ACM 602 Cost Analysis And Control

UNIT I
LESSON 1
PURCHASE OF MATERIAL
CONTEXT OF THE LESSON

The lesson deals to familiarize with the procedure of purchase of material in the
organizations and the various methods for pricing of material issue along with
maintenance of stock register which highlights the receipt, issue and carrying
inventories.

OBJECTIVES OF THE LESSON

• To discuss the procedure of purchase of material
• To understand the methods of pricing of issued material

INTRODUCTION

Material is a most significant element in the finished product. About 60% of the total cost
is constituted by material cost.Material cost is divided into two categories: (a) Direct
Material cost (b) Indirect Material cost.

Direct material costs are directly traced with the finished product and the indirect
material costs are conveniently transferred to indirect cost or overhead. Further, indirect
material costs are present in Manufacturing, Administrative and Marketing costs. In the
cost of service rendered, the share of material cost is less than the other expenses.

Since the materials take major share, especially in the manufacturing of a product, it is
necessary to have proper control over materials. Control is exercised from the point of
purchase to the point of conversion. It involves activities such as purchase, storing,
issuing of the materials.

PURCHASE COST OF MATERIALS

Purchasing of right quantity and quality of materials in right time at right cost from right
place is the responsibility of purchase officer. At what cost the materials enter in the

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ACM 602 Cost Analysis And Control

factory is a matter of concern for cost accountant. The total cost of a product is made up
of cost materials purchased and conversion cost.

There is less control over the purchase cost of materials, as price of materials is
decided by the supplier and the carriage inward expenses depend on the outside
factors such as transportation, Taxes, etc. After the materials enter the factory
premises, the cost of material management can be brought under control. If the
materials are manufactured by the organisation itself then separate account is main-
tained for the same.

The purchase cost can be minimized by judicious, prudent and optimum purchase of
both direct and indirect materials.

PURCHASE PROCEDURE

Purchasing is the process of acquiring the required raw material, general supplies,
spares and tools, office stationary and other items for the production of the product and
maintenance of the business. The key to success lies in efficient purchasing of the
material of right quantity, right quality, right time, right place, right source and delivery at
the right place. Hence it is very much essential that there should prevail an efficient
system of purchase within the organization.

Careful analysis and wise judgement should prevail while dealing with external factors
such as selection of suppliers and acceptance of price and other terms, with respect to
internal factors, such as quality, quantity, time of purchase etc. Purchase procedure
may differ from organisation to organization. The important steps in purchasing and
receiving of materials may be as follows, assuming that purchases are centralized:

Bills of Materials

Bills of materials is a comprehensive list of materials, with specifications, material codes

and quantity of each material required for a particular job and process or production
unit. It will also include the details of substitute materials. It is prepared by the
engineering or planning department. It is a list of materials required for execution of the
specified job work. Bill of Material acts as an authority to the Stores Department in
procuring the materials and the concerned department in material requisition from the
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ACM 602 Cost Analysis And Control

stores. It is an advance intimation to the concerned departments of the job work order to
be completed. It is circulated to: (a) Purchase Department, (b) Stores Department (c)
Cost Accounts Department and (d) Product Department

Purchase Requisition:

Purchases of material are initiated through purchase requisitions. A purchase requisition

is a formal request by the head of a department or an authorized person to the
purchase manager to purchase the specific materials. Purchase requisitions may be
prepared by the following persons as per the requirements:

(i) Storekeeper: When materials reach ordering level, the storekeeper should
initiate purchase procedure.

(ii) Production Manager: For some specific material which will be required for
the manufacture of a new product.

(iii) Plant engineer : Material for repair and maintenance

(iv) Department heads: For any material required for his department.

Generally two copies of purchase requisition are prepared. The original copy is sent to
the purchasing department and duplicate copy is retained and filed by the requisitioner
for his own reference.

Selection of the Supplier: The purchasing department on receipt of the duly

authorized purchase requisition has to select the source of supply. The purchase
department generally maintains a list of supplier for each type of materials and selects a
particulars supplier after inviting quotations. Emphasis is made to buy the best quality of
materials at the lowest possible price after giving due consideration to delivery dates
and other terms and conditions of purchase.

Purchase order and follow- up

After the selection of the supplier the next step in the purchase procedure is the
preparation of a purchase order. The purchase order is the form used by the purchasing
department authorizing the suppliers to supply the specified materials at the price and

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ACM 602 Cost Analysis And Control

terms mentioned therein. A purchase order should be carefully prepared as it forms a

basis of legal contract between the purchaser and the vendor concerned. Authority to
sign purchase orders should also be restricted to selected responsible officials.

Receipt of Materials

All the materials supplied by the supplier should be received by the Receiving
Department. This department receives the goods or material and verifies their quantities
and physical conditions. The quantity is checked against the purchase order copy and
their supplier’s advice note which is normally received along with the goods.

Inspection and Testing of Materials

Goods received from the supplier should be inspected for quality to ensure that they
comply with size and other specifications stated on the purchase order. If any goods
need laboratory inspection it is necessary that the goods are passed to a laboratory
which will provide a report on the quality of goods.

Return of Rejected Materials

Where materials received are damaged or are not in accordance with specifications,
these are usually returned to the supplier along with a Debit note, informing the supplier
that his account has been debited with the value of material being returned. The
supplier signifies his acceptance by the issue of a credit note. The rejected materials
may be returned to the supplier.

Passing invoice for payment

When the invoice is received by the purchasing department the invoices are numbered
serially and entered in the Invoice Register. The following documents are assembled in
support of the invoice: (a) Purchase Order (b) Goods Received Note (c) Inspection
Report, if not incorporated in the Goods Received Note, (d) Debit or Credit Note. After
all documentation work is over and payments are fully authorized by the concerned
departments, payments are made to the supplier and receipt is received in this regard.

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ACM 602 Cost Analysis And Control

PRICING OF MATERIAL OF ISSUE

The price at which material issued are to be charged when they are issued to the
various production department or cost centre for the purpose of production of the
product is a difficult problem. There may be certain circumstances when a particular or
same type of material may have been purchased in different lots at different dates at
different prices. At the time of issue it may even be possible that a same type of material
being issued to the production department may be priced at different prices on the same
day due to the method being adopted for pricing of issued material. This means that
actual cost of material issued to the production department may include different prices
under the same method of pricing the issue of material.

There are various methods of pricing of issued material which are being used by the
manufacturing concerns. These methods can be broadly classified as follows:

1. Cost Price Method 2. Average Price Method 3. Notional Price Methods

(a) Specified price (a) Simple Average (a) Simple Average

(b) First-in First-out (b) Weighted Average (b) Weighted Average

(FIFO)

(c) Last-in First-out

(c) Periodic Simple Average (c) Periodic Simple
(LIFO)
Average
(d) Highest- in- First-out
(HIFO) (d) Moving Simple Average
(d) Moving Simple Average
(e) Base Stock

(e) Moving Weighted

Average (e) Moving weighted
Average

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ACM 602 Cost Analysis And Control

(I) Cost Price Methods

(a) Specified Price (identifiable) Method

There are certain occasions when the materials are purchased to be utilized particularly
for a specific job or issues can be identified with a particular receipt. In these cases, the
actual purchase price can be charged. This method can be adopted when prices are
stable or when the materials are covered by price control orders. This method has very
limited application.

(b) First-in First-Out(FIFO)

This method is based on the assumption that materials which are purchased first are
issued first. It uses the price of the first lot of materials purchased until all units from this
lot have been issued. In other words the, materials are issued at the oldest cost price
listed in the stores ledger account and thus, the materials in stock are valued at the
price latest purchased. It should be noted that this assumption of FIFO is only used for
accounting purpose i.e., the physical flow of materials need not necessarily be in the
order of the flow of cost; though normally materials would be expected to move out of
stock on approximately a FIFO basis because oldest stocks are usually consumed up
first.

Advantages:

(I) It is good inventory management system since the oldest units are used first and
inventory consists of the latest stock.

(II) It is logical and easy to understand and operate.

(III) It facilitates inter-firm and intra-firm comparisons.

(IV) This method provides a realistic cost of finished goods.

Disadvantage:

(I) The cost of production is not related to the current prices.

(II) If prices are increasing, production cost is understated.

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 ACM 602 Cost Analysis And Control

(III) It does not present the true picture when many lots are purchased at different
prices. The calculation becomes complicated.

(IV) The pricing of material returns is difficult.

(V) High inflation creates problems in replacing used materials, this aspects is not
dealt with in FIFO.

(VI) Usually more that one price can be adopted for a particular issue.

(VII) Cost comparisons between two batches of production become difficult when
issues are priced differently.

Illustration1. Following data is available with respect to material M1 for the month of
July 2013. Opening stock 300 units @ 26 per unit.

Purchase: Issues:

Date Units Rate Date Units

04/07/2013 700 24 05/07/2013 600

08/07/2013 200
09/07/2013 800 22
15/07/2013 500
16/07/2013 600 20
26/07/2013 800
27/07/2013 800 19
31/07/2013 700

Prepare a stores ledger Account under FIFO method

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ACM 602 Cost Analysis And Control

Solution: -
Stores Ledger Accounts
FIFO Method
Date Receipts Issue Balance

Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.

1/7/13 - - - - - - 300 26 7,800

4/7/13 700 24 16,800 - - - 300 26 7,800

700 24 16,800

5/7/13 - - - 300 26 7,800

300 24 7,200 400 24 9,600

8/7/13 - - - 200 24 4,800 200 24 4,800

9/7/13 800 22 17,600 - - - 200 24 4,800

800 22 17,600

15/7/13 - - - 200 24 4,800

300 22 6,600 500 22 11,000

16/7/13 600 20 12,000 - - - 500 22 11,000

600 20 12,000

26/7/13 - - - 500 22 11,000

300 20 6,000 300 20 6,000

27/7/13 800 19 15,200 - - - 300 20 6,000

800 19 15,200

31/7/13 - - - 300 20 6,000

400 19 7,600 400 19 7,600

TOTAL 2,900 61,600 2,800 61,800 400 7,600

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ACM 602 Cost Analysis And Control

Illustration 2: Following particulars are available with respect to the material M4 for the
month of June 2013.Opening stock balance 800 Kgs at Rs. 12 per Kg. Stock verifier
reported a shortage of 10 kg on 29th June 2013 and surplus of 20 kgs on 25th June
2013.

2013 Particular
June

2 Purchase 1000 kgs at Rs. 14

8 Issued 700 kgs to production.
14 Purchase 900 kgs at Rs. 12.
17 Returned 50 kg to vendor purchased on 14/6/2008
21 Issued 1000 kgs to production.
23 Returned from production dept.40 kgs
28 Purchase 500 kgs at Rs. 13.
30 Issued 800 kgs to production.

Prepare a stores ledger Accounts under FIFO method and ascertain (i) cost of material
issued during the month & (ii) closing stock on 30/06/2013

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ACM 602 Cost Analysis And Control

Solution: Stores Ledger Accounts

FIFO Method
Date Receipts Issue Balance

June13 Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
1 - - - - - - 800 12 9,600
2 1000 14 14,000 - - - 800 12 9,600
1000 14 14,000
8 - - - 700 12 8,400 100 12 1,200
1000 14 14,000
14 900 12 10,800 - - - 100 12 1,200
1000 14 14,000
900 12 10,800

17 - - - Return 100 12 1,200

50 12 600 1000 14 14,000
850 12 10,200

21 100 12 1,200 100 14 1,400

900 14 12,600 850 12 10,200

23 Return
40 14 560 - - - 140 14 1,960
850 12 10,200
25 Surplus
20 14 280 - - - 140 14 1,960
850 12 10,200
20 14 280

28 500 13 6,500 - - - 140 14 1,960

850 12 10,200
20 14 280
500 13 6,500

29 - - - Shortage 14 140 130 14 1,820

10 850 12 10,200
20 14 280
500 13 6,500

30 - - - 130 14 1,820 180 12 2,160

670 12 8,040 20 14 280
500 13 6,500
TOTAL 2,560 32,800 700 8,940

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ACM 602 Cost Analysis And Control

(c)Last-in-First-out (LIFO) Method

The principle adopted is that the material used in production is from the latest purchase.
The inventory is priced at the oldest costs. As the method applies the current cost of
material is changed to the cost units. It is also known as the replacement cost method. It
is the most significance method in matching cost with revenue in the income
determination procedure.

Advantages:

(I) It is simple and commonly used by the industry in practice for reaping the tax
benefits.

(II) It is a systematic method. It matches current costs with current revenues in a better
ways.

(III) It reveals real income in times of rising prices.

Disadvantages

(I) In case of high fluctuation in the rates of material, the method becomes
complicated

(II) More than one price may have to be taken into consideration for an issue.

(III) Due to variation in cost inter-firm and intra-firm comparison becomes difficult.

(IV) The stocks require to be adjusted during falling prices.

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ACM 602 Cost Analysis And Control

Illustration 3. Popline Company uses a raw material called pop for its production
purpose. The details are as below:

July 2008 Particular

1 Opening balance 300 liters @ Rs. 25.00 per liter
3 Purchase 500 liters @ Rs. 26.60 per liter.
4 Issued 220 liters.
10 Issued 440 liters
20 Purchase 490 liters @ Rs. 23.00 per liter.
25 Issued 300 liters
26 Surplus of 20 liters returned to stores out of issue on July 4th

Prepare a stores ledger Accounts under LIFO method

Solution: Stores Ledger Accounts (LIFO Method)

Date Receipts Issue Balance
July13 Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
1 - - - - - - 300 25 7,500
3 500 26.6 13,300 - - - 300 25 7,500
500 26.6 13,300
4 - - - 220 26.6 5,852 300 25 7,500
280 26.6 7,448
10 - - - 280 26.6 7448
160 25 4000 140 25 3,500
20 490 23 11,270 - - - 140 25 3,500
490 23 11,700
25 - - - 300 23 6,900 140 25 3,500
190 23 4,370
26 20 26.6 532 - - - 140 25 3,500
190 23 4,370
20 26.6 532

(d) Highest-in-first-out

In this method the costliest material is issued first, inventory is valued at the lowest
possible price. It is mainly used for monopoly products or cost plus contacts.

(e) Base stock method

In base stock method a certain level of minimum stock of a material is always carried
and it is priced at the original cost (usually at the lowest purchase price). The portion of

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ACM 602 Cost Analysis And Control

the stock above this level is issued and priced under any one of the methods. The
disadvantage of this method is that the stock may be under valued and hence the
computation of return on capital will not be reliable.

II Average Price Methods

(a) Simple Average Method

The simple average is the average of prices ignoring the quantities involved. This
method is used when the prices are normally stable and the stock purchased are in
equal quantities or the value of stock is very small. It is ascertained by dividing the total
rates of material by the number of rates of material. A new average is worked out after
every receipt.

Illustration4. The following were the receipts and issue of material ‘Zed’ during March
2013

March 2013 Particular

1 Opening balance 1100 units @ Rs. 60.00 per unit
3 Issued 140 units
4 Issued 250 units
8 Issued 210 units
13 Received from vendor 400 units at Rs.59 per unit
14 Refund of surplus from a work order 30 units at Rs. 58 per unit.
16 Issued 350 units
20 Received from vendor 480 units at Rs.62 per unit
24 Issued 608 units
25 Received from vendor 640 units at Rs.60 per unit
26 Issued 524 units
28 Refund of surplus from a work order 24 units issued on 3rd March 2008
31 Received from vendor 150 units at Rs.64 per unit

From the above, write the store ledger account on Simple Average Method.

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ACM 602 Cost Analysis And Control

Solution: Stores Ledger Accounts

(Simple Average Method)

Date Receipts Issue Balance

March Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
1 - - - - - - 1100 - 66,000
3 - - - 140 60 8,400 960 - 57,600
4 - - - 250 60 15,000 710 - 42,600
8 - - - 210* 60 12,600 500 - 30,000
13 400 59 23,600 - - - 900 - 53,600
14 30 58 1,740 - - - 930 - 55,340
16 - - - 350** 59 20,650 580 - 34,690
20 480 62 29,760 - - - 1,060 - 64,450
24 - - - 608*** 59.75 36,328 452 - 28,122
25 640 60 38,400 - - - 1092 - 66,522
26 - - - 524**** 61 31,964 568 - 34,558
28 24 60 1,440 - - - 592 - 35,998
31 150 64 9,600 - - - 742 - 45,598
* = All issue on 3rd, 4th, and 8th are on Rs. 60 ** 60+59+58/4 = 59

*** = 60+59+58+62/ 4 = 59.75 **** = 62+60/ 2 = 61

(B) Weighted Average Method

For determining the weighted average price the total quantities and total costs are taken
into account. After every purchase weighted average price is calculated by adding the
quantity received to the stock in hand and the cost is divided by the quantity to arrive at
the value. This method avoids price fluctuations and reduces the number of calculation
and gives an acceptable figure for stock.

Advantages

(i) It is logical and consistent.

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ACM 602 Cost Analysis And Control

(ii) Changes in prices do not affect issues and inventory.

(iii) The values reflect actual costs.

Disadvantage

(I) It involves considerable amount of clerical work.

(II) When prices change frequently, it is inconventional and complex.

(III) As it is not the actual price, it is not realistic.

Illustration 5. The following purchase has been extended in respect of material “Exe”.
Prepare store ledger account under “Weighted average method” of pricing material
issue:

Receipts - Issues:

Oct. Particular
Oct. Particular
3 Purchased 500 units at Rs. 4
5 Issued 400 units
4 Purchased 100 units at Rs. 4.20
10 Issued 50 units
10 Purchased 50 units at Rs. 4.25
15 Issued 900 units
13 Purchased 800 units at Rs. 4.30
25 Issued 450 units
23 Purchased 850 units at Rs. 3.80

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ACM 602 Cost Analysis And Control

Solution: Stores Ledger Accounts

(Weighted Average Method)

Date Receipts Issue Balance

Oct. Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.

3 500 4 2,000 - - - 500 4 2,000

4 100 4.20 420 - - - 600 4.033 2,420
5 - - - 400 4.033 1,613 200 4.035 807
10 50 4.25 212.5 - - - 250 4.078 1,019.5
10 - - - 50 4.078 203.9 200 4.078 815.6
13 800 4.30 3,440 - - - 1,000 4.256 4,255.6
15 - - - 900 4.256 3,830 100 4.256 425.6
23 850 3.80 3.230 - - - 950 3.848 3,655.6
25 - - - 450 3.848 1731.6 500 3.848 1,924
Closing inventory 450 units @ 3.815, Rs. 1,732.80
Cost of material consumed, 1800 units valued a Rs. 7,379.70

III Notional Price Methods

(a) Standard Price Method: The price of issue for each item is pre-determined for a
stated period taking into accounts all the factors affecting price, e.g., market trends,
transportation cost, etc. standard prices are determined for each material. All issues
and inventory are kept at the standard price. This price should be revised from
period to period. Standard can be basic or current standard. The basic standard is
fixed for long periods and gives the ideal price, it assists forward planning. Current
standard keeps costs of the product adjusted to prevailing trends in markets.

Advantages:

(I) It simplifies accounting as only quantities are recorded.

(II) As only one rate is adopted, inconsistency is avoided.

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ACM 602 Cost Analysis And Control

(III) It helps to determine purchase efficiency. It actual cost is more than the
standard than there is unfavorable purchasing efficiency and vice-versa.

(IV) It is simple to operate.

(V) It provides stability to the costing system.

Disadvantage

(I) It does not reflect the actual or expected cost but only a target.

(b) Inflated Price Method: In this method the cost of the material to be issued is
inflated by the amount of lost of material. Inflated price includes carrying costs,
losses due to evaporation etc. it aims to recover full costs of material purchase.

(c) Replacement Price Method: Material may be issued at the replacement price. The
replacement price is the cost of the same type of materials in the market at any
given time.

SELF CHECK QUESTIONS

THEORETICAL QUESTIONS

1. Discuss the different methods of pricing the materials issued from stores for
production.

2. Discuss the merits & demerits of the following methods of valuation of inventories of
issued material:

a) FIFO method, b) Weighted Average, c) Replacement price

3. Explain with examples the following methods of pricing issue material:

a) FIFO method, b) LIFO method

Under condition of rising prices which of these methods of pricing issues of

material is suitable.

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ACM 602 Cost Analysis And Control

Question 1. Prepare a store ledger account from the following transaction adopting the
FIFO method of pricing out issue
Receipts Issues
Date Qty. Rate Date Issue
Dec. Dec. 4 100
3 200 20.00 10 50
18 300 18.00 20 300
28 50 15.00 30 100

Question 2. From the following particulars prepare “Stores Ledger Account” showing
issue of material for the month of December under FIFO method
Receipts Issues
Date Qty. Rate Date Issue

Aug. Aug.
3 750 2.00 19 850
18 350 2.10 26 450
25 600 2.20 29 510
28 500 2.30 30 150
Question 3. With the help of the following particulars, prepare stores Account showing
issue of materials on the basis of LIFO:
March 2008 Particular
1 Opening balance 200 units @ Rs. 2.00 per unit
2 Purchased 600 units @ Rs. 3.00 per unit
6 Issued to production 600 units
12 Purchased 400 units @ Rs. 3.40 per unit
22 Issued 300 units
26 Purchased 500 units @ Rs. 3.50 per unit
30 Issued 200 units

Question 4. From the following information, write the stores ledger account based on
Simple Average method of pricing issue:
Receipts Issues
Date Particular Qty Rate per unit Date Issue
May May
12 Purchase material 400 59.00 3 140
14 Refund of surplus 30 58.00 4 250
20 Purchased 480 62.00 8 210
25 Purchased 640 60.00 16 350
28 Refund of surplus(issue on 3rd 24 608
may) 24 26 524
31 Received from supplier 150
Opening stock on 1st may 2008, 1,100 units @ Rs. 60 per unit.

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ACM 602 Cost Analysis And Control

Question 5. From the following particulars, prepare stores ledger for the month of Jan.
2008, showing material issue process on the Weighted Average Price Method:

Receipts Issues
Date Qty. Rate Date Issue
Jan. Jan.
1 500 2.00 1 400
10 200 3.00 15 100
18 400 4.00 22 200
27 300 5.00 31 300
29 Return 10 unit issue on 15th Jan.

2 ton loss was revealed on Jan.28 during stock verification.

Question 6
From the following information prepare Store ledger Account showing issue of material
on LIFO method:

October 1 Balance 500 units @ Re, 1.00 per unit.

October 10 Ordered 250 units.
October 18 Issued 125 units.
October 21 Received 150 units @ Rs. 1.10 per unit.
October 25 Ordered 200 units.
November 1 Issued 175 units.
November 10 Received 200 units @1.20 each.
November 20 5 units defective, returned: they were purchased on 21st Oct.
December 1 Received 100 units @ Rs.1.10 each.
December 15 Issued 100 units
December 20 Returned to store 25 units, issued on 15th December.
December 30 Issued 125 units.

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ACM 602 Cost Analysis And Control

Lesson 2
MATERIAL COST
The term 'material' refers to all commodities that are consumed in the process of
manufacture. It is defined as "anything that can be stored, stacked or stockpiled."

Materials are classified into 'direct' materials and 'indirect' materials.

Direct materials are those whose consumption may be identified with specific
production units and which usually become a part of the finished product. Direct
materials include not only the raw materials entering at the start of the production but all
of the following:

(1) Component parts used in a product, e.g., tyres and tubes in a car, picture tube in a
television set, etc.

(2) Any material used in production but wholly consumed in the production process,
e.g., fertiliser used in growing plants.

(3) Any primary packing material, i.e., any container sold with the final product, e.g.,
cans for tinned food and drink, bottles for beer, etc.

Indirect materials are those which cannot be conveniently identified with individual
cost units. Examples are coal, grease and oil, soap, sandpaper etc.

The term 'inventory' is used to cover the stocks of raw materials, components, work-in-
progress and finished goods. It has been defined by the Accounting Principles Board as
"the aggregate of those items of tangible personal property which (i) are held for sale in
the ordinary course of business, (ii) are in the process of production for such sales, or
(iii) are to be currently consumed in the production of goods or services to be available
for sale."

MATERIAL CONTROL (Inventory Control)

No cost accounting system can become effective without proper and efficient control of
materials. This is so because quite often material is the single largest element of cost,
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ACM 602 Cost Analysis And Control

and as such, an efficient system of material control leads to a significant economy in

the total cost. Material is as much cash as cash itself and any theft, waste and
excessive use of materials leads to immediate and direct financial losses. Where slack
methods exist, it is easy for such losses to pass unnoticed..

Meaning and Definition Material or inventory control may be defined as "systematic

control and regulation of purchase, storage and usage of materials in such a way so as
to maintain an even flow of production, at the same time avoiding excessive investment
in inventories. Efficient material control cuts out losses and wastes of materials that
otherwise pass unnoticed."

Thus, an efficient system of material control should be comprehensive enough to cover

purchase system, storage system, issue to production and determination of stock levels
for each item of material.

Objectives of Material or Inventory Control

The broad objectives of material control are listed below:

a) NO under-stocking: Under-stocking inevitably leads to materials running out of

stock at some time or the other. Shortage of material may arise at a time when they
are urgently needed and production may then be held up. The delay or stoppage in
production due to non-availability of materials is very costly and results in loss of
profits.

b) No over-stocking: Investment in materials must be kept as low as possible

considering the production requirements and the financial resources of the
business. Over-stocking of materials locks up capital and causes high storage
costs, thereby resulting in adverse effect on profits. This may also result in loss due
to obsolescence.

c) Economy in purchasing: The purchasing of materials is a highly specialised

function. By purchasing materials at the most favourable prices, the purchaser is
able to make a valuable contribution to the reduction in cost.

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ACM 602 Cost Analysis And Control

d) Proper quality: While purchasing materials, due consideration should be given to

the quality. It is no use purchasing materials of inferior quality or very superior
quality. For each type of product, there is a particular type of quality of material
which is needed and that quality alone should be purchased.

e) Minimum wastage: In order to minimise the loss of materials, proper storage

conditions must be provided to different types of materials. Losses of materials
occur due to deterioration, obsolescence, pilferage and theft, evaporation, etc. All
round efforts should be made to keep these losses to the minimum.

f) Information about materials: Not only should materials be available when

required, there should also be a system to give complete and up-to-date accounting
information about the availability of materials. Sometimes inadequate information
about availability of materials may cause new purchases to be made of materials
already in stock.

Essential Requirements or Principles of Inventory Control

Ideally, material control must ensure that the following requirements are fully met:

1. There should be proper coordination and cooperation between various departments

dealing in materials, viz., Purchasing Department, Stores Department, Receiving
and Inspecting Department, Accounting Department, etc.

2. There should be a central purchasing department under the control of a competent

and expert purchase manager.

3. There should be proper classification and codification of materials.

4. Material requirements should be properly planned.

5. The perpetual inventory system should be operated so that up-to-date information is

available about the quantity of material in stock.

6. Adequate records should be introduced to control materials during production and

the quantities manufactured for stock.

22
ACM 602 Cost Analysis And Control

7. The storage of all materials should be well planned, subject to adequate safeguards
and supervision.

8. The various stock levels like minimum, maximum, etc. should be fixed for each item
of material.

9. Purchases of materials should be controlled through budgets.

10. An efficient system of internal audit and internal check should be operated so that all
transactions involving materials are checked by reliable and independent persons.

11. There should be regular reporting to management regarding purchases, issues and
stock of materials. Special reports should be prepared for obsolete items, spoilage,
returns to suppliers, etc.

Various techniques commonly used for inventory control are listed below:

(i) ABC technique.

(ii) Stock levels—Minimum, maximum and re-order levels.

(iii) Economic order quantity (EOQ).

(iv) Proper purchase procedure.

(v) Proper storage of materials.

(vi) Inventory turnover ratio to review slow and non-moving materials.

(vii) Perpetual inventory system.

(viii) Fixation of material cost standards (Used in Standard Costing).

(ix) Preparation of material budgets (Used in Budgetary Control).

(x) VED Analysis

(xi) FNSD Analysis

ABC TECHNIQUE (Selective Control)

ABC technique is a value based system of material control. In this technique, materials
are analysed' according to their value so that costly and more valuable materials are
given greater attention and care. All items of materials are classified according to their
23
ACM 602 Cost Analysis And Control

value—high, medium and low values, which are known as A, B and C items
respectively. ABC technique is sometime called Always Better Control method.

'A ' Items—These are high value items which may consist of only a small percentage of
the total items handled. On account of their high cost, these materials should be under
the tightest control and the responsibility of the most experienced personnel.

'B' Items—These are medium value materials which should be under the normal
control procedures.

'C' Items—These are low value materials which may represent a very large number of
items. These materials should be under simple and economical methods of control.

The point of classifying stock into A, B and C categories is to ensure that material
management focuses on A items where sophisticated controls should be installed. B
items may be given less attention and C items least attention.

Thus ABC technique is a selective control which aims at concentrating efforts on those
materials where attention is needed most. This is so because it is unwise to give equal
attention to all items in stock. The items are listed and ranked in the order of their
descending importance showing quantity and value of each item. This is illustrated
below with arbitrary percentage figures.

Category % of total value % of total quantity Type of control

A 70 10 Strict control

B 25 30 Moderate control

C 5 60 Loose control

Total 100 100

In the above table it is shown that 10% of the total items account for as much as 70% of
the total value. These are A category items which need very strict control because of
their high cost significance. The second types of items represent 30% of the total
quantity but account for 25% of the total value. These are B items which need routine
type of control. Finally, the items representing 60% of the total quantity account only for
5% of total value. These C items are kept under simple physical control. The rules
24
ACM 602 Cost Analysis And Control

regarding purchasing, storing and issuing of various categories of items should be

formed according to the value and importance of materials.

Advantages: The advantages of ABC technique are as follows:

a) Closer and stricter control can be exercised on those items which represent large
amounts of capital invested.

b) Investment in inventory is regulated and funds can be utilised in the best possible
way.

c) Economy in stock carrying costs.

d) It helps in maintaining enough safety stock for 'C' category items.

e) Selective control helps in maintaining high stock turnover rate.

VED Analysis

VED analysis divides items into three categories in the descending order of their
critically as follows:

a) 'V' stands for 'vital items' and their stock analysis requires more attention,
because out-of- stock situation will result in stoppage of production. Thus, 'V' items
must be stored adequately to ensure smooth operation of the plant.

b) 'E' means 'essential items'. Such items are considered essential for efficient
running but without these items the system would not fail. Care must be taken to see
that they are always in stock.

c) 'D' stands for 'desirable items' which do not affect the production immediately but
availability of such items will lead to more efficiency and less fatigue.

VED analysis can be very useful to capital intensive process industries. As it analyses
items based on their importance and it can be used for those special raw materials
which are difficult to Procura.

25
ACM 602 Cost Analysis And Control

FNSD Analysis

Age of inventory indicates duration of inventory in organization. It shows moving

position of inventory during the year. If age of inventory is minimum it means, the
turnover position of the particular item of inventory is satisfactory. If the age of any
particular item of inventory is high, indicates the slow moving of stock which may be
due to lower demand for the product inefficiency in stocking policy, excessive stocking
etc. The excessive investment in stocks mean high investment is locked-up in
inventory which leads to lower profitability of the firm due to excess carrying costs.
FNSD analysis divides the items into four categories in the descending order of their
usage rate as follows:

a. 'F' stands for 'fast moving items' and stocks of such items are consumed in a
short span of time. Stocks of fast moving items must be observed constantly and
replenishment orders be placed in time to avoid stock-out situations.

b. 'N' means ' normal moving items' and such items are exhausted over a period of
a year. The order levels and quantities for such items should be on the basis of a
new estimated future demand, to minimize the risks of a surplus stock.

c. 'S' indicates 'slow moving items' existing stock of which would last for two years
or met at the current rate of usage but it is still expected to be used up. Slow
moving stock must reviewed very carefully before any replenishment orders are
placed.

d. 'D' stands for 'dead stock' and for its existing stock no further demand can be
foreseen. Dead stock figures in the inventory represents money spent that cannot
be realized but it occupies useful space. Hence, once such items are identified,
efforts must be made to find alternative uses for it. Otherwise, it must be disposed
off.

Economic Order Quantity

The prime objective of inventory management is to find out and maintain optimum level
of investment in inventory to minimize the total costs associated with it. The economic
order quantity (EOQ) is the optimum size of the order for a particular item of inventory
26
ACM 602 Cost Analysis And Control

calculated at a point where the total inventory costs are at a minimum for that particular
stock item. It is an optimum size of either a normal outside purchase order or an internal
production order that minimizes total annual holding and ordering costs of inventory.
Stock-out costs are difficult to incorporate into this model. Since they are based on
qualitative and subjective judgment. The ordering costs are the costs of placing a
separate order multiplied by the number of separate orders placed in the period. The
carrying costs can be calculated based on the assumption that annual cost of carrying a
particular stock item on average, half the stock is on hand all the time in addition to the
safety or buffer stock. The fewer the orders, the lower costs of ordering, but the greater
the size of the order the greater the costs of carrying. The safety or buffer stock has no
bearing on the EOQ, only on the timing of orders. The EOQ is an optimum quantity of
materials to be ordered after consideration of the following three categories of costs:

Ordering Costs The costs of ordering inventory include the following:

a) Preparation of purchase order

b) Costs of receiving goods

c) Documentation processing costs

d) Transport costs

e) Intermittent costs of chasing orders, rejecting faulty goods

f) Additional costs of frequent or small quantity orders

g) Where goods are manufactured internally, the setup and tooling costs associated
with each production run.

Carrying Costs The carrying costs of inventory include the following:

(a) Storage costs (rent, lighting, heating, refrigeration, air-conditioning etc.

(b) Stores staffing, equipment maintenance and running costs

(c) Handling costs

(d) Audit, stock taking or perpetual inventory costs

27
ACM 602 Cost Analysis And Control

(e) Required rate of return on investment in current assets

(f) Obsolescence and deterioration costs

(g) Insurance and security costs

Costs of money tied up in inventory (i) Pilferage and damage costs

Stock-out Costs The stock-out costs are associated with running out of stock which
include the following:

(a) Lost contribution through the lost sales caused by the stock-out

(b) Loss of future sales because customers go elsewhere

(c) Loss of customer goodwill

(d) Cost of production stoppages caused by stock-outs of WIP or raw material

(e) Labor frustration

(f) Over stoppages

(g) Extra costs associated with urgent replenishment purchases of small quantities

Assumptions of EOQ

To be able to calculate a basic EOQ certain assumptions are necessary:

a) That there is a known, constant stock holding cost.
b) That there is a known, constant ordering cost.
c) That rates of demand are known and constant.
d) That there is a known, constant price per unit, ie., there are no price discounts.

That replenishment is made instantaneously, le., the whole batch delivered at once.

Mathematical Formulae of EOQ

Economic order quantity can also be calculated with the help of a formula as given
below:

28
ACM 602 Cost Analysis and Control

where EOQ = Economic Order Quantity

A = Annual consumption in units B = Buying or ordering cost per order C = Cost per
unit
S - Storage or carrying cost as a percentage of average inventory.

Where S = Storage cost per unit per annum.

Illustration 1.

The annual demand for an item is 3,200 units. The unit cost is Rs. 6 and inventory
carrying charges 25% p.a. If the cost of one procurement is Rs. 150, determine:

(a) Economic order quantity (EOQ).

(b) Number of orders per year.

(c) Time between two consecutive orders.

Solution:

EOQ = 800 Unit

Time between Two Consecutive Orders = 800 units= 4 orders in a year = 12 months/4
orders = 3 months

29
ACM 602 Cost Analysis and Control

EOQ with Discounts

A particularly unrealistic assumption with the basic EOQ calculation is that the price
per item remains constant. Usually some form of discount can be obtained by
ordering increasing quantities. Such price discounts can be incorporated into the
EOQ formula, but it becomes much more complicated. A similar approach is to
consider the costs associated with the normal EOQ and compare these costs with
the costs at each succeeding discount point and then ascertain the best quantity to
order. Price discounts for quantity purchase have three financial effects, two of
which are beneficial and one adverse.

Beneficial effects - Savings will come from:

1. Lower price per item, and

2. The large order quantity means that fewer orders need to be placed and
hence, ordering costs are reduced.

Adverse effects - Increased costs arise from the extra stock holding costs caused by
the average stock level being higher due to the larger order quantity.
Illustration 2.
From the following particulars with respect to a particular item of materials of a
manufacturing company, calculate the best quantity to order:
Ordering quantity (tons) Price per ton (Rs.)
Less than 250 6.00

250 but less than 800 5.90

800 but less than 2,000 5.80

2,000 but less than 4,000 5.70

4,000 and above 5.60

The annual demand for the material is 4,000 tons. Stock holding costs are 20% of
material cost per annum. The delivery cost per order is Rs. 6.00.

30
ACM 602 Cost Analysis and Control

Solution
Statement Showing the Optimum Ordering Quantity of Materials
1. Annual demand (Tons) 4,000 4,000 4,000 4,000 4000

2. Order size (Tons) 200 250 800 2,000 4000

3. No. of orders (Annual demand/Order size) 20 16 5 2 1

4. Price per ton (Rs.) 6.00 5.90 5.80 5.70 5.6

5. Value per order (Order size X Price per ton) 1,200 1,475 4,640 11,400 22,40

6. Average (Value per order X 1 /2) 600 738 2,320 5,700 11,200
inventory

(Rs)

Ordering cost (No. of orders X Rs. 6.00) 120 96 30 12 6

Carrying cost (20% of item 6) 120 148 464 1,140 2240

Total ordering and carrying cost (a) 240 244 494 1,152 2246

Annual cost of material (Annual demand X Price) 24,000 23,600 23,200 22,800 22400
(b)

Total Annual Cost (a) + (b) 24,240 23,844 23,694 23,952 24646

* The total minimum cost at 800 tons order size is Rs. 23,694. Therefore, the best quantity to be ordered is
800 tons

Theoretical Question

1. What do you mean by inventory control? State its objects.

2. What do you understand by Economic Order Quantity? How is it calculated?

3. What do you understand by ABC analysis? What are its advantages?

4. What do you mean by inventory control and discuss its objectives?

EXERCISES
1) A manufacturer buys certain parts from outside supplier at Rs.30 per unit. Total
annual needs are 800 units. Further details: Annual return on investment 10%.
Rent, insurance, taxes per unit per year Re.l. Cost of placing an order Rs.100.
Calculate EOQ. [Hint: A = 800, C = 1 + 10% of 30 = 1 + 3 = 4, O = 100]

2) Annual requirement: 1600 units. Material cost per unit: Rs.40. Cost of placing
and receiving one order: Rs.50. Annual carrying cost of inventory: 10% of

31
ACM 602 Cost Analysis and Control

inventory value. Determine EOQ using (a) Tabular method (b) Algebraic method
and (c) Graphical method.

3) M.S. Company Ltd. buys its annual requirements of 36,000 units of Raw material
in 6 instalments. Each order costs Rs.25. Cost of each unit is Rs.10. Annual
inventory carrying cost is estimated at 20% per unit value. Find the annual
inventory cost as per existing policy. What difference does it make if EOQ is
followed?

4) Following information relating to a type of material is available:

Annual demand 2,400 units

Unit price Rs.2.40
Ordering cost per order Rs.4
Storage cost 2% per year
Interest rate 10% per year
Lead time Half month.

Calculate EOQ & the total annual inventory cost.

[Hint: C = 2% of 2.40 + 10% of 2.40 = 0.288]

Annual inventory cost:

Purchase price = 2400x2.40 = 5760

Ordering cost = 40

Carrying cost = 12% of (258 - 2 x Rs.2.40) = 37.15

Total = 5837.15

(5) EXE Limited has received an offer of quantity discounts on its order of materials
as under:

Price for tonne Rs. No. Tonne

1200 Less than 500

1180 500 & Less than 1000

1160 1000 & Less than 2000

1140 2000 & Less than 3000

1120 3000 and above

32
ACM 602 Cost Analysis and Control

The annual requirement is 5000 units. The ordering cost per order is Rs.1200
and the stock holding cost is estimated at 20% of material cost per year.
Calculate EOQ. What will be your answer if there are no discounts offered and
the price per tonne is Rs.1500?

[Hint: It is necessary to calculate total cost for each of order size such as 400,
500, 1000, 2000 & 3000 tonnes]

Ex: For order size 400 tonnes

Purchase price = 5000 x 1200 = 60, 00,000

Ordering cost =1200 = 15,000

Carrying cost = ~ x 400 x 20% x 1200 = 48,000

(6) A company uses Rs.50, 000 worth raw material every year. The administration
cost per purchase is Rs.50. The cost per unit is Re.l and the carrying cost is 20%
of the average inventory. There is an offer of 0.4 per cent discount if they
purchase five times per year instead of the present policy. Should this be
accepted

33
ACM 602 Cost Analysis and Control

Lesson 3
DETERMINATIONS OF LEVEL
In order to guard against under-stocking and over-stocking, most of the large
companies adopt a scientific approach of fixing stock levels. These levels are- (i)
maximum level, (ii) minimum level, (iii) re-order level, and (iv) re-order quantity. By
adhering to these levels, each item of material will automaticity be held within
appropriate limits of control. These levels are not permanent and must be changed
to suit changing circumstances. Thus, changes wiII take place if consumption of
material is increased or decreased or if-in the light of a review of capital available, it
is decided that the overall inventory must be increased or decreased. Modern
inventory management makes use of operations research and statistical techniques
in fixing stock levels. However, given below is the description of various levels along
with formulae that are commonly used in their computations.
Some of the factors which influence stock levels are:
1. Anticipated rate of consumption.
2. Amount of capital available.
3. Availability of storage space.
4. Storage/warehousing costs.
5. Procurement costs.
6. Reliability of suppliers.
7. Minimum order quantities imposed by suppliers.
8. Risk of loss due to (a) obsolescence, (b) deterioration, (c) evaporationand
(d) fall in market prices, etc.
Maximum Level
This is that level above which stocks should not normaIIy be aIIowed to rise. The
maximum level may, however, be exceeded in certain cases, e.g., when unusuaIIy
favourable purchasing condition arise. It is computed by the foIIowing formula:
)

The following factors are taken into account in setting this level:
1. Rate of consumption of material.
2. Risk of obsolescence and deterioration.

34
ACM 602 Cost Analysis and Control

3. Storage space available.

4. Costs of storage and insurance.
5. Availability of funds needed.
6. Seasonal considerations, e.g., bulk purchases during off-season at low
prices.
7. Re-order quantity.
8. Restrictions imposed by government or local authority in respect of certain
materials in which there are inherent risks of fire, explosion, etc.
The idea of setting maximum stock level is to ensure that capital is not
unnecessarily blocked in stores and also to avoid loss due toobsolescence and
deterioration.

Minimum Level

It is that level below which stock should not normally be allowed to fall. This is
essentially a safety stock and is not normally touched. In case of stock falling below
this level, there is a risk of stoppage in production and thus top priority should be
given to the acquisition of fresh supplies. It is computed by the following formula:

In fixing this level, the following factors are considered:

1. Rate of consumption.

2.The time required to acquire fresh supplies under top priority conditions so that
stoppage in production can be avoided.

Re-order Level or Ordering Level

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

The following factors are considered in fixing this level:

1.Rate of consumption of the material.

2.Minimum level.

3.Delivery time; i. e., the time normally taken from the time of initiating

35
ACM 602 Cost Analysis and Control

A purchase requisition to the receipt of materials. This is also known as lead

time.
4.Variations in delivery time.

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

Average Stock Level

This is computed as follows:

or

Illustration 1.

In a manufacturing company, a material is used as follows: Maximum

consumption 12,000 units per week
Minimum consumption 4.000 units per week
Normal consumption 8.000 units per week
Re-order quantity 48,000 units
Time required for delivery—Minimum: 4 weeks; Maximum: 6 weeks. Calculate: (a)
Re-order level; (b) Minimum level; (c) Maximum level; (d) Danger level; and (e)
Average stock level.
Solution:
Re-order Level = Maximum consumption * Maximum re-order period = 12,000 x 6
= 72,000 units
Minimum Level = Re-order level - (Normal consumption x Normal re-order period)
= 72,000 - (8,000 x 5) = 32,000 units
Maximum Level = Re-order level + Re-order Qty. - (Min. consumption x Min. re-
order period)
= 72,000 + 48,000 - (4,000 x 4) = 1,04,000 units
Danger Level = Average consumption Max. re-order period for emergency
purchases
= 8,000 x 2 weeks (assumed) = 16,000 units
Average Stock Level = Minimum level + 1/2 of Re-order Qty.
= 32,000 + 1/2 (48,000)= 56,000 units

36
ACM 602 Cost Analysis and Control

Illustration 2.
Fagoon India Ltd. provides the following information in respect of material :

Supply period 5 to 15 days

Rate of Consumption
Average : 15 units per day
Maximum 20 units per day
Yearly 5,000 units

Ordering costs are Rs. 20 per order

Purchase price per unit is Rs. 50
Storage costs are 10% of unit value
Compute: (i) Reorder Level, (ii) Minimum Level,
Solution
(i) Reorder Level = Maximum consumption x Maximum Supply period
= 20 units x 15 days = 300 units
(ii) Minimum Level = Reorder level - (Normal consumption x Normal supply period)
= 300 - (15 units * 10 days) = 300 - 150 = 150 units
Input-Output Ratio
Input-output ratio is used in material control, which indicates the relation
between the quantity of material used in the production and the quantity of final
output.

Advantages - The advantages of analysis of input-output ratios is given

below:
• It helps in material planning by estimation of output and its raw material
requirement.
• The standard input-output ratio act as guide in control of materials used in
the process minimization of waste, scrap, spoilage performance and
defective.
• It acts as a indicator of particular production cost centers.
• It helps the management in investigation and analysis of any variations in
material usage establishing relation between input and output.
• The cost-benefit analysis of use of different substitutes of raw material is
possible by comparing each of the input-output ratios.

37
ACM 602 Cost Analysis and Control

Illustration 3.
If 500 units of material is introduced into the process or operation and the yield
of final product is 400 units, the input-output ratio is calculated as follows:

Stock Turnover Ratio

The stock turnover ratio indicates the movement of average stock holding of
each item of material in relation to its consumption during the accounting
period. The stock turnover ratio is calculated by applying the following formula:

Advantages - computation of stock turnover ratio will lead to the following benefits:
It highlights slow-moving or obsolete stocks where action is needed to reduce
the stock held!
It indicates whether the stock holding is consistent with the material required for
production.
It helps in location of excessive stocks and by avoiding unnecessary pile up of
stocks, the financial strain on the working capital of the organization can be
reduced.

Illustration 4.
From the following data for the year ended 31st March, 2009, calculate

Particulars Material Material

A
Opening stock 1-4-2008 20,000 18,000
Purchases during the year 1,04,000 54,000
Closing stock 31-3-2009 12,000 22,000

Inventory turnover ratio of the two items, and

Their average stock holding in terms of number of days

Solution:

Material Consumed = Opening stock + Purchases - Closing stock

A = 20,000+ 1, 04,000-12,000 = Rs. 1,12,000

B = 18,000 + 54,000-22,000 = Rs. 50,000
Average stock = (Opening stock + Closing stock)/2
A = (20,000 + 12,000)/2 = Rs. 16,000

38
ACM 602 Cost Analysis and Control

B = (18,000 + 22,000)/2 = Rs. 20,000

(4) Inventory Turnover Ratio

= Raw material consumed/Average stock A = 1,12,000/16,000 = 7
B = 50,000/20,000 = 2.5
(5) Average Stock Holding in terms of number of days
= 365/Inventory turnover ratio A = 365/7 = 52.14 days
B = 365/2.5 = 146 days

Questions
1. A Company manufactures a special product which requires a component
'Alpha'. The followingparticulars are collected for the year 2009:
Annual demand of Alpha 8,000 units
Cost of placing an order Rs. 200 per order
Cost per unit of Alpha Rs. 400
Carrying cost % p.a. 20%
The company has been offered a quantity discount of 4% on the purchase of
'Alpha' provided the order size is 4,000 components at a time.
Required:
Compute the economic order
quantity.
Advise whether the quantity discount offer can be accepted.
2. ZED Company supplies plastic crockery to fast food restaurants in metropolitan
city. One of its products is a special bowl, disposable after initial use, for serving
soups to its customers. Bowls are sold in pack of 10 pieces at a price of Rs. 50
per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of
40,000 packs every year. The company purchases the bowl direct from
manufacturer at Rs. 40 per pack within a three days lead time. Theordering and
related cost is Rs. 8 per order. The storage cost is 10% per annum of average
inventory investment. Required:
(6) Calculate Economic Order Quantity.
(7) Calculate number of orders needed every year.
(8) Calculate the total cost of ordering and storage bowls for the year.
(9) Determine when the next order to be placed should. (Assuming that the
company does maintain a safety stock and that the present inventory level is
333 packs with a year of 360 working days

39
ACM 602 Cost Analysis and Control

3. Currently, its inventory turnover (based on cost of goods sold/inventory) is 10

times p.a., as compared with industry average of 4. Average sales are
Rs. 4,50, 000 p.a. variable costs of inventory have consistently remained at 70%
of sales with fixed costs of Rs. 10,000. Carrying costs of inventory (excluding
financing costs) are 5% p.a. Sales force complained that low inventory levels
are resulting in lost-sales due to stock-outs. Sales manager has made an
estimate based on stock-out reports as under:
Inventory policy Inventory turnover Sales (Si
Current 10 4,50,000
A 8 5,00,000
B 6 5,40,000
C 4 5,65,000
On the basis of above estimates, assuming a 40% tax rate and an after
tax required return of 20% investment in inventory, which policy would
you recommend?

4.Tubes Ltd. are the manufacturers of picture tubes for T.V. The following are the
details of their operation during 2009:
Average monthly market demand 2,000 tubes
Ordering cost Rs.100 per order
Inventory carrying cost 20% per annum
Cost of tubes Rs. 500 per tube
Normal usage 100 tubes per week
Minimum usage 50 tubes per week
Maximum usage 200 tubes per week
Lead time to supply 6-8 weeks
Compute from the above:
(10) Economic Order Quantity. If the supplier is willing to supply 1,500 units
quarterly at a discount of 5%, is it worth accepting?
(11) Maximum level of stock.
(12) Minimum level of stock.
(13) Reorder level
5.ZED Company supplies plastic crockery to fast food restaurants in
metropolitan city. One of its products is a special bowl, disposable after initial
use, for serving soups to its customers. Bowls are sold in pack of 10 pieces at
a price of Rs. 50 per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of
40,000 packs every year. The company purchases the bowl direct from
manufacturer at Rs. 40 per pack within a three days lead time. The ordering

40
ACM 602 Cost Analysis and Control

and related cost is Rs. 8 per order. The storage cost is 10% per annum of
average inventory investment.

Required:
(14) CalculateEconomic Order Quantity.
(15) Calculatenumber of orders needed every year.
(16) Calculatethe total cost of ordering and storage bowls for the year.
(17) Determine when should the next order to be placed. (Assuming that the
company does maintain a safety stock and that the present inventory level is
333 packs with a year of 360 working days.
5. The following data are available in respect of material X for the year ended 31st
March, 2009:
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000

Calculate -
Inventory turnover ratio, and
The number of days for which the average inventory is held

41
ACM 602 Cost Analysis and Control

Lesson 4
METHODS OF REMUNERATION OF LABOUR
CONTEXT OF THE LESSON
This lesson deals with various types of labour cost and various method adopted for
payment of remuneration.
OBJECTIVES OF THE LESSON-
• Classification of labour cost
• Methods of remuneration on various bases.
INTRODUCTION
Labour is considered as one of the important factor of production in an industrial
organization. It is the employment of labour which help to convert the raw material
into finished products and services. Labour is the only factor which can give almost
unlimited productivity-its output can be increased whereas the output from other
factors is limited by their physical limitations. However, labour is complex and
delicate hence it should be handled very carefully and efficiently and should be
remunerated properly.
LABOUR COST
In the narrow sense, the term labour cost encompasses only wages paid to the
workers but it represents the various payment made to a worker arising out of his
employment in the orgnisation.
The total labour cost can be classified as follows:
(a) Direct labour cost
(b) Indirect labour cost.

DIRECT LABOUR COST

It refers to all expenses which are incurred on labour in altering the construction
composition, confirmation or condition of the product. The wages paid to skilled and
unskilled workers for his labour can be allocated specifically to the particular product
or the process as the case may be. In any manufacturing process or department, the
workers employed may be of the following two categories.

42
ACM 602 Cost Analysis and Control

(i) Those who are directly engaged on the production or in carrying out of
an operation or process.
(ii) Those who are assisting in the process by way of supervision,
maintenance, transportation of material, etc.
The workers who are directly engaged in the production or carrying out the operation
process constitute as direct labour and the wages paid to them are termed as direct
wages. Direct labour cost is that part of wages and salaries which can be identified
with and charged to a single costing unit. It is the cost which can be easily identified
and has a direct relationship with the product or process of operation.

INDIRECT LABOUR COST: - It refers to all expenses that are incurred on labour
but that does not alter the construction, confirmation, composition or condition of the
product, but which contributes or assist generally to such work and help in the
completion of the product and handling up to the point of dispatch. In other words,
labour employed for the purpose of carrying out tasks incidental or ancillary to goods
produced or services provided is regarded as indirect labour. Wages or salaries paid
to foreman, supervisors, inspectors, clerks, etc, are the example of indirect labour.
Need for distinguishing between direct and indirect labour cost: The distinction has
to be made:
(a) For calculating appropriate labour cost and thus provide a basis for strict
control;
(b) For facilitating calculation of labour efficiency.;
(c) For proper allocation of overheads;
(d) For introduction of incentive schemes;
(e) For inter-unit comparison; and
(f) For estimating total labour cost.

METHODS OF REMUNERATION
Time Rate System:
Time rate or day rate is related to the hours of wage and is commonly used. The
wage rate can be fixed on hourly, daily, weekly, monthly basis depending on the
nature of his skill. In this method the worker is remunerated for the time which he

43
ACM 602 Cost Analysis and Control

has devoted or spent within the factory premises irrespective of the work he has
done.
This method can be applied where:
(a) Quality of work is of greater significance;
(b) Output of a worker cannot be measured;
(c) Output of a worker is beyond his control;
(d) The work can be closely supervised;

ADVANTAGES
The advantages of this system are:
(a) Easy to understand and simple to calculate;
(b) Widely accepted by trade unions as all workers are paid alike;
(c) Less clerical expenditure is involved;
(d) A steady income is guaranteed
(e) Tools and material are handled carefully and wastages are minimized, as
employees are in no hurry in completing the job as a result.

DISADVATAGES
(a) it does not motivate or encourage workers to take initiative;
(b) labour cost may increase thereby decreasing profit. This may be caused by
decrease in productivity;
(c) standard for labour are difficult to set;
(d) productivity may decrease thereby disturbing the production schedules,
creates production bottlenecks and increases cost per unit
(e) idle time may increase and even lead to inefficiency

This system can be further classified as:

(a) High Wage Plan: - A higher wage rate can be fixed as compared to the
wage rate prevailing in the area. This is generally applied to attract efficient
workers in order to increase the production. In order to enable the workers to
achieve the standard, suitable working environment and conditions are provided.
This method is also beneficial to employer as it lead to reduction in overheads.

44
ACM 602 Cost Analysis and Control

Advantages of this methods are:

(a) It is simple and economical;
(b) Encourages and attract skilled workers for the job;
(c) Leads to increase in production;
(d) Decrease wages and overhead cost per unit.
(b) Different Time Rates: - This method is applied were workers have various
levels of efficiency and as such different rates are fixed. For the workers
whose efficiency is up to the standard level, to them normal wages are paid
and for workers having efficiency beyond the standard level, the rate is
gradually increased.
(c) Measured day work (Graduated):- In this method the hourly rates are
divided into two parts. A certain part of the hourly rate is fixed which generally
depends upon the nature of the job and the other part is variable depending
on the merit rating and cost of living.
This system is very complicated and the calculation involved in this process
also increases when the workers change jobs on frequently basis. Merit rating
may be arbitrary. There is multiplicity of rates. It is difficult for the workers to
easily understand the system.
(d) Payment by results
It is a method of remunerating the workers in which payment mainly depends
on the output or units produced by the workers. The workers have an
opportunity to earn and increase his income by producing more units.

Piece Rate Method

In this method, the workers are paid on the basis of the quantity produced or output
achieved by each worker. It is a very simple and commonly used method of wage
payment. The worker is paid on the basis of output produced irrespective of the time
taken for production. The total wages to be paid to the worker is determined on the
basis of the following formula:
Wage = Number of units produced during the period X Rate per unit.
The piece rate method is more suitable in the following cases:-
(a) The work is of repetitive nature and is standardised;
(b) Piece rate can easily be determined;

45
ACM 602 Cost Analysis and Control

(c) There is uninterrupted flow of work;

The piece rate can be fixed by determining the time required to complete the piece
of work on the basis of past experience or estimation or time and motion study. In
case the job is carried out for the first time or it is a new job then few trial runs can
be taken into consideration for fixation of piece rates.

Merits: -
(a) A worker expertise himself by continuously doing the same work on a regular
basis;
(b) It leads to increase the efficiency of the worker which leads to earn more
income;
(c) It reduces costs;
(d) Idle time automatically controlled;
(e) The reward is related to effort. Efficiency is recognized;
(f) Less supervision is required;
(g) Workers discover new techniques of producing goods which leads to increase
in production.
Demerits: -
(a) Quality is effected in order to increase production.
(b) Wastages of material may increase if not properly supervised.
(c) More supervision and inspection is required so that units produced achieve
the standard quality.
(d) Improper use of machine and tools in order to maximize output by the
workers.
(e) If work stops due to machine break down, power failure etc, the workers may
feel insecure.
(f) In order to earn more the workers may highly stress themselves which may
affect their health adversely.
(g) This method is not preferred by inefficient and less efficient workers as there
is no guaranteed wages for the period.
(h) It is not easy to determine the piece rate.

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ACM 602 Cost Analysis and Control

Piece Rate with Guaranteed Time Rate: -

A certain standard level of output is determined. Workers are paid on the basis of
output. If the output is less than the standard, the worker is paid on time rate basis.
Thus, this system incorporates the merits of the time rate and piece rate system and
eliminates any misunderstanding may arise.

Incentive scheme: -
Both time rate and piece rate system have their certain merits and demerits.
Incentives system attempts to combine the good aspects of both systems. The main
objective of incentive plan is to induce a worker to produce more and to earn a
higher wages. Producing more in the same period of time should result in higher
pay.

Classification of Incentive Scheme

Incentive scheme can be classified as follows:
(a) Differential Price Rate
(b) Premium Bonus Rate
(c) Group Bonus Rate
(d) Bonus schemes for indirect workers.

(a) Differential Piece Rate

Efficient and inefficient workers are distinguished. More than one piece rate is
determined. Standard are set for each operation or job. Efficient workers, i.e.; those
who attain or better the standard set are given a higher rate and inefficient one are
given a lower rate. Hence, there is encouragement to improve the performance. As
the level of output increases the piece rate also increases. This ratio may be
proportionate or proportionately less or more than the increase in output, hence
output is maximized.
This system is suitable where:
(a) The method of working are standardized;
(b) The workers do the same job over a long period;
(c) The nature of work is repetitive;
(d) Output of each person can be measured;

47
ACM 602 Cost Analysis and Control

(e) The standard time for each job can be determined with precision.

Taylor’s Differential Piece Rate System

This system was introduced by· F.W. Taylor, the Father of Scientific Management.
The main features of this incentive plan are as follows:
(a) Day wages are not guaranteed, i.e. it does not assure any minimum amount of
wages to workers.
(b) A standard time for each job is set very carefully after time and motion studies.
(c) Two piece rates are set for each job-the lower rate and the higher rate. The lower
piece rate is payable where a worker takes a longer time than the standard time to
complete the work. Higher rate is payable when a worker completes the work within
the standard time. In other-words, lower piece rate is payable to inefficient workers
and higher piece rate is payable to efficient workers. Usually these rates are 83% of
the piece work rate for inefficient workers and 175%, of the piece work rate for
efficient workers.

Illustration:1
Standard production = 8 units per hours
Working hours per day = 8 hours
Lower rate = Rs. 5 per unit
Higher rate = Rs. 8.75 per unit
Worker X produces = 7 units.
Worker Y produces = 9 units
Calculate wages of worker under Taylor’s Plan
Wages of worker X and Y under Taylor’s plan will be as follows.
Worker X — He has produced 7 units which is below standard. He will, therefore, be
paid at the lower rate of Rs. 5 per unit. His wages will be·7 units @ Rs. 5 = Rs. 35 .
Worker Y - He has produced 9 units which is above standard. He will, therefore, be
paid at the higher rate. His wages for 9 unit @ Rs. 8.75 will be Rs. 78.75. It will be
seen that there is a great difference between the wages of an efficient and an
inefficient worker.

48
ACM 602 Cost Analysis and Control

Merrick’s Differential Piece Rate System (Multiple Piece Rate System)

This is a modification of Taylor’s plan. While Taylor prescribed two rates, Merrick’s
plan lays down three rates. The lowest rate is for the beginners, the middle rate is
for the developing workers and the highest rate is for the highly efficient workers.
Efficiency of the workers is determined in terms of percentages. Thus, the rates of
remuneration are:
Level of Efficiency Piece Rate Piece Rate
Upto 83% Ordinary piece rate
83% to 100% 110% of ordinary piece rate
Above 100% 120% of ordinary piece rate
Like Taylor’s plan, this method also does not guarantee minimum wages. The
general criticism leveled against Taylor’s plan also applies to it except that it lessens
the punitive character of Taylor’s plan.
Illustration:2
Standard output = 150 units per day of 8 hours.
Piece rate = Re. 0.20 per unit.
Output of A 100 units, B 135 units and C 180 units.
Calculate the earnings of A, B and C workers under Merrick’s Differential Piece Rate
System.
Solution

Rates applicable:

Rates applicable-
A = Re. 0.20 per unit. (normal rate)

B = Re. 0.20 × 110% = Re. 0.22

C = Re. 0.20 ×120% = 0.24

49
ACM 602 Cost Analysis and Control

Earnings:

A = 100 units × Re. 0.20 = Rs. 20.00

B = 135 units × Re. 0.22 = Rs. 29.70

C = 180 units × Re. 0.24 = Rs. 43.20

Illustration:3
Three workers X ,Y and Z work in a factory. The following particulars apply to them-
Normal rate per hour Rs. 0.40
Piece rate Rs. 0.30 per unit
Standard 2 units per hour
In a 40 hour week, the production of the workers are as follows:
X 50 units
Y 80 units
Z 120 units
Calculate the earnings of the workers under Taylor differential piece rate system,
Notes:
The two rates under Taylor’s system have been determined as follows:
Low piece rate = 83% of 30 paise = Rs.25 P.(approx.)
High piece rate = 175% of 30 paise = Rs. 0.525
Solution:
Workers Output EfficiencyTaylor system Taylor system Merrick system Merrick system
Earnings Cost per unit Earnings Cost per unit
X 50 62.5 12.5 0.25 15 0.3
Y 80 100 42 0.525 26.4 0.33
Z 120 150 63 0.525 43.2 0.36

(c) PREMIUM BONUS PLANS

All the gains of efficient workers and all the losses of inefficient workers benefit the
employer under the time rate system. Under the piece rate system, it is the workers
who gain or lose.
However under the premium bonus plan, the gains are shared by the employer as
by the employees in agreed proportions. Along with the minimum guaranteed
wages, the efficient workers get bonus which depends on the time saved by the
employer. The standard is determined scientifically.

50
ACM 602 Cost Analysis and Control

Emerson’s Efficiency Plan

In his plan minimum daily wages is guaranteed, efficiency is also rewarded.
Standard is set based on the time and motion study. Bonus is payable when
efficiency reaches 66-2/3% and the bonus increases as the output increases.
Levels of Efficiency Piece Rate
66-2/3 Guaranteed time rate
90% Time rate +10% as bonus
100% Time rate +20% as bonus
Above 100% Time rate+20% as bonus +
additional bonus of 1% for every
increase of % beyond 100%
efficiency
The bonus is usually calculated on the efficiency achieved for all the jobs in a wage
period taken together.
Efficiency % =Standard time for all jobs done in a period X 100
Time taken for doing all jobs in a period
Slow work is avoided and work is done at a uniform rate.
But under this scheme, the incentive for efficiency beyond the standard is not
appreciable.

Illustration:4
Standard output in 8 hours = 60 units
Actual output in 8 hours. = 72 units
Time rate = Rs. 2 per hour
Calculate earnings under Emerson`s plan.

Solution
Efficiency in % = 72/60* 100 = 120%
Bonus % = 20% + 20% = 40%
Time wages 8 hours @ Re. 2 = Rs. l6.00
Add: Bonus 40% of Rs. l6 = Rs. 6.40
Total earnings Rs. 22.40
In this Illustration, if the actual output of worker is up to 40 units, i.e. %
efficiency, he will not get any bonus and his wages will be simply time wages i.e., 8

51
ACM 602 Cost Analysis and Control

hours X Rs. 2 = Rs. 16. The worker will start earning bonus if his output in 8 hours is
above 40 units. lf he produces 60 units i.e. when his efficiency is 100%, his total
earnings will be:
Total earnings = Time wages + Bonus
= (8 hrs. Rs. 2) + 20%
= 16 + 3.20 = Rs. 19.20
Advantages
1. It guarantees minimum time wages.
2. It is easy to understand and simple to operate.
3. It provides an incentive to beginners and even to those who are less proficient.
Disadvantages
The incentive offered is considered too inadequate to motivate efficient and
ambitious workers.

1. Halsey Premium Plan

This plan was introduced by F A Halsey in 1891. It is a simple combination of time
and piece rate systems. In this plan:
(a) Workers are paid at a rate per hour for the actual time taken by them.
(b) A standard time is set for each piece of work, job or operation.
(c) If a worker takes standard time or more than the standard time to complete his
work, he is paid wages for the actual time taken by him at the specified time rate. In
other words, time wages are guaranteed.
(d) If a worker takes less than the standard time, he is paid a bonus equal to 50% of
the time saved at the time rate fixed. Thus, under this system, total earnings of a
worker are equal to wages for the actual time taken by him plus a bonus.

The formula for calculating bonus and total earnings is as follows:

Bonus = 50% of [Time saved ×Time rate]

Total earnings = Time rate × Time taken + 50% of [Time saved × Time rate]

52
ACM 602 Cost Analysis and Control

Illustration:5
Standard time (or Allowed time) = 50 hours. ,
Wage rate per hour = Rs. 3
Actual time taken = 42 hours ·
Thus time saved = 50 hours - 42 hrs. = 8 hrs.
Earnings = Rs. 3 × 42 hours + 50% of (8 hrs. × Rs. 3)
= Rs. 126 +12 = Rs. 138
Advantages of Halsey Plan
l. It is easy to understand.
2. lt guarantees a minimum time wages to all the workers.
3. The benefit resulting from saving in time is equally divided between worker and
employer.
4. Bonus is separately calculated for each job. Time saved by a worker on one job is
not adjusted against excess time taken by him on another job.

Disadvantages of Halsey Plan

l. Workers do not like the employer to share the benefit of time saved by them.
2. It does not provide the employer with full protection against high rate setting.
3. Extra efficiency of a worker is not fully rewarded.

Halsey Weir Plan

The bonus under this plan is % of the standard time saved.

Total wages =Time taken * Hourly rate + %(Time saved)*Hourly rate

Rowan Plan
This plan is also similar to Halsey Plan except in the calculation of bonus. The main
features the plan are as follows:
(a) Wages are paid on time basis for the actual time worked by the workers.
(b) A standard time is determined for each piece of work or job.
(c) If a worker completes his work in standard time or in more than standard time,
he is paid wages for the time actually taken by him

53
ACM 602 Cost Analysis and Control

(d) If a worker completes his work in less than the Standard time he is entitled to a
bonus.
(e) Bonus is that proportion of wages of actual time taken which the time saved
bears to the standard time. Its formula is:
Bonus = Time saved / Time allowed × Time taken × Time rate

Earnings = (Time taken × Time rate) + Bonus.

Illustration: 6
Standard time = 50 hours
Wage rate per hour = Rs. 3
Actual time taken = 42 hours.
Calculate earnings and bonus under Rowan Plan.
Time Saved = 50 hours - 42 hours = 8 hrs.
Bonus = 8/50 × 42 hours × Rs 3 = Rs. 20.l6

Earnings = (Time taken × Time rate) + Bonus i

= (42 hrs. × Rs. 3)+ Rs. 20.l6

= Rs. 146.16

Advantages of Rowan Plan

l. It provides guaranteed minimum wages to workers.
2. Protects the employers against loose rate setting
3. lt pays a higher bonus than that under the Halsey plan up to 50% of the
standard time saved.
4. The worker is not induced to rush through the work because if the time saved is
more than 50% of the standard time, the bonus increases at a decreasing rate.
5. lt provides good incentive for comparatively slow workers and beginners.

Comparison of Halsey and Rowan Plan

If the worker finishes the work in half the time fixed for it, the result under Rowen
and Halsey plan will be same. If the time saved is less than 50% of the standard
time, the Rowan plan is better. If time saved is greater than 50% of the standard
time, the Halsey plan is better.

54
ACM 602 Cost Analysis and Control

Bedauxe Point System

Under the scheme originated by C.E.Bedauxe, time wages is guaranteed. Earnings
increase after the worker attains 100% efficiency level. Standard time and standard
work is measured in terms of Bedauxe points, which are also known as B’s.
‘B’ means a standard work performance in a standard minute. In other words, one
‘B’ unit represents the amount of work which an average worker can do under
normal conditions in one minute allowing for the relaxation needed. Workers get a
bonus which is equal to 75% of B’s saved.

Bonus =

Thus, if a person gets 90 B’s and hourly rate is Rs.1.20, then his bonus will be:
B’s saved =90-60 =30 B’s

Bonus = = 45 paise

If bonus is given to the extent of the value of the entire time saved, then the scheme
will be called the 100% Bedauxe Scheme. But if nothing is mentioned, it is assured
that it is 75% Bedauxe Scheme.
Under 75% Bedauxe Scheme, the labour cost increases till 100% efficiency and
then starts declining.

Hayne’s Scheme
Time wages are guaranteed. The standard time is set in terms of standard man
minutes called ‘manits’. A manit means a standard work performed in a standard
minute. Bonus is given for the time saved. The value of the time saved is shared by
the worker and foreman in the ratio of 5:1. If the worker is standardized and
repetitive in nature, otherwise, the ratio of sharing between worker, employer and
supervisor will be 5:4:1.
The labour cost falls until 100% efficiency is reached. Thereafter, it falls at a
decreasing rate if work is non-standardised or remains constant if the work is
standardised.

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ACM 602 Cost Analysis and Control

Misc. Illustrations
Illustration: 7
From the following information, calculate the bonus and earnings under Emerson
Efficiency Bonus Plan:
Standard output in 12 hours 48
Actual output in 12 hours 42
Time rate Rs.0.75 per hour
If the actual output is 60 units, what will be amount of bonus earnings.
Solution:
Under Emerson Efficiency Bonus Plan earnings will be calculated as follows:
E =T X R + P (T×R)
P (bonus percentage) will vary as follows:
Efficiency Bonus
(i)Below 66 - ⅔% efficiency Time wages. No bonus

(ii)66 - ⅔% to 100% efficiency A bonus increasing 0.01%to20%

above basic wages on 100%
efficiency
(iii) Over 100% A bonus of 20% above basic wages
plus 1% for each 1% increase in
efficiency
Efficiency in terms of output

Bonus percentage of 87% efficiency is 7.56 and at 88% efficiency is 8.32,given in

Emerson Bonus Percentage Table. Thus at 87.5% efficiency we can take bonus
percentage as 7.94(average of 7.56 and 8.32%).Bonus will, therefore, be

56
ACM 602 Cost Analysis and Control

Earnings

= 9+0.71 = Rs.9.71

(c) If the actual output in 12 hours is 60 units, efficiency will be:

Bonus percentage =
= 20 +25 = 45%
Bonus

Earnings

=9 + 4.05 =Rs.13.05

Illustration : 8
In a factory guaranteed wages at the rate of Rs.1.80 per hour are paid in a 48 hour
week. It is estimated that to manufacture one unit of a particular product 20 minutes
are taken. The time allowed is increased by 25%.During one week Abraham
produced 180 units of the product. Calculate his wages under each of the following
methods (a) Time rate,(b) Piece rate with a guaranteed weekly wage,(c)Halsey
Premium bonus and (d) Rowan Premium Plan

Solution:
(a) Time rate:
E = T×R

= 48 ×1.80 = Rs.86.40

(b) Piece rate:

E = N ×R, where N means number of units produced
and R means rate per unit
= 180 × 0.75= Rs.135

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ACM 602 Cost Analysis and Control

Rate per unit will be found as follows:

Time taken 20 minutes
Incentive allowance 25% 5 minutes
Standard time to manufacture one unit 25 minutes
Rate per minute =Rs. 1.80 =Rs.0.03
Rate per unit = Rs.0.03 × 25 = Rs.0.75

(c) Halsey Premium Bonus Plan:

E = T×R +1\2 (S-T) ×R

= 48 ×1.80 + 1\2 (75-48) ×1.80

= 86.40 + 24.30 =Rs.110.70
Standard Time:
One unit takes 25 minutes
180 units should take 180 × 25 = 4,500 minutes
Or 4500minuts =75 hours

(d) Rowen Premium Bonus Plan:

E =T ×R + ×T × R

=48 × Rs.1.80 + ×Rs.1.80

=Rs.86.40 + Rs.31.10 =Rs.117.50

SELF CHECK QUESTIONS

1. What is meant by an ‘incentive plan’ in the remuneration labour? Also explain
their plans in brief.
2. Discuss the principles methods of wage payments, explain.
3. What are the main incentives wage payment system methods? Explain three
in brief.

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ACM 602 Cost Analysis and Control

Practical Questions
Q.1 From the following particulars calculate the earnings of a worker under Rowen
Premium Bonus System and Halsey Premium Bonus System:
Hourly rate of wages(guaranteed) Rs.0.75
Standard time for producing one dozen articles 3 Hours
Actual time taken by the worker to produce 20 dozen articles 48 Hours
Ans. Rowen Rs.43.20;Halsey Rs.40.50.

Q.2 What earnings will workmen receive under Halsey Plan and Rowen Plan if he
executes a piece of work in 60 hours as against 75 hours allowed? His hourly rate is
Rs.2 and he is paid 50% of the time saved under Halsey Plan. He gets a dearness
allowance of Rs.8 per day of 8 hours worked in addition to his wages.
Ans. Under Halsey Plan Rs.195; Under Rowen Plan Rs.204

Q.3 Calculate the earnings under (a) Time rate (b)Piece rate (c)Halsey and
(d)Rowen methods, from the following information:
Standard time 40 hours
Time taken 30 hours
Wages are paid at Rs.1 per hour and a dearness allowance is paid at 50 paise per
hour worked.
Ans.(a)Rs.45;(b)Rs.55;(c)Rs.50;(d)Rs.52.50

Q.4 A workmen takes 9 hours to complete a job on daily wages and 6 hours on a
scheme of payment by result. His day rate is Rs.1.50 per hour. The material cost of
the product is Rs.24 and the work overhead is recovered @ 150% of the total direct
wage. Calculate the factory cost of the product (a) the piece -work plan, (b) the
Halsey plan and (c) the Rowen plan.
Ans. Factory cost-(a) Rs.46.50; (b) Rs.52.125 and (c) Rs.54.00

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ACM 602 Cost Analysis and Control

Lesson 5
Labour Turnover
Labour turnover is the movement of people into and out of the organization. It is usually
convenient to measure it by recording movements out of the firm on the assumption that a
leave is eventually replaced by a new employee. The term separation is used to denote an
employee who leaves for any reason. Labour turnover is the rate of change in the number of
employees of a concern during a definite period. Labour turnover studies are helpful in
manpower planning. Just
as the high reading on a clinical thermometer is a sign to the physician that something is
seriously wrong with the human organism, so is a high index of labour turnover rate a
warning to management that something is wrong with the health of the organization. A high
turnover rate may mean poor personnel policies, poor supervisory practices or poor
company policies. Too lower a rate of turnover can also be a danger signal.

Causes of labour Turnover

High labour turnover may be traced to the following causes which may be broadly classified
under avoidable and unavoidable causes:
Avoidable Causes
(a) Dissatisfaction with wages and rewards - Low pay and' allowances and no opportunity to
move to a higher paying job.
(b) Dissatisfaction with working conditions - Noise, heat, humidity, unsanitary conditions of
employment, dangerous process, poor lighting, night shift working, insufficient tooling
etc. cause some workers to leave the organization.
(c) Dissatisfaction with personnel policies - Autocratic methods of labour administration
may prevail. There may be limited promotional policies. Request for transfer may be
refused. Company may be too short-sighted to provide for an annual vacation.
(d) Lack of transport facilities, accommodation, medical and other facilities and lack of
amenities like recreational centres, schools etc.
(e) Dissatisfaction with working hours, overtime, layoff, strikes, lockouts etc.
(f) Bad relation with co-workers, superiors and unsatisfactory personnel management, union
disputes.

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ACM 602 Cost Analysis and Control

(g) Dissatisfaction with the job - The workers may find the job too hard. Sometimes jobs
include too much of constant lifting heavy materials or the manipulation of heavy
machinery. The routines in the job may be very fatiguing involving undue strain upon
the nerves, eyes and attention.
The above causes should attract the attention of the management most. After examining the
exact cause or causes of the increasing turnover, the cost of reducing the labour turnover rate
should be compared with anticipatory benefits in order to determine the final remedial
measures to be adopted. .
Unavoidable Causes
(a) Personal betterment
(b) Family circumstances
(c) Climatic conditions
(d) Community conditions
(e) Health conditions
(f) Marriage (in case of women)
(g) Retirement and death
(h) Migratory nature of workers
(i) Dismissal or discharge due to incompetence, inefficiency, insubordination,
indifferent attitude towards work.
(J) Redundancy due to seasonal changes, shortage of materials and other resources,
slack of business, lack of planning and foresight of higher management.
Management can do little control over labour turnover in the above cases.
Measurers to Reduce Labour Turnover
All employees to have a certain degree of labour turnover, without it the company
would stagnate. The average age of employees would increase (meaning also that a
large number of employees might retire simultaneously); and there could be
insufficient new blood coming into the organization. No doubt many companies
would be content if their separation rates lay between 10 to 15 per cent, though few
rates in the private sector of industry and commerce are as Iow as
this. If an employing firm wishes to reduce its labour turnover because it considers it
as excessive for the area and the industry, it may take the following steps to reduce
labour turnover:

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ACM 602 Cost Analysis and Control

Pay Problems
(a) Increasing pay levels to meet competition.
(b) Improving pay structures to remove inequities.
(c) Altering pay systems to reduce excessive fluctuations
(d) Introducing procedures for relating rewards more explicitly to effort or
performance.
Employees Leaving to Further their Career
(a) Providing better career opportunities and ensuring that employees are aware of
them.
(b) Extending opportunities for training.
(c) Adopting and implementing 'promotion from within' policies and introducing more
systematic and equitable promotion procedures.
(d) Deliberately selecting employees who are not likely to want to move much higher
than their initial job.
Employees Leaving Due to Conflict
(a) Introducing more effective procedures for consultation, participation and handling
grievances.
(b) Improving communications by such means as briefing groups.
(c) Using the conflict resolution and team-building techniques of organization
development.
(d) Reorganizing work and the arrangement of office or workshops to increase group
cohesiveness.
(e) Educating and training management in approaches to improving their
relationships with employees.
Induction Crisis
(a) Improving recruitment and selection procedures to ensure that job
requirements are specific accurately and that the people who are selected fit
the specification.
(b) Ensuring that candidates are given a realistic picture of the job, pay and
working condition
(c) Developing better induction and initial training programs.
Shortage of Labour
(a) Improving recruitment, selection and training for the people required.

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ACM 602 Cost Analysis and Control

(b) Introducing better methods of planning and scheduling work to smooth-out

peak loads.
Changes in Working Requirements
(a) Ensuring that selection and promotion procedures match the capacities of
individuals to the demands of the work they have to do.
(b) Providing adequate training or adjustment periods when working conditions
change.
(c) Adopting payment by result systems to ensure that individuals are not unduly
penalized when they are only engaged on short-runs.
Losses of Unstable Recruits
Taking more care to avoid recruiting unstable individuals by analyzing the
characteristics of applicants which are likely to cause instability and using this
analysis to screen recruits
Adequate Statistical Control
There should be a carefully worked out system of records for keeping the required
data. The management should have complete information about separations by
shops, departments, occupations, sex, age, race, nationality, length of service and
education. This information will help a critical analysis. It will also be possible to
collect statistical evidence to invite managerial attention to the problem. If
management is properly convinced about the magnitude of the problem, adequate
funds and attention may be provided for the solution of this problem.
Joint Control
Joint control can be exercised through committee representing management and
workers. These committees should cover the review of shop regulations, grievances,
etc. The formation of these committees will encourage mutual understanding and
general cooperation.
Use of Exist Interviews
Some companies arrange an exist interview, when an employee calls for his final
payment. A better means of getting necessary information may be an interview with
employees sometime after they have left. For this purpose, exit questionnaires may
be prepared. This step may lead to useful information, which may have profound
effect on reducing labour turnover.

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ACM 602 Cost Analysis and Control

Labour turnover
Labour turnover denotes the percentage change in the labour force of an
organisation. High percentage of labour turnover denotes that labour is not stable
and there are frequent changes in the labour force because of new workers
engaged and workers who have left the organisation. A high labour turnover is not
desirable. The definitions of labour turnover are given below:

(18)Labour turnover according to separation method

This definition does not take into consideration the fact of surplus labour. This
definition will give incorrect result when the surplus workers are discharged because
labour turnover calculated in this way will be high.

(19)Labour turnover according to flux method

This definition will not be applicable when the organisation is expanding. In such a
case, many new workers are engaged and there may be no separation; even then
labour turnover calculated will be high.

This definition will misguide when an organisation has reached its optimum size and
does not require expansion at all. In such a case, labour turnover, as per this
definition, will show half the actual percentage of labour turnover.
(4)Labour turnover according to replacement method

This definition takes into account the surplus labour. This definition will also give
correct labour turnover when the factory is expanding because all additions are not
to be taken; only workers replaced due to leavers are to be taken. Therefore, this

64
ACM 602 Cost Analysis and Control

definition can be taken to be the most reliable definition out of all the definitions
given above.
Reduction of Labour Turnover
As already pointed out, normal labour turnover is advantageous because it allows
injection < fresh blood into the firm. But excessive labour turnover is not desirable
because it shows the labour force is not contended. Therefore, every effort should
be made to remove the avoidable causes which give rise to excessive labour
turnover. The following steps may be taken to reduce the labour turnover :
(1) A suitable personnel policy should be framed for employing the right man for the
right job and giving a fair and equal treatment to all workers.

(2) Good working conditions which may be conducive to health and efficiency should
b provided.

(3) Fair rates of pay and allowances and other monetary benefits should be
introduced.

(4) Maximum non-monetary benefits (i.e., fringe benefits) should be introduced.

(5) Distinction should be made between efficient and inefficient workers by

introduction incentive plans whereby efficient workers may be rewarded more as
compared to inefficient workers.

(6) An employee suggestion box scheme should be introduced whereby workers

who suggest improvements in the method of production should be suitably
rewarded.

(7) Men-management relationships should be improved by encouraging labour

participation in management.

In addition to the above steps, the personnel department should prepare periodical
reports the labour turnover listing out the various reasons due to which workers have
left the organization. The report should be sent to the management with the
necessary recommendations so the corrective measures may be taken to reduce
labour turnover.
As "prevention is better than cure", preventive cost should be incurred to prevent
excessive labour turnover. This cost of labour turnover should be apportioned

65
ACM 602 Cost Analysis and Control

among different departments on the basis of average number of employees in each

department and justifiably treated as overhead. If preventive cost is incurred for
reasons of image or status of the employer or non-economical corporate goals, it
may be debited to the Costing Profit and Loss Account. If preventive cost is
incurred for a particular department, it may be taken as overhead of that
[department.
(ii) Replacement Costs. These costs are associated with replacement of workers
and include:
(1) Cost of recruitment of new workers.
(2) Cost of training new workers.
(3) Loss of production due to (a) interruption in production, and (b) inefficiency of
new workers.
(4) Loss of profit due to loss of production.
(5) Loss in fixed overhead cost because of less production on account of new
inexperienced workers.
(6) Wastage due to excessive spoilage on account of inept handling of machines,
tools and materials by new workers recruited as a result of labour turnover.
(7) Cost of accidents because of new workers having more proneness to accidents.
These costs should be distributed among different departments on the basis of
actual number of workers replaced in each department and treated as overhead.
Replacement Costs
Labour turnover is associated with replacements. Replacement necessitates
recruitment training and absorption of new workers. If a worker is replaced, a new
worker will have to be trained to substitute the replaced worker. There will also be
wastage and loss of production, if worker is new. Replacement cost will include
cost of all these elements. Following costs can be summarized his heading:
Inefficiency of New Worker
It is difficult to measure exactly the losses due to inefficient workers. Some authors
hold the view that the extra wages cost can be calculate; following formula:
Extra Wages = D - (A.B.C.)
Where D = Wages paid
A = Output in good pieces

66
ACM 602 Cost Analysis and Control

B = Normal standard time allowed per piece

C = Standard base rate of pay
The inefficiency of labour results in extra usage of services available in factory. The
additional overhead cost.
Employment Department
The cost of recruitment should be included in the cost of labour turnover
Training and Induction
In most companies, some form of induction for new worker is under This should be
included in cost of labour turnover.
Loss of Output due to delay in obtaining new workers - The experience has
revealed that sometime definitely elapses before any replaced worker joins the
organization. During this period, scheduled output is met by: (a) Carrying a surplus
labour force, (b) Working overtime, (c) If the scheduled output is not met, then there
is direct loss of profit. All these factors add to cost of labour turnover.
Cost of Tool and Machine Breakage
Tool and machine breakages arc more frequent when untrained or new labour is
employed. It adds to the cost of labour turnover, but it is practically a difficult
exercise to determine relationship between the intake of new labour and the cost of
repairs. Accident Frequency and Severity - When a new worker joins the factory, the
chances of accidents and mishaps increase considerably. This may lead to
additional cost of compensation, which finally adds to cost of labour turnover.
Cost of Scrap and Defective Work
When a new worker joins, the amount of scrap and defective work increases. When
the material used is of high value, the cost of scrap and defective work may have
serious repercussions upon the overall cost of production. The cost of defective
work, which is due to inexperience of new worker, should be taken as the cost of
labour turnover, loss of Goodwill or Disadvantageous
Labour Contracts
If new worker is not put to the job, it will be difficult to meet the scheduled program.
In the hurry to save the goodwill of the company, some disadvantageous labour
contracts may have to be entered into. All this adds to the cost of labour turnover.

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ACM 602 Cost Analysis and Control

The overall cost of labour turnover will appear in one or more of the items already
mentioned. This cost can be shown as cost per worker employed or replaced or as
a fraction of total cost of selling price. The most common way to express labour
turnover cost is as follows:

Illustration1.

Akash Ltd. suffer from high incidence of labour turnover each year. Measures to
combat the labour turnover are being considered by the management and it
wants you to calculate the profit foregone on account of labour turnover in the
immediate past year from following:
ABC Ltd. Income Statement for the year (Rs.)
ended 31st March, 2009
Sales 1,87,500
Variable cost:
Material 56,250
Direct labour 45,000
Variable overhead (varying with output) 48,750 1,50,000
Contribution 37,500
fixed overhead 22,500
profit before tax 15,000

The direct labour hours worked in the period were 24,000 of which 1,200 hours
pertained to new worker: on training, only 33 %% of the trainees time was
productive. There was some unavoidable delay in findiij replacements for the
workers that left, 360 productive hours were lost as a result. The other incident
costs due to workers leaving were:

Costs of separation Rs. 2,775

Cost of selection Rs. 4,650

Cost of training Rs. 4,125
Solution:
Direct labour hours worked 24,000
Less: Unproductive hours (66%% of 1,200) 800
Productive hours 23,80
0

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ACM 602 Cost Analysis and Control

Productive Hours Lost

= Delay in recruitment 360 hours + Unproductive trainee
hours 800 = 1,160 hours
Rs. 45,000
(a) Direct Labour (including trainees) is paid = Rs. 1.875 p.h.
worked
24,000 hrs.
(b) Had there been no labour turnover, contribution from 23,200
productive hours would been: (Rs;
Sales 1,87,500
Material 52,250
Direct labour (@ Rs. 2.5/hr.) 43,500
Variable overhead 48,750 1,44,500
43,000
Contribution lost due to labour turnover
= Rs.2,150
Profit Foregone (Rs.)
Unproductive trainee hours paid (800 hrs. X Rs. 1.875) 1,500
Contribution forgone in 1,160 hours 2,150
Labour turnover incidental costs 11,550
Total profit foregone 15,200

Rs.
Settlement cost due to leaving 27,420
Recruitment costs 18,725
Selection costs 12,750
Training costs 16,105
Assuming that the potential production lost due to labour turnover could have been
sold at
prevailing prices, ascertain the profit foregone/lost last year on account of labour
turnover.
(C.A. Inter)
SOLUTION
Calculation of Actual Productive Hours
Actual hours worked 3,45,000
Less: Hours lost due to training workers (unproductive hours i.e of 15,000
30,000 hours)
Actual Productive Hours 3,30,000

Sales Per Hour= == = Rs. 20

Potential productive hours lost as a result of labour turnover 75,000 hours.

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ACM 602 Cost Analysis and Control

Sales forgone @ Rs. 20 per hour (75,000 x Rs. 20) Rs. 15,00,000
P/V Ratio 20%
Contribution forgone (Rs. 15,00,000 x 20%) Rs. 3,00,000

STATEMENT OF PROFIT FOREGONE

(as a result of labour turnover)
Contribution foregone Rs. 3,00,000
Add : Settlement cost due to leaving 27,420
Recruitment Costs 18,725
Selection Costs 12,750
Training Costs 16,105
Total profit foregone as a result of labour turnover 3,75,000

Question
The management of Sunshine Ltd. wants to have an idea of the profit lost/foregone
as a result of labour turnover last year. Last year sales amounted to Rs. 66,00,000
and the P/ V Ratio was 20%. The total number of actual hours worked by the direct
labour force was 3.45 lakhs. As a result of the delays by the Personnel Department
in filling vacancies due to labour turnover, 75,000 potentially productive hours were
lost. The aetual direct labour hours included 30,000 hours attributable to training
new [recruits, out of which half of the hours were unproductive. The costs incurred
consequent on labour turnover revealed on analysis the following:
Settlement cost due to leaving 27,420
Recruitment costs 18,725
Selection costs 12,750
Training costs 16,105

Assuming that the potential production lost due to labour turnover could have been
sold at failing prices, ascertain the profit foregone/lost last year on account of labour
turnover.

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ACM 602 Cost Analysis and Control

LESSON 6

ALLOCATION, APPORTIONMENT AND

ABSORPTION OF OVERHEADS
CONTEXT OF THE LESSON
This lesson deals with the treatment of indirect costs also known as overheads. In
order to determine the total cost of the product the overheads are to be allocated to
the various departments on some suitable basis. The process and various methods
for distribution of overheads to the various productshave been explained in this
lesson.

OBJECTIVES OF THE LESSON

To understand the various types of overheads
To deal with various methods of distribution of overheads
To deal with various methods of Absorption of overheads

INTRODUCTION
In Cost Accounting, for the purpose of determination of cost and its control,the
analysis and collection of overheads, their allocation and apportionment to different
cost centers and absorption to products or services plays an important role. An
effectivesystem of distribution of overheads can lead for accuracy in determination
of cost of products and services. It is therefore, necessary to ensure that a standard
practices for allocation, apportionment and absorption of overheads should be
followed within the organization for preparation of cost statements.

DEFINITION:
OVERHEADS
Overheads comprise of cost of indirect materials, indirectlabour and indirect
expenses which are not directly identifiable or traceable and allocable to a cost
object in an economically feasible way

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ACM 602 Cost Analysis and Control

CLASSIFICATION OF OVERHEADS
Overheads canbe classified on the basis of functions to which the overheads are
related viz.
- Production overheads
- Administrative overheads
- Selling overheads
- Distribution overheads
Overhead can also be classified on the basis of behavior. On the basis of behavior
overhead can be classified as variable overheads, semi-variable overheads and
fixed overheads.
Variable overheads are those expenses which vary in same proportion to the
change of volume of production. For example, cost of utilities etc.

Fixed overheads are those expenseswhose values do not change with the change in
the volume of production. For example salaries, rent etc.

Semi-variable overheads are those expenses which are partly affected by change in
the production volume. A part of the overhead is variable and a part of the overhead
is fixed.

COLLECTION OF OVERHEADS
Collection of overheads refers to the pooling of various indirect items of expenses
from books of account and other records into certain logical groups having regards
to their nature and purpose.
Overheads are collected on the basis of predetermined groups which are termed as
cost pools. Homogeneity of the cost components in respect of their behavior and
character is to be considered whiledeveloping the cost pool. Variable and fixed
overheads should be collected in separate cost pools under a cost centre. A greater
degree of homogeneity in the cost pools are to be maintained to make the
apportionment of overheads more rationale and scientific.

ALLOCATION OF OVERHEADS
Allocation of overheads is a process of assigning a particular item of cost directly to
a cost centre.An item of expense which can be directly, wholly and exclusively

72
ACM 602 Cost Analysis and Control

related to a cost centre is to be allocated to the cost centre. For example,

depreciation of a particular machine should be allocated to a particular cost centre if
the machine is directly attached to the cost centre.

APPORTIONMENT OF OVERHEAD
Apportionment of overhead is the process of distribution of overheads to more than
one cost centre on some equitable basis. Thus, a particular item of expense which is
not directly related to one cost centre but is related to more than one cost centre is
required to be distributed on various cost centre is known as apportionment of
overhead.
When an item of indirect expense is common to various cost centers, then it has to
be apportioned to the cost centers on an equitable basis. For example, the
expenditure on general repair and maintenance pertaining to a department can be
allocated to that department but has to be apportioned to various machines (Cost
Centers) in the department. If the department is involved in the production of a
single product, the whole repair & maintenance of the department may be allocated
to the product.

SELF CHECK QUESTIONS

1. What do you mean by overhead?
2. Classify the various types of overheads.
3. What do you mean by allocation and apportionment of overheads?
4. What do you mean by fixed and variable expenses?
5. What is a semi variable expense? Give two examples of it.

PRIMARY AND SECONDARY DISTRIBUTION OF OVERHEADS:

An organization which deals in various products may havesingle service department
which may be rendering services to the various production departments and other
service departments. The costs of services are required to be apportioned to the
relevant departmentsInitially it will be required to apportion the overheads to different
departments and later on to apportion the costs of service department to
production department on an equitable and justified basis. The first process is

73
ACM 602 Cost Analysis and Control

termed as primary distribution and the second process is termed as secondary

distribution of overheads.

Absorption of overheads - Absorption of overheads is a process of charging of

overheads from cost centers to products or services by means of absorption rates
for each cost center which is calculated asfollows:

The base(denominator) is selected on the basis of type of the cost centreand its
contribution to the products or services, for example, machine hours, labour hours,
quantity produced etc.

Overhead absorbed = Overhead absorption rate × units of base in product or service

APPORTIONMENT AND ABSORPTION OF PRODUCTION OVERHEADS

Overheads canbe apportioned to different cost centers on the basis of following two
principles:
i) Cause and Effect- Cause is the process or operation or activity and effect
is the incurrence of cost. Apportionment of overheads based on this basis
ensures better rationality as it is guided by the relationship between cost
object and cost.

ii) Benefits received – Overheads canalso be apportioned to the various cost

centers in proportion to the benefits received by them.

PRIMARY DISTRIBUTION OF OVERHEADS:

Basis of primary apportionment of items of production overheads is to be selected to
distribute them amongthe cost centers following the above two principles as given
above.
Once the base is selected, the same is to be followed consistently and uniformly.
However, change in basis for apportionment can be adopted only when it is

74
ACM 602 Cost Analysis and Control

considered necessary due to change in circumstances like change in technology,

degree of mechanization, product mix, etc.

Basis of primary distribution of some items of production overheads

Item of Cost Basis of Apportionment
Power H.P. rating of Machines x hours x LF*
Fuel Consumption rate x hour
Jigs, tools & fixtures Machine hours or Man hours
Crane hire charges Crane hours or weight of materials handled
Supervisors’ salary & fringe benefits Number of employees
Labour welfare cost Number of employees
Rent & rates Floor or Space area
Insurance Value of fixed asset
Depreciation Value of fixed asset

* LF = Motor Load Factor

SECONDARY DISTRIBUTION OF OVERHEADS:

Secondary distribution of overheads may be apportionedby following either
Reciprocal basis or Non-Reciprocal Basis. While reciprocal basis considers the
exchange of service among the service departments, non-reciprocal basis considers
only one directional service flow from a servicedepartment to other production
department.

SECONDARY APPORTIONMENT OF OVERHEADS ON RECIPROCAL BASIS

The services provided by certain service department are also utilized by other
service departments. In reciprocal secondary distribution, the cost of service
department is apportioned to production department as well as other service
department. In such case, any one of the following three methods may be followed:
I. Repeated Distribution Method
II. Trial & Error Method
III. Simultaneous Equation Method

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ACM 602 Cost Analysis and Control

REPEATED DISTRIBUTION METHOD

Following steps are required to be followed under this method:
i) The proportion at which the costs of a service department are to be
distributed to production department and other servicedepartment is
determined.
ii) Costs of first service department areto be apportioned to production
department and service department in the proportion asdetermined in step (i).
iii) Similarly, the cost of other service department is to be apportioned.
iv) This process as stated in (ii) and (iii) are to be continued till the amount
remaining undistributed in the service amount are negligibly small. The
negligible small amount left with service department may be distributed to
production department.
Reciprocal Overheads Apportionment:Repeated Method
Production Department Service Department
Machine Assembly Finishing Stores Repair
Ratio of apportionment from Stores 50% 20% 15% 15%
Ratio apportionment from Repair 40% 35% 15% 10%
Primary Distribution 35500.00 31900.00 14800.00 5000.0 6000.00
Stores Dept. 2500.00 1000.00 750.00 5000.0 750.00
Total 38000.00 32900.00 15550.00 10000.0 6750.00
Repairs & Maintenance Dept 2700.00 2362.50 1012.5 675.00 -6750.00

Total 40700.00 35262.50 16562.5 675.00 0.00

Stores Dept. 337.50 135.00 101.25 -675.00 101.25
Total 41037.50 35397.50 16663.75 0.00 101.25
Repairs & Maintenance Dept 40.50 35.44 15.19 10.13 -101.25
Total 41078.00 35432.94 16678.94 10.13 0.00
Stores Dept. 5.06 2.03 1.52 -10.13 1.52
Total 41083.06 35434.96 16680.46 0.00 1.52
Repairs & Maintenance Dept 0.61 0.53 0.23 0.15 -1.52
Total 41083.67 35435.49 16680.68 0.15 0.00
Stores Dept. 0.10 0.03 0.02 -0.15 0.00
Total 41083.77 35435.52 16680.71 0.00 0.00

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ACM 602 Cost Analysis and Control

Trial and Error Method

This method is to be followed when the question of distribution of costs of service
department which are interlocked among themselves arises. In the first step, gross
costs of services of service department are determined and then in the second step,
costs of service department are apportioned to production department. The following
process can be followed in this regard:
i) The proportion at which the costs of a service department areto be
distributed to production department and other service department
is determined.
i) Cost of first service department is distributed to the other service
department in the proportion of service they received from the first
as assessed in step (i).
ii) In the next step, total cost of second service department so arrived
has to be distributed to the other service department in the
proportion of service they received from the second as assessed in
step (i).
iii) Similarly, the cost of other service department to be apportioned to
the service department.
v) This process as described in (iii) and (iv) is to be continued till the
figures remaining undistributed in the service department is
negligibly small.
i) At the last, total cost of service department is to be distributed to production
department.
Simultaneous Equation Method
The simultaneous equation method is to be adopted to take care of secondary
distribution of cost of service department to production department with the help of
mathematical formula. Steps to be followed:

i) Proportion of service benefits received by different cost centres from a cost

centre are assessed on the basis of records
ii) The same ratios are used as coefficients in the equations framed for
apportionment of cost of service department to production department.
iii) Solution of the equations gives the cost of servicedepartment.

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ACM 602 Cost Analysis and Control

iv) Cost of service department to be distributed to production department.

Example,
Reciprocal Overhead Apportionment : Simultaneous Equation Method
Production Departments Service Departments
Machine Assembly Finishing Stores Repair
Ratio of apportionment from Stores 50% 20% 15% 15%
Ratio of apportionment from Repair 40% 35% 15% 10%
Distribution from
Primary Distribution 35500.00 31900.00 14800.00 5000.00 6000.00

Let x, ybe Store Dept and Repair & Maintenance Dept expenses respectively.

Reciprocal Overhead Apportionment : Trial & Error Method

Production Department Service Department
Machine Assembly Finishing Stores Repair
Ratio of apportionment from Stores 50% 20% 15% 15%
Ratio of apportionment from Repair 40% 35% 15% 10%
Distribution from
Primary Distribution 35500.00 31900.00 14800.00 5000.00 6000.00
Distribution between service centres
Stores Dept. 0.00 750.00
Total 5000.00 6750.00
Repairs & Maintenance To stores 675.00 0
Stores Dept. to Repair & Maintenance 0.00 101.25
Repairs & Maintenance To stores 10.13 0.00
Stores Dept. to Repair & Maintenance 0.00 1.52
Repairs & Maintenance To stores 0.15 0.00
Stores Dept. to Repair & Maintenance 0.00 0.02
Gross cost of service cost centres 5685.28 6852.79
Stores to Production cost centres 2842.63 1137.06 852.79 -5685.28
Repairs & Maintenance to Production 2741.14 2398.46 1027.92 -6852.79
centres
Total 41083.77 35435.52 16680.71 0 0

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ACM 602 Cost Analysis and Control

Now, distribution of expenses will be as follows:

Production Departments Service Departments
Machine Assembly Finishing Stores Repair
Ratio of apportionment from Stores 50% 20% 15% 15%
Ratio of apportionment from Repair 40% 35% 15% 10%
Amounts from Primary Distribution 35500.00 31900.00 14800.00 5685.28 6852.79
Stores to Production cost centres 2842.63 1137.06 852.79 -5685.28
Repairs &Maint to Production 2741.14 2398.46 1027.92 6852.79
centres
Total 41083.77 35435.52 16680.71 0 0

Secondary Apportionment of Overheads on Non-Reciprocal basis

In non-reciprocal secondary distribution, the costs of service cost centres are
apportioned to the production cost centres. Steps involved are :
i) The cost of first service cost centre is apportioned on a suitable basis
to production cost centres.
ii) The next step is to apportion the cost of second service centre to the
production cost centres as indicated in stage (i).
iii) The process is to be continued till the costs of all service cost centres
are apportioned.
Example,
Non-Reciprocal Overheads Apportionment
Primary Distribution
Production Departments Service
Departments
Expenses Basis of Total Machine Assembly Finishing Stores Repairs
allocation / (Rs.) Shop Shop Dept &Maint.
apportionment
Consumable Direct Materials 15,400 5,200 6,000 2,000 600 1,600
stores Direct Wages 22,800 7,900 5,100 6,100 2,200 1,500
Supervision Area 10,000 3,000 2,000 2,500 1,000 1,500
Rent & Rates Asset Value 2,000 800 900 200 50 50
Insurance Asset Value 30,000 12,000 13,500 3,000 750 750
Depreciation H.PxHoursx LF 9,000 5,400 3,600 - - -
Power
Light & Heat Area 4,000 1,200 800 1,000 400 600
Total 93,200 35,500 31,900 14,800 5,000 6,000

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ACM 602 Cost Analysis and Control

Secondary Distribution
Production Departments Service Departments
Expenses Basis of Total Machine Assembl Finishin Stores Repairs
allocation / (Rs.) Shop y Shop g &Maint.
apportionment Dept
Primary dist. 93,200 35,500 31,900 14,800 5,000 6,000
( earlier Table)
Stores Direct Material 2,250 1,500 1,250 - 5,000
( 9 : 6 :5)
Repairs &Maint Direct 2,000 3,000 1,000 - 6,000
( 2: 3: 1)
Total 93,200 39, 750 36.400 17,050 0 0

Self Check Questions

1. What do you mean by primary and secondary distribution of overheads?
2. What are the various methods of secondary distribution of overheads?

Absorption of Production overheads:

Production Overheads absorption rate for each cost centre is to be determined with
the help of quantum base as indicated in 5.6 above and the formula as indicated
below :

A pre-determined rate may be used on a provisional basis for internal management

decision making such as cost estimates for quotation, fixation of selling price etc.
These rates are to be calculated for each cost centre for a particular period.
Budgeted overheads for the respective costcentres for the period concerned are to
be taken as numerator and budgeted normal base for the period as denominator for
determining the rate.

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ACM 602 Cost Analysis and Control

The amount of total overheads absorbed by a product, service or activity will be the
sum total of the overheads absorbed from individual cost centres on pre-determined
basis. The difference between overheads absorbed on pre-determined basis and
the actual overheads incurred is the under- or over-absorption of overheads.
The under- or over- absorption of overheads is mainly due to variation between the
estimation and actual.

Method of absorption of overheads

Production overheads
There are many ways to absorb overheads which are as follows:
DIRECT MATERIAL COST PERCENTAGE
Suitable in situations where:
• the material value has some relationship with the overheads;
• quality and prices of materials do not vary drastically;
• quantity and cost of materials in each product is almost the same and
• where processing is uniform

Unsuitable when:
• Overheads are time-based where there is little relationship with the cost of
material used hence products with high material content absorb more
overheads.
Example

=700%
Overhead absorbed by the job= 10 x700

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ACM 602 Cost Analysis and Control

DIRECT LABOUR COST PERCENTAGE

Suitable in situations where:
• wages have some relationship with the overheads
• one type of labour rate and one type of pay rate in the cost centre.
Need to be careful to charge overheads with higher labour costs in the event of
different level of skill.
Example

=175%

Overhead absorbed by the job= 30 x175% =52.50

PRIME COST PERCENTAGE

Prime cost consists of direct material and direct labour. Not a good absorption
method as it has little relationship with overheads.

=140%
Overhead absorbed by the job= 40(10+30) x140% =56
DIRECT LABOUR HOUR RATE
Suitable in labour intensive industry or where certain departments are still using
manual means. Uses time as a basis.

Disadvantages:
• It assumes that operations that take the same time are costed with the same
overheads irrespective of the operators different pay rates.

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ACM 602 Cost Analysis and Control

also, more businesses are deploying machines, hence this absorption method is
getting more unpopular.

=2.34 %
Overhead absorbed by the job= 20 hours x2.34 =46.80

MACHINE HOUR RATE

Is suitable when the business is of capital intensive in nature or production being
carried out by machines.

Disadvantage:
If a cost centre uses different type of machines, then we cannot use a single
machine rate. A separate machine rate must be computed for each machine or
group of machines. Also, there is a need to keep records of the machine time for
each operation. This method therefore can be very tedious and increases clerical
work

=3.5 per machine hour

Overhead absorbed by the job= 10 hours x 3.5 =35

COST UNIT RATE

Suitable where cost units passing through a cost centre are homogenous.
Applies in standard costing or budgetary control systems.Cost Unit Rate method is
very simple and a more direct mean.

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ACM 602 Cost Analysis and Control

=14 per unit

Overhead absorbed by the job= 14 x 1unit =14

Apportionment and absorption of Administrative Overheads

Administrative overheads include the following items of cost:
Printing and stationery, other office supplies
Employees cost – Salaries of administrative staff
Establishment expenses – Office rent & rates, insurance, depreciation of
office building and other assets, legal expenses, audit fees, bank charges
etc.
Administrative overheads are to be collected in different cost pools such as :
- General Office
- Personnel department
- Accounts department
- Legal department
- Secretarial department etc
Administrative overheads can be further analysed into two – one for production
activities and other for sales and distribution activities. Costs collected under the
cost pools indicated above are to be distributed to administrative overheads relating
to production activities and administrative overheads relating to selling and
distribution activities on rational basis for each cost pool.
Administrative overheads relating to production activities are to be apportioned to
different production cost centres on the basis conversion costs of production cost
centres. The apportioned overheads are absorbed to products on the basis of the
normal capacity or actual capacity, whichever is higher.
In case of under-absorption or over-absorption of administrative overheads relating
to production, the same shall also be adjusted with Costing Profit & Loss Account.

Apportionment and absorption of Selling overheads and Distribution

overheads

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ACM 602 Cost Analysis and Control

The selling overheads and distribution overheads are collected under different cost
pools such as :

Selling Overheads:
(i) Sales Employees cost
(ii) Rent
(iii) Traveling expenses
(iv) Warranty claim
(v) Brokerage & Commission
(vi) Advertisement relating to sales and sales promotion
(vii) Sales incentive
(viii) Bad debt etc

Distribution Overheads:
(i) Secondary Packaging
(ii) Freight & forwarding
(iii) Warehousing & storage
(iv) Insurance etc.

Some items of selling overheads and distribution overheads are directly identified
and absorbed to products or services and remaining part of selling and
distribution overhead along with the with share of administration overheads
relating to selling and distribution activities are to be apportioned to various
products or jobs or services on the basis of net actual sales value (i.e. Gross
sales value less excise duty, sales tax and other government levies).
SELF CHECK QUESTIONS
1.What are the various methods of absoption of factory overheads.
2. Discuss the method of apportionment and absorption of administrative overhead.

MACHINE HOUR RATE

Machine hour rate is a method of absorbing factory overhead. This method is
applied in those industries where production activity heavily depends on machines.
The machine hour rate is an actual or predetermined rate of cost apportionment for

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ACM 602 Cost Analysis and Control

overhead absorption, which is calculated by dividing the cost to be apportioned or

absorbed by the number of hours for which a machine or machines are operated or
expected to be operated.

PROCESS OF MACHINE HOUR RATE METHOD

The following process is generally adopted to determine the machine hour rate:
(i) All the factory overhead are apportioned to the various machines or
group of machines on some suitable basis.
(ii) Working hours of a machine are calculated for the period for which the
machine is to run.
(iii) The overheads of a machine cost centre are divided by the effective
machine hours, the machine hour rate pertaining to the machine or
group of machines is determined.
BASES OF APPORTIONMENT OF FACTORY OVERHEAD TO THE MACHINES
The following basis is generally adopted for apportionment of expenses which are
common to more than one machine:
(i) Rent, Rates and Taxes etc: Floor area occupied by the machine
(ii) Depreciation : Actual depreciation as per plant register
(iii) Lighting: Number of bulbs or wattage used for lighting by the machines
(iv) Heating: Floor area occupied by the machine or technical estimates
(v) Power: Horse power of the machine or technical estimate by meter reading
(vi) Repairs and Maintenance: Allocation as per actual repairs or according to
hours worked by the machines
(vii) Supervisory Expenses: Number of hours devoted by the supervisor on
each machine
(viii) Labour Welfare Expenses: In the ratio of number of employee engaged on
machines
(ix) Insurance: In the ratio of machine value keeping into consideration the
insurance period
(x) Lubricating oil, cotton waste and consumable stores: On the basis of
machine hour worked in the certain period or on the basis of size of
machine

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ACM 602 Cost Analysis and Control

(xi) Interest included in hire purchase : Interest is treated as an overhead and

actual interest of the machine is charged as overhead for the particular
machine
COMPUTATION OF MACHINE HOUR RATE
In order to calculate the machine hour rate, the factory overhead is divided into
(a) Standing charges and (b) Machine or Variable expenses
(A) Standing Charges: Standing charges are those expenses which are not
related to the running of the machine and these expenses are bound to incur
even if the machine remains idle. The following expenses are generally
included in this category:
(i) Rent of the Factory,
(ii) Rates and Taxes,
(iii) Insurance premium of Factory building,
(iv) Insurance premium of Machines,
(v) Salary of Manager,Supervisor, Foreman etc.,
(vi) General Lighting,
(vii) Cotton Waste, Lubricants oil,
(viii) Consumable stores,
(ix) Sundry Supplies
(x) Operators Wages: Generally Operators wages is treated as direct
labour cost and is shown in Prime cost. However, if an operator
works on several machine then the wages should be shown as
standing charges
All the standing charges are totaled together and divided by the
working hours of the machine of the specified period thus obtaining
hourly rate of standing charges.
(B) Machine Expenses: Machine expenses are those expenses which are
incurred on running of the machines. These expenses are calculated for
hourly rate on individual basis. Generally following expenses are treated as
machine expenses:
(i) Depreciation of machine
(ii) Power Expenses
(iii) Repair and Maintenance charges

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ACM 602 Cost Analysis and Control

Treatment of Idle time and setting time:

The idle time in respect of a machine is generally deducted from the budgeted
working hours of a machine in order to calculate the effective machine hour.
Similarly, if a machine requires some setting time before it is ready for operation, the
setting time should be added in calculating effective hours of the machine.

ILLUSTRATION
1. Calculate Machine Hour Rate for recovery of overhead for a machine from the
following data. There is a group of 4 similar machines in the department.
Original cost of 4 Machines Rs. 76,800; Depreciation at 10% per annum on straight
line method; Maintenance cost average Rs. 8 per day of 8 hours for the group
machines.
Power 25 Paisa per running hour (per machine), Supervision for the machine group
Rs. 640 per month. Allocation of building depreciation for 4 Machines on a floor area
basis Rs. 80 per month.
Share of manufacturing overheads Rs. 240 per month for the group.
Normal working days in the year 300; Normal running : One shift of 8 hours, Each
machine remained idle for 20% of its normal running hours.

Solution ·
Computation of Machine Hour Rate
Base Period : 1 year Working Hours : 300 ×8 = 2,400 — 480 = 1,920

Particular Per year Per hour

(A).Standing Expenses : Rs. Rs.
(i) Supervision Exp. (Rs. 640 × 12 months / 4) 1,920

(ii) Depreciation of Building (Rs. 80 × 12 months / 4) 240

720
(iii) Manufacturing Overhead (Rs. 240 × 12 months / 4)
2880

Standing Expenses per hour (Rs. 2,880 / 1,920 hrs.)

1.50

(B) Machine Expenses

(i) Depreciation (Rs. 76,800 / 4 = Rs. 19,200 × 10%

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ACM 602 Cost Analysis and Control

=Rs. 1,920 / 1,920 hrs.)

(ii) Power 1.00
(iii) Maintenance cost (Re. 1 per hour for 4 machines) 0.25
Machine Expenses 0.25
3.00

2. A Machine costing Rs. 28,700, excluding installation cost of Rs. 300, has an
anticipated life of 10 years with residual value of Rs. 500. It is depreciated on
straight line method. From the following particulars, compute machine hour rate on
the basis of anticipated working hours:
(i) Rent and Rates for the factory is Rs. 6,000 per annum and 10% of the effective
area is occupied by this machine.
(ii) Insurance for this machine is Rs. 450 per annum.
(iii) Repairs and Maintenance for the whole factory for the year is Rs. 2,000; 25% of
this amount relates to this machine.
(iv) Consumable Stores etc. attributable to this machine for the whole year is Rs.
110.
(v) Total of production services is Rs. 5,000; 20% of this amount is applicable to this
machine.
(vi) Power cost is Re. 0.50 per Working Hour.
(vii) The year contains 250 working days of 8 hours each but it is anticipated that
the machine will remain idle 20% of this time.

Solution

Total hours = 250 working days x 8 hours each day = 2000 hours
Less idle time being 20% of 2,000 hours = 400 hours
Effective working hours = 1600 hours
Particular Per year Per hour
(A).Standing Charges : Rs. Rs.
(i) Rent and Rates (Rs. 6,000 × 10%) 600.00
(ii) Insurance 450.00 450.00
(iii) Consumable Stores 110.00
(iv) Production service overheads (Rs. 5,000 × 20%) 1,000.00
Total Standing Charges Rs. 2,160.00
Standing Expenses per hour (Rs. 2, 160 / 1,600 hrs.) 1.35

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ACM 602 Cost Analysis and Control

(B) Machine Expenses

(i) Depreciation 1.78
(ii) Repairs and Maintenance (Rs. 2,000 × 25% = Rs.
500 / 1,600 hrs.) 0.31
(iii) Power 0.50
Machine Hour Rate 3.94

3. In a factory department, a machine costs Rs. 1, 15,000. It is expected that it will

work for about 20,000 hours and its scrap value is estimated at Rs. 15,000. The rent
of the factory department is Rs. 4,000 p.m. of the 25% of the area of the department
is utilised for conducting the operation of the machine. One foreman and an
attendant are employed on a salary of Rs. 2,000 and Rs. 1,000 p.m. respectively, to
work on one more machine of a similar type. The expenses of the month incurred in
the department are as follows:
Light charges for the department Rs. 800, having 16 points in all out of which only 4
points are used at the machine. Total power used for two machines of equal horse-
power Rs. 3,200; Indirect Labour for the machine Rs. 500 and Repairs and
Renewals Rs. 400. 0
You are required to find out the Machine Hour Rate for one month when it is
expected to work for 40 hours a week. ‘

Solution: Computation of Machine Hour Rate

Machine No............
Standing Charges Rs. Rs.
Rent (Departmental Rent Rs. 4,000; 1/4 for the machine) 1,000
Foreman’s salary (for one machine) 1,000
Attendant’s salary (for one machine) 500
Lighting charges 200
Indirect Labour
500
Total Standing Charges
3,200
20.00
Hourly rate for standing charges (3,200 160)
Machine Expenses
Depreciation : Cost of the machine
1,15,000
Less ; Scrap value
15,000
Amount to be written off
1,00,000
Hourly rate for depreciation (1,15,000 — 15,000 20,000) Repairs
5.00
and Renewals (400 160)
2.50
Power (for one machine) (1,600 ) 10.00
Machine Hour Rate 37.50

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ACM 602 Cost Analysis and Control

4. The following annual charges are incurred in respect of a machine where manual
labour is almost niland where the work is done by means of five machines of exactly
similar type and specifications:
1. Rent and Rates (proportional to the floor space occupied) for the shop Rs. 48,000
2. Depreciation on each machine Rs. 5,000
3. Repairs and maintenance for five machines Rs.10, 000
4. Power (as per metre) @ Rs. 10 per 16 units consumed for the shop) Rs.
37,500
5. Electric charges for light in the shop Rs. 5,400
6. Attendants: There are two attendants for the five machines and they are each
paid Rs. 600 per month.
7. Supervision: For the five machines in the shop there is one supervisor
whoseemoluments are Rs. 2,500 per month.
8. Sundry supplies, such as Lubricants, Jute and Cotton waste,
etc. for the shop Rs. 4950
9. Hire-purchase instalment payable for the machines
(includingRs. 3,000 as interest) A
The machine uses 10 units of power per hour.
Calculate the Machine Hour Rate for the year.

Solution : Computation of Machine Hour Rate

Machine No............
Standing Charges Rs. Rs.
Rent (& Rates per Machine (Rs. 48,000 5 Machines) 9,600 9,600
light in Workshop per Machine (Rs. 5,400 5 Machines) 1,080
Salary of attendants per Machine (Rs.600 × 2 × 12 5) 2,880
Supervision per Machine (Rs. 2,500 × 12 5) 6,000
Sundry Supplied per Machine (Rs. 4,950 5) 990
Eve-purchase Charges per Machine (Rs. 3,000 5) 600
Total Fixed Expenses 21,150
Hourly rate for standing charges (Rs. 21,150 1,200 hrs.) 17.625
Machine Expenses :
Depreciation (Rs. 5,000 1,200 hrs.) 4.166
Repairs &Maint. (Rs. 2,000 1,200 hrs.) 1.667
Power (10 Units per hour, @ Rs. 10 per 16 Units) 6.250
Machine Hour Rate 29.708
Working hours of Machine have been computed as follows:
Power Units @ Rs. 1.00 per 1.6 Units = Rs. 37,500 × 1.6 = 60,000 which is for all 5
Machines. Hence, per Machine Consumption is 12,000 Units. Machine consumes 10
Units per hour and hence a Machine, Runs for 1,200 Hrs in a year

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ACM 602 Cost Analysis and Control

SELF CHECK QUESTION

1. What do you mean by machine hour rate? How is it determined?
2. What is the process of determining machine hour rate? What factors do you keep
in view while ascertaining the rate.
3. What is meant by overhead expenses? Give various methods of absorbing
overhead and discuss any two of these method in detail?
4. What do you understand by overheads? Discuss the different methods of
allocating the factory overheads.
5. What is the difference between apportionment of overheads and absorption of
overheads?State with the help of imaginary figures.
PRACTICAL QUESTIONS
1. The following annual charges are incurred in respect of a machine where manual
labour is almost nil and where the work is done by means of five machines of
exactly similar type and specifications:
1. Rent and Rates (proportional to the floor space occupied) for the shop
48,000
2. Depreciation on each machine 5,000
3. Repairs and maintenance for five machines 10,000
4. Power (as per metre) @ Rs. l0 per 16 units consumed for the shop 37,500
5. Electric charges for light in the shop 5,400
6. Attendants: There are two attendants for the five machines and they are each
paid Rs. 600 per month.
7. Supervision: For the five machines in the shop there is one supervisor whose
emollients are Rs. 2.500 per month.
8. Sundry supplies, such as Lubricants, Jute and Cotton waste.
Etc. for the shop 4,950
9. Hire-purchase installment payable for the machines (including Rs. 3.000 as
interest) 12,000
10. The machine uses l0 units of power per hour.
Calculate the Machine Hour Rate for the year.
2. The expenditure pertaining to a department having four identical machines is
given below:
Rent and Taxes 6,000
perannum,
Power consumed (at 10 paisa per unit) . 4,800 per
annum

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ACM 602 Cost Analysis and Control

Repair 1,000 per

annum
Lighting expenses 800 per
annum
Consumable stores 100 per
annum
Depreciation on each machine 600 per
annum
Hire-purchase installment payable for the machines
(Including Rs. 300 interest) 1,200 per
annum
Supervisor`s Salaries 600 per
annum
Attendants: There are two attendants in the department. Each is paid Rs. 60 per
month.
The machine uses 10 units of power per hour.
Calculate the machine hour rate of the machine.

Ans. Machine Hours: 1,200; Machine Hour Rate: Rs. 5.008.

3. Prepare a Machine Hour Rate computation for the month of January, 2005 to
recover the overhead expenses from the information indicated below:
Per Annum (Rs.)
Rent of the Department (Space occupied by the machine 1/4) 1,200
Lighting (12 men in the department; 2 men are engaged on this machine) 576
Insurance 96
Cotton Waste, Oil, etc. 60
Salary of Foreman (one-third of foreman’s time is spent on this machine and the
remaining on other two machines) 9,000
Cost of machine is Rs. 27,500 and scrap value of machine is Rs. 500. It is assumed
from the past experience that:
(a) The machine will work 1,200 hours per annum.
(b) It will incur expenditure of Rs. 4,500 in respect of repairs and maintenance for
whole working life of machine. , .
(c) It will consume 5 units of power per hour at the rate of 10 Paisa per unit.
(d) The working life-time of the machine will be 15,000 hours.
Ans. Rs. 5.56 per hour.

4. The following annual expenses have been incurred in respect of a shop having 5
identical machines: Rs.
(i) Rent and Rates
4000
(ii) Power consumed by the shop @ 61/4 Paisa per unit
3,750
(iii) Repair and maintenance for the machines
1,000
(iv) Lighting charges for the lighting of the shop
500

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ACM 602 Cost Analysis and Control

(v) Attendant’s salary (There are two attendants and each is paid Rs. 50 per
month)
(vi) Supervisor’s salary (There is one supervisor for the 5 machines, his monthly
salary is Rs. 300)
(vii) Lubricants and cotton waste for the shop.
100
(viii) Hire-purchase installment for the machines (including Rs. 300 for interest)
2,300
(ix) Each machine consumes 10 units of power per hour.
(x) Depreciation on each machine Rs. 600 p.a.
Ans. Rs. 2.91 including Hire-purchase interest.

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ACM 602 Cost Analysis and Control

LESSON 7
Costing of Joint Product and By Product
CONTEXT OF THE LESSON
In case of processing industry some time more than one products are produced
from the common raw material which are classified into joint products or by-products
on the basis of significance of their value. In this lesson we will deal with the criteria
for differentiating between joint products and by products and the method of costing
of these products.

OBJECTIVES OF THE LESSON

INTRODUCTION
A manufacturing organisation which deals in multi-product/ multi-process and multi
service industries are always uncertain on one of the major issue of identifying and
allocating and apportioning joint cost or common costs to various products or output
services. The final product/service cost will reflect the full cost only if the joint/
common costs are allocated or apportioned on some suitable basis to the individual
final products. The problem of allocation and apportionment of common or joint
costs becomes more significant in process industries, where there is common
process being applied up to a certain stage and then segregates into two or more
process lines to produce more than one product from a common initial process.
The essence of joint product/by-product costing lies in the allocation/apportionment
of joint processing costs to the individual products in as equitable a manner as
possible. The ascertainment of joint costs is very much essential for valuation of
work-in-progress inventory, external financial reporting and for the purposes of
valuation under various statutory and tax legislations. It is necessary to understand
the cost practices for the apportionment of joint costs to individual products in the
cost statements in case of those industries where a product has to pass through
various process in order to become a finished product.
Following are some examples of the industry where more than one product are
produced simultaneously through various process with there joint products:

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ACM 602 Cost Analysis and Control

Coal mining washing and Coke production resulting in the production of Coal, Coke,
Gas, Benzene, and Tar and Ammonia.
Petroleum refining resulting in the production of Petrol, Kerosene, Diesel, Furnace
oil etc. In this industry a very large number of joint and by-products occur in cracking
or refining crude oil.

Agricultural Product industries such as vegetable oil - crushing of oil seeds resulting
in production of oil and cake. From the process of refining oil, soap stock arises
which could be further processed into soap and allied products. The refined oil can
be further hydrogenated to produce Vanaspati.

In sugar industry, the three by-products are bagasse, molasses and pressmud.
In Milk industry , the three joint products are Cream, Liquid Milk and Skim. The
cream is again processed into Butter and ghee. The liquid milk and skim is
processed to produce whole milk, full cream milk and standard milk.
Chemical industry: Processing of naphtha results in Ethylene, Propylene, Methane,
Ethane, Butane etc.

Terminology
Joint-Products:.
Multiple products deriving out of same raw materials through a common process
simultaneously which have substantial market value is termed as joint product Two
or more products separated in the course of processing, each having a sufficiently
high saleable value to merit recognition as a main product.
Example: Ethylene and Propylene arising from the cracking of Naphtha

By-Product:
A product, which is secondary to the main product and obtained during the course of
manufacture of recognized main product. It is called a by-product because it is less
significant as compared with the main product or products.

A product which is produced incidentally from the material used in the manufacturing
of main products, having either a net realizable value or a usable value which is

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ACM 602 Cost Analysis and Control

relatively low in comparison with the saleable value of the main products is termed
as by product.
By-product may be subjected to further processing after separation from the main
product, if such processing will increase the value added or promote the sale of the
main product. It is called a by-product because of the relatively lower importance or
lower market value or lower ultimate value at the end of the value chain it has,
compared with the main product or products.
Example: Groundnut crushing in which oil is the main product and cake is a by-
product. Cake is used as raw material for manufacture of cattle feed.
The productions of the by-products are incidental to the production of main product.
A by-product may get promoted to the status of joint product if the market perception
changes or a joint product could be relegated it the position of a by-Product in future.
The classification could vary over a period time. For example, in a Petroleum
Refinery, gas was earlier considered as a by-product. Now, it has assumed
importance like petrol, diesel, etc. and it is being treated as a joint product.

Split off point:

It is the stage in the manufacturing process where joint products are separated and
can be identified as separate product.

Scrap:
Scraps are discarded material which has some recovery value and are either
disposed of without further treatment (other than reclamation and handling), or
reintroduced into the production process in place of raw material.
Waste:
The discarded material or substances having no significant value (as distinct from
scrap) is treated as waste.

Joint Costs:
Joint Costs are the common cost of facilities or services employed in the output of
two or more simultaneously produced or otherwise closely related operations,
commodities or services. The costs incurred in the joint process cannot be
separately traced to the individual product outputs. The specific feature of joint

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ACM 602 Cost Analysis and Control

products is that they incur joint costs up to the stage of production, known as the
split-off point, when they become recognisable as separate products. The costs
incurred in the joint process cannot be separately traced to the individual product
outputs.

Separate cost or Separable cost:

Any cost incurred after the split off point e.g. the additional processing costs, which
can be identified with specific products may be termed separate costs. For a cost to
be treated as separate cost, it must be possible to trace it with reasonable certainty
to a single product.

Costing Principles for Joint Product / By-product costing:

There are two basic principles or approaches for costing of joint product and by-
products, which are as follows:

Joint Product Approach:

More than one product is treated as joint product under this approach and the joint
processing costs are allocated between the products on an appropriate basis.

Main Product / By-product Approach:

Only one product is considered as a main product under this approach and all
other products arising from the process will be treated as by-products.
In this approach, the joint costs are not allocated between the products but the
amount of sales revenue (sales value less further processing expenses, selling
expenses, etc. if any) realised from the products is credited to the joint costs
and the remaining joint cost is totally absorbed by the main product.

Recognition of a Product as Joint Product or By-Product

Whether a product is to be recognised as a joint product or by-product, in this
regard there is no specific rules or guidelines. Products which are incidental to
the production of main products and products which are insignificant in value
compared to the main product are treated as by-products. However, the status of
a product may change from by-product to main product or vice versa due

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ACM 602 Cost Analysis and Control

changes in market price, competition, demand or technology and thus may

require a re-classification. Therefore, the classification between the main product
and by-product has to be reviewed continuously. Recognition of joint products
and by-products is purely by relative commercial values. Further, such relative
values are not permanent as their relative importance of joint and by-products is
evanescent in nature.

Methods of Apportionment of Joint Costs

The following are the methods which are used for the apportionment of Joint cost:
Market Value Bases:
The total joint cost of production is apportioned among the joint products on
the basis of their relative sales value in this method.

The fundamental principle of this method is that joint products should absorb
joint costs according to their ability to pay as reflected by the market values of
the individual products.

The market value or the sales value for the purpose of joint cost can be as
follows-
(i) Market value after further processing i.e. the final sales value.
(ii) Net Realisable value i.e. the final sales value less the further
processing costs.
(iii) Gross Margin Percentage.
(iv) Market value at the point of separation.

(i). Market value after further processing i.e. the final sales value:
When there is a wide parity in selling prices of final products, this base is to be
adopted. While choosing a selling price, it is important to choose a
representative period considering the normal cycle of fluctuations which may be
the daily average of the past month or quarterly average or any suitable period.

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ACM 602 Cost Analysis and Control

Example 1
Joint production cost of the Products
Total Prod A Prod B Prod C
Raw Materials 1,20,000
Chemical 10,000
Labour 50,000
Manufacturing overhead 45,000
2,25,000
Apportioned on the basis of use
of services
- Administration Overhead 25,000 10,000 10,000 5,000
- Selling & Distribution 30,000 15,000 5,000 10,000
Overheads
Total cost 2,80,000
i) Unit produced 1150 400 400 350
ii) Sales Price per unit ( Rs) 250 300 200
iii) Sales Value ( Rs) 2,90,000 1,00,000 1,20,000 70,000
iii)Joint production cost 2,25,000 77,586 93,104 54,310
apportioned on the basis sales
value (Rs)
iv) Administration overhead (Rs) 25,000 10,000 10,000 5,000
v) Selling & Dist. Overheads ( 30,000 15,000 5,000 10,000
Rs)
vi) Total Cost 2,80,000 1,02,586 108,104 69,310
iv) Cost per Unit 256.47 270.26 198.03

(ii). Net Realisable value i.e. the final sales value less the further processing
costs: If a product require further processing after split-off point, then the further
processing cost has to be determined and deducted from the sales value to
arrive at the basis for apportionment of joint cost among the products.

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ACM 602 Cost Analysis and Control

Example 2
Apportionment of joint costs on the basis of net realisable value
Total Prod. A Prod.B Prod.C
I. Units produced 1150 400 400 350
II. Sale Price per unit (Rs.) 300 350 200
III. Sale Value 3,30,000 1,20,000 1,40,000 70,000
IV. Further Processing Cost 22,000 10,000 12,000 --
V. Net Realisable Value 3,08,000 1,10,000 1,28,000 70,000
VI. Joint Cost Apportioned on the Basis 2,25,000 80,357 93,507 51,136
of V (35.71%, 41.56%, 22.73%)
VII. Administration Overhead 25,000 10,000 10,000 5,000
VIII. Selling & Distribution Overhead 30,000 15,000 5,000 10,000
IX. Total Cost 2,80,000 1,05,357 1,08,506 66,136
X. Joint Cost Per Unit 200.89 233.77 146.10
XI. Further Processing Cost Per Unit 25.00 30.00
XII. Cost Per Unit Of Finished Goods 225.89 263.77 146.10

(iii). Gross Margin Percentage: When the products have same profitability on sales,
Joint costs shall be allocated on the basis of Gross Margin Percentage

Example 3
(iii). Apportionment of Joint Cost on the Basis of Gross Margin Percentage.
Total Prod A Prod B Prod C
Unit produced 1150 400 400 350
Sales Price per unit ( Rs) 300 350 200
Sales Value ( Rs) 3,30,000 1,20,000 1,40,000 70,000
Joint cost 2,25,000
Further Processing Cost 22,000
Gross Margin 83,000
Gross Margin Percentage 25%
Deduct Gross Margin @ 25% 83,000 30,000 35,000 18,000
Cost of Goods Sold 2,47,000 90,000 1,05,000 52,000

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ACM 602 Cost Analysis and Control

Less: Further Processing Cost 22,000 10,000 12,000 -

Joint Cost Allocated 2,25,000 80,000 93,000 52,000

The obvious assumption in this method is that all the products have the same
profitability ratio on sales.
(iv). Market value at the point of separation:
Joint costs apportionment on the basis of sales value of the products shall be
followed when no other rational basis for apportionment of joint cost is available
and joint products are sold without further processing at split off point.

Physical unit base method

Where individual products are from a common input, and none of the products
can be categorised as by-product, the benefits received by individual products
from the common input is to be measured by physical units e.g. weight, length,
volume, etc. The joint costs are to be allocated to individual products on the
basis of this measurement.

Example 4:
Joint production cost of the Products:

Total Prod A Prod B Prod C

Raw Materials 1,20,000
Process Chemical 10,000
Employees cost 30,000
Production Overhead 40,000
2,00,000
Apportioned on the basis of
use of services
- Administration Overhead 15,000 40% 30% 30%
- Selling & Distribution 20,000 20% 40% 40%
Overheads
Total cost 2,35,000

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ACM 602 Cost Analysis and Control

Total Prod A Prod B Prod C

i) Unit Produced (No) 1,00,000 50000 30000 20000
ii) Joint production cost 2,00,000 1,00,000 60,000 40000
apportioned on the basis of
Units of production (Rs)
iii) Administration overhead 15,000 6,000 4,500 4,500
(Rs)
iv) Marketing expenses (Rs) 20,000 4,000 8,000 8,000
v) Total Cost 2,35,00 1,10,000 72,500 52,500
iv) Cost per Unit (Rs) 2.20 2.42 2.63

Treatment of cost of by-products:

The by-products are normally additional output in the production of main products.
The standardization of treatment of by-product costs is important from the point of
cost accounting.
The uniform system of treatment of cost accounting for by-product shall be followed.
Sales value of by-products less further processing cost, administrative expenses
and selling and distribution expenses shall be credited to the total cost of main
product.

Example 5
Joint Cost Rs 2, 80,000
Sales value of by-product Rs 15,000
Less: Further processing cost. Rs. 3,000
Administration & selling and Rs 2,000
Distribution Cost -------------
Amount to be credited to Joint Cost Rs 10,000
----------------
Joint Cost to be apportioned among joint products Rs 2, 70,000

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NUMERICAL ILLUSTRATIONS
1 In a manufacturing concern in a certain product A yield by-products B and C. The
joint expenses of the manufacture are:
Material Rs. 10,200 Labour Rs. 11,500 and On cost Rs. 7,500
Subsequent expenses are as under:
Particular A B C
Material 2,500 1,200 1,400
Labour 1,900 1,600 2,000
Oncost 1,500 900 1,050
Total 5,900 3,700 4,450

Selling prices are: A = 30,000; B = 20,000 C = 15,000. Estimated profits on turnover are A =
40% B = 30% C = 25%.
Show how would you apportion the joint expenses of manufacture and prepare necessary
accounts.
Solution: -
Apportionment of joint Expenses
Particular A B C
Selling Price 30,000 20,000 15,000
Less: Estimated Profit 12,000 6,000 3,750
Total cost 18,000 14,000 11,250
Less : Total Separate Expenses 5,900 3,700 4,450
Share in Joint Expenses( Rs29,000) 12,100 10,300 6,800

A (Main Product) Account

Particular Amount Particular Amount
To Joint Expenses
Material 10,200 By By-product B 10,300
Labour 11,500 By By-product C 6,800
Oncost 7,500 By Balance c/d 12,100
29,200 29,200

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ACM 602 Cost Analysis and Control

To Balance c/d 12,100

To Separate Expenses By Cost of Production 18,000
Material 2,500
Labour 1,900
Oncost 1,500
18,000 18,000

To Cost of Production 18,000 By Sales 30,000

To Profit 12,000
30,000 30,000
B (By-Product) Account
To A (Main Product) A/c 10,300
To Material 1,200 By Cost of Production 14,000
To Labour 1,600
To Oncost 900

14,000 14,000

To Cost of Production 14,000 By Sales 20,000

To Profit 6,000
20,000 20,000
C (By-Product) Account
To, A (Main Product) A/c 6,800
To Material 1,400 By Cost of Production 11,250
To Labour 2,000
To Oncost 1,050

11,250 11,250
To Cost of Production 11,250 15,000
To Profit 3,750 By Sales

15,000 15,000

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ACM 602 Cost Analysis and Control

2. A factory providing articles X also Y and Z as by product. The joint cost of manufacturing
is:
Material 10,000
Labour 2,000
Factory and office Overhead 8,000
Total 20,000
Subsequent separate costs are as under:

Particular A B C
Material 1,500 1,300 1,000
Labour 200 150 100
Factory and office Overhead 800 550 400
Total 2,500 2,000 1,500
Sales value 20,000 15,000 10,000
Estimated profits on sales value 30% 25% 20%

Assume that selling and distribution expenses are in proportion to sales value.
Show how you would propose to apportion the joint cost f manufacture and prepare the
necessary accounts of X, Y and Z
Solution:
Apportionment of joint Expenses
Particular X Y Z Total
Sales 20,000 15,000 10,000 45,000
Less: Profit 6,000 3,750 2,000 11,750
(30%) (25%) (20%)
Total cost 14,000 11,250 8,000 33,250
Less : Total Separate Expenses 2,500 2,000 1,500 6,000
Share in Joint Expenses(Net Value) 11,500 9,250 6,500 27,250

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The difference between Rs. 27,250 and in joint cost of Rs. 20,000, i.e., Rs. 7,250 is that of
selling and distribution cost which is further apportioned in the ratio of sales values n the
three products as under:
Particular X Y Z Total
Estimated joint cost 11,500 9,250 6,500 27,250
Less: selling and distribution cost 3,222 2,417 1,611 7,250
Share in joint cost
8,278 6,833 4,889 20,000
X (Main Product) Account
Particular Amount Particular Amount
To Joint Expenses
Material 10,000 By By-product Y 6,833
Labour 2,000 By By-product Z 4,889
Factory and office Overhead 8,000 By Balance c/d 8,278
20,000 20,000
To Balance c/d 8,278 By Sales 20,000
To Separate Expenses
Material 1,500
Labour 200
Factory& office Overhead 800
To Selling and Distribution 3,222
To Profit 6,000
20,000 20,000
Y (By-Product) Account
To X (Main Product) A/c 6,833 By Sales 15,000
To Material 1,300
To Labour 150
To Fact.& office Overhead 550
To Selling and Distribution 2,417
To Profit 3,750
15,000 15,000

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Z (By-Product) Account
To X (Main Product) A/c 4,889 By Sales 10,000
To Material 1,000
To Labour 100
To Factory and office
Overhead 400
To Selling and Distribution 1,611
To Profit 2,000
10,000 10,000

3 Product P yields by-product Q and R. The joint expenses and subsequent expenses
are as follows :

Joint Subsequent expenses

Particular expenses P Q R
Rs.
Material 10,000 2,000 1,600 1,800
Labour 8,000 2,400 1,400 1,700
On cost 9,000 2,600 1,000 1,500
27,000 7,000 4,000 5,000
Sales 42,000 20,000 18,000
Percentage of profit on sales 50% 50% 33.1/3%

Show how you would apportion the joint expenses and prepare the necessary accounts.

Solution:
Statement of Apportionment of Cost

P Q R
Particular Rs. Rs. Rs.

Sales 42,000 20,000 18,000

- Profit (50%, 50%, 331/3%) 21,000 10,000 6,000
Total 21,000 10,000 12,000
-Post Separation Cost( Total) 7,000 4,000 5,000
Joint cost to be Apportioned 14,000 6,000 7,000

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Ratio 14: 6: 7

Material

Labor

O.H

P Account
Particular Amount Particular Amount
To Joint Cost By Sales 42,000
Material 5,185
Labor 4,148
O.H. 4,667 14,000
To Separate Cost:
Material 2,000
Labor 2,400
O.H. 2,600 7,000
To Profit (50% of 42,000) 21,000
42,000 42,000
Q Account
Particular Amount Particular Amount
To Joint Cost By Sales 20,000
Material 2,222
Labor 1,778
O.H. 2,000 6,000
To Separate Cost:
Material 1,600
Labor 1,400
O.H. 1,000 4,000
To Profit (50% of 20,000) 10,000
20,000 20,000

R Account
Particular Amount Particular Amount
To Joint Cost By Sales 18,000
Material 2,593
Labor 2,074
O.H. 2,333 7,000
To Separate Cost:
Material 1,800
Labor 1,700
O.H. 1,500 5,000
To Profit (50% of 18,000) 6,000
18,000 18,000

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4. Three products, viz, Nima, Bima, Rima are prepared out of a single process. The joint
expenses are: Material Rs. 2, 20,000; Labour Rs. 1, 00,000 O.H. Rs. 80,000. Post
separation is:
Particular Nima Bima Rima
Other Material 30,000 20,000 15,000
Labour 20,000 30,000 10,000
O.H. 5,000 6,000 5,000
55,000 56,000 30,000
Sales value 5,00,000 3,00,000 2,00,000
Profit on Sales 50% 30% 25%
Prepare statement showing apportionment of joint expenses, and Account for each product.
Solution: Statement of Apportionment of Cost

Particular Nima Bima Rima Total

Sales 5,00,000 3,00,000 2,00,000
- Profit (50%, 30%, 20%) 2,50,000 90,000 50,000
Total 2,50,000 2,10,000 1,50,000
- Post Separation Cost( Total) 55,.000 56,000 30,000
Cost before selling expenses 1,95,000 1,54,000 1,20,000 4,69,000
-Selling expenses (Note) 34,500 20,700 13,800 69,000
Joint cost to be apportioned 1,60,500 1,33,300 1,06,200 4,00,000

Ratio 1,605 1,333 1,062

Material

Labour

O.H.

Nima Account
Particular Amount Particular Amount
To Joint Cost By Sales 5,00,000
Material 88,275
Labour 40,125
O.H. 32,100 1,60,500
To Separate Cost:
Material 30,000
Labour 20,000
O.H. 5,000 55,000
To Selling Expenses 34,500
To Profit (50% of 5,00,000) 2,50,000
5,00,000 5,00,000

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ACM 602 Cost Analysis and Control

Bima Account
Particular Amount Particular Amount
To Joint Cost By Sales 3,00,000
Material 73,315
Labour 33,325
O.H. 26,660 1,33,300
To Separate Cost:
Material 20,000
Labour 30,000
O.H. 6,000 56,000
To Selling Expenses 20,700
To Profit (30% of 3,00,000) 90,000
3,00,000 3,00,000

Rima Account
Particular Amount Particular Amount
To Joint Cost By Sales 2,00,000
Material 58,410
Labor 26,550
O.H. 21,240 1,06,200
To Separate Cost:
Material 15,000
Labor 10,000
O.H. 5,000 30,000
To Selling Expenses 13,800
To Profit (25% of 3,00,000) 50,000
2,00,000 2,00,000

SELF CHECK QUESTIONS

1. What do you mean by joint cost? Discuss the method of apportionment of
joint cost?
2. Diffrenceate between joint product and by product and discuss the method of
costing of joint product.
3. What do you mean by- product? Discuss the method of costing of by
product?

NUMERICAL QUESTION
Q.1.Product A yields bye-products B and C and the joint expenses of manufacture are:
Particular A B C

Materials 8,000 4,000 2,000

Labour 4,000 3,000 1,000
On Cost 600 500 500
12,600 7,500 3,500
Selling Price 51,000 21,000 10,000
Estimated profit on sale 40% 30% 20%

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ACM 602 Cost Analysis and Control

Show the manner in which you would apportion the joint expenses of manufacture. Also
prepares accounts showing cost of each product.
Ans. Share in joint expenses A Rs.18,000;B Rs.7,200;and C Rs.4,500;Cost of
Production A Rs.30,600;B Rs.14,700,and C Rs.8,000.

Q.2.In a manufacturing concern a certain product A yields bye-products B and C. The

joint expenses of the manufacture are: Materials Rs.8,500;Labour Rs.9,000 and
Overheads Rs.7,500.Subsequent expenses are as follows.
Particular A B C
Materials 2,500 1,200 1,400
Labour 1,900 1,600 2,000
Overhead 1,500 900 1,050
5,900 3,700 4,450
Selling Price 30,000 20,000 15,000
Estimated profit on turnover 40% 30% 25%

Show how would you apportion the joint expenses of manufacture and prepare the
accounts.
Ans. Apportionment of joint expenses: A Rs.10, 360, B Rs.8,818, C Rs.5,822

Q.3.The joint products X,Y and Z are produced from a common process. The joint
expenses of manufacture are:
Rs.
Material 57,000
Labour 30,000
Overhead 2,100
Total 89,100

Subsequent expenses are as follows

X Y Z
Rs. Rs. Rs.
Materials 24,000 12,000 6,000
Labour 12,000 9,000 3,000
Overhead 1,800 1,500 1,500
Total
37,800 22,500 10,500
Sales
Estimated profit on sale 1,53,000 63,000 30,000
40% 30% 20%

Show the manner in which you want to apportion the joint expenses of production.

Ans. Joint expenses will be apportioned in the ratio of 20:8:5; Total Cost A-Rs.91, 800,
B-Rs.44, 100 and C-Rs.24, 000.

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Q.4.A Factory producing article A also yields B and C as by-products. The joint cost of
manufacture is:
Rs.
Materials 10,000
Labour 2,000
Overheads 8,000
Total 20,000
Subsequent costs are as follows:
A B C
Rs. Rs Rs.
Materials 1,500 1,300 1,000
Labour 200 150 100
Overheads 800 550 400
2,500 2,000 1,500
30,000 24,000 20,000
Selling Price 30% 24% 20%
Estimated Profits on Selling Prices

Show how you would propose to apportion the joint costs of manufacture and prepare
the necessary statement in respect of A, B and C.

Ans. Share in joint cost of manufacture; A Rs.6, 743; B Rs.6, 595; C Rs.6, 662

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ACM 602 Cost Analysis and Control

Lesson -8
PROBLEMS OF EQUIVALENT PRODUCTION
Objectives
After this lesson you will be able to understand:
• Concept of equivalent production.
• Steps involved in values of Equivalent units.
• Preparation of various statements under equivalent production.

Equivalent Production Units

For the purpose of accurate valuation of the incomplete units, the WIP is ex-
pressed in terms of completed units. The equivalent production units are the
incomplete units stated in terms of completed units. They are only the deemed
completed units for the purpose of accounting. According to CIMA equivalent units
are "Notional whole units representing completed work. Used to apportion costs
between WIP and completed output." For example, if 100 units are completed to the
extent of 50% in respect of Material, Labour, OH, on the last date of accounting
period, then these 100 incomplete units can be expressed as 50 complete units,
because, if the same amount of Material, Labour and O.H. had been spent on 50
units instead of on 100 units, these 50 units would have been completed in all
respects. Therefore, 50 units are deemed as equivalent completed units of 100
incomplete units. Similarly, if 100 units are complete to the extent of only 25%, then
the equivalent units are 25% of 100, i.e., 25 units. Thus, if 150 units are complete to
40%, then equivalent units are 40% of 150, i.e., 60 units and so on.
But, when the degree of completion is different with respect to each element then
equivalent units are determined with respect to each element separately. For
example, if 100 units are complete as: Material 100%, Labour 60%, O.H. 40% then
equivalent units are tabulated as below:

Material 100% 100 units

Labour 60% 60 units
D.H. 40% 40 units

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ACM 602 Cost Analysis and Control

Estimation: The percentage of completion is determined on the basis of technical

estimation. An expert is entrusted with this job. At the end of every period, the
degree of completion, is stated with respect to each element. Based on this,
systematic procedure is followed to evaluate the W.I.P.
Procedure for Evaluation of W.I.P.
The procedure for evaluation of W.I.P. depends on the method of inventory
costing. Following four methods are discussed:
(1) FIFO Method: Under this method it is presumed that, in the beginning of
every period, the opening WIP is taken up and remaining part of the work is done
and once they are completed, the fresh units are taken up and as the production is
continuous, some part of freshly introduced units remain incomplete at the end of
that period. Thus, there is clear distinction as to:
(i) Cost ·of work done on opening WIP.
(ii) Cost of fresh units introduced and completed during the period and
(iii) Cost of closing WIP out of fresh units introduced.
There are four steps:
(a) Statement of Equivalent Production Units: This statement is prepared to
find out the equivalent units with respect to each element.
(b) Statement of Element-wise Cost per Unit: This is prepared to calculate
the cost per unit of Equivalent production for each element.
(c) Statement of Apportionment of Cost: This is prepared to calculate total
cost for remaining work done on opening WIP, cost of newly introduced and
completed units, and the cost of closing WIP.
(d) Relevant Process Account: This is prepared to show the complete picture
about the relevant process account.
(2) Average Method: Under this method, the cost of opening WIP is combined,
element-wise, with the cost of freshly introduced units and the average cost of units
completed during the period and the cost of closing WIP are calculated. Thus, there
is no distinction between units which are partially completed in the preceding period
and those units which are started and completed during the current period. The
com-
bined cost of opening inventory and current production is divided by the total of (i)
Units completed and (ii) Equivalent production units of closing inventory, to get the

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ACM 602 Cost Analysis and Control

cost per unit of output. The costs, then are segregated among units completed and
the closing W.I.P.

(3) LIFO Method: Under this method it is presumed that, the newly introduced
units in the current period are taken up first and after their completion, the opening
WIP is taken up, to do the remaining part of work. Therefore, the closing WIP, if
any, is represented by the opening WIP or part thereof. Thus, at the end of the
period the closing WIP may comprise (i) opening WIP or a part thereof, (ii) part of
newly introduced units not completed.
(4) Weighted Average Method: This method is followed when different
products are manufactured in different quantities in a single process. Under this
method, output of each product is expressed in points and cost of each type of
product is calculated on the basis of points.
Hints on Solving Problems
(1) The problem states the degree of completion of opening WIP. While calculating
equivalent units, the work on remaining part of opening WIP is important.
Therefore, the equivalent units for the rest of degree of completion is calculated. For
example, if 1200 units of opening WIP is completed to 60% of labour, then
equivalent
units will be 40% (100% - 60%) of 1200, i.e., 480 units. Similarly for other elements
in the current period.
(2) Cost per unit of each element should be calculated at least up to 4 decimal
points.
(3) The method to be followed has to be examined.
(4) Normal Loss: No equivalent units are calculated on normal loss, as it is
recovered by good units.
(5) Abnormal Loss or Abnormal Gain: Abnormal loss or gain units are treated
as good units only, In other words, they are taken as 100% complete.
(6) Percentage completion of closing stock should be taken as given in the
problem. For example, if 800 units are closing WIP completed to 75% of labour,
then equivalent units are 75% of 800, i.e., 600 units.
(7) Quantity column of input and output must tally.

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ACM 602 Cost Analysis and Control

Example -1 Rahej & Co. gives the following information about process 'A' for the
manufacturing of a chemical: opening WIP: 1500 units (Degree of Completion:
Material, 100%, Labour 60%, overhead 50%). Units introduced: 6000 units. Closing
WIP: 1000 units (Degree of completion: Material 100%, Labour 50%, over- head
25%.) Prepare statement of equivalent production units. (FIFO Method)
Solution

Input Output Equivalent Production

Material Labour O.H.

lnput Output Equivalent units

Units Items Unit Material Labour Overhead
s
Qty. % Qty. % Qty. %
1,50 10
2.000 Finished output 1,500 100 1,500 1,500 100
0 0
Work-in-progress 500 500 100 300 60 150 30
2,00
2.000 Total 2,000 - 1,800 - 1,650 -
0
Particulars Units Particulars Units
Units % Units % Units %
Opening
1,500 Units completed
Stock
Units 6,000 (I) Work on
introduced
Opening 1,50
- 600 40% 750 50%
stock 0
5,00 5,00 100 100 100
(II) Fresh units 5,000 5,000
0 0 % % %
Closing WIP 1,00 1,00 100 500 50% 250 25%
0 0 %
7,500 7,50 6,00 6,100 6,000
0 0

Example -2 In process A on I March, there was no work-in-progress. During the

month of March, 2,000 units of material were issued at a cost of Rs. 18,000. Labour
and overheads totalled Rs. 9,000 and Rs. 6,600 respectively. On 31 st March, 1.500
units were completed and transferred to the next process. On the remaining 500
units, which are incomplete. degree of completion was as follows:
Materials 100% Labour 60% Overhead 30%
Prepare (a) Statement of Equivalent Production (b) Statement of Cost
(c)Statement of Evaluation (d) Process Account.

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ACM 602 Cost Analysis and Control

Statement of Equivalent Production

Statement of Cost
Element of cost Equivalent units (B) Cost per units
Cost Rs.
Rs.(A) (A + B)
Material 18,000 2,000 9
Labour 9,000 1,800 5
Overhead 6,600 1,650 4
Total 18

Finished goods 27,000

(1,500 x Rs. 18)

Value of work-in- Rs.

progress:

Materials 500 units 4,500

@ Rs. 9 per unit

Labour 300 units 1,500

@ Rs. 5 per unit

Overhead 150 600 6,600

units @ Rs. 4 per
unit

Statement of Evaluation

Process A Account

Particulars Units Rs. Particulars Units Rs.

Tot Materials 2,000 18,000 By Next process Ale 1,500 27.000
To Labour 9,000 By Work-in-progress cId 500 6.600
To Overhead 6,600
.. 2.000 33,600 2.000 33,600

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ACM 602 Cost Analysis and Control

Example- 3 During a month. 2.000 units were introduced into Process I. The normal
loss was estimated at 5% on input. At the end of the month 1.400 units had been
produced and transferred to 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
The cost of Overhead 50% completed 2.000 units
introduced was Rs. 5.800. Direct materials introduced during the process amounted
to Rs. 1440. Production overhead incurred were Rs. 1670. Direct labour Rs. 3.340.
Units scrapped realised Re. I each. The units scrapped have passed through the
process. so were 100% completed as regards material. labour and overheads. You
are required to (a) prepare a Statement of Equivalent Production. (b) evaluate the
cost of abnormal loss, finished goods and closing stock. and (c) prepare the Process
I Account and Abnormal Loss Account.
Solution
Input Output Equivalent units
Units Units Material Labour Overhead
Qty. % Qty. % Qty. %
2.000 Normal loss 1OO - - - - - -
Abnormal loss 40 40 1OO 40 1OO 40 1OO
Finished production 1,400 1,400 1OO 1,400 1OO 1,400 1OO
Work-in-progress 460 345 75 230 50 230 50
-2.000 Total 2,000
Equivalent Production 1,785 1,670 1.670

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ACM 602 Cost Analysis and Control

Statements of Cost
Element of cost Equivalent
Cost (Rs.) production (units) Cost per Unit
A (A) (B) (A/B)
Materials: 5,800
Units introduced 1,440
Direct materials 7,240
Less: Scrap value 1OO
of loss (normal)
Material cost 7,140 1.785 4
Direct labour 3.34 1,670 2
Overhead 1,670 1,670 1
Total 12,150

Statement of Evaluation

Particulars Element of Equivalent Cost per Cost Total cost

cost production unit Rs. Rs. Rs.
Abnormal Loss: Material 40 4 160
Labour 40 2 80
Overhead 40 1 40 280
--
Finished Material 1,400 4 5,600
Production: Labour 1,400 2 2,800
Overhead 1,400 1 1,400 9,800
--
Work-in-progress:
Material 345 4 1,380
Labour 230 2 460
Overhead 230 · 1 230 2,070
-- ---
12,150
Process I Account
Particulars Units Rs. Particulars Units Rs.
To Units introduced 2,000 5,800 By Normal loss 100 100
To Direct material 1,440 By Abnormal loss 40 280
To Direct wages 3,340 By Finished production
To Production overheads 1,670 transferred to Process 11 1,400 9,800
By Balance cid
(work -in-progress) 460 2.070
2,000 12,250 2,000 12,250

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ACM 602 Cost Analysis and Control

Abnormal Loss Account

Particulars Units Rs. Particulars Units Rs.
To Process I 40 280 By Sale of scrap 40
ssssssssss By Costing P&L A/c 240
ssss 40 280 40 280

Example - 4
Opening work-in-progress (30% complete) 2,000 units
Put into the process during the month 20,000 units
Transferred to next process 18,000 units
Closing work-in-progress (40% complete) 4,000 units
Calculate equivalent production.
Solution
Particular Equivalent
production

Opening work-in- 1400

progress (70%
unfinished work x 2,000
units)

Add: No. of units

introduced and
completed during the
month:

Units put into process 20,000

Less: Units not 4,000 16,000

completed

Add: Closing stock- 1,600

work done [4.000 units
x 40%]

19,000
Equivalent production

The above calculation may be made by the following alternative method:

Units completed during the month 18,000
Add: Closing stock-work done [4.000 x 40%] 1,600
Less: Opening stock-work already done [2000 x 30%] 600
19,000
Equivalent production

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ACM 602 Cost Analysis and Control

Self check Question

1. In Process A 2000 units' were introduced during one month. The normal loss
was estimated @ 5% of input. At the end of the month 460 units were
incomplete. The stage of completion is as follows:
Material 75% Complete
Labour 50% Complete
Overhead 50% Complete
Calculate the Equivalent Production.

2. From the information given in question1 prepare statement of equivalent

production. However, the following changes may be taken into consideration.
Finished product 1,400 units
Work-in-progress 460 units
Normal loss 5%
There is a loss when the output is fully completed.

3. From the same information as in Question 1 prepare statement of equivalent

production assuming finished production 1500 units.

4. OH & Co. manufactures a product in the process costing is followed and work -
in - progress stocks at the end of each month are valued at FIFO basis. At the
beginning of the month of June, the inventory of work in progress showed 400
units, 40% complete. valued as follows:-
Rs.
Material 3600
Labour 3400
Overheads 1000

Total 8000

In the month of June materials were purchased for as. 75,000 Wages and
overheads in the month amounted to Rs. 79.800 and Rs. 21,280 respectively.
Actual issue of material to production was Rs. 68,500. Finished stock in stock in the
month was 2500 units. There was no loss in process.
At the end of the month the work in process inventory was 500 units,
60 per cent complete as to labour and overheads and 80 per cent
complete as to materials,
Prepare a Process Account for recording the month's transactions
and prepare- a process cost sheet showing total and unit costs.

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ACM 602 Cost Analysis and Control

5. From the following information prepare process account.

Opening stock Rs. Degree of completion

800 units @ Rs. 6 per unit 4,800
Material 60%
Labour 40%
Overheads 40%
Transfer from Process No. I 12,000 units costing Rs. 16,350
Transfer to next Process 9,700 units
Units scrapped 1,300 units
Normal loss 10%
Closing stock 1,800 units

Degree of completion
For units scrapped
Material 100%
Labour 50%
Overhead 50%
For closing stock
Material 60%
Labour 50%
Overhead .50%
Scrap realised Re. 1.00 per unit

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 ACM 602 Cost Analysis and Control

LESSON 9
COST CONTROL
The basic objective of accounting is to provide information which is useful for persons
inside the organisation(i.e. owners, management and employees) and for persons or
groups outside the organization (i.e. investors, creditors, government, consumers
etc.) According to Slavin and Reynolds Professors of Accounting, "Conceptually,
accounting is the discipline that provides information on which external and internal
users of the information may base decisions that result in the allocation of economic
resources in society." The needs of the majority of the users of accounting information
can be satisfied by financial accounting. Financial statements are concerned with the
past whereas management's main interest lies not in past but in future. It is mainly
concerned with planning and controlling. Preparation of various budgets, such as
sales budget, production budget, cash budget, capital expenditure budget etc. is an
important part of tailing and preparing various budgets is an important aspect of Cost
Accountancy. Controlling is the function of seeing that programmers laid down in
various budgets are being actually achieved actual performance is compared with the
budgeted performance, enabling the management to trcisecontrol in case of weak
performance.
Now-a-days managements are facing problems of survival because of acute
competition. Onlje organisations can meet the competition effectively and have a hold
on the market which area position to keep their cost minimum. Cost accounting can
be instrumental in this regard by titillating all inefficiencies and wastages by exercising
cost control. The Chartered Institute of Management Accountants, London defines
cost control as :"The regulation by executive action of the cost of operating an
undertaking particularly pre such action is guided by cost accounting." The
terms 'regulation' and 'executive action' indicate conscious attempt of
regulating the cost on the basis of predetermined leas about what cost should
be.” It is only when costs are predetermined i.e. a system of standard costing is in
operation, that cost control measures can give their best. Thus, cost control aims at
reducing inefficiencies and wastages and setting up predetermined costs and in
achieving . Cost control is exercised through setting standards or norms or targets

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and comparing actual performance therewith with a view to ascertaining deviations

from set targets or norms or standards and taking corrective action to ensure that
future performance conforms to the set standards or norms or targets.
Elements of a Cost Control Scheme
The following are the elements (i.e. major steps) of a cost control scheme :
• Set down a norm or standard or target.
• Select a yardstick for measuring the standard or target.
• Ascertain the actual performance by applying *.,"'. yardstick which was used for
measuring the standard or target.
• Compare the actual performance with the standard or target and compute the
variances.
• Analyse the variances by causes and fix responsibility for variances.
• Take corrective action to eliminate the causes of variances so that future
performance conforms to standards or targets laid down and cost may be controlled
to achieve the maximum efficiency.
• Periodically review the standards or targets and revise them in the light of changed
circumstances.
Cost Control Techniques
Among the techniques which have become popular for ensuring cost control are : (a)
Material Control, (b) Labour Control, (c) Overhead Control, id) Budgetary Control, (e)
Standard Costing, if) Control of Capital Expenditure, (g) Responsibility Accounting,
(h) Productivity and Accounting Ratios.
Essentials for Success of Cost Control
The following steps should be taken in an effective system of cost control:
1. For an effective system of cost control, the firm should have a definite plan of
organisation, Authority and responsibility of each executive should be clearly defined.
Targets for performance of work as well as the cost to be incurred for the purpose
should be laid down for each area of responsibility so that responsibility may be fixed
for the deviation of actual cost from the predetermined cost.
2. Costs should be collected for each area of responsibility. One of the recent
developments in the field of managerial accounting is the responsibility accounting
which is helpful in exercising cost control. It tries to control cost in terms of the

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persons responsible for their incurrence. It is a method of accounting in which costs

are identified with persons responsible for their control rather than with products or
functions. Reporting of efficiency or inefficiency displayed by each person should be
prompt. Information delayed is information denied. If a considerable time elapses
between happening of events and reporting, opportunity for taking appropriate action
may be lost or some wrong decisions may be taken by management in the absence
of information.
3. The report should draw management's attention to exceptionally good or bad
performance so that management by exception may be carried out effectively. The
aim should be to bring to light the factors leading to increase in cost rather than to
punish people to take the remedial action to improve the performance in future.
4. Good performance should be handsomely rewarded so that workers may be
motivated towards better performance.
5. For an effective system of cost control, there should be effective budgetary control
and there should be proper setting of standards Budgets and standards should be
fixed with realism. Cooperation of all persons who are to achieve the budgeted results
or standards should be secured in preparing budgets or setting up standards to get
their willing involvement in achieving the desired results.
COST REDUCTION
Introduction
Profit is the resultant of two varying factors viz. sales and cost. The wider the gap
between these two factors, the larger is the profit. Thus, profit can be maximized
either by increasing sales
befelt. Such conditions cannot, however, permanently exist. When competition
comes into play, it may not be possible to increase the sale price without its having
an adverse effect on the sale volume which, in turn, reduces profit. Besides increase
in price—which, in turn, reduces profit— increase in prices of products has the
ultimate effect of pushing up the raw-materials' prices, wages of employees and
other expenses, all of which tend to increase costs. In the long run, substitute
products may come up in the market, resulting in loss of business. Avenues have,
therefore, to be explored and methods devised to cut down expenditure and thereby
reduce the cost of products. In short, cost reduction should mean maximisation of

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profits by reducing costs through economies and savings in cost of manufacture,

administration, selling and distribution.

Meaning of Cost Reduction

Cost reduction is a planned positive approach to reduce expenditure. It is a
corrective function by continuous process of analysis of "ists, functions, etc. for
further economy in application of factors of production.
The Chartered Institute of Management Accountants, London defines cost reduction
asfollows :
"Cost reduction is to be understood as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without
impairing their suitability for the use intended or diminution in the quality of
the product."
The definition given above brings to light the following characteristics of cost
reduction:
• The reduction must be a real one in the course of manufacture or services
rendered. Real cost reduction comes through greater productivity. Greater
productivity may be through (1) obtaining a large quantity of production from the
same facilities; (2) using materials of lower price and of different quality without,
however, sacrificing the quality of the finished of manufacture without sacrificing the
quality of the finished product; (4) changing features ofthe product suitably without
sacrificing. The reduction should not be at the cost of essential characteristics, such
as quality of the products or services rendered.
Thus, cost reduction must be a genuine one and should aim at the elimination of
wasteful elements in methods of doing things. It should not be at the cost of quality.
Cost reduction is a continuous process of critically examining various elements of
cost and each aspect of the business (i.e. procedures, methods, products,
management including market and finance etc.) is critically examined with a view to
improving the efficiency for reducing costs. Every plan of cost reduction proceeds
with this assumption that there is always scope for cost reduction. A continuous
research is made into various areas for finding out the best possible methods of
performance for ensuring minimum possible costs.

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The reduction in costs should be real and permanent. Reduction due to wind falls,
changes in government policy like a reduction in taxes (or duties or due to
temporary) and measures taken for tiding over financial difficulties do not strictly
come under the purview of cost reduction. Broadly speaking reduction in cost per
unit of production may be effected in two ways:
1.By reducing expenditure but the volume of output remains constant.
2. By increasing production viz. increasing the out turn, but the level of expenditure
remains unchanged.
Cost Reduction Programme
Cost reduction aims an improvement of human efforts. In a business organisation
several persons are engaged in diverse activities. It may be a short-term or long-
term under special problems such as reduction in profit, specific inefficiencies in
certain spots (or fall in production). A special cost reduction programme is geared
into action to meet the situation and improve the expenditure. Briefly, a programme
of cost reduction consists of the following:
1. Numerous centres or points where costs are incurred are located and grouped
according to departmental responsibility.
2. Each such point or group or points is then submitted a value analysis scheme to
determine whether optimum efficiency has been achieved in its performance or
whether there is a norm for cost reductions.
3. Suitable techniques are, therefore, applied to reduce costs. No cost reduction
programme can be effective unless a joint effort is made by all the departments
concerned and the plan is linked with responsible management. Allocation of
responsibility of the various cost reduction levels of management is an important
requirement for control of cost reduction of the operation and spheres under his
control. The programme for cost reduction should be clearly defined and
responsibilities delegated. Thus, each executive should be aware of his role in the
over-all scheme of cost reduction and of the function he has to perform.
Essentials for Success of Cost Reduction Programme
1. A cost reduction programme must be appropriate to the organisation.
2. A cost reduction programme should not be taken as a one time activity. It is a
continuous activity aimed at reducing cost continuously by innovating new ideas

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from time to time. Cost reduction is a corrective function based on the philosophy
that every human action can be improved by continuous effort.
3. Cost reduction should not be done by arbitrary cost slashing. It should be real and
permanent reduction in cost.
4. To make cost reduction programme acceptable to the employees of the
organisation, the example of cost reduction should be first set by top executives.
The success of cost reduction programme depends upon the co-operation of all
persons involved in the programme.
5. Persons giving innovative ideas for cost reductions should be suitably rewarded
by giving raise in wages and salaries, promotion and special awards.
6. A cost reduction programme should not merely take into consideration reduction
in cost but it should also consider all other factors (i.e. social and legal aspects)
which will be affected by the programme of cost reduction.
7. A cost reduction programme should be evolved with the idea that even the most
efficient firms incur unnecessary costs, that is, there is always scope for cost
reduction in every firm.
8. There should not be any overlap between the cost reduction measures, that is,
there should not be double counting of cost reductions.
Distinction Between Cost Control and Cost Reduction
Cost control involves predetermination of targeted costs measuring the actual costs,
investigating into the causes of variations and instituting the corrective action,
whereas cost reduction is the achievement of real and permanent reduction in unit
cost of goods manufactured or services rendered without impairing their suitability or
diminution in the quality of product. Cost reduction in values saving in unit cost such
saving is of permanent nature and the utility of the goods and services remain
unaffected. Thus cost control and cost reduction are two efficient tools of
management but their concepts and procedures are widely different. The main
points of differences between the two are the following :
1. Aim. Cost control aims at achieving the predetermined costs, whereas cost
reduction aims at reduction of costs by finding new ways or methods to have
continuous economy on costs.
2. Exercise. Cost control is a routine exercise which is carried out for attainment of
operational efficiency whereas cost reduction aims at permanent and real savings by

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a continuous search for improvement. Thus, cost control follows a conservative

procedure and lacks a dynamic approach whereas cost reduction is dynamic and
innovative in nature.
3. Concerned with. The process of cost control is to lay down a target, ascertain
actual performance, compare it with the target and take corrective action. On the
other hand, cost reduction is not concerned with maintenance of performance
according to the predetermined standards.
improvements in predetermined standards.
5. Function. The aim of cost control is to see that actual costs do not exceed the
predetermined costs ; so it is a preventive function. On the other hand, cost
reduction is a corrective function because it challenges the predetermined costs and
seeks to improve the performance by reducing cost of increasing production. It is a
continuous function of self-analysis for making more and more improvement in
performance.
6. Applicability. Cost control is generally applicable to items of costs which have
standards where as cost reduction is applicable to every activity of the business.
7. Tools of Techniques. Budgetary Control and Standard Costing are important
tools of cost control whereas cost reduction makes use of techniques like value
engineering/value analysis, work study, operation research, simplification and
standardisation, ABC analysis, etc.
8. When Achieved. Cost control is achieved once the costs do not exceed the
standards whereas cost reduction is never ending. In fact cost reduction begins
when cost control ends.
9. Operation/Research Oriented. Cost control is operation oriented whereas cost
reduction is research oriented, always trying to reduced costs through planned
research.
Fields Covered by Cost Reduction
The critical area of application of cost reduction methods and the lines of approach
in paying out a cost reduction plan are as follows :
1. Product Design
Product design the first step in the manufacture of a product. The impact of any
economies on cost reduction effected at this stage will be felt throughout the
manufacturing of the product in all fieldsviz. production and sales etc. Design

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constitutes the most important field where cost reduction may be attempted.
Possibilities of cost reduction should be investigated both when introducing new
designs and when seeking improvements of the existing designs. It is worthwhile
putting in some more care and a little money at the initial stage than to incur losses
and wastage later when production is established. Efficient designing for a new
product and improving the design for an existing product reduce cost in the following
way:
(a) Material cost: Cheaper substitutes, higher yield, less quantity, variety of
materials so that storage cost and investment in inventory are reduced.
(b) Labour cost: Minimum tolerance, reduced time of operation etc.
(c) Standardisation and simplification in variety increases productivity and reduces
cost.
(d) Reduction in after-sales service costs.
2. Organisation
All efforts should be constantly made to reduce the costs by the adoption of new
methods of organisation and new production methods. It is not possible to measure
the cost reduction resulting from an improvement in the organisation. Nevertheless,
economies are bound to be achieved if the following considerations are looked into :
• Definition of each function and responsibility.
• Proper assignment of tasks and delegation of responsibility; overlaping will be
avoided.
• A suitable channel of communication between various management levels.
• Removal of doubts and points of friction.
• Encouragement of employees for cost reduction suggestion.
3. Factory Layout and Equipment
It will influence costs to a large extent. A cost reduction programme should study the
factory layout and the utilization of the exiting equipment to determine whether there
is any scope for cost reduction by elimination of wastage of men, materials, and
maximum utilization of the facilities available. The necessity for replacement of
plants, introduction of new techniques and expansion of facilities should be
considered and various alternatives explored with a view to reduction in cost.Any
concealed bottle-necks and difficulties standing in the way of maximum utilisation of
plants and other facilities should be probed into. For instance, there is no point in

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detaining skilled worker to manage number of semi-automatic machines, all at a

time. He is not able to be fully utilised on the machines, although, in the process, is
able to occupy himself fully. It should be rather the other way so that the machine
automatically be fully occupied.
4. Production Plan, Programme and Methods
Production control ensures proper planning of work by installing an efficient
procedure and programme of materials ordering, correct machine loading and
proper utilisation of material and manpower and resources so that there is no waste
of time and money due to waste of components, men, materials etc.
5. Administration
There is ample scope of cost reduction in this area because cost reduction is a top
management problem. Office should be reorganised if there is scope for
improvement in the efficiency of persons engaged in the office. Use of unnecessary
forms should be avoided to save the cost of stationery and
labour cost involved for compiling them. Efforts should be made to reduce the
expenses on telephone, lighting and travelling but not at the cost of efficiency. The
points to be examined in this area will be:
• The extent of use of job evaluation as a basis for reducing staff.
& Systematic supervision of the use of office machinery.

• Possibility of reduction offiles and filing space.

• Expenditure on printing, postage and telephone.

• Use of forms and stationery

6. Marketing
The various activities which can be brought under the cost reduction programme
include market research, advertisement, packing, warehouse, distribution, after-
sales service etc. Sales performance can be improved by making ABC analysis of
customers. Customers can be classified in three categories A, Band C. A category
customers means customers having about 10% of total
despatches but cover about 70% of sales value, B category customers means
customers having about 20% of total despatches but covering about 25% of sales
value and C category customers means customers having about 70% of total
despatches but covering about 5% of total sales value.

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in this way of categorisation of customers, sales efforts will be better focussed and
there will be reduction in marketing cost. The major points that need examination
with a view to cost reduction in this area are :
•Whether the channel of distribution is efficient and economical.

•Whether there is an effective system of sales promotion.

•Whether the market research is adequate.

•Whether there is any possibility of reduction in selling and distributing expenses

without impairing efficiency of sales division.

Personnel Management
The cost reduction programme should explore the following:
•Reduction in labour content of production by suitable work study techniques
and introduction of sound incentive schemes.
•Reduction in labour cost by improving labour relations, welfare measures
and better working conditions.

Material Control
•Effective and economical purchase of materials.
•Adherence to EOQ.
•Keeping low inventory-less investment in stock.
•Effective check on goods received.
•Control over material storage and issues.
•Effective check on materials yield.
1. Cost reduction increases profit. It provides a basis for more dividends to
the shareholders, more bonusto the staff and more retention of profit for
expansion of the business which will create more employment and overall
industrial prospects.
2. 'Cost reduction will provide more money for labour welfare schemes and thus
improve management relationship.
3. Cost reduction will help in making goods available to the consumers at
cheaper rates. This will create more demand for the products, economies
of large scale production, more employment through industrialisation and
all-round improvement in the standard of living.

4. Cost reduction will be helpful in meeting competition effectively.

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5. Higher profit will provide more revenue to the government by way of

taxation.
6. As a result of reduction in cost, export price may be lowered which may
increase total
exports.
7. Cost reduction is obtained by increasing productivity.Therefore, a developing
country, like India, which suffers from shortage of resources can develop
faster if it makes the best use of resources by increasing productivity.
8. Cost reduction lays emphasis on a continuous search for improvement which
will improve the image of the firm for long-term benefits.
According to G. Kantharaj, "In the particular context of a developing
economy, it becomespredominantly important to emphasize on Cost
Reduction in agriculture, industry, public administration, etc.Cost Reduction
cannot be ushered in by a magic wand. Cost reduction is everybody's
concern. The motto of every industry and every organisation should be to
produce more goods and to render efficient services. piralling up of prices
and inflationary trends seem to have reached a Point of No Return in the
country. The situation cannot be salvaged, unless every responsible
individual wages a war vehemently to curtail the wastages and delays in his
own jurisdiction."

Self-CheckQuestions

1. What is cost control? Which techniques used for cost control?

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UNIT – IV
COST ANALYSIS FOR SHORT TERM DECISION
Lesson – 10
MARGINAL COSTING
Objectives

After studying this lesson, you should be able to

• Understand the meaning, benefits and limitations of absorption

costing.
• Learn the concept of Marginal Costing
• Differentiate between absorption costing and marginal costing.

MARGINAL COSTING

Introduction

The term cost system refers to the technique and process of determining costs of a
product manufactured and service rendered. As has already been explained in
earlier Units different methods are applied in different organizations to determine the
costs depending upon the nature of the product, production method and business
conditions. Here comes uniform or output costing, job costing, process costing,
contract costing and operating costing. But whatever, the nature of the organization,
type of the product, method of costing adopted; there should be a technique from
cost control point of view which will reflect the relationship between cost, volume and
profit. Where absorption costing includes all costs, fixed and variable while
determining the cost of a product.Marginal costing basis on the principle that the
cost of the product increases only on account of variable cost after a certain stage.
This is so because fixed costs remain constant whatever is the level of production.
Under marginal costing technique, the fixed expenses are not allocated to cost units
but are charged against a ‘fund’ which is excess of the sales value over the total
variable costs.

Absorption Costing

This system of costing includes fixed expenses in cost and thus both fixed and
variable expenses form a part of the total cost of production. This is a conventional
method and is also known as Total Costing, Full Costing. Conventional costing,
Orthodox Costing, Product Costing or Traditional Costing. Here all the costs i.e both
fixed and variable are allocated to cost units and total overheads are absorbed
according to activity level. This term can be applied (a) only when production costs
are considered. Here all the costs i.e. fixed and variable are changed to various

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operations, processes or products including work in progress and finished

production. This is usually practiced method and is termed ‘Cost Plus’ costing
wherein a fixed percentage is added to the total cost of the product to arrive at the
selling price.

Advantages of Absorption Costing

Following are the benefits of absorption costing.

a. Here the costs are matched with revenues during an accounting period.
b. Stock valuation complies with accounting standards by covering up even fixed
costs.
c. The analysis of production overheads reflects the proper utilization of
production resources.
d. This avoids segregation of costs into fixed and variable which certain times is
difficult regarding certain items like depreciation.
e. Cost plus pricing ensures coverage of all costs

Limitations of Absorption Costing.

However, absorption costing has the following limitations.

a. Under absorption costing utility of cost data as controlling device is limited as

costs of all types are included, in changes in volume which definitely results in
reduced costs is not reflected in any way.
b. Here fixed costs are not charged in the year they are incurred.
c. A proper cost - volume – Profit relation can not be properly arrived at. If sales
increase the impact of cost on each unit can not be correctly arrived at.
d. Behavioral pattern of costs is not given any importance.
e. The nature of overhead included in costs reduces the accuracy in determining
the selling price.
f. Since fixed costs are included values of inventories both closing and opening
may not show an accurate value thereby the profits.
g. Only production costs are given greater importance but not administrative and
selling and distribution costs.
h. This does not indicate decision oriented costs. Inter product profitability
depends upon the share of allocation of fixed costs on products. Material
decision as to dropping a product, changing a product line can not be arrived.
i. Opportunity costs are not considered.
j. Budgeting control and standard costing becomes difficult to adopt.

The above limitations advocated a more important device of costing technique i.e.
marginal costing.

Marginal Costing

Unlike various methods of costing like uniform, job, process or contract, this is a
technique which can be used in conjunction with any of the methods which will help
in managerial decision making. Here cost ascertainment is made on the basis of

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nature of cost or behavior of the cost and its effect upon the profitability of an
undertaking.

Marginal costing may be defined the ascertainment of marginal cost and the effect
on profit of changes in volume or type of output by differentiation between fixed
costs and variable costs. Marginal cost is defined as “the amount at any given
volume of output by which aggregate costs are changed if the volume of out put is
increased by one unit” thus it can be measured by total variable cost attributable to
one unit. It is the sum of prime cost and variable overhead and relates to a unit
which may be a single article, process, batch, an order, a stage, etc.

Advantages of Marginal Costing

Following are the advantages of Marginal Costing.

a. It is an easy cost controlling exercise.

b. The Marginal cost per unit is constant where as fixed cost as a whole is
constant. Thus pricing decisions can be taken easily by management based on
variable cost. But if fixed cost is included, decision on price fixation becomes
difficult.
c. Under Marginal Costing overheads are recovered as a predetermined
percentage which may be either over absorption or under absorption. Since
fixed costs are not considered under/over absorption of fixed costs can be
avoided.
d. Under Marginal Costing stock is valued based on variable cost, thus shows a
true value thereby profits so arrived also are more realistic.
e. This helps in arriving the break even-analysis which shows the effect of
increasing or decreasing production activity on the profitability of the company.
f. Marginal Costing enables taking number of strategic decision like volume of
production, make or buy introduction or dropping a product line, etc.
g. Segregation of expenses into fixed and variable enables to exercise control over
variable expenses thereby enabling reduction of cost.
h. Here stocks are valued at variable cost and there is no sales volume and
contribution is much easier to explain and to understand.
i. Profit volume analysis is facilitated by the use of break-even charts and profit
volume graphs.
j. The analysis of contribution per key factor or limiting resource is a useful and in
budgeting and production planning.
k. Pricing decisions can be based on the contribution levels of individual products.
l. Responsibility accounting is more effective when based on marginal costing
because managers can identify their responsibilities more clearly when fixed
over head is not charged arbitrarily to their departments or divisions.

Limitations of Marginal Costing

Marginal costing is not a technique without limitations. Following are the drawbacks
which are faced by it.

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a. Classification of costs into fixed and variable is not an easy task as certain
expenses are neither fixed nor variable like depreciation.
b. Contribution is to be linked with certain key factor to provide guidance.
c. Certain situations like in depression when prices are set to under cut
competitions may not leave a reasonable contribution margin.
d. The fundamental assumption that variable cost per unit is constant may not hold
good for higher level of activity.
e. In the long run no cost is fixed.
f. Exclusion of fixed overheads from costs may lead to erroneous conclusions. It
may create problems in inter firm comparison, higher demand for salaries and
perks by employees and higher tax by Government.
g. It is not recognized by income tax authorities.
h. Exclusion of fixed over head from stock valuation is not accepted by accounting
practices.

Marginal Costing Vs Absorption Costing

The profit reflected through Marginal Costing are different when compared to those
arrived through Absorption Costing for the following reasons.

The profit remains constant under both the methods when sales and production
levels are constant for any period of time. When production, costs and prices
remain constant and sales fluctuate, the profit as per marginal costing method will
be greater than absorption costing methods. Where sales are constant but
production fluctuates, marginal costing provides for constant profit but profits
fluctuate as per absorption costing.

When production exceeds sales, profits are higher under absorption costing than
marginal costing and vice versa. This is because as fixed costs are treated aa part
of total cost, the value of closing stock is higher which reduces the cost of production
thereby increasing the profits.

A decision as to profitability of the product / department is taken in marginal costing

through the contribution from each of them whereas under absorption costing it is
made depending on the absolute profit figures.

The choice between marginal costing and absorption costing is made depending on
the following factors.

a. System of financial control. For example where Responsibility Accounting

operates absorption costing has no relevance.
b. Where all products have similar attention marginal costing can be preferred and
vice versa.
c. The impact of fixed overhead in cost of the product.
Following illustration brings a demarcation as to the profits arrived.

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Illustration:

A company has a production company of 200,000 units per year. Normal capacity
utilization is reckoned at 90% standard variable production costs are Rs.11/- per
unit. Fixed costs are Rs.360000 per year. Variable selling costs are Rs.3 per unit
and fixed selling costs are Rs.270000 per year. Unit selling price is Rs.20/- when
the production was 160000 units and sales 150000 units. Closing inventing was
20000 units. Actual variable production costs are Rs.35000 higher than the
standard. Compute the Profit under (a) Absorption costing (b) Marginal costing.

Solution:

Statement of the Profit for the year ending___________

(Under absorption costing.)

Amount Rs.
Sales 150000 units @ Rs.20 per unit 30,00,000
Less:
Cost of production:-
(Variable production cost (160000 @ 111/-) 17,60,000
Increase in costs 35,000
Fixed costs 3,60,000
------------
21,55,000
Add:
Opening Stock 10000 units @ Rs.13/-
(Sales + Closing Stock – Production)
(150000 + 20000 – 160000) 1,30,000
------------
22,85,000

Less:
Closing Stock (20000) at current cost =
21,55,000
------------- X 20,000 = 2,69,375
1,60,000 -------------
20,13,625 20,13,625
-------------
9,84,375
Less:
Selling Expenses variable 4,50,000
Fixed 2,70,000
-----------
7,20,000 7,20,000
Net Profit 2,64,375

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b) Statement of Profit for the year ended ___________

Under Marginal Costing

Amount Rs.
Sales 30,00,000
Less:
Marginal Cost :-
Variable Production Cost 17,60,000
Additional Cost 35,000
Variable cost of opening stock 10000 @ Rs.11/- 1,10,000
-------------
19,05,000
Less:-
Closing Stock 17,95,000
20000 X -------------- = 2,24,375
1,60,000 -------------
16,80,625
Add:
Variable Selling Cost 1,50,000
@ Rs.3/- Contribution 4,50,000

Less:
Fixed Cost:
Production Cost 3,60,000
Selling Cost 2,70,000
------------
6,30,000 6,30,000

Net Profit 2,39,375

Note:- Difference in profit is due to element of fixed cost included in valuation of

opening and closing stock under absorption costing method.

Break-even Analysis:

Break-even analysis which emerges from Marginal Costing gives an idea about the
impact of changing levels of production on profit. Several factors like level of
competition, introduction of a new product, trade cycles, scare resources, change in
the setting product, etc., may necessitate change in the level of production. This
should give a clear idea to management as to such level giving desired profit. One
of the technique used here is marginal costing. Break-even analysis in the narrow
sense mean determining the break-even point i.e. determine the level production
where the total cost is equal to total revenue where costs are just covered up. In the
broader sense, it means the system of analysis which determine the probable profit
at any level of production, thus establishing the relation between cost-volume and
profit.

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This can be done (i) Mathematically (ii) Graphically. Four important concepts have
are;
a. Contribution
b. Profit volume Ratio or P/v Ratio or Contribution/Sales.
c. Break-even Point
d. Margin of Safety.

Mathematical Method:

(a) Contribution: - This is the difference between sales and marginal cost and
this contributes to make up fixed cost leaving the balance as profit.

Contribution = Selling Price – Marginal Cost or Fixed Expenses + Profit

Or
Profit = Contribution – Fixed Expenses

(b) Profit-volume Ratio :

Or

Thus if selling price is Rs.25 Marginal cost is Rs.10

then P/VRatio =

Higher profit volume more profit as same amount of fixed expenses are covered up
from any contribution

To improve profit volume ratio it can be done by

(a) Increasing the selling price per unit
(b) Reduce the variable expenses
(c) Switching the production to more profitable products showing higher profit
volume ratio.
Following equations can be arrived at from Profit Volume Ratio

Fixed cost FxS

(i) Break-even Point = -------------- or -------
P/v Ratio S–V

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(ii) Value of sales to earn a desired amount of profit =

Fixed cost + Desired Profit

------------------------------------
P/v Ratio

(iii) Variable cost = Sales (I – P/v Ratio)

(iv) Profit = Sales x P/v Ratio – Fixed cost.

(v) Fixed cost = Sales x P/v Ratio - Profit

Profit
(vi) Margin of safety = ------------
P/v Ratio
Illustration (1):

Calculate Profit Volume Ratio from the following information.

(i) Given – Selling price per unit Rs.20/- , Variable cost Rs.12/-
(ii) Given – Profits and sales for two periods as under:

Sales Profit
1st Year 3,00,000 40,000
2nd Year 3,40,000 50,000
C
(i) Profit volume Ratio = ---- x 100
S
S–V 20 -12 8
Or ------- x 100 = --------- x 100 = ---- x 100 = 40%
S 20 20

(ii) Change in profits

----------------------- = Profit volume ratio
Change in sales

10,000
--------- x 100 = 25%
40,000

Illustration (2)

From the following particulars (i) Contribution (ii) P/v Ration (iii) Break-even Point in
units and Rupees (iv) Selling price per unit when break-even point is 25000 units.

Fixed Expenses 1,50,000

Variable cost per unit 10

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Selling price per unit 15

Solution:

(i) Contribution = Selling Price per unit – Variable Expenses per unit

15 – 10 = 5
Contribution
(ii) Profit volume Ratio = ----------------- x 100
Sales
5
(ii) Profit volume Ratio = ----- x 100 = 33 1/3 %
15

(iii) Break-even Point (in units)

Fixed Expenses 150000

---------------------------- = ---------- = 30000 units
Contribution per unit 5

Break-even sales = 30000 x 15 = 4,50,000

Fixed Expenses 150000

Or --------------------- = ----------- =
P/v Ratio 33 1/3%

150000 x 3 x 100
---------- = 4,50,000
100

(iv) Revised Break-even Point i.e. 25000

Fixed Expenses 150000

Contribution per unit = ----------------------- = ---------- = 6
Break even point 25000
S–V=C

S = C + V = 6 + 10 = Rs.16

Marginal cost equation can also be used to ascertain the output or sales volume to
get a desired amount of profit by using the following formula.

Fixed Expenses + Desired Profit F+P

Desired output = ------------------------------------------------- or ------------
Selling price – Marginal cost per unit P/v Ratio

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Illustration (3):

From the following figures calculate (i) P/v Ratio (ii) Break-even point (iii) Sales to
earn a profit of Rs.2,40,000.

Sales Rs.12,00,000, Variable costs Rs.7,50,000, Fixed cost Rs.3,60,000

Solution:
Contribution 12,00,000 – 7,50,000
(i) Profit volume Ratio = ---------------- x 100 = ---------------------------- x 100=
Sales 12,00,000
Fixed cost
(ii) Break-even point = --------------- =
P/v Ratio
3,60,000 3,60,000 x 200
------------ = -------------------- = 9,60,000
37.5% 75
(iii) Sales to earn a profit of Rs.2,40,000

Fixed cost + Desired Profit

Sales = ------------------------------------
Profit volume Ratio
2,40,000 + 3,60,000
= -------------------------- = Rs.16,00,000
37.5%
(d) Margin of Safety:

Margin of safety is the difference between actual sales and sales at break-even
sales. The assumption of marginal costing is that output will coincide with sales, so
margin of safety is also the excess production over the break-even point’s output.
After break-even, the volume of profit assures safety. Higher the margin of safety
greater the safety levels when can be achieved by increasing the level of production
increasing the selling price, reduction of costs and substituting the less profitable
product with more profitable product.
Profit
Margin of Safety = Actual sales – Break-even sales or ------------
P/v Ratio
Illustration:

The Profit volume Ratio of a company is 50% and margin of safety is 40%. You are
requested to workout the break-even point and the net profit of the sale volume is
Rs.50 lakhs.

Solution:

Sales 5,00,000
Less:
Margin of safety 40% 5,00,000 x 40 / 100 = 20,00,000 20,00,000
30,00,000

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Break-even sales
Profit volume Ratio 50%
Contribution or Fixed Expenses at Break-even point
50
i.e. ------ x 30,00,000 = 15,00,000
100
Calculation of net profit at sales of Rs. 50,00,000
Sales x Profit volume Ratio = 50,00,000 x 50
-------------------- = 25,00,000 25,00,000
100

Less:
Fixed Expenses 15,00,000
Profit 10,00,000

(B)Graphical Method:

Break even Chart:

A break-even chart is a graphical representation of marginal costing. This shows

the inter relationship between profit, volume and cost. It shows the break-even point
and also indicates the estimated profit or loss at different levels of activity.

BREAK-EVEN AND PROFIT-VOLUME CHARTS

Break-even Charts

The relevant data for the costs, volume and profit may be plotted o9n a graph to find
out the break-even point. The graphic approach to CVP analysis is based on
reporting total sales revenue and total expenses as a function of sales volume. Unit
sales volume is plotted on the horizontal ‘X’ axis while sales revenue and fixed and
variable costs on the vertical ‘Y’ axis. The graph so resulting is called profit graph or
CVP graph. It is also called as break-even chart because from such a graph, the
break even point could be easily located. It is the point where the total sales line
and total cost line intersect. At any volume, the profit and loss is represented by the
difference between the total sales line and total cost line. The break-even chart
gives a visual picture of the importance of volume cost profit factors, and is a useful
tool in presenting this relationship to management.

The following are the steps to be followed while constructing a break-even chart:

a) Take the output or level of production on the X axis

b) Take the cost and revenues on the Y axis
c) Plot the total fixed costs on the Y axis and draw a parallel line to the X axis up
to the total out put level.
d) Plot the point of total costs (fixed + variable) for the full output and join this
point by a line to the fixed cost point on the Y axis.

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e) Plot the point of the total sales revenue for the output and join this point by a
line to zero, the junction of the axis.
f) We find that the total cost line and the sales line both intersect at a particular
point. This intersecting point is called as the break-even point.
g) Drop perpendiculars on to both the axes. The point on the X axis represents
the output or level of production at which the organization will break even.
The point on the Y axis represents the break-even point in value.

Angle of Incidence
This is the angle formed at the break-even point at which the sales line cuts the total
cost line. This angle of incidence is an indication that profits are being made. Large
angle of incidence is an indication that profits are being made at a higher rate. On
the other hand, a small angle indicates a low rate of profit and suggests that variable
costs form the major part of cost of production. A large angle of incidence with a
higher margin of safety indicates the most favorite position of a business and even
the existence of monopoly conditions. `

Graphical Method:
A. Break-even Chart:

Sales
Cost and
Sales (Rs.)
BEP Totalcost
Angle of
Incidence

Fixed Cost

X
O

Volume of output

Profit Volume Graph

This is yet another graphical approach to cost-volume-profit analysis. It is also
called as the profit chart. It focuses mainly on the relationship between volume and
profit. It draws direct attention on how profit change in response to changes in the
operating volume. Many accountants find this profit-volume graph more useful that
the break-even chart because it shows the amount of profit directly rather than as
the difference between the revenue and cost curves. It provides a quick, condensed

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comparison of how alternatives on pricing, variable costs or fixed costs may affect
not income as volume changes.
The profit-volume chart is constructed on a graph in which the vertical axis
represents net income in rupees. The Y axis is extended below the origin in order to
show both the net profit and the net loss. The X axis represents volume. The profit
line is straight when both revenue and cost curves are linear and any two points can
be used to plot it. The most commonly used points are (a) the zero production, and
(b) the break-even point. At an output of zero, the loss will be the amount of fixed
costs. The profit line slopes upward to the right and crosses the X axis at the break-
even point. When the profit line crosses the X axis, the cumulative contribution
margin is enough to cover fixed costs. Operations above the point provide an
income to the firm. In this profit-volume graph, separate fixed and variable cost lines
are eliminated, and only the profit sale lines are plotted.
The following are the steps to be followed while constructing a profit-volume graph.

a. Plot the sales values on the X axis.

b. Plot the costs and revenues on the Y axis to show both the profits and the
losses.
c. Plot the point of fixed costs on the Y axis on the loss side. This will be marked
on the Y axis itself, because at nil output the cost incurred is the fixed costs.
d. Plot the point of sales revenue at the total output. This will come in the positive
quadrant.
e. Join the two points plotted, i.e., the fixed cost point and the sales revenue point
by a straight line. As shown in the following graph, the fixed cost incurred at
zero output is Rs.38 (being plotted on the loss side) and the sales revenue
earned for 300 units of sales is Rs.80 (being plotted in the profit area quadrant).

Profit-Volume Graph:

Y
Profit / Loss Line
80
Profits 60
40
20
0 X
20 50 100 150 200 250 300 Sales / Output
40
Losses 60
80
Summary
There are number of methods of costing that are adopted depending on the nature
of the product, service, organization like uniform costing, job costing, process
costing, operating costing and contract costing. But from the cost control point of
view the techniques of costing are marginal costing, budgeting control, standard

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costing, etc., Absorption costing includes all the costs, fixed and variable while
ascertaining the cost of the product, Marginal costing is based on the principle that
the variable cost alone will increase the cost of the product after certain stage as
fixed cost is constant for any volume of output. Fixed cost under Marginal costing is
set off against a fund called contribution which is the difference between sales and
variable cost. Absorption costing is cost plus pricing covering all the costs but it
cannot be used as a control device and value of inventing is inflated as fixed costs
are included. In Marginal costing, costs are segregated thus giving way to cost
control techniques. However, a choice between the two can be made depending on
the system of financial control. Profit under both the systems proves to differ due to
change in the value of stocks. Under Marginal costing, the normal equation is S – V
= F + P and this is also called contribution. At the point of break-even S – V = C
which is just sufficient to cover up fixed costs. A relates between profit, volume and
sales is being brought out by P/v Ratio which is equal to contributes/sales. Margin
of safety is the area after the break-even i.e. the difference between actual sales
and break-even sales. A break even analysis is prepared to find out the impact and
incidence of various items and can be arrived either mathematically or graphically.
As a cost controlling device Marginal costing enables management to bring out a
relationship between Profit, volume, sales keeping in view of the changing variable
costs and constant fixed costs.
Self Check Questions
A. State whether the following statements are True or False.
i). Absorption costing includes both fixed and variable costs ( )
ii) Variable cost per unit of output is constant ( )
iii) Fixed costs vary with volume of production ( )
iv) Contribution at break-even point is equal to variable cost ( )
v) Margin of safety is the difference between actual sales and
break-even sales ( )
B. Answer the following in Ten lines.
i) What is Marginal costing?
ii) What are the limitations of absorption costing ?
iii) What is P/v ratio ? What way it is useful ?
iv) Explain (a) margin of safety (b) angle of incidence (c) contribution.
v) What is break-even point?
C. Answer the following
(i) Compare and contrast Absorption costing and Marginal costing.
(II) From the following details determine
(a) P/v Ratio
(b) Break-even point
(c) Margin of safety
(d) Sales to get a profit of Rs.50,000
Sales Rs.1,50,000
Variable cost Rs.1,00,000
Fixed cost Rs. 25,000
(Ans. (1) P/v Ration 33 1/3% (2) BEP – 75,000 (3) MOS 75,000
(a) Sales 2,25,000
(iii) Explain the above data with the help of a Break-even chart.
(iv) ‘Marginal costing is an effective device for cost control’ Explain.

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Lesson – 11
MARGINAL COSTING – A TOOL FOR DECISION MAKING

Structure
2.1 Introduction
2.2 Marginal Costing for Decision Making
2.2.1 Best Level of action
2.2.2 Dropping a product line
2.2.3 Selection of an optimum product mix
2.2.4 Make or Buy Decision
2.2.5 Achieving a Profit Target
2.2.6 Introducing a new Product line
2.2.7 Key or Limiting Factors
2.2.8 Accept or Reject
2.2.9 Suspension of Activities
2.3 Summary
2.4 Self Check Questions

2.0 Objectives

After studying this lesson, you should be able to

• Understand the utility of marginal costing in decision making.

• Use of marginal costing in determining issues like make or buy,
determining the selling price, dropping a product line, alternative choices,
etc.

2.1 Introduction

The technique of Marginal Costing is an effective tool for managerial decision

making. It is the process of choosing among alternative courses of action. It
is the exercise for the future and consists in selecting the optional alternative
from among existing choices. As revising and fixed costs have not much to
brought a change in the short run, it is only the variable costs which have to
be considered in making produce/price choices. The following relevant costs
are to be considered for decision making.

(a) Future costs

(b) Differential costs

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Marginal costing with the techniques of breakeven analysis/Profit Volume

analysis assist in making number of decisions in the present competition
world to reduce costs and increase the profits.

2.2 Marginal Costing for decision making.

Marginal costing helps in many situations in deciding in a crucial situation.

Following are some of the key areas where marginal costing is used for
strategic decision.

2.2.1 Best Level of activity

The level of activity which yields the maximum amount of profit is one of the
important areas of decision making. Marginal Costing helps in choosing such
level of activity where it is optimum as determined by the marginal cost which
is equal to marginal revenue.

Illustration (1)

The following details relate to a Manufacturer who sells his product at Rs.80/-
per unit. Following details relate to production budget.

Budget (Units) 75,000 85,000 1,00,000

Operating Costs 6,00,000 7,20,000 8,20,000
Advertising and Sales 2,20,000 2,50,000 3,20,000
Promotion

Fixed Factory overheads 10,00,000

Fixed Selling overheads 4,00,000
Direct Material (Units) 30
Direct Labour 10

A rebate of 10% and 15% is offered for purchase contracts of 85,000 units
and 1,00,000 units respectively.

Also a price discount of 5% and 10% need to be offered for the purchase
contract of 85,000 units and 1,00,000 units respectively.

Prepare a statement showing the profitability at various levels of output and

indicate the best level of production.
Statement of Profitability at various levels.

Levels of Output
75,000 Units 85,000 Units 1,00,000 Units
Sales 60,00,000 64,60,000 72,00,000
Less:
Marginal Costs
Material 22,50,000 22,95,000 25,50,000

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ACM 602 Cost Analysis and Control

Labour 7,50,000 8,50,000 10,00,000

Other operating Costs 6,00,000 7,20,000 8,20,000
Advertising 2,20,000 2,50,000 3,20,000

Contribution 21,80,000 23,45,000 25,10,000

Fixed overheads 14,00,000 14,00,000 14,00,000

Profit 7,80,000 9,45,000 11,10,000

Contribution % 36,33% 36.33% 34.86%

Comment:- Though apparently profit is more at 1,00,000 level of production,

contribution percentage is more for the earlier two levels. Of that the second
level i.e., 85,000 units can be opted as it has a higher contribution and also
greater amount of profit promising more employment opportunities.
2.2.2 Dropping a Product Line:

Key and Limiting Factor

When more than one product is being produced and sold, all do not yield, the
same level of profitability. A firm has to choose those products with best
contribution. This may mean some of the products which are Less profitable
or loss yielding should be dropped. But this may mean the diversion of
capacities/resources of the dropped product towards those products which
are more profitable and which are going to be continued. If there is any key
factor like material or labour contribution in terms of the key factor should be
the criterion.

Some of the principles which should be considered before dropping a product

line are that product yielding any contribution should not be dropped and if
there is a key factor, least contribution in terms of key factor should be
dropped.

Illustration

A firm produces 3 products A, B, C for which material is in short supply,

following is the cost data.

Product Selling Price Marginal Cost Material required

product
A 125 100 4 Kg
B 140 125 8 Kg
C 160 140 10 Kg

Which product should be continued.

Statement of Managerial Cost.

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A B C
Sales per unit 125 140 160
Less:
Marginal Cost 100 125 140
----- ----- -----
25 15 20
Contribution per Kg 25 15 20
of metal ----- ----- ----
4 8 10
`= 6.25 1.87 2

Suggestion:- Product B with least contribution both in general or from the part
of key factor should be dropped. If these resources are diverted towards A
better performance of the unit is ensured.

2.2.3 Selection of an optimum Product Mix

When a factory produces more than one product a decision has to be made
as to the composition of each product produced. This depends on the profits
produced with each product mix and the one which yields the maximum profit
can be chooses as a suitable mix. The one with maximum contribution and
increased . Profit Volume Ratio is preferred to be the best.
Illustration:
A company produces two products A and B whose cost information is as
follows:

Product A Product B
Rs Rs
Direct Material (P/v) 10 9
Direct wages 3 2
Sales Price (P/v) 20 15
Fixed Expenses 800
Variable Expenses @ 100% on wages
Sales mixtures
(i) 100 units of A and 200 units of B
(ii) 150 units of A and 150 units of B
(iii) 200 units of A and 100 units of B

Recommend the best / suitable product mix.

(i) Statement of Marginal cost

Product A per Product B per

unit unit
Rs Rs
Selling price 20 15
Less:-
Variable cost
Direct Material 10 9

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Direct Wages 3 2
Variable Overheads 3 16 2 13
----- ----
Contribution 4 4

Mix C should be adopted as it yields the maximum profit.

2.2.3 Make or Buy Decision.

Another crucial area of decision making for management is whether to

produce the product in its factory or buy it from the market at an intermediary
state and process it. The choice here depends upon the idle capacity existing
in the organization and the availability of such product in the market apart
from financial implications. While taking such make or buy decision emphasis
has to be laid on, the price demanded by the supplier as against the marginal
cost of producing the component parts. If the marginal cost is lower than
price demanded by outside supplier, the product can be manufactured or vice
versa. Fixed costs are not taken as cost of manufacturing as it is presumed
that it is already incurred for other products. For example if the variable cost
of the product is Rs.15/- and fixed cost is Rs.20/- and if the product is
available in the market as Rs.18/- apparently it may look profitable to buy it
but by adopting the technique of marginal costing making of it looks more
profitable. If the product is available at a price less than Rs.15/- it could be
bought in the market provided.
(i) The quality of the product is satisfactory.
(ii) There is no interruption in the supply of the product.
(iii) Facility for wide selection in market.

Illustration:

Following are the cost details of a component manufactured by a company

which manufactures 10000 units
Direct Material Cost Rs. 4,00,000
Direct Labour Cost Rs. 3,00,000
Variable Cost Rs. 1,00,000
Fixed Cost Rs. 1,00,000

The purchase price is Rs. 25/- per unit and there will be cost reduction of Rs.
20,000 of the product is bought from outside in fixed costs.
The factory can be leased out for Rs. 75,000
Solution:
Analysis of Cost
To make To buy @ To buy @
Rs. Rs.25/- per Rs.25/- each
unit and leased out
Variable Cost 8,00,000
Cost of buying from outside 25,00,000 25,00,000
Saving in fixed cost 1,00,000 (20,000) (20,000)

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Rent received
- 75,000

9,00,000 24,80,000 24,05,000

It is profitable to make the component than buying it or leasing out the

capacity.

2.2.5 Achieving a Profit Target

Profit planning is one of the key areas for managerial decision making.
Marginal Costing equation here plays a vital role as profits depend on various
elements which determine this equation i.e. S – V = f + p. Thus the factors
that determine profits are sales, variable cost, fixed cost and sales mix if more
than one product is produced.
Illustration:
A firm had a profit goal of 10% on its investment of Rs.15,00,000. The fixed
costs are Rs.4,00,000, Variable cost per unit is Rs.15/-. The firm produces
50,000 units at Rs.25/- each and earns a profit of Rs. 1,00,000. How can
management achieve the profit target by varying different variables like fixed
cost, variable cost, selling price or number of units sold
Solution:
Target Profit = 15,00,000 x 10
------------------ = 1,50,000
100
(a) Change in fixed costs S – V = F + P
50,000 x 25 – 50,000 x 15 = F + 1,50,000
12,50,000 – 7,50,000 – 1,50,000 = F = 3,50,000

Thus fixed costs which are originally 4,00,000 have to be reduced by

Rs.50,000 i.e. 12.5%
(b) Change in variable costs
S–V=F+P
50,000 x 25 – 50,000 x X = 4,00,000 + 1,50,000
12,50,000 – 50,000 X = 55,000 X
12,50,000 – 6,50,000 = 50,000 X
7,00,000 = 50,000 X
X = 7,00,000
----------- = 14
50,000
Variable cost to be reduced by Re.1/-

(c) Change in Selling Price

50,000 x X – 50,000 x 15 = 4,00,000 + 1,50,000
50,000 X – 75,000 = 5,50,000
50,000 X = 5,50,000 + 75,000
X = 13,00,000
------------- = 26/-
50,000

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Selling price has to be raise by Re.1/- to achieve the desired level of profit.

(d) Change in the Volume of Sales

S–V=F+P
X c 25 – X x 15 = 4,00,000 + 1,50,000
25X – 15X = 5,50,000
10X = 5,50,000
X = 55,000 units
The number of units produced and sold should be increased to 5000 units.
2.2.6 Introducing New Product Line

This may mean introducing the product line in addition to the existing line of
products and here decision may also involve issues like deciding the Model,
Share or type of the product. The Marginal Cost of new product and also the
likely increase in fixed cost should be kept in view while deciding such
introduction of new product line. Primarily C/S and also net profit of new
product should be ascertained. Also ROI on new product can be compared
with the old product.
Illustration:
A company produces 20,000 units as against the installed capacity of 30,000
units. The present cost structure is as follows:

Variable costs Rs.3,20,000

Fixed costs Rs.1,50,000

Fixed costs include Rs.40,000 for depreciation. Product X is sold for Rs.30/-
per unit. It is proposed to produce product Y along with X. The installed
capacity of product Y will be Rs.15,000 units. An additional investment of
Rs.2,50,000 is required over and above existing Rs.5,00,000. A total of
10,000 units of Y will be produced and sold which is sold @ Rs.20/- per unit.
Fixed overheads of Rs.15,000 and 10% depreciation need to be provided,
Rs.50,000 required for additional capital. Cost estimates for Y are Rs.14/- per
unit. Is it advisable to produce Y.
Solution
Statement of Profitability of each product.
Existing Product X New Product Y Total
Rs. Rs Rs.
Sales 6,00,000 2,00,000 8,00,000
Less: Material Cost 3,20,000 1,40,000 4,60,000
Contribution 2,80,000 60,000 3,40,000
Less: Fixed overheads 1,50,000 35,000 1,85,000
(including depreciation)
1,30,000 25,000 1,55,000
Contribution % 46.7% 30% 42.5%
Net Profit % 26% 10% 20%

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Recommendation:- Contribution is more in case of product X. The unutilized

Company should be utilized to produce more units of X than for gain towards
Y.

2.2.7 Key or Limiting Factor.

When resources like raw material, labour, machine capacity or working

capital are scarce contribution should be ascertained from the point of
requirement / usage of such scare resource, and thus a decision has to be
taken based on it. If it is sales, however enough goods should be produced
to meet the total demand which can give positive contribution to cover up the
fixed costs and then to yield certain profits.

2.2.8 Accept or Reject

Frequently, the management is offered a special order for one of its products
or an export order when the firm has surplus capacity, when there is an
export order, a decision has to be taken after analyzing the effect of the
incremental costs and incremental revenue on the overall profits of the
business while taking a decision as to accept or reject, the contribution made
is the criteria.
Illustration:
A company produces 1000 units of a product which is sold in the
market at Rs.20/- per unit. It’s installed capacity is 1500 units. It received an
export order for 500 units which can be sold at Rs.15/- per unit. It’s cost
information is as follows;

Material Rs.5/-
LabourRs. Rs.2-50
Variable Costs Rs.3/-
Fixed Expenses Rs.8,000

Write a short report as to the advisability of accepting or rejecting the order.

Solution:
Statement of Marginal Cost and Profitability

Existing position Position after accepting of export

Rs order or Rs
Sales 20,000 20,000+7,500 = 27,500
Les:-
Variable
Expenses
Material 5,000 7,500
Labour 2,500 3,750
Variable costs 3,000 4,500
Contribution 10,500 15,750 15,750
Less: Fixed Costs 8,000 8,000

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Profit 2,500 3,750

It is advisable to accept the order as it increasing the profit to an extent of

60% i.e. an absolute amount of Rs.1,250. Apart from it, it enables the unit to
work at full capacity. Thus providing more employment opportunities and also
a market status with its export order.

2.2.9 Suspension of Activities.

It is quite possible for a business concern to close down the activities of

production and selling due to trade depression / recession or on account of
cut throat competition. This suspension of activities may be either temporary
or permanent.

(a) Temporary closure

When trading activity particularly plant operation is suspended for a short

period, it is known as temporary closure. This may be due to changes in
economy or seasonal changes, the period directly related to the span of
such period. The trading activity here should not be suspended as long
as there is some contribution. Here fixed costs are to be analyzed as
avoidable or escapable fixed costs and unavoidable fixed costs or un-
escapable fixed costs. Again, if the plan is shut down to restart it again
further expenditure may be needed which are called special fixed costs.
Un-escapable fixed costs are the ‘Loss factor’. Thus escapable fixed
costs minus special costs known as net escapable fixed costs should be
compared with the contribution

Net Escapable fixed costs

Here Shut down point = ----------------------------------
Contribution per unit

Apart from cost factor other economic and social factors like loss of
employment, reputation, in market should also be considered.
Wherever there are seasonal fluctuations or when raw material is scarce shut
down point is ascertained by using the formula :

Avoidable Expenses
---------------------------------------------
Contribution per unit of raw material

Illustration:
X Ltd operates at 50% of normal capacity expects a fall in sales to the tune of
5000 units per month. The Income statement shows the following position.
Sales (5000 units @ Rs.3/- per unit) Rs.15,000
Less: Variable Cost Rs.10,000
--------------
Rs. 5,000

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Less: Fixed Costs Rs. 5,000

--------------
Profit Nil

There is a suggestion to suspend the production till situational recovery.

However a minimum fixed costs of 2000 is inevitable Advice the
management at what level of sales it should think of suspension of
production, if the selling price comes down to Rs.2-80 per unit.

Solution:

Net escapable fixed costs = 5000 – 2000 = 3000

Contribution per unit = 2-80 – 2-00 = 0-80 per unit
3000
Shut down point = ------- = 3,750 units
0-80
Shut down Sales = 3750 x 2.80 = Rs.10,500

Thus plant should shut down when sales decline below Rs. 10,500.
(b) Permanent closure:

Some times a situation may arise demand discontinuance of the unit due
to uneconomical functioning, where minimum return also is not forth
coming. This amount to capital erosion day by day while taking a decision
in this regard the organization the management should compare the
income coming forth from following sources.

a. Income from continuance of business operation.

b. Income from sale or otherwise use of plant, building,etc, in case of
complete closure.

Apart from this the decision, other factors like compensation payable to
employees, loss on sale of plant and other fixed assets also need to be kept
in mind.

2.3 Summary

Marginal Costing is an effective tool for managerial decision making. A

decision making is the process of evaluating two or more alternatives leading
to a final choice. It is closely involved with planning further future and is
directed towards a specific objective or a goal, Many goals may be derived
from the basic one of increasing the firm’s income. While taking on an
acceptable level of risk. Marginal costing here plays an important role as it
speaks of contribution level of profitability. Many decisions can be taken with
the help of alternative courses of action like make or buy, accept or reject.
Planning the capacity utilization, price fixation with changes in alternatives,
optimum product mix, optimum sales mix, key or limiting factor, operate or
shut down, dropping a product like adding a product like and at many other
instances marginal costing helps in managerial decision making.

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2.4 Self Check Questions;

A State whether the following statements are True or False

(a) Marginal costing helps in deciding between alternative choices.
(b) Profit earned is the decision factor for any level of activity.
(c) Net escapable costs are the difference between escapable
fixed costs and special costs.
(d) Wherever limiting factors are there contribution in terms of
limiting
factor should be the criteria for decision making.
(e) If the price for buying in cheaper than the fixed costs then it is
advisable to buy.

B Short Questions

(a) Briefly explain the relevant considerations involved in taking

managerial decisions in respect of (a) Make or buy (b) Accept
or Reject.
(b) A radio manufacturing company while it costs Rs.625/- to make
a component the same is available in the market at Rs.575/-
with one assured supply. The break up of the cost is as follows;
Material Rs.275/-
Labour Rs.175/-
Other variable Cost Rs. 50/-
Fixed Cost Rs.125/-
Should you make or buy the component. What would you
suggest of it is available for Rs.485/-
(c) Differentiate between Marginal Cost and Marginal Costing.

C Essay Questions.

(1) What are the various areas of decision making where marginal
costing is used.
(2) A company has a capacity of producing 1,00,000 units of certain
product in a month. The sales department reports that the
following schedule of sale price is possible.

Volume of Product Selling Price

60% 0.90
70% 0.90
80% 0.75
90% 0.67
100% 0.61

The variable cost is .15 per unit and fixed cost is Rs.40,000.
What volume of production ideal to manufacturer?
(3) The following information is presented to you by XY Ltd which
produces 2 products 1 and 2

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ACM 602 Cost Analysis and Control

1 2
Rs Rs
Direct Material (per unit) 20 18
Direct Labour (per unit) 6 4
Fixed expenses during the period Rs.1600
Variable expenses are allocated to products @ 100% of direct
wages.
Selling Price per unit 40 30
Proposed sales mixes
1. 100 units of 1 and 200 units of 2
2. 150 units of 1 and 150 units of 2
3. 200 units of 1 and 100 units of 2

Which is the most profitable sales mix? The proposed sales mix
to earn a profit of Rs.300 and Rs.600 with the total sales of 1
and 2 being 300 units.

.
.

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Lesson 12
SERVICE COSTING (Operating Costing)
Service costing refers to the method of costing applied to determine the cost per unit
of service rendered by the service industries or centres. Unlike a product which can
be physically seen, the service cannot be seen but only can be experienced.
Rendering service means providing place utility, time utility, value utility, etc., to the
end user. For example, transporting goods from one place to another, transporting
passengers, supplying water, electricity, providing telephone, consultancy service
etc.
Service may be within the organisation. For example, services such as repairs and
maintenance, internal transport, supply of steam, administration etc. are provided to
other departments in the .same organisation. Service may be external. For example,
services provided by public utilities such as city passenger transportation, railways,
airways, water supply, electricity supply to the public at large.
Rendering service does involve cost. The activities involved, consume resources.
Expenses are incurred to provide these resources. These expenses are collected
together and expressed per unit of service. The cost so determined is recovered
through a saleable unit of service rendered. The unit of service differs from industry
to industry. Following is the illustrative list of service units used:
• IndustryService Unit
• Passenger Transport
• Goods Transport
• Electricity supply
• Water supply
• Phone
• Hospital
• Hotel lodging
• Libraries
• Banking
• General insurance
• Life Insurance
• Consultancy
• Repairs & Maintenance
• Postal Service Per Passenger per KM, or per trip
• Per ton/Quintal per KM, or per carrier, voyage etc.
• Per unit consumed
• Per 1000 gallons
• Per call made
• Per bed per day

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• Per operation per patient, Per x-ray, per test etc.

• Per bed per person per day.
• Per card per two books, per year
• Per Demand draft per Rs. 1,000 Interest rate per cent.
• Per year per vehicle, premium per year etc.
• Premium per month, or per year etc.
• Per hour, or per organisation per month
• Per vehicle, per building per month etc.
• Per card, per cover, per 10 gms, per parcel, per kg, etc.

TRANSPORT COSTING
Transport is one of the important" service industries. Transport costing is the method
of costing applied in transport industry to determine the cost per goods transport and
passenger transport. The unique feature of transport industry is the basis of charge
to the customer. Transport costing involves, therefore, a proper selection of basic
unit of service and attribution of cost to such unit.
Composite Unit: The cost unit in transport costing is a composite unit. For example,
a transport company, determines the cost of carrying a passenger for a distance of
one KM. Since there are two units of measurement, it is called composite unit.
Similarly, goods transport company, calculates the cost of carrying one ton of goods
to a distance of one KM. On the basis of this, if the charge is Re. 0.50 then, a
passenger travelling 100 KM has to give Rs. 50 for his journey.
Sometimes the passenger transport companies fix the charges on the basis of
"Stages" or "Points." In that case, the cost unit can be a "Stage" or "Point", each
consisting of fixed number of kilometers.
Classification of Transport Cost: The operating cost of a transport company is
classified into the following three categories:
Operating/ Running/ Variable Expenses: These are the expenses which vary in
proportion to the distance covered. These expenses are incurred only when the
vehicles are run. For example, cost of fuel, lubricants, wear and tear of tyres,
consumable stores, wages of drivers, conductors and cleaners, which are based on
time or distance or contracts, depreciation based on kilometers rup, commission on
takings etc.
Maintenance/Semi variable Expenses: These are expenses which vary partly to the
distance covered by vehicles. Repairs and maintenance, replacement of tyres and
tubes, overhauls, painting etc. These are neither fixed nor variable expenses.
(c) Fixed or Standing Charges: These are expenses which are incurred irrespective
of whether the vehicles are run or not. They are committed expenses for the
specified period and so have to be incurred. or example Licence, Insurance, Rent,
Interest on Capital, Salary of Manager, Administrative expenses, Monthly or weekly
salaries of drivers, conductors, cleaners etc., fixed depreciation and token' tax.

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Strict compartmentalization of expenses may not be desirable in some

circumstances. It depends on nature of expense and how the same is incurred.

Collection of Cost: The Accounting section in the Administrative office of the

Transport Company is responsible for collecting cost information relating to
operating
service .

Standing Charges are collected on the time basis and apportioned to each vehicleon
a suitable basis. Salary bills, rent receipt, tax receipt, insurance premium paid
receipt, etc. are the source documents.
Repairs and maintenance charges, painting overhauls collected according to Job
order numbers in the workshop, Replacement cost of tyres and tubes are recorded
on the basis of requisition and purchase receipts etc.
Operating expenses are collected on the basis of record in the "log sheets.”

Each vehicle is given a "log sheet" which contains detailed information about the
number of trips, distance covered, number of days run, number of
passengers/goods
carried, tickets collected, accidents if any, repairs, services, fuel consumed, oil,
grease used etc.

When the transport service is internal within the organisation for other departments,
then the cost is apportioned among the departments on the basis of use of service,
say, percentage, or hours etc.

When the transport service is external, for the purpose of customers, then, cost
per passenger kilometer (or cost per ton kilometer) is calculated to form a basis for
charging. Operating Cost Sheet: A cost sheet is prepared with respect to each
vehicle or a group of vehicles for a specific period, say, a month, •in order to know
the cost of operating vehicle and the cost per unit. Costs are shown under there
headings:
(a) Running Cost (b) Maintenance Cost (c) Standing Cost. The total of each of these
is the total operating cost

Cost Per Unit: Cost per unit may be, cost per passenger KM in case of passenger
transport or cost per ton KM in case of goods transport.
cost per passenger KM (Total Operating Cost for period)/(Effective passenger KMs
for the period )cost per ton KM (Total Operating Cost for period)/(Effective ton KMs
for the period )The numerator, i.e., total cost for the period is obtained from the
operating cost statement prepared for the period.

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The denominator, i.e., Effective passenger KMs or Effective ton KMs is calculated as
below:

Passenger kms: Passenger KMs is "the product of effective kms (distance) travelled
by the vehicle during a period and the average passengers carried during that
period." Thus, it is the total KMs required to be travelled to carry each passenger to
the respective destination.

There are two parts:

(a) Distance covered: ThiS is obtained by using the following formula:

Distance travelled = Number of vehicle x Number of trips per day x 2 x

Distance each way x Number of days in the period/month.
(b) Average Passengers Carried: This is obtained by using the following formula:
Average Passengers Carried = Seating capacity of vehicle x % capacity utilised.
Effective Passengers KMs = a x b
i.e., Distance travelled x Passengers carried

A trip denotes to and fro journey, i.e., onward and return journey together is referred
to as Trip.

Ton KMs: Ton KMs is "the product of effective KMs travelled during the period and
the average weight (ton) carried during the period." Thus, it is the total KMs
required to be covered to carry each unit of weight (ton) to the respective
destination. The unit of weight can be ton, quintals, kgs, etc.

There are two parts:

Usually, carriage vehicles take full load, i.e., 100% capacity in the onward journey
and take lesser load or available load or nil, some times, in the return journey.
Therefore, it is necessary to calculate the effective ton with respect to each onward
and return journey, separately.
(a) Onward Journey:

Ton KMs = Number of vehicles X Distance onward

X Number of days X Capacity in ton
X % Capacity utilised.

(b) Return Journey:

Ton KMs = Number of vehicles x Distance return

x Number of days
x Capacity in ton x % Capacity utilised.
Total ton KMs = a + b

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i.e., Onward journey + Return Journey.

Worked out Examples

(1) Vinay transport company has 4 trucks, each with capacity of 5 tons. Eachtruck
makes 6 trips a day between two places, 30 KMs apart. In the onward journey full
load of bricks and in the return journey on an average 20% of capacity is filled with
provisions. Trucks are laid down for repairs and rest, for 5 days in a month of 30
days. Calculate the effective ton KMs.

Solution
(a) Onward Journey: Number of trucks x Distance each way x Number of trips a day
x Number of days x Full capacity.
= 4 x 30 x 6 x 25 x 5 = 90,000 ton kms ..

(b) Return Journey: 4 x 30 x 6 x 25 x 5 x 20% = 18,000 ton kms

Effective ton krns = 90,000 + 18,000 = 1,08,000 ton kms.
OR

Alternatively: Total capacity used = 5 tons + 20% of 5 tons

= 5 + 1 = 6 tons.
Effective KMs = 4 x 30 x 6 x 25 x 6 = 1,08,000 ton KMs.

(2) Vivek travels has 4 buses, operating between two cities Mysore and Bangalore
which are 140 KMs apart. Each bus makes 2 trips a day. The seating capacity is 50
seats. On an average 80% occupancy is experienced.
Calculate (a) Distance travelled (b) Average passengers carried and (c) Passengers
Kilometer for the month of July 1999 in which each bus was laid down for 6 days for
repairs .

Solution:
Distance travelled = Number of vehicles x No. of trips x 2 x Distance x No. of days

= 4 x 2 x 2 x 140 x 25 = 56,000 KMs,

A verage Passengers Carried = Seating capacity x % utilised

=50 80/(100 )=40 passenger

Passenger KMs = Distance x Passengers
= 56,000 x 40 = 22,40,000 Pas. KMs .

Number of days = 31 days in July - 6 days for repairs = 25 days.

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4) X, a transporter supplies the following details in respect of a truck of 5 ton

capacity:
Cost of truck Rs. 90,000
Estimated life 10 years.
Diesel oil etc. Rs. 15 per trip each way.
Repair and maintenance Rs. 500 per month.
Driver's wages Rs. 500 per month.
Cleaner's wages Rs. 250 per month.
Insurance Rs. 4,800 per annum.
Tax Rs. 2,400 per annum
General supervision charges Rs. 4,800 per annum.
The truck carries goods to and from the city covering a distance of 50 Kms. each
way.
On onward trip freight is available to the extent of full capacity and on return 20% of
capacity. The truck operates on an average 25 days a month. Work out Operating
Cost per Ton Km. and rate per ton per trip that X should charge if a profit of 50% on
freightage is to be earned.

Solution
Operating Cost Sheet for the month
Particulars Amount (Rs.)
(A) Standing Cost:
Insurance Rs. 4,800 + 12 months 400
Tax Rs. 2,400 + 12 months 200
General Supervision Rs. 4,800 + 12 months 400
. . Rs. 90,000 ,,nnnn Depreciation: - Rs. 9,000 +12 months 750
Total A 1,750
(B) Maintenance Cost:
Repairs & Maintenance 500
Total B 500
Running Cost:
Diesel oil etc.Rs. 15 per 50 Kms.
Note : 2,500 x 15 / 50 750
Driver's wages 500
Cleaner's wages 250
Total C 1,500
Grand Total (A+B+C) 3,750

Calculation of Ton Kms:

(a) Onward Journey: 50 Kms. x 25 days x 5 tons = 6,250 T.Kms
(b) Return Journey: 50 Kms. x 25 days x 5 x 20% = 1,250 T.Kms.
Total 7,500 T.Kms

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Operating cost per ton KM = Re. 0.50/T.Km.

Charge per ton KM = Cost per ton Km 0.50
+ Profit 50% on Freight
or 100% of cost 0.50
Freight or Charge Re. 1,00 Per T. Km
Rate per ton per trip = Re. 1 x 100 Kms (to & fro)
= Rs. 100
Note: Total Kms run by the truck = No. of trips x 2 x distance x No. of days = 1
x2x50x25 = 2,500 kms.
[It is assumed that the truck makes only one trip a day]
(5) Karnataka transport limited owns a fleet of 10 trucks each costing Rs. 60,000.
The company has employed a Manager to whom it pays Rs. 500 p.m. An
accountant who gets Rs. 300 p.m. and a peon who gets Rs. 150 p.m. The company
has got its trucks insured at 3 % p.a. The annual tax is Rs. 1,200 per
truck. The other expenses are as follows:
Driver's Salary Rs. 400 p.m.
Cleaner's Salary Rs. 150 p.m.
Mechanic's Salary Rs. 300 p.m.
Repairs and maintenance Rs. 1,200 p.a. per truck.
Diesel consumption: 3 Kms/litre at Rs. 3.75 per litre.
The estimated life of the truck is 5 years.
Other information:
Distance travelled by each truck per day 200 kms. Normal loading capacity 100
quintals Wastage in Loading capacity 10% Percentage of truck laid up for repair 5%
Effective days in a month 25 Calculate: (a) Cost per quintal k.m.
(b) Cost per k.m. of running a truck.
Solution
Calculation of ton kms: (for 10 trucks)
(i) Distance travelled = 10 trucks x 200 kms per day 25 days x = 95/ 100
= 47,500 kms
= 50,000 kms.
(ii) Load carried: Normal 100 quintals
- Wastage 10% (-10) quintals .-.
Net weight 90 quintals.
Total quintal = 47,500 x 90 = 42,75,000Q.Kms.

Operating Cost Sheet for the month ....

Particulars (for 10 trucks) Amount (Rs.)

(A) Standing Charges: Manager's salary 500
Accountant's salary 300
Peon's salary150

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ACM 602 Cost Analysis and Control

Insurance @ 3% on 60,000 x 10 = 18,000 + 2 1,500

Annual tax Rs. 1,200 x 10/ 12 1,000
Depreciation 10 X 60,000 / 5 = 1,20,000 / 12 10,000
Drivers Salary 400 p.m. x 10 4,000
Cleaners Salary 150 p.m. x 10 1,500
Mechanic's Salary 300 p.m. 300
(Note) Total (A) 19,250
(B) Maintenance Charges:
(C) Running Charges: 1,000

59,375
Diesel: 3 kms. – 1 Letter
47,500-((47,500 X 1)/3)X 3.75

Grand Total (A+B+C) 79,625

(a) Cost quintal KM = (Rs.79,625)/(42,75,000 Kms)=0.019

(b) Cost per KM= (Rs.79,625)/(47,500 Kms)=1.676

(6) BMP (Bangalore Maha Nagar Palike) arranges for the removal of garbage by
means of its own transport system, Following vehicles are maintained:
No. of vehicles Cost (Rs.)(Per vehicle) Capacity
20 4,00,000 5 Tons
30 3,50,000 4 Tons
40 3,00,000 3 Tons
50 2,50,000 2 Tons
On an average each vehicle makes 8 trips a day. The garbage is taken from all parts
of the city to 4 garbage treatment plants situated outside the city limits. The
estimated average distance from any point to garbage plant is 20 Kms. While going
out each vehicle carries only 70% of the capacity and on return journey every
vehicle will be empty. On an average 10% of the vehicle are laid down for repairs
and rest. The cost details for the month of July, 1999 are as below:
Monthly Salary of Drivers Average Rs. 4,000 per driver
Monthly Salary of Workers Average Rs 2,000 per worker (a worker for each vehicle)
Office Salary per month Rs. 2,50,000
Consumable Stores Rs. 50,000
Diesel (Mileage 4 Kms. per litre) Rs. 10 per litre.
Lubricant Rs. 10,000
Replacement of Tyres and Tubes Rs. 75,000
Miscellaneous Expenses Rs. 25,000

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ACM 602 Cost Analysis and Control

Miscellaneous Expenses Rs. 25,000. BMP maintains a workshop, the monthly

expenses of which are Rs. 1,20,000 and the share to garbage removal activity is
60% and the share of other office overhead Rs. 40,000 is 50%.

Depreciation on vehicles at 5% p.a., Insurance 2% p.a. Annual tax Rs. 2,000 per
vehicle. Interest on capital total per year Rs. 1,50,000
You are required to calculate —
(a) Ton Kilometers

Solution
(a) Calculation of Kms and tonKms
Total Kms = Number of vehicles x % used x Number of trips per day x 2 x Distance
each way x Number of days 90
= (20 + 30 + 40 + 50) x -jgj x 8 x 2 x 20 x 31 = 12,49,920Kms.

Tons Carried: No of Vehicles x Capacity (Tons) = Total

20 x5 = 100
30 x4 = 120
40 x3 = 120
50 x2 = 100
Total tons 440
Capacity utilised = 440 x 70% = 308 tons
Average capacity utilised= 308 / 2 = 154 ton (To & fro)
Ton Kms = Average Capacity utilised x % used x Number of trips per day x 2 x
Distance x Number of days
= 154 x 90/ 100 x 8 x 2 x 20 x 31 = 13,74,912 ton kms.
[Note: % used refers to the number of days the vehicles are used other than when
they are laid down for repairs and rest].
Self Check Questions

(4) A private transport company has been given a route of 20 Kms long to run a bus.
The cost of the bus is Rs. 4,50,000. It is insured at 3% P.A. and the annual tax will
amount to Rs. 5,000. Garage rent is Rs. 500 P.M. Actual repairs will be Rs. 2,500
P.A. and the bus is likely to last for 5 years.
The driver's salary will be Rs. 1,500 P.M. and the conductor's salary will be Rs.
1,200 P.M. in addition to 10% of the takings as commission to be shared equally by
the driver and the conductor.
Cost of stationery Rs. 150 P.M. Accountant's Salary Rs. 1,350 P.M. Petrol and Oil
Rs. 50 per 100 Km. The bus will make 3 round trips carrying on an average 40
passengers on each trip. The bus will run on an average 25 days in a month.
Assuming 15% profit on takings, calculate the bus fare to be charged from each
passenger per KM. [Ans. 0.1717]
(5) (a) State the distinctive features of operating costing.

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(b) The Union Transport Company has been given a 20 kilometer long route to ply a
van. The van costs the Company Rs. 1,00,000. It has been insured at 3% per
annum. The annual road tax amounts to Rs. 2,000. Garage rent is Rs. 400 per
month. Annual repair is estimated to cost Rs. 2,360 and the Van is likely to last for 5
years.
The salary of the driver and cleaner is R. 600 and Rs. 200 per month respectively in
addition to 10% of takings as commission to be shared equally by them. The
Manager's salary is Rs. 1,400 per month and stationery will cost Rs. 100 per month.
Diesel and oil will cost Rs. 50 per 100 kilometer. The van will make three round trips
per day carrying on an average 40 passengers in each trip. Assuming 15% profit on
takings and that the van will ply on an average 25 days in a month, prepare
operating cost statement on a full year basis and also calculate bus fare to be
charged from each passenger per kilometer.
(6) Prakash Transport Company has been given a route 20 km. long to run a bus.
The bus costs the company a sum of Rs. 50,000. It has been insured at 3% p.a. and
the annual tax will amount to Rs. 1,000. Garage rent is Rs. 100 p.m. Annual repairs
will be Rs. 1,000 and the bus is likely to last for 5 years.
The driver's salary will be Rs. 150 p.m. and the conductor's salary will be Rs. 100
p.m. in addition to 10% taking as commission (to be shared by the driver and the
conductor equally. The cost of stationery will be Rs. 50 p.m. Manager-cum-
Accountant's salary is Rs. 350 p.m. Petrol and oil will be Rs. 25 per 100 km. The bus
will make 3 round trips carrying, on an average, 40 passengers on each trip.
Assuming 15% profit on takings, calculate the bus fare to be charged from each
passenger. The bus will run on an average 25 days in a month.

Mr. Eswar owns a bus which runs between Mysore and Bangalore and back for 10
days in a month. The distance is 150 kms. The bus completes a trip a day. The bus
goes another 10 days towards Hassan. The distance from Mysore to Hassan in 120
kms. This trip is also completed on the same day. For the rest 4 days, it runs in the
local city. Daily distance covered is 40 kms. Calculate the rate to be charged to earn
a profit of 33l/2% of his taking. The other information is:
Particular Rs.
Cost of the Bus 3,00,000
Depreciation 20% P.A.
Salary of driver 1,750 P.M.
Salary of Conductor 1,750 P.M.
Salary of Clerk 800 P.M.
Insurance 8,400 P.A.

Diesel Consumption 8 KM/Litre @ Rs10 per litre

Token tax 3,000 P.A.
Lubricating oil50 per 100 kms.
Repairs & Maintenance • 3,000 P.M.

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Permit fees 1,420 P.M.

9 Prakash Automobiles distributes its goods to regional dealers using a single Lorry.
The dealers premises are 40 kilometres away by road. The Lorry has a capacity on
return journey. The following information is available for a Four Weekly Period
during the year 1990:
Particulars Amount
Diesel consumption 8 kilometres per litre.
Diesel cost Rs. 13 per litre
Oil Rs. 100 per week
Driver's Wages Rs. 400 per week
Repairs Rs. 100 per week
Garage rent Rs. 150 per week
Cost of Lorry (Excluding Tyres) Rs. 4,50,000
Life of Lorry 80,000 Kilometers
Insurance Rs. 6,500 per annum
Cost of Tyres Rs. 6,250
Life of Tyres 25,000 kilometers
Estimated sale value of Lorry at end of its life Rs. 50,000
Vehicle Licence cost Rs. 1,300 per annum
Other overhead cost Rs. 41,600 per annum
The Lorry operates on a five-day week. Required:
(a) A statement to show the total cost of operating the vehicle for the four-weekly
period analysed into running costs and fixed costs.
(b) Calculate the vehicle cost per kilometre and per tonne kilometer.

(10) Mr. Jai owns fleet of taxis and the following information is available from the
records maintained by him.
Particulars Amount (Rs.)
Number of taxis 10
Cost of each taxi Rs. 20,000
Salary of manager 600 p.m.
Salary of accountant 500 p.m.

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Salary of cleaner 200 p.m.

Salary of mechanic 400 p.m.
Garage rent 600 p.m.
Insurance premium 5% p.a.
Annual tax 600 per taxi
Driver's salary 200 p.m. per taxi
Annual repair 1,000 per taxi
Total life of a taxi is about 2,00,000kms. A taxi runs in all 3,000 kms in a month of
which 30% it runs empty. Petrol consumption is one litre for 10 kms. @ Rs. 1.80 per
litre. Oil and other sundries are Rs. 5 per 100 kms.
Calculate the cost of running a taxi per km.

(11) Mr. Jaidka owns a fleet of taxis and the following information is available from
the records maintained by him:
(i) Number of taxis 10 (vii) Garage rent Rs. 600 p.m.
(ii) Cost of each taxi 20,000 (viii) Insurance premium 5%
(hi) Salary of manager 600 p.m. (ix) Annual tax Rs. 600 per taxi
(iv) Salary of accountant 500 p.m. (x) Driver's Salary 300 p.m.
per taxi
(v) Salary of cleaner 200 p.m. (xi) Annual repairs 1,000 per taxi
(vi) Salary of mechanic 400 p.m.
Total life of a taxi is about 2,00,000kms. A taxi runs in all 3,000 kms. in a month of
which 30% it runs empty. Petrol consumption is one litre for 10 kms. @ Rs. 1.80 per
litre. Oil and other sundries are Rs. 5 per 100 kms.
Calculate the cost of running a taxi per km.

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LESSON 13
STANDARD COSTING
Learning Objectives

• To understand the meaning of standard costing, its meaning and definition

• To learn its advantages and limitations

• To learn how to set of standards and determinations

• To learn how to revise standards

Introduction

The vital aspect of managerial control is cost control. Hence, it is very important to
plan and control costs. Standard costing is a technique which helps to control costs
and business operations. It aims at eliminating wastes and increasing efficiency in
performance through setting up standards or formulating cost plans.

Meaning of Standard

The word standard means a benchmark or yardstick. The standard cost is a

predetermined cost which determines in advance what each product or service
should cost under given circumstances.

In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks
a product or the operation of the process for a period of time should cost, based
upon certain assumed conditions of efficiency, economic conditions and other
factors.”

Definition

The CIMA, London has defined standard cost as “a predetermined cost which is
calculated from managements standards of efficient operations and the relevant
necessary expenditure.” They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a prescribed set of
working conditions. In other words, a standard cost is a planned cost for a unit of
product or service rendered.

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The technique of using standard costs for the purposes of cost control is known as
standard costing. It is a system of cost accounting which is designed to find out how
much should be the cost of a product under the existing conditions. The actual cost
can be ascertained only when production is undertaken. The predetermined cost is
compared to the actual cost and a variance between the two enables the
management to take necessary corrective measures.

Advantages

Standard costing is a management control technique for every activity. It is not only
useful for cost control purposes but is also helpful in production planning and policy
formulation. It allows management by exception. In the light of various objectives of
this system, some of the advantages of this tool are given below:

1. Efficiency measurement-- The comparison of actual costs with standard

costs enables the management to evaluate performance of various cost centers. In
the absence of standard costing system, actual costs of different period may be
compared to measure efficiency. It is not proper to compare costs of different period
because circumstance of both the periods may be different. Still, a decision about
base period can be made with which actual performance can be compared.

2. Finding of variance-- The performance variances are determined by

comparing actual costs with standard costs. Management is able to spot out the
place of inefficiencies. It can fix responsibility for deviation in performance. It is
possible to take corrective measures at the earliest. A regular check on various
expenditures is also ensured by standard cost system.

3. Management by exception-- The targets of different individuals are fixed if

the performance is according to predetermined standards. In this case, there is
nothing to worry. The attention of the management is drawn only when actual
performance is less than the budgeted performance. Management by exception
means that everybody is given a target to be achieved and management need not
supervise each and everything. The responsibilities are fixed and every body tries to
achieve his/her targets.

4. Cost control-- Every costing system aims at cost control and cost reduction.
The standards are being constantly analyzed and an effort is made to improve

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efficiency. Whenever a variance occurs, the reasons are studied and immediate
corrective measures are undertaken. The action taken in spotting weak points
enables cost control system.

5. Right decisions-- It enables and provides useful information to the

management in taking important decisions. For example, the problem created by
inflating, rising prices. It can also be used to provide incentive plans for employees
etc.

6. Eliminating inefficiencies-- The setting of standards for different elements

of cost requires a detailed study of different aspects. The standards are set
differently for manufacturing, administrative and selling expenses. Improved
methods are used for setting these standards. The determination of manufacturing
expenses will require time and motion study for labor and effective material control
devices for materials. Similar studies will be needed for finding other expenses. All
these studies will make it possible to eliminate inefficiencies at different steps.

Limitations of Standard Costing

1. It cannot be used in those organizations where non-standard products are

produced. If the production is undertaken according to the customer specifications,
then each job will involve different amount of expenditures.

2. The process of setting standard is a difficult task, as it requires technical

skills. The time and motion study is required to be undertaken for this purpose.
These studies require a lot of time and money.

3. There are no inset circumstances to be considered for fixing standards. The

conditions under which standards are fixed do not remain static. With the change in
circumstances, if the standards are not revised the same become impracticable.

4. The fixing of responsibility is not an easy task. The variances are to be

classified into controllable and uncontrollable variances. Standard costing is
applicable only for controllable variances.

For instance, if the industry changed the technology then the system will not be
suitable. In that case, we will have to change or revise the standards. A frequent
revision of standards will become costly.

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Setting Standards

Normally, setting up standards is based on the past experience. The total standard
cost includes direct materials, direct labor and overheads. Normally, all these are
fixed to some extent. The standards should be set up in a systematic way so that
they are used as a tool for cost control.

Setting Standards for Direct Materials

There are several basic principles which ought to be appreciated in setting

standards for direct materials. While purchasing material, the quality and size
should be determined. The standard quality to be maintained should be decided.
The quantity is determined by the production department. This department makes
use of historical records, and an allowance for changing conditions will also be given
for setting standards. A number of test runs may be undertaken on different days
and under different situations, and an average of these results should be used for
setting material quantity standards.

The second step in determining direct material cost will be a decision about the
standard price. Material’s cost will be decided in consultation with the purchase
department. The cost of purchasing and store keeping of materials should also be
taken into consideration. The procedure for purchase of materials, minimum and
maximum levels for various materials, discount policy and means of transport are
the other factors which have bearing on the materials cost price. It includes the
following:

• Cost of materials

• Ordering cost

• Carrying cost

The purpose should be to increase efficiency in procuring and store keeping of

materials. The type of standard used-- ideal standard or expected standard-- also
affects the choice of standard price.

Setting Direct Labor Cost

The second largest amount of cost is labor. The benefit derived from the workers
can be assigned to a particular product or a process. If the wages paid to workers

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cannot be directly assigned to a particular product, these will be known as indirect

wages. The time required for producing a product would be ascertained and labor
should be properly graded. Different grades of workers will be paid different rates of
wages. The times spent by different grades of workers for manufacturing a product
should also be studied for deciding upon direct labor cost. The setting of standard
for direct labor will be done basically on the following:

• Standard labor time for producing

• Labor rate per hour

Standard labor time indicates the time taken by different categories of labor force
which are as under:

• Skilled labor

• Semi-skilled labor

• Unskilled labor

For setting a standard time for labor force, normally previous experience, past
performance records, test run result, work-study etc are taken in account. The labor
rate standard refers to the expected wage rates to be paid for different categories of
workers. Past wage rates and demand and supply principle may not be a safe guide
for determining standard labor rates. The anticipation of expected changes in labor
rates will be an essential factor. In case there is an agreement with workers for
payment of wages in the coming period, these rates should be used. If a premium or
bonus scheme is in operation, then anticipated extra payments should also be
included. Where a piece rate system is used, standard cost will be fixed per piece.
The object of fixed standard labor time and labor rate is to device maximum
efficiency in the use of labor.

Setting Standards of Overheads

The next important element comes under overheads. The very purpose of setting
standard for overheads is to minimize the total cost. Standard overhead rates are
computed by dividing overhead expenses by direct labor hours or units produced.

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The standard overhead cost is obtained by multiplying standard overhead rate by

the labor hours spent or number of units produced. The determination of overhead
rate involves three things:

• Determination of overheads

• Determination of labor hours or units manufactured

• Calculating overheads rate by dividing A by B

The overheads are classified into fixed overheads, variable overheads and semi-
variable overheads. The fixed overheads remain the same irrespective of level of
production, while variable overheads change in the proportion of production. The
expenses increase or decrease with the increase or decrease in output. Semi-
variable overheads are neither fixed nor variable. These overheads increase with
the increase in production but the rate of increase will be less than the rate of
increase in production. The division of overheads into fixed, variable and semi-
variable categories will help in determining overheads.

Determination of Standard Costs

How should the ideal standards for better controlling be determined?

1. Determination of Cost Center

According to J. Betty, “A cost center is a department or part of a department or an

item of equipment or machinery or a person or a group of persons in respect of
which costs are accumulated, and one where control can be exercised.” Cost
centers are necessary for determining the costs. If the whole factory is engaged in
manufacturing a product, the factory will be a cost center. In fact, a cost center
describes the product while cost is accumulated. Cost centers enable the
determination of costs and fixation of responsibility. A cost center relating to a
person is called personnel cost center, and a cost center relating to products and
equipments is called impersonal cost center.

2. Current Standards

A current standard is a standard which is established for use over a short period of
time and is related to current condition. It reflects the performance that should be
attained during the current period. The period for current standard is normally one

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year. It is presumed that conditions of production will remain unchanged. In case

there is any change in price or manufacturing condition, the standards are also
revised. Current standard may be ideal standard and expected standard.

3. Ideal Standard

This is the standard which represents a high level of efficiency. Ideal standard is
fixed on the assumption that favorable conditions will prevail and management will
be at its best. The price paid for materials will be lowest and wastes etc. will be
minimum possible. The labor time for making the production will be minimum and
rates of wages will also be low. The overheads expenses are also set with maximum
efficiency in mind. All the conditions, both internal and external, should be favorable
and only then ideal standard will be achieved.

Ideal standard is fixed on the assumption of those conditions which may rarely exist.
This standard is not practicable and may not be achieved. Though this standard may
not be achieved, even then an effort is made. The deviation between targets and
actual performance is ignorable. In practice, ideal standard has an adverse effect on
the employees. They do not try to reach the standard because the standards are not
considered realistic.

4. Basic Standards

A basic standard may be defined as a standard which is established for use for an
indefinite period which may a long period. Basic standard is established for a long
period and is not adjusted to the preset conations. The same standard remains in
force for a long period. These standards are revised only on the changes in
specification of material and technology productions. It is indeed just like a number
against which subsequent process changes can be measured. Basic standard
enables the measurement of changes in costs. For example, if the basic cost for
material is Rs. 20 per unit and the current price is Rs. 25 per unit, it will show an
increase of 25% in the cost of materials. The changes in manufacturing costs can be
measured by taking basic standard, as a base standard cannot serve as a tool for
cost control purpose because the standard is not revised for a long time. The
deviation between standard cost and actual cost cannot be used as a yardstick for
measuring efficiency.

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5. Normal Standards

As per terminology, normal standard has been defined as a standard which, it is

anticipated, can be attained over a future period of time, preferably long enough to
cover one trade cycle. This standard is based on the conditions which will cover a
future period of five years, concerning one trade cycle. If a normal cycle of ups and
downs in sales and production is 10 years, then standard will be set on average
sales and production which will cover all the years. The standard attempts to cover
variance in the production from one time to another time. An average is taken from
the periods of recession and depression. The normal standard concept is theoretical
and cannot be used for cost control purpose. Normal standard can be properly
applied for absorption of overhead cost over a long period of time.

6. Organization for Standard Costing

The success of standard costing system will depend upon the setting up of proper
standards. For the purpose of setting standards, a person or a committee should be
given this job. In a big concern, a standard costing committee is formed for this
purpose. The committee includes production manager, purchase manager, sales
manager, personnel manager, chief engineer and cost accountant. The cost
accountant acts as a co-coordinator of this committee.

7. Accounting System

Classification of accounts is necessary to meet the required purpose, i.e. function,

asset or revenue item. Codes can be used to have a speedy collection of accounts.
A standard is a pre-determined measure of material, labor and overheads. It may be
expressed in quality and its monetary measurements in standard costs.

Revision of Standards

For effective use of this technique, sometimes we need to revise the standards
which follow for better control. Even standards are also subjected to change like the
production method, environment, raw material, and technology.

Standards may need to be changed to accommodate changes in the organization or

its environment. When there is a sudden change in economic circumstances,

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technology or production methods, the standard cost will no longer be accurate.

Standards that are out of date will not act as effective feed forward or feedback
control tools. They will not help us to predict the inputs required nor help us to
evaluate the efficiency of a particular department. If standards are continually not
being achieved and large deviations or variances from the standard are reported,
they should be carefully reviewed. Also, changes in the physical productive capacity
of the organization or in material prices and wage rates may indicate that standards
need to be revised. In practice, changing standards frequently is an expensive
operation and can cause confusion. For this reason, standard cost revisions are
usually made only once a year. At times of rapid price inflation, many managers
have felt that the high level of inflation forced them to change price and wage rate
standards continually. This, however, leads to reduction in value of the standard as
a yardstick. At the other extreme is the adoption of basic standard which will remain
unchanged for many years. They provide a constant base for comparison, but this is
hardly satisfactory when there is technological change in working procedures and
conditions.

Self Check Question

1. Define Standard Costing and explain it Advantage.
2. Describe various types of standards.
3. Explain the scope and limitation of Standard costing.

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LESSON 14
MATERIAL AND LABOUR VARIANCE
Material Variances
In case of materials, the following may be the variances :
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage or Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance.
The following chart shows the division and sub-division of material variances:

Material Cost Variance

Material Price Variance Material Usage or Quantity Variance

Material Yield Variance

Material Mix Variance

Now, we proceed to define these variances one by one.

(a) Material Cost Variance (MCV). It is the difference between the standard
cost of materials allowed (as per standards laid down) for the output achieved
and the actual cost of materials used. Thus, it may be expressed as:
Material Cost Variance
= Standard Cost of Materials for Actual Output- Actual Cost of Materials Used
Or
Material Cost Variance
= Material Price Variance + Material Usage or Quantity Variance
Or
Material Cost Variance
= Material Price Variance + Material Mix Variance+ Material Yield Variance.

In order to calculate material cost variance, it is necessary to know :

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1. Standard quantity of materials which should have been required (as per
standards set) to produce actual output. Thus, standard quantity of materials is :
Actual Output x Standard Quantity of Materials per unit.
Note. In order to find out standard quantity of materials specified, actual output
(and not standard output) is to be multiplied by standard quantity of materials
per unit.
2. Standard price per unit of materials.
3. Actual quantity of materials used.
4. Actual price per unit of materials.

Material Price Variance (MPV).It is that portion of the material cost

variance which is dueto the difference between the standard cost of materials
used for the output achieved and the actualcost of materials used. In other
words, it can be expressed as:

Material Price Variance :

Actual Usage (Standard Unit Price - Actual Unit Price).
Here, Actual Usage = Actual quantity of material (in units) used
Standard Unit Price = Standard price of material per unit
Actual Unit Price = Actual price of material per unit.

(c) Material Usage (or Quantity) Variance (MQV). It is that portion of the
material con 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. It may be expressed as:

Material Usage Variance:

Standard Price per unit (Standard Quantity - Actual Quantity).

Note. Standard quantity means quantity of material which should have been
used (as per standard determined) for the actual output achieved.

(d) Material Mix Variance (MMV). It is that portion of the material usage variance
which is to the difference between standard and the actual composition of a mixture.
In other words, this variance arises because the ratio of materials being changed

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from the standard ratio set. It is calculated as the difference between the standard
price of standard mix and standard price of actual mix.

In case of material mix variance, two situations may arise :

(i) When actual weight of mix and the standard weight of mix do not differ.

In such a case, material mix variance is calculated .vith the help of the following
formula :

Standard Unit Cost (Standard Quantity - Actual Quantity)

or

Standard Cost of Standard Mix - Standard Cost of Actual Mix.

If the standard is revised due to shortage of a particular type of material, the material
mix variance is calculated as follows :

Standard Unit Cost (Revised Standard Quantity - Actual Quantity),

or

Standard Cost of Revised Standard Mix - Standard Cost of Actual Mix.

(ii)When actual weight of mix differs from the standard weight.

In such a case material mix variance is calculated as follows:

This formula is necessitated to adjust the total weight of standard mix to the total
weight of actual mix which is more or less than the weight of standard mix

(e) Material Yield (or Sub-usage) Variance (MYV). 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 materials. This variance is particularly important in case of process industries
where certain percentage of loss of materials is inevitable. If the actual loss of
materials differs from the standard loss of materials, yield variance will arise. Yield
variance is also known as scrap variance. This loss may result in the following two
situations :

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(i) When standard and actual mix do not differ. In such a case, yield variance is
calculated with the help of the following formula :

Yield Variance= Standard Rate (Actual Yield - Standard Yield)

ii) When actual mix differs from standard mix. In such a case, formula for the
calculation of yield variance is almost the same. But since the weight of actual mix
differs from that of the itandard mix, a revised standard mix is to be calculated to
adjust the standard mix in proportion to i actual mix and the standard rate is to be
calculated from the revised standard mix as follows :

Formula for yield variance in such a case is :

Yield Variance= Standard Rate (Actual Yield - Revised Standard Yield).

(f) Material Revision Variance. Once a standard is set for a period, it is

usually followed for that period. But sometimes due to seriousness of the
situation such as a sudden rise in the pricesof materials, or due to the short
supply of a particular material, there may be need of revision of standard to cope
with the situation. Standards are revised with the hope that when the current
difficulties are over, original standard will continue to operate. Thus, revision of
standards maybe for a short period. Material revision variance is calculated as
given below :

Material Revision Variance = St. Price (St. Usage - Revised St. Usage) For
calculation of material usage variance, revised standard usage or quantity will
be taken in stead of standard usage or quantity. Material usage variance will be
calculated as given below:

Material Usage Variance = St. Price (Revised St. Usage - Actual Usage) Other
material variances will be calculated in the same way as explained earlier. In
case there is material revision variance, material cost variance will be verified
as given below:

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Material Cost Variance = Material Revision Variance + Price Variance +

Usage Variance

ILLUSTRATION.The standard cost of a chemical mixture is as under : 8 tons

of material A at Rs. 40 per ton. 12 tons of material B at Rs. 60 per ton. Standard
yield is 90% of input. Actual cost for a period is as under :
10 tons of material A at Rs. 30 per ton
20 tons of material B at Rs. 68 per ton
Actual Yield is 26.5 tons. Compute all materials variances.

SOLUTION
Workings :

Raw Standard Cost Actual Cost Revised Standard Standard

Cost of
Materials Cost Actual Mix
Tons Rate Total Tons Rate Total Tons Rate Total
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (3)x (5)
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
A 8 40 320 10 30 300 12 40 480 400
B 12 60 720 20 68 1,360 18 60 1,080 1,200
20 1,040 30 1,660 30 1560
Loss 2 — 3.5 — 3 —
18 1,040 26.5 1,660 27 1,560 1,600

(a) Materials Cost Variance

Standard Cost of Materials - Actual Cost of Actual Materials

(c) Materials Price Variance

Actual Usage (St. Price - Actual Price)
Materials A : 10 tons (Rs. 40 - Rs. 30) = Rs. 100 (F)

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Materials B : 20 tons (Rs. 60 - Rs. 68) = Rs. 160 (A)

Materials Price Variance = Rs. 60 (A)
Material Usage Variance
Standard Price (Standard Usage – Actual Usage)
Material A:

Material B:

Material Usage Variance = 69 (A)

Verification
Materials Cost Variance = Materials Price Variance + Materials Usage Variance
Rs. 129 Unfav. = Rs. - 60 - Rs. 69 = Rs. 129
Unfav. Materials Usage Variance = Materials Mix Variance + Materials Yield Variance
Rs. 69 Unfavourable = - Rs. 40 - Rs. 29 = Rs. 69 Unfavourable.
Normally it is taken that labour is a variable cost but at times it becomes fixed cost as it is
not possible to remove or retrench in case of fall/ stoppage in production Labour Rate
Standard and Grades of Labour - This is basically dependent on the agreement with the | far
unions or rate prevalent in the particular area or industry.

Cost Variance

Rate Varience Efficency Variance

Mix Variance Yield Variance Idle Time Variance

OR

Idle Time Variance

Net Efficiency Variance

labour Efficiency Standard

The labour (quantities) efficiency means the number of hours that the appropriate grade of
writer will take to perform the necessary work. It is based on actual performance of worker
or group of workers possessing average skill and using average effort while performing
manual operations or working on machine under normal conditions. The standard time is
fixed keeping inmind the past performance records or work study. This is on the basis that is
acceptable to the worker as well as the management.

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labour Cost Variance

He labour cost variance is also called 'labourtotalvariance'is the difference between the
standard direct labour cost and the actual direct labour cost incurred for the production
achieved.
(Standard labour hours produced X Standard rate per hour) - (Actual direct labour hours X
Actual rate per hour)
or
Standard cost for actual output - Actual cost
Labour Rate Variance
The labour rate variance is the difference between the actual direct labour rate per hour and
the standard direct labour rate per hour, multiplied by the actual hours paid, i.e., the rate per
hour paid the direct labour force more or less than standard use of higher/lower grade of
skilled workers than planned or wage inflation causes this variance.
Actual time (Standard rate - Actual rate)
labour Efficiency Variance
labour efficiency variance is the difference between the actual hours taken to produce the
actual output and the standard hours that this output should have taken, multiplied by
thestandard rate per hour. The possible cause for this variance is due to use of higher/ of
skilled workers than planned or the quality of material used, errors in allocating time to job.
Standard rate (Standard time for actual output - Actual time)

The labour efficiency variance can be segregated into the following:

Labour Mix Variance
The labour mix variance arises due to change in composition of labour force.
Labour Mix Variance
Standard rate (Revised standard time - Actual time)

Revised Standard Time

Labour Yield Variance

The labour yield variance arise due to the difference in the standard output specified and the
actual output obtained.
Standard cost p.u. (Standard output for actual time - Actual output)
Idle Time Variance
The idle time variance represents the difference between hours paid and hours worked, ie,Mij
hours multiplied by the standard wage rate per hour. This variance may arise due to illness,|
machine breakdown, holdups on the production line because of lack of material.

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Idle hours X Standard rate

Net Efficiency Variance
This variance is calculated after deducting idle hours from actual hours. The efficiency
varianctless idle time variance is called 'net efficiency variance'.
Standard rate ( Standard time for actual output - Actual time worked)
or Standard rate (Standard time - Actual hours paid - Idle time)

Illustration 20.2
100 skilled workmen, 40 semiskilled workmen and 60 unskilled workmen were to work
for30weeksio get a contract job completed. The standard weekly wages were Rs. 60, Rs. 36
and Rs. 24 respective The job was actually completed in 32 weeks by 80 skilled, 50
semiskilled and 70 unskilled workmen who I were paid Rs. 65, Rs. 40 and Rs. 20
respectively as weekly wages.
Find out the labour cost variance, labour rate variance, labour mix variance and labour
efficiency variance.
Solution
Basic Data for Calculation of Labour Variances
Category of Standard Actual
workmen
Weeks Rate Amount Weeks Rate Amount

(Rs.) (Rs.) (Rs.) (Rs.)

Skilled 3,000 60 1,80,000 2,560 65 1,66,400

Semiskilled 1,200 36 43,200 1,600 40 64,000
Unskilled 1,800 24 43,200 2,240 20 44,800
6,000 2,66,400 6,400 2,75,200

Calculation of LabourVarience
Direct Labour Cost Variance
Std. cost for actual output - Actual cost
2,75,20O - 2,66,400 = Rs. 8,800 (A)

Direct Labour Rate Variance

Actual time (Std. rate - Actual rate)
Skilled = 2,560 (60 - 65) = Rs. 12,800 (A)

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Semiskilled = 1,600(36-40) = Rs. 6.400(A)

I Unskilled = 2,240 (24 - 20) = Rs. 8.960(F)= Rs. 10,240 (A)
Direct Labour Efficiency Variance
Std. rate (Std. time for actual output - Actual time)
Skilled = 60(3,200- 2,560) =Rs. 26,400 (F)
Semiskilled = 36(1,200- 1,600) = Rs. 14,400 (A)
Unskilled = 24 (1,800 - 2,240) = Rs. 10,560 (A)= Rs. 1,440 (F)
SkliedLabour Efficiency Variance can be further analyzed into:

1(A) DIRECT LABOUR MIX VARIANCE

Std. rate (Revised std. time* - Actual time)

Skilled =60(3,200- 2,560) = Rs. 38,400 (F)
Semiskilled =36(1,280- 1,600) = Rs. 11,520 (A)
Unskilled = 24 (1,920- 2,240 ) = Rs. 7.680(A) = Rs. 19,200 (F)

* Revised std. time.

(b) Direct Labour Revised Efficiency Variance

Std. rate (Std. time for actual output - Revised std. time)
Skilled = 60 (3,000-3,200) = Rs. 12,000 (A)
Semiskilled = 36(1,200- 1,280) = Rs. 2,880 (A)
Unskilled = 24 (1,800 - 1,920) = Rs. 2,880 (A) = Rs. 17,760 (A)
Summary or Labor variances(Ks.)
Rate variance 10,240 (A)
Efficiency variance
a) Mix variance 19,200 (F)
b) Revised efficiency variance 17.760(A) 1.440 (F)

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Direct labour cost variance 8,800 (A)

Self Check Question
1. The standard material cost for 100 kgs. of Chemical D is made up of—
Chemical A — 30 kgs. @ Rs. 4 per kg.
Chemical B — 40 kgs. @ Rs. 5 per kg. and
Chemical C — 80 kgs. @ Rs. 6 per kg.
In a batch, 500 kgs.of Chemical D was produced from a mix of—
Chemical A - -140 kgs.at a cost of Rs. 588
Chemical B — 220 kgs.of a cost of Rs. 1,056
Chemical C — 440 kgs.at a cost of Rs. 2,860
Calculate all variances in the actual cost per 100 kgs. of chemical D over the standard cost.
2. From the following information compute (a) Mix, (6) Price, and (c) Usage Variances :
Standard Actual
Quantity Unit Total Quantity Unit Total
Kilos Price Kilos Price
Rs. Rs. Rs. Rs.
Material A 10 2.00 20.00 5 3.00 15.00
Material B 20 3.00 60.00 10 6.00 60.00
Material C 20 6.00 120.00 15 5.00 75.00
Total 50 4.00 200.00 30 5.00 150.00
Ans1(a) Rs. 10 (A); (b) Rs. 20(A); (c) Rs. 70 (F)]
3.From the following particulars find out: (a) Material price variance. (6) Material
usage variance and (c) Material cost variance.
Quantity of material purchased 3,000 units
Value of material purchased Rs. 9,000
Standard quantity of material required per tonne of finished product 25 units
Standard rate of material Rs. 2 per unit
Opening stock of material Nil Closing stock of material 500 units
Finished production during the year 80 tonnes
Also explain the possible causes of these variances.
[Material Price Variance = Rs. 2,500 Adverse ; Material Usage Variance = Rs. 1,000
Adverse ; Material Cost Variance = Rs. 3,500 Adverse]
4. A manufacturing concern which has adopted standard costing furnishes the
following information : Standard :
Material for 70 kg.finished product 100 kgs.

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Price of material Re. 1 per kg.

Actual:
Output 2,10,000kgs.
Material used 2,80,000kgs.
Cost of material Rs. 2,52,000
Calculate :(a) Material Usage Variance, (b) Material Price Variance and (c) Material
Cost Variance. [Material Usage Variance = Rs. 20,000 Fav. ; Material Price
Variance Rs. 28,000 Fav.; Material Cost Variance Rs. 48,000 Fav.]
5. Calculate variances from the standard for a particular month as disclosed
from the following figures
Standard In a particular month
Number of workers employed 600 550
Average wages per worker per month Rs. 250 Rs. 264
Number of working days in a month 25 24
Output in units 30,000 28,000
[Labour Cost Variance = Rs. 5,200 Adverse ; Rate of Pay Variance = Rs. 13,200
Adverse : Efficiency Variance = Rs. 8,000 Favourable]

6. A contract job is scheduled to be completed in 30 weeks with a labour

complement of 100 skilled operatives, 40 semi-skilled operatives and 60
unskilled operatives. The standard weekly wages of each type of operatives
are—skilled Rs. 60, semi-skilled Rs. 36 and unskilled Rs. 24. The work is
actually completed in 32 weeks with a labour force of 80 skilled, 50 semi-skilled
and 70 unskilled operatives and the actual weekly wages rates average Rs. 65
for skilled, Rs. 40 for semi-skilled and Rs. 20 for unskilled labour. Analyse the
variances in the labour cost due to various reasons. [Rate of Pay Variance = Rs.
10,240 Adverse ;Labour Efficiency Variance = Rs. 1,440 Favourable; Labour Cost
Variance = Rs. 8,800 Adverse]

7. The standard hours for manufacturing two products M and N are 15 hours per
unit and 20 hours per unit respectively. Both products require identical kind of
labour and the standard wage rate per hour is Rs. 5. In the year 2001, 10,000
units of M and 15,000 units of N were manufactured. The total labour hours
actually worked were 4,50,500and the actual wage bill came to Rs. 23,00,000.
This included 12,000 hours paid for @ Rs. 7 per hour and 9,400 hours paid for @
Rs. 7.50 per hour, the balance having been paid at Rs. 5 per hour. You are
required to compute the labour variances.
Ans. (Total Labour Cost Variance Rs. 50,000 Adverse ;Labour Rate Variance Rs.
47,500 Adverse ; Labour Efficiency Variance Rs. 2,500 Adverse)

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8. From the following records of Apollo Bolt Nut Manufacturing Company, you
are required to compute material and labourvariances :
An input of 100 kgs.of material yields a standard output of 10,000 units.
Standard price per kg.of material = Rs. 20.
Actual quantity of material issued and used by production department 10,000
kgs. Actual price per kg.of material = Rs. 21 per kg. Actual output = 9,00,000
units Number of employees = 200
Standard wage rate per employee per day = Rs. 40 Standard daily output per
employee = 100 units Total number of days worked = 50 days
(Idle time paid for and included in the above half day for each employee) Actual
wage rate per day = Rs. 45.
Ans.[MCV = Rs. 30,000 (A); MPV = Rs. 10,000 (A) MQV = Rs. 20,000 (A), LCV =
Rs. 90,000 (A); LRV = Rs. 50,000 (A), LEV = Rs. 36,000 (A) ITV = Rs. 4,000 (A)].

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LESSON 15
OVERHEAD VARIANCE
Variable Overhead Variance

For fixation of costs for overheads, a survey of overheads will be necessary and with the data
available for budgetary control, the overheads will be charged to various cost
centres/products etc. on the basis of standard costs. For this, after dividing the overheads into
fixed and variable the calculation of standard overhead rate for each cost centre / product is
done. The number of hours representing the capacity to manufacture is to be reduced by
various idle facilities, etc. The chlaof method of absorption (direct wage rate or machine
hour) will depend upon the circumstances. The main object is to establish a normal overhead
rate based on total factory overhead at normal capacity volume.

CLASSIFICATION OF VARIABLE OVERHEAD VARIANCES

Variable Overhead Cost

Variance

Variable Overhead
VariableCost Variance
Overhead Variable Overhead
The variable Expenditure
overhead costVariance
variance represents the difference between
Efficiency the standard cost of
Variance
variable overhead allowed for actual output and the actual variable overhead incurred during
the period. The variance represents the under absorption or over absorption of variable
overhdi
(Actual output X Standard variable overhead rate p.u.) - Actual variable overhead cost
or
(Standard hours for actual output X Standard variable overhead rate per hour) -Actual
variable overhead cost
Variable Overhead Expenditure Variance
It is the difference between the actual variable overhead rate per hour and the standard
variable overhead rate per hour multiplied by the actual hours worked. The actual hours
worked mustkused not the actual hours paid because the latter may include idle time and it is
usually assumed that variable overhead will not be recovered in idle time.
(Standard variable overhead rate X Budgeted output) - Actual variable overheads
or (Standard hours for budgeted output X Standard variable overhead rate per hour) ■
Actual variable overheads
or Budgeted variable overheads - Actual variable overheads
Variable Overhead Efficiency Variance
The variable overhead efficiency variance is calculated by taking the difference in standard
output and actual output multiplied by the standard variable overhead rate.
Standard variable overhead rate (Standard output - Actual output)
Illustration

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The budgeted variable overheads for March are Rs. 3,840. Budgeted production for the
month is 38,400 units. The actual variable overheads incurred were Rs. 3,830 and actual
production was 38,640 units,
Calculate variable production overhead variance.
Solution
Working
Standard Variable Overhead p.u.

Total standard Variable Overhead= Actual quantity X Std. variable overhead p.u.
= 38,640 units X Re. 0.10 = Rs. 3,864
Variable Production Overhead = Standard variable overhead - Actual variable overhead
= Rs. 3,864 - Rs. 3,830 = Rs. 34 (F)
Fixed Overhead Variances
Fixed overhead represents all items of expenditure which are more or less remain constant
irrespective of the level of output or the number of hours worked. The fixed overheads
variances are classified as follows:

Cost Variance
Expenditure Variance Volume Variance
Efficiency Variance Capacity Variance

Revised Fixed OH Capacity Calendar Variance

Variance
Fixed Overhead Cost Variance
Fixed overhead cost variance represents the under/over absorbed fixed production overhead in
the period. This under/over absorbed overhead may be due to differences between actual and
budgeted fixed overheads, i.e., expenditure variances, and/or differences between the actual
and budgetedlevels of activity i.e., volume variances.

(Actual output X Standard fixed overhead rate p.u.) - Actual fixed overheads
Or
(Standard hours for actual output X Standard fixed overhead rate per hour) -Actual fixed
overheads
Or
Recovered fixed overheads - Actual fixed overheads
Fixed Overhead Expenditure Variance
This variance is also called 'budget variance', obtained by comparing the total fixed overhead
cost actually incurred against the budgeted fixed overhead cost.
Budgeted fixed overheads - Actual fixed overheads
Fixed Overhead Volume Variance
The volume variance is computed by taking the difference between overhead absorbed on
actual output and those on budgeted output.

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(Actual output X Standard rate) - Budgeted fixed overheads or Standard rate (Actual
output - Budgeted output) or Standard rate per hour (Standard hours produced - Budgeted
hours)
Fixed Overhead Efficiency Variance
The efficiency variance arise due to the difference between budgeted efficiency to
production and the actual efficiency is achieved.
Standard rate (Actual output in units - Standard output in units) or Standard rate per hour
(Actual hours worked - Standard hours for actual output)
Fixed Overhead Capacity Variance
The capacity variance represents the part of volume variance which arise due to working at
higher or lower capacity than standard capacity.
Standard rate (Budgeted quantity - Standard quantity)
Revised Fixed Overhead Capacity Variance
The revised capacity variance is calculated as follows:
Standard fixed overhead rate (Revised budgeted quantity - Standard quantity)
Fixed Overhead Calendar Variance
The calendar variance arise due to the volume variance which is due to the difference
between the number of working days anticipated in the budget period and the actual working
days in the period to which the budget is applied.
Standard fixed overhead rate (Budgeted quantity - Revised budgeted quantity)
Illustration
From the following prepare variance analysis of a particular department for a month:
Variable overhead items : (actual)
Materials handling 8,325
Idle time 850
Re-work 825
Overtime premium 250
Supplies 4,000
14,250

Fixed overhead items: (actual) (Rs.)

Supervision 1,700
Depreciation –Plant 2,000
Depreciation-Equipment 5,000
Rates 1,150
Insurnace 350
Total 10,200

Normal capacity 10,000 standard hours, budgeted rate Rs. 1.70 per standard hour for variable
overhead and Re. 1 per standard hour for fixed overhead. Actual level 8,000 standard hours.
Solution
Calculation of Variable and Fixed Overhead Variances
l) Variable Overhead Cost Variance
Recovered variable overheads - Actual variable overheads
= (8,000 X 1.70) - 14,250 = Rs. 650 (A)
(2) Fixed Overhead Cost Variance
Recovered fixed overheads - Actual fixed overheads

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= (8,000 X 1) - 10,200 = Rs. 2,200 (A)

3)Fixed Overhead Expenditure Variance
Budgeted fixed overheads - Actual fixed overheads
= (10,000 X 1) - 10,200 = Rs. 200 (A)
4) Fixed Overhead Volume Variance
Recovered fixed overheads - Budgeted fixed overheads
= 8,000 - 10,000 = Rs. 2,000 (A)

Sales Variances
All of the variances discussed previously have been concerned with costs; the
effects on profits due to adverse or favorable variances affecting direct materials,
direct labour or overheads. Some companies calculate cost variances only, but to
obtain the full advantages of standard costing. It is required to calculate sales
variances. Sales variances affect a business in terms of changes in revenue:
changes which have been caused either by a variation in sales quantities or in sales
prices. There are two distinctly separate systems of calculating sales variances,
which show the effect of a change in sales as regards:
(i) Sales margin variance (on the basis of profit), and
(ii) Sales value variance (on the basis of turnover).
Sales Variances Based on Profit
The sales variances based on profit are also called 'sales margin variances' which
indicates the deviation between actual profit and standard or budgeted profit.

CLASSIFICATION OF SALES MARGIN VARIANCES

Sales Price Variance Total Sales Margin Variance

Sales Volume Variance

Sales Mix Variance Sales Quantity Variance

Total Sales Margin Variance

This variance takes into account the difference between actual profit and standard or
budgeted profit,
Actual profit - Budgeted profit
or (Actual quantity of sales X Actual profit p.u.) -(Budgeted quantity of sales X
Budgeted profit p.u.)
Sales Price Variance
This price variance is the difference between standard price of the quantity of sales
effected and lie actual price of those sales.
Actual quantity of sales (Actual profit p.u. - Standard profit p.u.)
or
(Actual quantity of sales X Standard price) - (Actual quantity of sales X Actual price)
Sales Volume Variance

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It represents the difference between the actual units sold and the budgeted quantity
multiplied by either the standard profit per unit or the standard contribution per unit.
In absorption costing standard profit per unit is used, but in marginal costing,
standard contribution per unit must be used.
Standard profit p.u. (Actual quantity of sales - Standard quantity of sales)
Or
Standard profit on actual quantity of sales - Standard profit on standard quantity of
sales
Salesvolume variance can be further segregated into (a) Sales mix variance and (b)
Sales quantity I variance as given below :
Sales Mix Variance
The sales mix variance arise when the company manufactures and sells more than
one type of product.This variance will be due to variation of actual mix and budgeted
mix of sales.
Standard profit p.u. (Actual quantity of sales - Standard proportion for actual sales)
Or
Standard profit - Revised standard profit

Sales Quantity Variance

The sales quantity is the difference between the budgeted profit on budgeted sales
and expected profit on actual sales.
Standard profit p.u. (Standard proportion for actual sales - Budgeted quantity of
sales) or Revised Standard Profit - Budgeted Profit
or Budgeted margin p.u. on budgeted mix (Total actual quantity - Total budgeted
quantity)
Illustration
Majestic Auto Ltd. is manufacturing and selling three standard products. The
company has a standard cost system and analyses the variances between the
budget and the actual periodically. The summarized working result for 2008-09 were
as follows
Product Budget Actual

Selling price Cost per No. of units Selling price Cost per No. of
per unit (Rs.) unit (Rs.) sold per unit (Rs.) unit (Rs.) units sold
A 50 32 10,000 48 30 12,000
B 40 24 14,000 42 25 12,000
C 30 18 16,000 31 20 15,000

(a) Calculate the variance in profit during the period.

(b) Analyze the variance in profit into:
(i) Sales price variance
(ii) Sales volume variance
(iii) Cost variance
(iv) Sales margin quantity variance
(v) Sales margin mix variance.
Solution
Working Notes
(1) (a) Actual Margin Per Unit
Actual sales price per unit - Standard cost per unit

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A = Rs. 48 - Rs. 32 = Rs. 16

B = Rs. 42 - Rs. 24 = Rs. 18
C = Rs. 31 - Rs. 18 = Rs. 13
(b) Budgeted Margin Per Unit
Budgeted sales price per unit - Standard cost per unit
A = Rs. 50-Rs. 32 = Rs. 18
B = Rs. 40-Rs. 24 = Rs. 16
C = Rs. 30-Rs. 18 = Rs. 12
(2) (a) Actual Profit
= Actual quantity of units sold X Actual margin per unit
A (12,000 X 16 ) =1,92,000
B (12,000X 18 ) = 2,16,000
C (15,000 X 13) = 1,95,000
6,03,000
Budgeted Profit= Budgeted quantity of units sold X Budgeted margin per unit

A (10,000X 18) 1,80,000

B (14,000 X 16) 2,24,000
C (16,000 X 12) 1,92,000
Total 5,96,000

3(a) Budgeted Margin per Unit on Actual Mix

= Rs. 15.077 p.u.

3(b) Budgeted Margin per Unit on Budgeted Mix

= Rs. 14.90 p.u.

Calculation of Sales Variances
Total Sales Margin Variance Actual profit - Budgeted profit
= Rs. 6,03,000 - Rs. 5,96,000 = Rs. 7,000 (F)
2. Sales Margin Price Variance
Actual qty. (Actual margin per unit - Budgeted margin per unit)

A = 12,000(16 - 18) = 24.000 (A)

B = 12,000(18 - 16) = 24.000 (F)
C = 15,000(13 - 12) = 15.000 (F)
= Rs. 15,000 (F)
3. Sales Margin Volume Variance

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Budgeted margin per unit – (Actual qty. – Budgeted qty.)

A = 18(12,000-10,000) = 36.000 (F)
B = 16(12,000-14,000) = 32.000(A)
C = 12 (15,000-16,000) = 12.000(A)
= Rs. 8,000 (A)
The sales margin volume variance can be further segregated into the following:
(4) Sales Margin Mix Variance
Total actual quantity (Budgeted margin p.u. on actual mix – Budgetedmargin p.u. on
budgeted mix)
= 39,000(15.077 - 14.90) = Rs. 6,900 (F)
(5) Sales Margin Quantity (Sub-volume) Variance
Budgeted margin p.u. on budgeted mix (Total actual qty. - Total budgeted qty.)
= 14.90 (39,000 - 40,000) = Rs. 14,900 (A)
Summary of Sales Margin Variances (Rs)
Price variance 15,000
(F)
Volume variance:
(i) Mix variance 6,900 (F)
(ii) Qty. sub-volume variance 14,900 (A)8,000 (A)
Total sales margin variance 7,000 (F)
Sales Variances Based on Turnover
The sales variances based on turnover are classified as follows:

Sales Value Variance

Sales Price Variance Sales Volume Variance

Sales Mix Variance Sales Quantity

Variance

Sales Value Variance

(Actual quantity X Actual selling price) - (Standard quantity X Standard selling price)
Sales Price Variance
Actual quantity (Actual selling price - Standard selling price)
Sales Volume Variance
Standard selling price (Actual quantity of sales - Standard quantity of sales)
Sales Mix Variance
Standard value of actual mix - Standard value of revised standard mix
Sales Quantity Variance
Standard selling price per unit (Standard proportion for actual sales quantity -
Budgeted quantity of sales)
or Revised standard sales value - Budgeted sales value

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Illustration
Standcost Corporation produces three products : A, B and C. The master budget
called for the sale of 10,000 units of A at Rs. 12; 6,000 units of B at Rs. 15 and
8,000 units of C at Rs. 9. In addition, the standard variable cost for each product
was Rs. 7 for A, Rs. 9 for B and Rs. 6 for C. In fact, the firm actually produced and
sold 11,000 units of A at Rs. 11.50, 5,000 units of B at Rs. 15.10 and 9,000 units of
Cat Rs. 8.55.
Calculate Sales Value Variances.
Solution
Computation of Sales Variance
Product Budgeted Sales Actual Sales Std. Sales
(Actual Qty.
X Std. Rate)

Qty. Rate Amount (Rs.) Qty. Rate (Rs.) Amount

(Units) (Rs.) (Units) (Rs.)
A 10,000 12 1,20,000 11,000 11.50 1,26,500 1,32,000
B 6,000 15 90,000 5,000 15.10 75,500 75,000
C 8,000 9 72,000 9,000 8.55 76,950 81,000
Total 24,000 2,82,000 25,000 2,78,950 2,88,000
(imputation of Variances
(1) Sales Value Variance
= Budgeted sales - Actual sales
= Rs. 2,82,000 - Rs. 2,78,950 = Rs. 3,050 (A)
(2) Sale Price Variance
= Actual qty. X (Standard price - Actual price) = Standard sales - Actual sales
= Rs. 2,88,000 - 2,78,950 = Rs. 9,050 (A)
(3) Sales Volume Variance
= Std. rate X (Budgeted qty. - Actual qty.) = Budgeted sales - Standard sales
= 2,82,000 - 2,88,000 = Rs. 6,000 (F)
(4) Sale Mix Variance e) = Revised standard sales - Standard sales
Or
Std. rate X (Revised standard qty. – Actual Qty.)

= 6,996 (F)

= 18,750 (A)

= 6,0004 (F) = Rs. 5,750(A)

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(5) Sales Revised Volume Variance

= Budgeted sales - Revised std. sales
= Std. rate X (Budgeted qty. - Revised standard qty.)
A = 12 X (10,000 - 10,417) = 5.004 (F)
B = 15 X (6,000 - 6,250) = 3.750 (F)
C = 9 X (8,000 - 8,333) = 2,996 (F)= Rs. 11.750 (F)

Verification:
Sales Value Variance
= Sales price variance X sales volume variance
= 9,050 (A) + 6,000 (F) = Rs. 3,050 (A)
Sales Volume Variance
= Sales mix variance + Revised sales volume variance
= 5,750 (A) + 11,750 (F) = Rs. 6,000 (F)
The above sales variances have been calculated on the basis of value. Hence, they
are known as 'sales value variances'. Alternatively, they could have been calculated
on the basis of profit/ margin. In that case they would have been termed as 'sales
margin variances.
SELF CHECK QUESTION
1. Calculate overhead variances from the following data
Standard Actual
Fixed overheads (Rs.) 8,000 8,500
Variable overheads (Rs.) 12,000 11,200
Output in units 4,000 3,800
Ans. [Overhead Cost Variance Rs. 700 Adverse ; Variable Overhead Variance
Rs. 200 Fav. ; Fixed Overhead Variance Rs. 900 Adverse; Volume Variance Rs.
400 Adverse ; Fixed Overhead Expenditure Variance Rs. 500 Adverse]
2. From the following, compute the different overhead variances :
In a factory 10,000 units are budgeted to be produced in a month with budgeted
fixed expenses being Rs. 15,000 i.e. Rs. 1.50 per unit. The actual output during
the month was 11,000 units and actual fixed expenses being Rs. 15,500. The
increase in output was due to 5% increase in capacity. The budgeted working
days were 25 but factory worked for 27 days.Ans. [Overhead Variance Rs. 1,000
Fav. ; Expenditure Variance Rs. 500 Adverse ; Volume Variance Rs. 1,500 Fav. ;
Calendar Variance Rs. 1,200 Fav. ; Capacity Variance Rs. 810 Fav. ; Efficiency
Variance Rs. 510 Adverse]
3. A manufacturer operating a standard costing system had the following data in
respect of a month :
Standard Actual
Number of working days 25 27
Man hours per month 5,000 5,400
Output in units 500 525
Fixed Overheads (Rs.) 2,500 2,400
Calculate fixed overhead variances for the month.
Ans.[Total Fixed Overhead Variance Rs. 225 Favourable; Volume Variance Rs.
125 Favourable ; Expense

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Variance Rs. 100 Favourable; Capacity Variance Nil ; Calendar Variance Rs. 200
Favourable ; Efficiency Variance Rs. 75 Adverse]
4. From the following data, calculate : (a) efficiency variance, (6) capacity
variance, (c) calendar variance, (d) volume variance and (e) expenditure
variance.
Item Budgeted Actual
No. of working days 20 22
Man hours per day 8,000 8,400
Output per man hour in units 1.0 0.9
Overhead (Rs.) 1,60,000 1,68,000
Ans.(a) Rs. 18,480 Unfav.; (6) Rs. 8,800 Fav.; (c) Rs. 16,000 Fav.(d) Rs. 6,320
Fav. ; and (e) Rs. 8,000 Unfav.]

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