by the sales manager. While preparing sales budget we have to consider the past sales
data ,
market conditions, general trade and business conditions etc

Illustration 1
A manufacturing company submits the following figures of product ‘Z’ for the first
quarter of
2010.
Sales (in units)January 50,000
February 40,000
March 60,000

Selling price per unit Rs. 100

Sales target of 1st quarter 2011:
Sales quantity increase 20%
Sales price increase 10%
Prepare sales budget for the first quarter of 2011.

Solution:
SALES BUDGET
For the first quarter of 2011

Months Units Price per unit Value

January 60,000 110 66,00,000
February 48,000 110 52,80,000
March 72,000 110 79,20,000
1,80,000 1,98,00,000
============ ==========
2. Production budget: It is the forecast of the quantity of production for the budget
period. It
is usually expressed in physical quantity

Illustration 2
A manufacturing company submits the following figures relating to product X for the
first quarter
of 2010.

Sales targets: January 60,000 units

February 48,000 units
March 72,000 units

Stock position: 1-1-2010(% of January 2010 sale) - 50%

Stock position: 31-3-2010 40,000 units
Stock position: End January & February 50%
(% of subsequent month’s sales)
You are required to prepare production budget for the first quarter of 2010.

Solution
PRODUCTION BUDGET FOR THE FIRST QUARTER OF 2010

Month Sales(Units) +closing stock -Opening stock Production

(Units) (in Units (units)
January 60,000 24,000 30,000 54,000
February 48,000 36,000 24,000 60,000
March 72,000 40,000 36,000 76,000
1,90,000
=======

3. Material budget: It shows the estimated quantities as well as cost of raw material
required
for the production of different product during the budget period.
4. Purchase budget: It shows the quantity of different type of materials to be purchased
during the budget period taking into consideration the level of activity and the inventory
levels.
5. Cash budget: It is prepared only after all the other functional budgets are prepared. It
is
also known as financial budget. It is a statement showing estimated cash inflows and cash
outflows over the budgeted period.
The cash budget is prepared on the basis of the cash forecast. The cash forecast is an
estimate showing the availability or otherwise of adequate amount of cash in a future
period
for meeting the operating expenses and all other commitments. It summarizes the
anticipated cash receipts and cash payments for the budget period.
There are three methods for preparing the cash budget. They are:
a. The receipts and payment method
b. Adjusted Profit and Loss account method
c. Balance sheet method.
Example 2(Receipts and Payment method)
A company is expecting to have Rs. 25000cash in hand on 1st April 2000 and it requires
you to
prepare an estimate of cash position during the three month, April to June 2000. The
following
information is supplied to you.

Months Sales(Rs) Purchase(Rs) Wages(Rs) Expenses(Rs)

February 70,000 40,000 8,000

6,000
March 92,000 52,000 9,000
7,000
May 1,00,000 60,000 10,000
8,000
June 1,20,000 55,000 12,000
9,000

Other information:
1. Period of credit allowed by suppliers – two months
2. 25% of sale is for cash and the period of credit allowed to customers for credit sale is
one
month.
3. Delay in payment of wages and expenses – one month.
4. Income tax of Rs.25,000 is to be paid in June 2000.

Solution:
CASH BUDGET FOR THE PERIOD ENDING JUNE 2000

April May(Rs.) June(Rs.) Total(Rs.)

(Rs.)
Opening balance 53,000 81,000 -------
Receipts: 25,000
Cash sales 25,000 30,000 78,000
Cash from debtors 23,000 69,000 75,000 2,04,000
Total 60,000 94,000 1,05,000 2,82,000
83,000
Payments:
Creditors
Wages 40,000 50,000 52,000 1,42,000
Expenses 8,000 9,000 10,000 27,000
Income Tax 7,000 7,000 8,000 22,000
Total --- ----- 25,000 25,000
 55,000 66,000 95,000 2,10,000
Closing balance 53,000 81,000 91,000 ----
b. Adjusted Profit and Loss method: Under this method, profit is adjusted by adding
back
depreciations, provisions, stock and work in progress, capital receipts, decrease in
debtors, increase
in creditors etc. Similarly, dividends, capital payments, increase in debtors, increase in
stock and
decrease in creditors are deducted. The adjusted profit will be the estimated cash
available. Under
this method, the following information becomes necessary.

1. Expected opening balance

2. Net profit for the period
3. Changes in current asset and current liabilities
4. Capital receipts and capital expenditure
5. Payment of dividend

c. Balance sheet method: Under this method, a budgeted balance sheet is prepared for
the
budgeted period, showing all assets and liabilities except cash. The two sides of the
balance sheet
are then balanced. The balance then represents cash at bank or overdraft, depending upon
whether
the assets total is more than that of the liabilities total or the latter is more than that of the
former

Advantages of Cash budget:

1. It helps to ascertain the shortage of cash
2. It helps to identify excess of cash, so that the surplus cash can be invested for a short
period
3. It helps to ensure sufficient cash is available when required.
Recent trends in budgeting:
1. Zero Base Budgeting (ZBB): According to the official CIMA terminology, zero base
budgeting is, “ a method of budgeting which requires each cost element to be specifically
justified, as though the activities to which the budget relates were being undertaken for
the
first time. Without approval, the budget allowance is zero” . Under ZBB the
programmes and activities get evaluated and ranked from zero base as if these were

Advantages of ZBB
1. It considers every time alternative ways of performing the same job. It helps the
management to get a critical appraisal of its activities.
2. It is helpful to the management in making optimum allocation of scarce resources
3. ZBB is particularly useful for service departments and Governments
4. It ensures active participation of managers in the budgeting process.
5. It promote high level of motivation at the level of unit managers
6. It focuses on output in relation to value for money.
7. It makes managers cost conscious and helps them in identifying priorities in the overall
interest of the organization.
launched for first time. In this technique of budgeting the unwanted projects and activities
get dropped and wanted and desirable activities and projects get included in the budget.

Features:
a. It starts from zero
b. All activities are identified in appropriate decision packages
c. All programmes are considered totally afresh
d. A detailed cost benefit analysis of each programme is undertaken
e. There is an officer responsible for each decision packages
f. Priorities are established and decision packages are ranked

Difference between Traditional budgeting and ZBB

Traditional budgeting ZBB

1. Begins with previous year’s 1. Begins with zero a based
budget 2. Focuses on goals and objectives
2. Focuses on money 3. Produces alternative level of
3. Produces a single level of expenditure and desired result
expenditure for an activity 4. Resources are allocated on the basis of
4. Resources are allocated not on the cost benefit analysis
basis of cost benefit analysis 5. Prepared once in every five years
5. Prepared annually

2. Activity base budgeting: The CIMA official terminology defines activity based
budgeting
as,” a method of budgeting based on an activity frame work and utilizing cost driver data
in
the budget setting and variance feedback processes.” In the case of traditional budgeting,
budgets are established on the basis of budget centers. In the case of activity based
budgeting, however, the budget centres are activity based cost pools or cost centres in
relation to which budgets are prepared. Separate cost pools are established for each type
of
activity.
3. Performance budgeting: - Performance oriented budgets are established in such a
manner
that each item of expenditure related to a specific responsibility centre is closely linked
with
the performance of that centre. The following matters will be specified very clearly in
such
budgeting
a. Objectives of the organization and for which funds are requested
b. Cost of activities proposed for the achievement of these objectives
c. Quantitative measures to measure the performance
d. Quantum of work to be performed under each activity

Advantages of performance budgeting:

1. It improves budget formulation process
2. It enhances accountability of the executives
3. It facilitate more effective performance audit
4. It presents clearly the purpose and objectives for which funds are required
Practical Problems:
I. ABC Company Ltd .has given the following particulars. You are required to prepare a
Cash budget for the three months ending 31st Dec. 2010.

Months Sales(Rs) Materials(Rs) Wages(Rs) Overhead(Rs)

August 20,000 10200 3,800 1,900

September 25,000 11000 3,900 2,100
October 23,000 9800 4,000 2,300
November 26,000 9000 4,200 2,400
December 30,000 10800 4,500 2,500

Credit items are:-

1. Debtors/Sales – 10% sales are on cash basis, 50% of the credit sales are collected
next month and the balance in the following month.
2. Creditors - - Materials 2 months
--Wages 1/5 month
-- Overhead ½ month

3. Cash balance on 1st October 2010 is expected to be Rs. 8,000

4. A machinery will be installed in August, 2010 at a cost of Rs. 1,00,000. The monthly
Installment of Rs. 5,000 is payable from October onwards.
5. Dividend at 10% on preference share capital of Rs. 3,00,000 will be paid on 1st
December ,2010
6. Advance to be received for sale of vehicles Rs. 20,000 in December
7. Income tax (advance) to be paid in December Rs. 5,000.
 STANDARD COSTING
Meaning of ‘standard’ and ‘standard cost’: In the ordinary language, the term
‘standard’ means
a yardstick of measurement. The CIMA terminology defines this term as, “a benchmark
measurement of resources usage, set in defined conditions.”
Standard cost is a pre determined operating cost calculated from management’s standards
of
efficient operation and the relevant necessary expenditure.
Need for Standard Costs: The need for standard cost arises for the following reasons

1. Cost control
2. Measurement of efficiency
3. Fixation of selling price
4. Economy in cost of costing
Estimated cost: Pre determined costs may either be estimated or standard cost.
Estimated cost is a
pre determined cost for a future period under normal conditions of operations. It is a
prospective

costing. Cost estimation is made for submitting tenders or quoting price of a product or a
unit of
services

Definition of standard costing:

Standard costing is a technique of cost control. The CIMA official terminology defines it
as “ a
control technique which compares standard costs and revenues with actual results to
obtain
variances which are used to stimulated improved performance.”
In standard costing the actual costs incurred are compared with the standard costs. The
difference
between the two is called variance.
Features: The following are the important characteristics of the standard costing system
1. Standard costs are set for various elements of total cost
2. It makes a comparison of actual cost with standard cost
3. Main objective of standard costing is to control cost
4. Variances are reported to management for the purpose of decision making

Standard costing and Budgetary control

Both standard costing and budgetary control are similar in principle since both are
concerned with
setting performance and cost levels for control purposes. Neither of the two techniques
can be
operated successfully without the other. Budgetary control and standard costing are
inseparably
linked together.
Distinction between standard costing and budgetary control:
1. Budget is based on past performance, while standard is established on the basis of
technical
estimates.
2. Budgets consider both income and expenditure whereas standards are for expenditure
only.
3. Budgets projects financial accounts, while standard cost project cost accounts
4. In standard costing, variances are analyzed in detail, but such a detailed analysis of
variance
is not possible in budgetary control.
5. Budget fix minimum limit while standard fix targets

6. Budgets are used for the forecasting men, money and materials, standards cannot be
used
for forecasting.
7. Budgetary control technique is applicable to all types of businesses. However standard
costing is useful only for manufacturing organizations.
8. The standards are expressed in per unit of production whereas budgets are for specific
periods and are expressed in total.
9. Budgetary control does not require standardization of product. But standard costing
requires standardization of product.
Objectives of standard costing:
1. Performance measurement
2. Cost control
3. Stock valuation
4. Establishing selling prices
5. Profit planning and decision making
6. Basis of estimating
7. Assisting establishment of budgets

Basic requirements of standard costing:

a. Organization structure: The existence of a sound organization structure with well
defined
authority relationship is the basic requirement of a standard costing system.
b. Technical and engineering studies: It is very necessary to make thorough study of the
production methods and the processes required for production.
c. Preparation of manual: It is also necessary to prepare a detailed manual for the
guidance
of staff. The manual should describe the system to be introduced and the benefits thereof.
d. Type of standards: It is very necessary to determine the type of standard to be used,
whether current, basic or normal standard.
e. Co-operation of Executives and staff:- Without the co-operation of the executives
and
staff, it is very difficult to run the standard costing system.
f. Fixation of standards: Standard should be set for each element of cost and it should be
scientific

Steps involved in Standard Costing:-

The procedure for establishing standard costing is summarized as follows:-
1. Establishment of cost centres: - A cost centre is a location, person or item of
equipment
for which costs may be ascertained and used for the purpose of cost control. Cost centres
are set up for cost ascertainment and cost control.
2. Classification and codification of accounts: - It facilitates quick collection and
analysis of
cost information.
3. Establishment of standards: The success of the standard costing system depends up
on the
reliability and accuracy of standards. Standards are always established scientifically.
4. Ascertainment of actual cost: Measuring the actual cost which is incurred in the next
step
in the standard costing

5. Comparison of Standard cost and Actual cost.

6. Analysis of Variances
7. Reporting of variance
Types of standards

1. Basic standards: A standard established for use over a long period is known as the
basic
standard. It remains unaltered over a long period. Its use is to show long term trends, and
it
operates in a similar way to index numbers. It is also known as the ‘bogey, standard. This
standard is used for items or costs which are likely to remain constant over a long period.
2. Current standard: A standard established for use over a short period of time and
related to
current conditions, is known as the ‘current standard’. This standard shows what the
performance should be under current conditions. Conditions during which period the
standard is used are known as current conditions.
3. Ideal standards & Expected standards:- Ideal standard is that which can be attained
under the most favourable conditions, while expected standard is that which is expected
to
be attained during a specified budget period. It is a target which is attainable and can be
achieved if the expected conditions operate during the period for which the standard is
set.
4. Normal standard: This standard is defined as “the average standard which it is
anticipated
can be attained over a future period of time, preferably long enough to cover one trade
cycle.”It is difficult to follow normal standards in practice as it is not possible to forecast
performance with a reasonable degree of accuracy for a long period of time.

Analysis of Variances:
Variance is the difference between a standard cost and the comparable actual cost
incurred during a
period. It is the deviation of actual cost from the standard cost. In other words, the
deviation of the
actual cost or profit or sales from the standard cost or profit or sales is known as variance.
If the
actual cost is less than the standard, the difference is known as favourable or positive
variance and
it is symbol of efficiency. If the actual cost is more than the standard cost, the difference
is known
as unfavorable variance. Analysis of variance means carrying out the appropriate
investigation to
identify the reasons for the variance.
Another way of classifying variance may be controllable and uncontrollable variances. If
a
variance is due to inefficiency of a cost centre, it is said to be controllable variance. Such
variance
can be corrected by taking a suitable action. A variance due to external reasons like
increase in
prices of material, labour etc it is a case of uncontrollable variances.

Types of variances
Analysis of variances may be done in respect of each element of cost and sales. It
includes
1. Direct material variance
2. Direct labour variance
3. Overhead variance
4. Sales variance

MATERIAL VARIANCES
It includes:
a. Material Cost Variance (MCV): It is the difference between the standard cost of
materials
allowed for the output achieved and the actual cost of materials used. It may be expressed
as:
MCV=Standard cost of materials for actual output – Actual cost of materials used
Std. cost of material = std qty x std price per unit
Actual cost of material = Actual qty x actual price
b. Material Price Variance (MPV): It is that portion of the material cost variance which
is due to
the difference between the standard cost of materials used for the output achieved and the
actual
cost of materials used.
MPV = Actual qty x (std price – Actual price)
c. Material Usage Variance or Material Quantity Variance(MQV): It is that portion
of
material cost variance which is due to the difference between the standard quantity of
materials
specified for the actual output and the actual quantity of materials used.
MUV = Std price per unit (Std qty – Actual qty)
d. Material Mix Variance (MMV): It is that portion of the material usage variance
which is due
to the difference between standard and actual composition of a mixture. It is calculated as
the
difference between the standard price of the standard mix standard price of the actual
mix.
In case of material mix variance, two situations may arise: Actual weight of mix and the
A.
Standard weight of mix do not differ: - In this case material mix variance is calculated by
applying the following formula
MMV= Std price (Std qty x Actual qty)
If the standard is revised due to shortage of a particular type of material, the material mix
variance is calculated as follows:
MMV= Std price (Revised std qty – Actual qty)
B. Actual weight of mix differ from standard weight weight of mix:- In such a case,
material mix
variance is calculated as follows:

Total weight of actual mix

----------------------------------------- x Std cost of std mix - Std cost of actual mix
Total weight of std mix
e. Material Yield Variance :- It is that portion of the material usage variance which is
due to the
difference between the standard yield specified and the actual yield obtained. This
variance
measures the abnormal loss or saving of material.
Illustration I. From the following information, compute Price, usage and mix variances.

Standard Actual
Qty Price Total Qty Price Total
Material A 10 3 30 15 4 60
Material B 15 4 60 25 3 75
Material C 25 2 50 35 2 70
----------------------- --------------------------
50 140 75 205
=== === === ====

Solution:

1. Material price variance:

Actual usage (Std price - Actual Price)
Material A = 15 (3 - 4) = Rs. 15 adverse
Material B = 25 (4 – 3) = Rs. 25 Favourable
Material C = 35 (2 – 2) = Nil

Total Price variance Rs. 10 Favourable

==============

2. Material Usage variance:

Standard rate (Std usage – actual usage)
Material A = 3( 10 – 15 ) =Rs. 15 Adverse
Material B = 4 (15 – 25 ) =Rs. 40 Adverse
Material C = 2 (25 – 35) = Rs. 20 Adverse
----------------------

Total material usage Variance=Rs. 75 Adverse

3. Material Mix Variance:

Total weight of actual mix
----------------------------------------- x Std cost of std mix - Std cost of actual mix
Total weight of std mix
15+25+35
------------ x 10 x Rs. 15 x Rs4 + 25 x Rs. 2) - 15 x Rs. 3 + 25 x Rs. 4 + 35 x Rs. 2
10+15+25

=75/50 x Rs. 140 – Rs. 215

= Rs. 210 – Rs. 215 = Rs. 5 Adverse
Illustration 2. It is estimated that a product requires 50 units of material at the rate of Rs.
3 per
unit. The actual consumption of material for manufacturing the same product came to 60
units at
the rate of Rs. 2.9 per unit. Calculate
1. Material cost variance
2. Material price variance
3. Material usage variance

Solution:
1. Material cost variance = Std cost – Actual cost
Std cost = Std qty x Std price per unit = 50 x 3 = 150
Actual cost = Actual qty x Actual price per unit = 60 x 2.90 =174
Material Cost Variance = 150 – 174 = 24 un favourable
2. Material Price Variance = Actual qty x (Std price – actual price)
60 x (3 – 2.90) = 6 favourable
3. Material usage variance = Std price x (Std qty – Actual qty)
3x (50 -60 ) = Rs. 30 unfavourable

Labour Variance: When standard cost of labour differs from actual wage cost, the
labour variance
arises. The following are the important types of labour variances
1. Labour cost variance: It is the difference between standard cost of labour allowed for
actual output achieved and the actual cost of labour.
LCV = Std cost of labour – Actual cost labour
2. Labour rate variance: It is that part of labour cost variance, which arises due to the
difference between standard rate specified and the actual rate paid.
LRV = Actual time x (Std rate – Actual rate)
3. Labour Efficiency Variance: It is that portion of labour cost variance which arises
due to
the difference between standard labour hours specified for the activity achieved and the
actual labour hours expended.
LEV = Standard rate x (Standard time for actual output – Actual time)

It arises because of the following reasons:

a. Use of incorrect grade of labour
b. Insufficient training
c. Bad supervision
d. Incorrect instructions
e. Bad working conditions
f. Worker’s dissatisfaction
g. Defective equipment and machinery
h. Wrong item of equipments
i. Excessive labour turn over, and
j. Fixation of incorrect standards.

Illustration: I
Calculate labour cost variance from the following data:
Standard hours: 40
Rate : Rs. 3 per hour
Actual hours : 60
Rate : Rs. 4 per hour
Solution:

Labour cost Variance = Standard cost of labour – Actual cost of labour

= (40x3) – (60x4)
=120 – 240 =Rs. 120 Adverse

Illustration II
The standard and actual figures of a firm are as under
Standard time for the job : 1000 hrs
Standard rate per hour : Re.0.50
Actual time taken : 900 hours
Actual wages paid : Rs.360
Compute labour variances.

Solution:
Labour Cost Variance:= Standard cost of labour – Actual cost of labour
= (1000x0.50) – (900 x 0.40)
=500 – 360
= Rs. 140 Fav
Labour Mix Variance = Actual time x (Standard rate – Actual rate)
= 900x (0.50 – 0.40)
= Rs. 90 Fav
Labour efficiency Variance = Standard rate x (Standard time for actual output – Actual
time)
=0.50 x (1000 – 900)
= Rs. 50 Fav.

Overhead Variances:
The term overhead, which comprises indirect materials, indirect labour and indirect
expenses, may
relate to factory, office or selling and distribution. It is the sum of variable overhead
variance and
fixed overhead variance. In other words, it is the difference between standard overhead
cost
charged to production and the actual overhead cost incurred.
Variable overhead Cost variance: This represents the difference between the standard
cost of
variable overhead allowed for actual output and the actual variable overhead incurred
during the
period. Variable overhead cost variance is made up of variable overhead expenditure
variance and
variable overhead efficiency variance.
It is computed by the application of the following formula:
a. When OH rate per unit is used
VOH Cost Variance = (Actual output x Std variable OH rate per unit) – Actual Variable
OH
Std. VOH rate per unit = Std variable OH

--------------------
Std out put

b. When OH rate per hour is used

VOH Cost Variance =(Std hours for actual output x Std variable OH rate per hour) –
Actual
VOH
Std VOH rate per hour = Std VOH

----------------
Std hours

Variable Over head Expenditure Variance:

It is the difference between the standard variable OH rate per hour and the actual variable
OH rate
per hour, multiplied by the actual hours worked.
Variable OH expenditure Variance = (Actual hours worked x Std Variable OH rate per
hour) – Actual variable OH
OR
(Std output for actual hours x Std OH rate per unit) – Actual variable OH

Variable OH efficiency Variance: It is the difference between the variable overhead

allowed for
production and the variable overhead absorbed through production.
Variable OH Efficiency Variance = Std Variable OH rate per hour (Std hours for actual
production – Actual hours)
If actual hours is less, it is favourable variance and vice versa.
Illustration
From the following data for the month of Feb., Calculate OH variances.
Budgeted production for the month - 150 units
Budgeted variable OHs - Rs. 3750
Std time for one unit - 10 hrs
Actual production for the month - 125 units
Actual variable OHs -Rs. 3 600/
Actual hours worked - 2250 hrs

Solution
Std OHs for actual production (125 units) = 3750/150 x 125
= Rs. 3125

Std OH rate per hour:

Total std hours = 150 units x 10 =1500 hrs
Rate per hour = 3750/1500 = Rs. 2.5
Actual OH rate per hour = 3600/2250 hrs = Rs. 1.6

Std. hours for actual production = 125 units x 10 hours = 1250 hrs

1. VOH Cost Variance = (Actual output x Std variable OH rate per unit) – Actual
Variable OH
= (125 x 25) – 3600
=3125 – 3600 = 475 Adverse

2. Variable Overhead Expenditure Variance = (Actual hours worked x Std Variable OH

rate
per hour) – Actual variable OH

= (2250 x2.5) – 3600

= Rs. 2025 F

3. Variable Overhead Efficiency Variance = Std Variable OH rate per hour(Std hours for
actual production – Actual hours)
=2.5 (1250 -2250)
= Rs. 2500 A

Fixed Over head variance:

It is the difference between standard fixed overhead allowed for actual output and the
actual fixed
overhead incurred. Fixed overhead cost variance is calculated by using the following
equation
Fixed OH cost Variance = Std. fixed OH for actual Output – Actual fixed OH
If actual OH is less, it is favourable variance and vice versa. Fixed OH cost variance is
divided into
two – fixed overhead expenditure variance and fixed overhead volume variance.
Fixed OH Expenditure variance: It is the difference between budgeted fixed overhead
and actual
fixed overhead.
Fixed Overhead expenditure variance = Budgeted fixed OH – Actual Fixed OH
Fixed OH volume Variance: It is the difference between Std fixed OH allowed for
actual output
and the budgeted fixed overhead for the period.
Fixed Overhead Volume Variance = Std. fixed overhead for actual output – Budgeted
fixed
Overheads

Illustration:
From the following data relating to June 2011, Calculate fixed OH variances:
Budgeted hours for the month = 180 hrs
Budgeted output for the month = 9,000 units
Budgeted fixed overheads = Rs. 27,000
Actual production for the month = 9,200 units
Actual hours for production = 175 units
Actual fixed overheads = Rs. 28,000

Solution:
1. Fixed overhead cost variance = Std fixed overhead for actual output – Actual fixed
overhead
= 27600 – 28000 = Rs. 400 A

2. Fixed Overhead expenditure Variance = Budgeted fixed overhead – Actual fixed

overhead
= 27,000 - 28,000 = Rs. 1000 A

3. Fixed Overhead Volume Variance = Std fixed overhead for actual output – Budgeted
fixed
overheads
= 27600 - 27000 = Rs. 600 F

Note: Std. overhead for actual output (9200 units) = 27000/9000 x 9200
= Rs. 27600