ACCOUNTING FOR MANAGERS UNIT – III

Q1. Why is correct valuation of inventory essential? What is the basic principle involved
while valuing inventories?
Ans: Inventory has to be properly valued because of the following reasons:
i. Determination of Income: The valuation of inventory is necessary for determining the
true income earned by a business during a particular period. Gross profit is the excess of
sales over cost of goods sold. Cost of goods sold is ascertained by adding opening
inventory to and deducting closing inventory from purchases.
ii. Determination of financial position: The inventory at the end of period is to be shown as
a current asset in the balance sheet of the business. In case the inventory is not properly
valued, the balance sheet will not disclose the correct financial position of the business.

The Requirement for Correct Valuation of Inventory is given below:

 Centralized purchase function i.e., all the purchases should be through purchase
department.
 Material is purchased with authority.
 Proper planning purchase function.
 Standardization of materials.
 Materials should be of proper quality and specification.
 Planned storage of all materials in stores.
 Selection of suppliers keeping in view the quality, price and delivery.
 Direct materials used in production should be charged to production on an appropriate and
consistent pricing basis.
 Indirect materials used in production and service departments should be appropriately
apportioned and absorbed into product cost.
 Proper documentation and accounting of material receipt and issues.
 Material issues only with proper authority.
 Maintenance of bin cards and stores ledger and regular reconciliation of both the records.
 Adoption of perpetual inventory system and continuous stock taking.
 Fixation of inventory levels i.e., maximum, minimum, re-order and danger levels.
 Proper internal checks.
 Proper procedures in dealing with shortages and discrepancies.
 Proper classification and coding of materials.

Basic Principles involved while Valuing Inventories:

 Entry into the stores should be restricted only to authorized persons.
 Material requisition should be signed only by the authorized persons.
 Proper maintenance of stores records like bin card/stock card, stores ledger etc.
 Regular check by independent staff to detect and correct mistakes.
 Issue of material only against proper requisition slip.
 Recording of all movements of stocks.
 Physical verification and counting at the time of receipt and issue of material.
 Use of FIFO (First In First Out) method for stock issues for avoidance of deterioration and
obsolescence.

Q2. Distinguish between Management Accounting and Cost Accounting. Explain various
classification of cost in brief.
Ans: Cost Accounting Vs. Management Accounting:
Management Accounting and Cost Accounting are two important branches of accounting.
Management Accounting is concerned with application of appropriate techniques and concepts
which help management in discharging its functions efficiently.
Management Accounting and Cost Accounting both are internal to the organization. Both are
optional and have the objectives of assisting management in its function of planning, decision-
making, controlling, etc. However, the two differ significantly as below:
i. Evolution: Cost Accounting is the outcome of industrial revolution. It was evolved in the
beginning of twentieth century as a supplement of Financial Accounting whereas the
evolution of Management Accounting is of five decades only.
ii. Objectives: The main objective of management accounting is to provide accounting
information to management for decision-making whereas cost accounting aims at cost
ascertainment, cost control and cost analysis for special decision-making.
iii. Approach: Cost Accounting is mostly historical in its approach and it projects the past.
Management Accounting is futuristic in its approach; it is more predictive in nature than cost
accounting.
iv. Scope: The scope of management accounting is much wider than cost accounting.
Management accounting embraces financial accounting, cost accounting, tax planning, tax
accounting, management reporting and many aspects of financial management and non-
monetary facts also. It considers both cost and revenue data. On the contrary, cost accounting
is concerned with mainly cost data.
v. Evaluation of Performance: Management Accounting is concerned both with assisting
management is its future functions, as well as evaluating the performance of the management
as an institution. Cost accounting is concerned merely with assisting in management
functions and does not provide for the evaluation of the performance of management.
vi. Accounting Principles and Format: Cost accounts are prepared in a defined format and
certain principles and procedures are followed for recording costs. On the contrary, there are
no definite principles in Management Accounting and no specific rules and formats are used
in preparing statements and reports.
 vii. Cost Aspect: Cost accounting is concerned more with ascertainment, allocation, distribution
and accounting aspects of costs. Management accounting is concerned more with impact and
effect aspect of costs.
viii. Long-range Planning: Management accounting is concerned with short-range and long-
range planning and uses the techniques of sensitivity analysis, profitability structure etc. but
cost accounting is concerned with short-range planning.
ix. Analysis and Interpretation of Data: Management accounting does report not only,
financial and cost data but analyzes and interprets such data in the light of other relevant
information. The coverage of management accounting is also much wider than cost
accounting. Management accounting covers financial management, funds flow and cash flow
analyzes, ratio analysis, capital budgeting, cost of capital, pricing, etc.; cost accounting has
nothing to do with such matters.

CLASSIFICATION OF COST:
A cost statement is prepared to know the total cost of production. In this Statement, the total cost
is classified on the basis of elements of cost, as follows:
1. Prime Cost: Prime Cost is also called as direct cost, first cost or flat cost. The main objective
of knowing the prime cost is to divide the total cost into direct and indirect costs. The total of
all direct costs is known by the sum of direct material, direct labour and direct expenses and
is called as prime cost.
Prime Cost = Direct material + Direct wages + Direct expenses
2. Works Cost or Factory Cost: The objective of knowing the works or factory cost is to
control the factory cost and to know the efficiency of the factory. Works cost is also know
the efficiency of the factory. Works cost is also known as production cost or manufacturing
cost. If costs of indirect material, indirect labour and indirect expenses of the factory are
added to prime cost, works cost is arrived at:
Works cost = Prime cost + Indirect material + Indirect wages + Indirect
expenses of the factory
3. Office Cost: If administrative and office overheads are added to factory or works cost, office
cost is arrived at. This cost is also termed as administrative cost or the total cost of
production.
Office Cost = Works cost + Office overheads
4. Total Cost: If selling and distribution overheads are added to office cost, the total cost is
arrived at. It is also termed as cost of sales.
Total Cost = Office cost + Selling and Distribution expenses
5. Selling Price: If the desired profit is added to the total cost or cost of sales, the selling price
is arrived at.
The difference between the selling price and the total cost shall be the profit or loss.
Selling Price = Total Cost + Profit or Profit = Sales – Total Cost
The above classification can be presented as follows:
 Particulars Rs. Per Unit
Opening Stock of Raw Material xxxx
Add: Purchase of Raw Material xxxx

----------
xxxx
Less: Closing Stock of Raw Material xxxx xxxx xxxx
Raw Material Consumed
Add: Direct Labor xxxx xxxx
Direct Expenses xxxx xxxx
Prime Cost xxxx xxxx
Add: Factory of Works Over heads xxxx xxxx
Add: Opening Stock of Work-in-Progress xxxx xxxx
Less Closing Stock of Work-in-progress xxxx xxxx
Less: Sale of Scrap xxxx xxxx
Factory or Works Cost xxxx xxxx
Add: Office and Administration Over heads xxxx xxxx
Cost of Production xxxx xxxx
Add: Opening Stock of Finished Goods xxxx xxxx
Less: Closing stock of Finished Goods xxxx xxxx
Cost of Goods Sold xxxx xxxx
Add: Selling and Distribution Overheads xxxx xxxx
Cost of Sales xxxx xxxx
Profit xxxx xxxx
Sales xxxx xxxx

Q3. “During Inflationary trend, it is advisable to follow LIFO method for valuing the
inventories.” Explain the above statement with an hypothetical example.
Ans: Inventory:
Inventory means and includes the goods and services being sold by the firm and the raw
materials or other components being used in the manufacturing of such goods and services. A
retail shopkeeper keeps an inventory of finished goods to be offered to customers whenever
demanded by them. On the other hand, a manufacturing concern has to keep a stockpile of not
only the finished goods it is producing, but also of all physical ingredients being used in the
production process.

Inventories are assets of the firm and require investment. If the inventories are too big, they
become a strain on the resources, however, if they are too small, the firm may lose the sales.
Therefore, the firm must have an optimum level of inventories.
LIFO method is based on the assumption that the last items of goods purchased are the first to be
sold. Thus according to this method, inventory consists of item purchased at the earliest cost.

During inflationary trend, LIFO is followed so that the production will be relatively overcharged
resulting in lower profitability, deflating profits and reducing income tax liability. This statement
will be clearer by the following example:
Example: The following are the details regarding purchases of a certain item during the month
of July.
Purchases:
July 11 Purchases 200 units @ Rs 7 Rs 1,400
July 18 Purchases 900 units @ Rs 8 Rs 7,200
July 20 Purchases 300 units @ Rs 9 Rs 2,700
Rs 11,300
Issues:
July 14 Issues 150 units
July 25 Issues 950 units
Now we have to calculate the value of inventory according to LIFO Method and FIFO Method,
so that we can make sure that in case of inflation LIFO method of valuation is better than FIFO
method.
Solution: Here, we maintain stock ledger on the basis of FIFO method. That is, the inventory that
comes in first, goes out first.
Stock Ledger
Valuation Based on FIFO Method
Receipts Issues Balance
Date Qty Rate Amount Qty Rate Amount Qty Rate Amount
July 11 200 7 1400 - - - 200 7 1400
July 14 - - - 150 7 1050 50 7 350
July 18 900 8 7200 - - - 50 7 350
900 8 7200
July 20 300 9 2700 - - - 50 7 350
900 8 7200
300 9 2700
July 25 - - - 50 7 350 300 9 2700
900 8 7200
Now, we maintain stock ledger on the basis of LIFO method. That is, the stock comes last, goes
out first.
Stock Ledger
Valuation Based on LIFO Method
Receipts Issues Balance
Date Qty Rate Amount Qty Rate Amount Qty Rate Amount
July 11 200 7 1400 - - - 200 7 1400
July 14 - - - 150 7 1050 50 7 350
July 18 900 8 7200 - - - 50 7 350
900 8 7200
July 20 300 9 2700 - - - 50 7 350
900 8 7200
300 9 2700
July 25 - - - 300 9 2700 50 7 350
650 8 5200 250 8 2000
Result: In case of LIFO valuation method the value of goods consumer is Rs 8,950 (i.e. Rs
11,300 – Rs 2,350). Whereas in case of FIFO valuation method the value of goods consumer is
Rs 8,600 (i.e. Rs 11,300 – Rs 2,750). Valuating inventory through LIFO method increases the
cost thus reducing the profit and tax liability. Thus we can say during inflationary trend, LIFO
method of inventory valuation should be followed so that the production will be relatively
overcharged resulting in lower profitability, deflating profits and reducing income tax liability.

Q4. What is meant by Cost Accounting? Discuss in detail the advantages of Cost
Accounting.
Ans: Cost accounting is a tool that provides knowledge to the management. So that they can take
appropriate decisions to fulfill the goals. It helps to take decisions, to control the cost, to estimate
the cost of product and also to estimate the selling price of the product. It gives full and detailed
knowledge about the cost structure of product.
Objectives of Cost Accounting:
i. Cost Determination: The main objective of cost accounting is to determine the total and
per unit cost of product, service, contract or process.
ii. Cost Control: With the help of different branches of cost accounting, we can control the
cost of product. For this purposes techniques of budgetary control and standard costing can
be used.
iii. Cost Reduction: Cost accounting system gives valuable information at early stages, which
helps to reduce cost.
iv. Guidance to Management: At different time internal management requires different types
of cost information, which is provided with the help of cost accounting.
v. Determination of Selling Price: After having determined cost, selling price of a product
can be easily calculated in such a way that concern get its planned profit.
vi. Compliance to Statutory Requirements: U/s 209 of Companies Act 1956 some
companies has to prepare its cost accounts. So cost accounting fulfilled this legal
requirement.
Advantages of Cost Accounting:
i. Helps in optimum utilization of men, material and machines.
 ii. Identifies the areas requiring corrective action.
iii. Helps management in formulation of policies.
iv. Presents a tailor-made solution for the problem.
v. Helps management in making short-term decisions by use of techniques like marginal
costing, etc.
vi. Provides useful data for final accounts by giving cost of closing stock of raw materials,
work-in-progress and finished products.
vii. Provides a data-base for reference by Government, Wage tribunals and Trade Unions etc.,
viii. Helps in formation of cost centres and responsibility centres to exercise control.
ix. Helps to face increasing difficulties in setting prices and improving efficiency.
x. Facilitates use of specialized techniques like cost reduction, value analysis, operation
research and management by exception, etc.
xi. Threads its way through every phase of business and to a large extent influence the make-
up of the entire enterprise – its products, its markets and its methods of operation.
xii. Focuses attention on the profitability of each product and service unlike financial
accounting, which presents profitability for company as a whole.

Q5. “LIFO provides a more meaningful income statement than FIFO, even though it
provides a less meaningful balance sheet.” Explain.
Ans: LIFO provides a more meaningful income statement than FIFO:
This method operates in just reverse order of FIFO method. As against the FIFO method, the
issues under this method is priced in the reverse order of purchase i.e., the price of the latest
available consignment is taken first. Thus, the price of the last batch of materials purchased is
used for all issues until all units from this batch have been issued. Later, the price of the previous
batch received is used. It should be noted that physical flow materials may not conform to LIFO
assumption. 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 current price levels, as far as
possible.
Three points should be noted regarding this method:
i. Material issues are priced at actual cost.
ii. Charge to production for material cost is at the latest prices paid.
iii. Closing stock valuation is at the oldest prices paid and is completely out of line with
the current prices.
Advantages:
i. Easy to operate: Like FIFO method, this is simple to operate and is useful when
transactions are not too many and the prices are fairly steady.
ii. No unrealized profit: Under this method, actual cost of materials is charged to
production, so this method like FIFO does not result in any unrealized profit or loss.
iii. Prices reflect current market prices: Materials are charged to production at the
latest prices paid. Thus, effect of current market prices of materials is reflected in
the cost of sales, provided the materials are recently purchased. In times of rising
 prices, quotation of prices for company’s product will be competitive and
profitable.
Q6. State the need for emergence of Activity Based Costing.
Ans: Activity Based Costing has been defined as “the collection of financial and operation
performance information tracing the significant activities of the firm to product costs”.
It is cost attribution to cost units on the basis of benefit received from indirect activities e.g.,
ordering, setting up, assuring quality. ABC is a recent development in cost Accounting which
attempts to absorb overheads into product costs on a more realistic basis.
Supporters of the technique argue that many costs are un necessarily treated as common costs
and are arbitrarily absorbed using a basis such as direct labour hours, machine hours, etc. many
organizations have now adopted advanced manufacturing technology (AMT) with the result that
overheads are increasing and labour costs are becoming a smaller portion of total costs.

Direct Costs Indirect Costs Non-product Costs

Activity Cost Pools

(Product Costs)

Activity Cost
Driver Rates

Cost Objects (Products,

Services, Customers,
Project Contracts, etc.)

Costing systems which absorb overheads on a direct labour basis are therefore, not relevant in an
AMT environment. The basic idea of ABC is that costs are grouped according to what drives
them or causes them to be incurred. The cost drivers are then used as an absorption base.

Activity based costing is the method of cost attribution to cost units on the basis of benefits
received from indirect activities i.e. ordering, setting up, assuring quality etc. It emphasizes links
between performance of particular activities and the demands that these activities make on the
resources of the organization. Methodology in allocation of overheads is different in ABC
system.
Under ABC, cost pools are created for each activity and such activities are related with each type
of product to determine the cost of such product i.e. cost of only those activities are charged to
the product which go in the making of the product. The technique of ABC involves identification
of production path, identification of activities that go into making a product, selection of suitable
drivers, creation of cost pools, calculating the overhead application rate and allocation of the
costs based on the application rate. The important objectives of ABC are summarized below:
i. To identify value-added activities in transactions.
ii. To chalk out ways to eliminate non-value added activities.
iii. To attach costs in response to the price resistance demonstrated by customers.
iv. To distribute overheads on the basis of activity.
v. To validate the success of the quality drive with ABC
vi. To ensure accurate product costing for decision-making process.

Q7. Discuss the different stages in the Activity Based Costing.

Ans: The important steps involved in installation of ABC system are as follows:
i. Specification of Objectives: The motives for pursuing an ABC system must be established
at the outset. Generally, the objectives are: (a) To improve product costing where a belief
exists that existing methods under cost some products and over cost others; or (b) to identify
non-value adding activities in the production process which might be a suitable focus for
attention or elimination.
ii. Identification of Costs for ABC: Direct costs, like materials and direct labour, are easily
assigned directly to products. Some indirect costs that are product specific (e.g. specific
advertising, dealer’s commission), may be directly assigned to the product. Hence the
remaining indirect costs form the focus of ABC. Such costs are indirectly assigned to the cost
object (i.e. product) via cost pools and activity drivers.
iii. Process Specification: This involves identification of different stages of the production
process, the commitment of resources to each processing times and bottlenecks. This will
provide a list of transactions, which may, or may not, be defined as ‘activities’ at a
subsequent stage.
iv. Activity Definition: The list of transactions as identified in the previous stage is analyzed.
This ensures aggregation or grouping of common activities and elimination of immaterial
activities. Activities are categorized into ‘primary activities’ and ‘support activities’. The
resultant cost pools will likely have a number of different events, or drivers, associated with
their incurrence.
v. Activity driver selection: Activity cost drivers used to relate the overheads collected in the
cost pools to the cost objects (products) should be determined. This is based on the factor that
drives the consumption of the activity, i.e., the answer to the question: What causes the
activity to incur costs? Generally a single driver is selected for every activity even though
multiple and interrelated activity drivers exist.
 vi. Costing: A single representative activity driver can be used to assign costs from the
activity pools to the cost objects. Such linking of total costs to cost objects is generally based
on the activity cost driver rate.
vii. Staff Training: The cooperation of the workforce is critical to the successful
implementation of ABC. Staff training should be oriented to create an awareness of the
purpose of ABC. The need for staff co-optation in the concerned team effort for mutual
benefit must be emphasized throughout the training activity.
viii. Review and Follow-up: The actual operation of the ABC system should be closely
monitored. Periodic review and follow-up action is necessary for successful implementation
of the system.

Q8. What are the advantages and limitations of ABC?

Ans: The reasons for support of ABC concept and criticism leveled against are summarized
below:
Advantages:
a. Management Information System is strengthened with better and accurate information.
b. It provides insight into elements of costs. Redundant costs can, therefore, be identified
and remedial measure taken.
c. Valuation of inventory requires assessment of cost rates. By the process of ABC accurate
cost rates can be determined. Accurate assessment of cost rate is prerequisite for proper
valuation of inventory and specially in the case of work-in-process.
d. It helps managers in fixing of competitive selling prices.
e. Information regarding capacity utilization is available for decision-making.
f. It helps in identifying and elimination of bottlenecks in the production for maximizing
use of resources.
g. It identifies non-value added activities, for effective control and maximizing margin.
Criticism:
a. Requires total commitment and support from top level management.
b. Requires positive attitude and employees support for successful implementation.
c. Requires substantial amount of money for implementation.
d. Requires trained professionals, who are limited in number.